Chapter 3
Public Good, Commodity, or Resource?
Water is characterized in many ways: “precious resource,” “blue gold,” “the oil of the twenty-first century,” “vital commodity,” and so on.While these descriptions may have headline value, they offer little practical guidance for addressing and solving water issues. That is all well and fine with the latitude afforded mainstream journalism, but at best these labels lack nuance and at worst they inhibit market-based solutions to the problem. If water is vital and, as such, a public good, then the implication is that governments must intervene to provide equitable distribution. However, if it is truly a commodity, the implication is that market forces alone can readily provide optimal allocation.
Such a discussion might sound like a preoccupation with semantics. In fact, the proper description of water as a public good, a commodity, or a resource is not only critical to the sustainable management of the planet’s water but underlies the fundamental premise from an investment perspective. The reality is that while water is one of the most basic and simplest of molecules essential for life, it is also exceedingly complex—physically, economically, and, certainly, politically.
What Is Water?
On a societal level, water must be defined in a way that facilitates water resource management decisions.
Some economists argue simply that water must be defined either as a social (public) good or a private good. It is precisely the language we use to describe water that determines how we address the numerous complex issues. Unbeknownst to most water investors, the distinction is critical. It goes to the very root of the economics associated with the provision of water and the resulting abundance or paucity of market opportunities. Further, the distinction is a common thread that weaves its way through virtually all of the ensuing discussions related to the many facets of the water industry.
The Right to Water versus Water Rights
It is important to address the notion of a human “right” to water. How far should we go in insisting that water, and healthy water in particular, is a basic right for every person on Earth? The issue cannot be summarily addressed and discarded. Nor can it be so preoccupying as to ignore the economic value of water. My view is the human right to water trumps the “invisible hand” of the free market, but, at the same time, elevating water to a human right must not paralyze what needs to be done to achieve water resource sustainability. And the fact is that sustainability requires an element of market influence.
Water Rights
At least in definition, the private ownership of water (namely, water rights) is diametrically opposed to the right to water. Practically speaking, however, the two extremes can, and must, eventually be reconciled. And, in fact, it is the inevitable reconciliation of these seemingly opposite doctrines that creates one of the potentially most significant investment opportunities of the second half of the twenty-first century and beyond.
Water rights are a highly specialized type of real property.While the holders of water rights include governments, public districts, and mutual companies, it is the private and investor-owned water right holders that most often draw disdain from those focused on the human right to water. Of all the aspects of a market-driven approach to the provision of water, none epitomize the concept as blatantly as water rights. But because the private ownership of water can be made intrinsically less marketable than others due to the legal way in which it is defined, there is a paradoxical imposition of governmental will as dictated by the ideology of lawmakers. In other words, even a private ownership right can contain the trappings of a social good. For example, any restriction on transferability is a restriction on efficiency.The ideal criteria for drafting water rights will be explored in greater detail in the broader context of water marketing. For now, suffice it to say that water marketing is an area with far-reaching investment potential and is a dynamic component of the water business that investors must monitor closely.
Water as a Public (Social) Good
There is no such thing as a list of products or “goods” that fall neatly into the category of social goods. Inclusion is, generally speaking, one of default. If a good cannot be provided through a market system, then it is a social good that must be provided by the public sector. In this context, the word cannot refers to either complete market failure or an inefficiently functioning market. Obviously, the determination of any given market “failure” is highly subjective and open to debate. As such, perhaps it’s more instructive is to start with the premise that some role of government is a given, with the exact role determined by the prevailing political and/or social ideologies in the relevant community.
When it comes to the provision of water, it is especially easy to extend this macro construct to the micro level, or, stated differently, from the global to the local level. As a budding resource economist designing water rate (tariff) schedules for municipalities, the first thing I learned was that even the most sophisticated econometric models could not overcome a political agenda. To politicians, water rate models are the equivalent of black-box quant funds; they work well when they produce the results that you want, but events at the margin are to be discounted as too many standard deviations from reality. For economists, however, everything happens at the margin. But try explaining the marginal cost of providing water to the local member of a private golf course, for example. All of a sudden, the price of membership is irrelevant and water is a social good.
Historically speaking, much of the fervor associated with water results from a belief that water is somehow unique—so unique that it warrants governmental direction rather than being subjected to the perils of private ownership and the discretion of the “invisible hand.” The allocational shortcomings of both the prior appropriations and riparian water rights doctrines in the United States result from the lack of institutional development justified by the uniqueness of water. The prevalence of government in water reflects the notion that decentralized decision making with respect to the allocation of water does not ensure the optimal distribution; that is, water is a public good. From there, political and social ideologies take root. One particular problem with viewing water solely as a public good (and especially a global public good) is that it falls somewhere in between oil and air on the exclusivity spectrum. If I consume a gallon of gasoline, you cannot consume that same gallon. As I breathe air, however, my inhalation does not impact your ability to also do so. Water has characteristics of both rival consumption and nonexcludability. That’s a problem, but one that would resolve itself if water were truly a commodity.
Water as a Commodity
When water is analyzed in the context of a commodity, it is important to realize that the current discussion is not focused on water as a commodity class but whether water exhibits the economic characteristics of a commodity, particularly in regard to pricing. (Notwithstanding, the asset class issue is very important to investors and deserves a separate discussion after a greater understanding of the water industry.) A commodity is a largely homogenous physical substance that is interchangeable with another product of the same type, traded principally on the basis of a bulk price determined by supply and demand in an open market. Based on that definition, water is nowhere near a commodity. Indeed, at this point in the development of the water industry, it is almost the antithesis of a commodity; treated water is not homogenous (and even raw water is not fungible), there are no substitutes, there are few mechanisms to establish an equilibrium-driven price, and there is no spot market for water. Nonetheless, there are many economic forces at work that are driving water into becoming more and more like a commodity.
As the cost of water rises, water becomes like other economic goods (as opposed to public goods) for which there are supplies, demands, and a pricing and marketing structure to balance the supplies and demands. This transformation is what is referred to as the “commoditization” of water.The market economy serves to efficiently allocate resources in the provision of private goods. Consumers bid for what they want to buy and thus reveal their preferences to producers.The catalyst for change is the inevitable upward adjustment in the cost and price of water.
I am not implying that a much higher (true) cost of water is the panacea of global water issues. If water were a commodity, conventional wisdom would imply that the price would decline as more is provided. This was the premise behind the now antiquated use of declining block rate schedules in charging for water usage. The water utility industry sought to apply the principle of economies of scale in water pricing by charging a lower per-unit (gallon or liter) rate as consumption increased based on the traditional notion that fixed costs were being spread over greater numbers and, therefore, the price should decline in accordance. This is all well and fine if the cost base is adequately calculated, but if it does not include an element of scarcity, or increasing marginal costs of supplies, then the true cost will not be recovered. Such is the position in which water utilities find themselves, having not charged for “replacement” value and, therefore, not accommodating the massive requirement for upgrades to the point where we now have a trillion-dollar infrastructure spending gap.
Water as a commodity also assumes that there is a firmly entrenched market for water that acts in accordance with market forces to achieve equilibrium in supply and demand. The commoditization of water has enormous implications for investors. The market signals contained through a market price impact the entire water industry, from the relative feasibility of desalination to the need for real-time metering, to privatization, to reuse and, ultimately, to sustainable water use. Molecular water may be a commodity but clean water certainly is not. And clean water is the problem. Accordingly, at this stage in the development of the global industry, water, in all of its forms, must be viewed as a resource subject to the principles of resource economics.
The Answer: Water as a Resource
When you look at the schematic of the Earth’s water budget, two things become glaringly apparent. First, the amount of easily accessible surface water is only a tiny fraction of the total amount of water available on the planet. And, second, water is not homogenous; it comes in many forms. There is seawater, brackish water, groundwater, surface water, glaciers, and so on. And not even taken into account are “alternative” supplies, such as reclaimed water, conserved water, and “greywater.” Each is a resource with its own particular characteristics—depletable, renewable, recyclable, replenishable, or any combination thereof.
Resource Economics
It must be remembered that the classification of water determines how it is allocated to address the global water challenges. Efficiency in allocating water depends on the proper framework. For example, with respect to the allocation of surface water among competing water uses, the dictates of efficiency are clear. As economists explain, surface water should be allocated so that all uses derive an equivalent marginal net benefit.
If marginal net benefits are not equalized, it is possible to increase net benefits by transferring water from those uses with low net marginal benefits to those with higher net marginal benefits. By transferring the water to the users who value the marginal water most, the net benefits of the water use are increased; those losing water are giving up less than those receiving the additional water are gaining. When the marginal net benefits are equalized, no such transfer is possible.
1Tom Tietenberg’s theory does not reflect how water is allocated in practice. Instead, allocation is skewed by government definitions of property and by the lack of a market price designed to bring supply and demand into equilibrium.
“Unfortunately, water management and water-related institutions seldom achieve either a separation between fact and value or the assignment of responsibility for making these two different kinds of judgments to those best qualified to make them.”
2 This is not the process-oriented enchantment with the free market that it appears to be. Indeed, an overemphasis on prices and markets could contribute more to the preservation of artificial scarcity than to the elimination of supply inefficiencies. This is simply the recognition that the current institutions governing the allocation of water resources are not based firmly on economic principles of efficiency.
The distinction between water as a public good, a commodity, or a resource underlies the framework by which we can properly address the efficient or inefficient allocation of water. Military defenses are distributed based on political ideology, oil is allocated based on price, and water is in that transitional stage where allocation and distribution are both required. Water is a resource that must be influenced by market forces within the context of a proper institutional (governmental) framework.
Water Pricing
I alluded to the inherently political nature of the vast majority of municipal water governing institutions. In the water rate design business, we adopted an occupational variation of a familiar tongue-in-cheek expression: “There are two things that you do not want to see being made. One is sausage and the other is water rates.” Ideally, a forward-looking water pricing theory provides a class-specific cost-of-service model that charges consumers of a particular class (e.g., residential, multifamily, commercial, industrial, irrigation) in accordance with the particular and unique marginal costs that their consumption imposes on the water system. In reality, the most elaborate cost-of-service econometric models are no match for the subjectivity of an elected municipal water board seeking to appease disparate classes of water users. Whether a golf course, irrigation district, residential user, or small business, the special interests must be appeased in order to get consensus on any water rate hike. The political furor that accompanies the derivation of water rates is something to behold. I highly recommend that readers attend the next hearing by the local water company as it seeks the required public comment on water and wastewater rate hikes.
In my early days as a resource economist, I conducted an empirical study that was designed to estimate the residential demand curve for water. That’s economist-speak for determining if the price of water influences demand. In one instance, I concluded that the price of water in a particular location was simply too low to affect consumptive behavior. Judging by the political furor that often accompanies water utility pricing policy, it is often not clear just how economic principles are to be applied to water resource problems. The water rate schedule is not only the price tag for water but also a reflection of broader goals and policies of those involved in rate making. It is this aspect that permeates the view that water is a “public good” that cannot be provided for through the market system. And, as the theory goes, if there is no market mechanism to determine equilibrium, then it generally falls upon the government to dictate optimality.
Equimarginal Value in Use
Economic principles of resource allocation dictate that when costs are incurred in the acquisition and transport of water supplies to customers, the principle of equimarginal value in use is combined with the principle of marginal cost pricing. Additional units of water can always be made available by expending more resources to acquire and transport it at a certain, albeit probably unacceptable, marginal cost. The question of where to stop increasing the supplies made available is then added to the question of how to arrange for the allocation of the supplies in store at any point in time. On efficiency grounds, additional units should be made available as long as any customers are willing to pay the incremental, or marginal, costs incurred. To meet the criterion of equimarginal value in use, however, the price must be made equal to all customers within a class served under identical marginal cost conditions. Marginal cost pricing is widely touted in the water supply industry, but few water utilities actually incorporate it into their rate schedules. Concerns over revenue stability and equity often prevail over the logic of charging for the true cost of service. It is precisely because of practical considerations such as location, use patterns, type of service, and so on, that the marginal costs of serving all customers will not be the same.The consumption characteristics of residential customers indicate that the real price of providing water must increase to reflect the true costs associated with the particular patterns of demand imposed on the system. This concept encourages change in water pricing as a conservation method.
While the regulatory setting indicates that the real cost of providing water will rise, the conservation trend virtually guarantees it.The use of pricing in particular has a dramatic effect because it links the supply and demand for water. As this occurs, the alternatives to the way we traditionally obtain water—from the tap—become attractive. So, in addition to nonprice considerations (quality concerns) that are currently driving the market for tap water substitutes, price will reinforce the shift in demand. The answer, then, to the original question as to who will benefit from the conservation of water is that point-of-use treatment technology will gain. The reason for the reluctance of the water supply industry to implement exactly what they espouse then becomes clear.
The transition to a market solution started as the institutions set up to deal with water as a public good failed to provide an efficient allocation of the resource. As increases in water use depleted easily developable supplies, more costly additional supplies were sought. As the costs of water increased, water resources became more like other economic products for which there are supplies, demands, and a pricing and marketing structure to balance the supplies and demands. Consumers, suppliers, and regulators now are recognizing that water is a complex resource—legally, hydrologically, and economically.
The real price of water is poised to rise significantly after decades of decline due to several factors. First, water is still a highly regulated industry, which imposes significant costs. Second, traditional rate structures that were set artificially low will require a catch-up in rates to adequately replace existing facilities. Third, the scarcity factor inherent in water resources is being incorporated into the supply component of the price of water. And, finally, the increasing importance of water-related technology as a response to water problems will require economic incentives to encourage their adoption. Pricing will provide the mechanism to shift from managing supply to managing change. Water price increases have historically fallen well short of even inflation, let alone true marginal cost increases. And while that is changing across the world as one locality after another has implemented drastic rate increases, especially in wastewater, double-digit increases are likely to become the norm for many years until the funding gap begins to narrow appreciably.
The water industry is like all other industries that must respond to change. Technological, environmental, social, and regulatory changes in the water industry operate to influence the way in which water is provided. As the real price of water rises to reflect the true economic and environmental costs associated with providing it, water utilities will be under substantial political pressure to offset price increases through economic efficiency. As efficiency considerations enter into water pricing, traditional services will be undertaken by new participants seeking to isolate and contain costs. The commoditization of water, then, will facilitate the unbundling of services within the traditional structure of the water industry. Markets (prices) reconcile the difference between what is wanted and what is available. Governments reconcile the difference between what is available and what is needed.The former allocates, the latter distributes.
Accordingly, the water industry likely will be segmented by value added criteria whereby new participants, or existing players in new roles, will provide an unbundled service. One example is privatization. With total annualized water quality costs expected to reach $87 billion by the year 2010, there will be an incentive for cost containment as well as the transfer of new water-related technologies to the marketplace. Water quality expenditures are driven primarily by private spending for the control of industrial effluent discharges and the pretreatment of wastewater, and by local government spending for the construction and operation of treatment facilities. As such, the ways in which economic change translates into investment opportunities are related to the financing mechanisms necessary to fuel the transition.
Just what form will this capital transformation take and what are the investment ramifications? Any time there is a structural change in an industry caused by shifts in the economic fundamentals there is a huge potential for corresponding economic gain. We can look to other industries for guidance. The rationing of health care led to overcapacity in hospital beds and resulted in massive consolidation of the hospital management industry. Commercialization in the biotechnology industry generated substantial growth and investment opportunities. Regulatory upheaval and oversupply in the natural gas industry led to the unbundling of services.
It is accurate to say that scarcity, pollution, or subsidization are not problems in regard to our water resources.The problem is an economic one. It is clear that the institutions sanctioned entirely by operation of government have failed to allocate water in an economically efficient manner. Instead, water should be treated like other private goods for which there are supplies, demands, and a pricing and marketing structure to balance the supplies and demands. As this complete transition will take many decades, the notion of water as a resource takes on an extremely attractive allure, especially for investors desiring to capitalize on the investment potential of water within their lifetime. Moving from the price of water to the cost of providing clean water is a disconnect that must be addressed. Estimates of the global costs associated with meeting demand are staggering and provide a backdrop to the enormous investment potential.