Sunday, March 15, 2009

Free market in water and the regulatory challenge

During the high noon of free-market capitalism in the aftermath of the collapse of the Soviet Union, it was thought that unrestrained free market capitalism could provide solutions for any public policy challenge. It was thought that these markets are best suited to optimally and efficiently allocate scarce resources among competing claims to those with the highest economic use, minimize transaction costs, and have within themselves the mechanisms to make course corrections and remedy distortions. As part of this trend, privatization of public service utilities had become the norm.

More than three decades after the experiment with market mechanism for delivering public utility services was was launched in Chile, the poster child of privatization, NYT has this report card. Starting from 1981, Chile had conferred private property rights on water, a public resource elsewhere, and permitted buying and selling of water like other commodities, with little government oversight or safeguards for the environment.

The result of this unfettered play of markets has been a system that promotes speculation, endangers the environment and allows smaller interests to be muscled out by powerful forces, like Chile’s mining industry. It writes, "Private ownership is so concentrated in some areas that a single electricity company from Spain, Endesa, has bought up 80% of the water rights in a huge region in the south, causing an uproar. In the north, agricultural producers are competing with mining companies to siphon off rivers and tap scarce water supplies, leaving many towns bone dry and withering."

Market based allocation and unbridled trading, coupled with a two-year drought, has created numerous anchronisms like in Atacama desert city of CopiapĆ³, where "there are many more water rights for the river than water that arrives from the river". The absence of adequate environmental regulations have left ground water sources and rivers and lakes, contaminated by mining companies, whose heavy metals and other substances associated with mineral processing are found in these water sources.

The NYT article traces the fate of the town on Quillagua, which is in Guinness World Records as the "driest place" for 37 years, but had prospered off the Loa River, reaching a population of 800 by the 1940s, "A long-haul train stopped here — today the station is abandoned — and the town’s school was near its 120-student capacity. Today there are 16 students... without suitable water to raise crops, many residents saw no reason to continue resisting outside offers to buy the water rights in their town. One mining company, Soquimich, or S.Q.M., ended up buying about 75 percent of the rights in Quillagua. Most residents moved away; those who remain average around 50 years old... In 2007, the national water agency started investigating claims that Soquimich was extracting even more water from the Loa River than it was due. The inquiry is still pending."

In another recent development, the state of California declared a state of water emergency, because of three years of below-average rain and snowfall, a step that urges urban water agencies to reduce water use by 20% or face mandatory rationing if situation worsens.

This report card on the Chilean experiment and the California's problems provide excellent contextual settings for analyzing Prof. Robert Stavins' ineresting blog posts on the misconceptions about water pricing and the advocacy that price signals are the most effective mechanism for efficiently managing water demand(research article here). Prof. Stavins argues, highlighting the difference between the costs of a price of a can of soda and equal quantity of water, that water is heavily under-priced in the US, therefore eliminating all incentives to conserve scarce supplies.

While Prof Stavins is spot on in claiming that "efficient use of water will take place only when the price reflects the actual additional cost of making that water available", it is far too simple to assume that price mechanims can allocate water most efficiently and fairly. He is also right in analysing the fact that only a very small (estimated to be no more than 5% in the US) proportion of water is actually used for essential activities like drinking and cooking, thereby leaving enough room for price signal to effectively allocate the resource. (though here too, when coupled with bathroom, toilets and other essential activities, the share would go beyond 50%) His arguement about "seasonal pricing" of water, to take account of the reduced supply conditions during summer is also well founded. Further, the use of a system of "life-line prices" or provision of a minimum quantity free of charge, and focussing on price signals at higher consumption levels makes eminent sense.

However, especially in view of the Chilean and other experiences from across the world, any market based allocatory mechanism has to be under-pinned by and effective and enabling regulatory framework that will police the expected market failures. For a start, given the essential nature of water use and competing claims with industries and other uses, market based allocation should have clear and unambiguous first charge on water resources for domestic use. Among domestic users, it is possible for price signals, "life-line prices", and increasing block tariff (IBT) based approaches, to allocate water in a fair and efficient manner. Further, at the upstream, it is important that water extraction be subjected to all the required environmental safeguards so as to ensure that the negative pollution related externalities of industrial water extraction and use are left to be incurred by the society.

Of equal importance are issues related to riparian, especially lower, rights which are vital to ensuring that local communities are not denied their traditional right of water usage for their domestic and livelihood (agriculture and animal husbandry) purposes. It is easy to get carried away by the logic of property rights and price signals and construct market mechanisms that effectively overlooks these traditional claims and excludes (or prices out) all such categories. Needless to say, all such arrangements are unsustainable and recipes for disaster.

Further, the effectiveness of market-based systems, especially to manage the upstream supply-side of water, by using property rights and trading meachnisms may be of questionable value. Such arrangements presupposes the presence of a competitive market, with enough depth and breadth in traders and quantity supplied/traded. However, from countless experinces across the world, it has been found that three issues come in the way of such arrangements - consumption demand varies across seasons; supply is subject to vagaries of the weather; and supply generally declines with each passing year as the scarce available resource invariably gets allocated among an increasing number of users, each of whose demand in turn keeps growing.

It is for the same reason that un-bundling of water supply systems, similar to the example of electricity sector, and as suggested by Prof Stavins, may be counter-productive. As the experience of California with electricity suggests, the un-bundling of water systems and embracing of market based mechanisms, are no guarantee to ensuring that supply of water to bulk users like municipal suppliers can be made competitive.

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