California’s Cap-and-Trade Water Proposal: A Planner’s ‘Market’ (Part I)

“The U.C. Davis proposal to establish an environmental water market partly induced by environmental regulatory drought does not hold water.  And we find pricing environmental water sales by auctions to reflect inflated non-market prices derived from the “project influence” of inducing a water shortage as a result of the San Joaquin River Restoration Settlement Project of 2009 …. Nonetheless, we welcome the opportunity to open up a discussion of how markets might alleviate drought hardship on farmers and, wherever possible, on the environment.”

Road sign on rural highway in Kern County, California, erected in 2010:

With implications for the huge hydropower and natural gas powered market in California, on Feb. 11, 2014, a team of water experts[1] associated with University of California at Davis, the Public Policy Institute of California (PPIC), and the University of California and Stanford law schools, called for the creation of a “special water market.”

Their proposal calls for the creation of a “drought environmental water market” to generate “revenues that would help support fish and wildlife recovery” to alleviate the California drought.  Their paper, posted at the U.C. Davis Center for Watershed Sciences website, is titled “Why Give Away Fish Flows for Free During a Drought?” 

Although the proponents of this new water market don’t use these terms, what they are proposing is a version of a cap and trade market for Wildlife Refuge Water.  The amount of developed water (not all precipitation) that is distributed to various uses in California is as follows:

The environment is allocated 22.4 million acre-feet of water in a dry year in California but 62.1 million acre-feet of water in a wet year, while agricultural and urban uses remain fairly constant in absolute numbers.

In California’s Cap and Trade emissions market the amount of pollution is capped unless a polluter buys emissions credits or is given approval to undertake pollution offset projects typically at a lesser cost (e.g., reforestation, ozone depleting projects, livestock digesters, or urban forestry projects).

In the U.C. Davis-PPIC water market proposal the amount of agricultural irrigation water would first be capped by court orders and regulations and diverted to restore salmon runs in California’s major rivers by letting it flow to the ocean. The water diverted from farmers for fish could be traded back to farmers during dry spells at a possible hostage price, a price inflated by shortages caused by diversions of farm water for the environment, or a fiat price arbitrarily set by government. Needless to say, neither of these prices would reflect Fair Market Value as codified in prevailing law.

More troublesome, the proposal would end up double charging farmers for water they already paid for, for fish restoration project costs farmers already funded, and for the costs to pay back the bonds on the Central Valley Project that are already loaded in their water rates.

Unintentional Regulatory-Created Markets

For twenty years I held the position of chief real estate appraiser for one of the largest water districts in California, which involved the valuation of sales and leases of agricultural land and water.

My colleague Charles B. Warren, ASA, and I were the first to have recognized that from 1999 to 2001 Telecom Deregulation had unintentionally created a market price for fiber optic easements that before  were only considered as negative property burdens.  A market in fiber optic easements solved the timely build out of the U.S. fiber optic system that otherwise would have been slowed by use of eminent domain.

So we were interested in the proposal to deploy markets to solve California’s dual drought crisis. This was caused by a third consecutive year of sparse rainfall and a 58% annual diversion of irrigation water in the Central Valley since 1990 to restore salmon runs in the San Joaquin River (see slide No. 5 “Description of Conservation Measures: Long Term Average, CVP S. of Delta Ag Service Contract Allocation – see here). Given the historical failure of centralized government to solve a foreseeable protracted drought in California, we welcomed the U.C. Davis-PPIC group’s call for water markets.

However, after having delved into the U.C. Davis-PPIC team’s proposal we have some serious misgivings.

What Price Environmental Water? ?

The proponents admit the structure of this new market would not be a voluntarily purchase of water for fish and wildlife refuges as has been done in the past.  Rather, it would create a whole new legal class of senior environmental water rights that could be sold in an artificial market.  As we understand it, in such a market the sellers of environmental water would be “free riders.” They would not have to buy this water right as would occur in a true market, such as sales of radio spectrum by the Federal Communications Commission.

The U.C. Davis proposal calls for the sale of such environmental water rights to farmers at:

“The fair market value of the water made available,

The cost of compensatory environmental actions, or

A fixed or negotiated fee established by the regulatory agency. “

“The Fair Market Value of the Water Made Available.”   For the most part there is no such thing as the “fair market value” of water in California because water is a socialized public good.  Water is free.  It is the cost to capture, store, convey, and treat water that translates into what is called its price.  Wholesale water prices are based on fixed costs, not market prices except in rare, heavily regulated water transfers where the prices are negotiated and must be approved by government agencies.

 “Cost of Compensatory Legal Actions.”  Pricing water at the “cost of compensatory legal actions” could be interpreted as an environmental extortion price of the avoided costs of legal actions and environmental clearances. Market Value is not the price that an unwilling buyer can be shaken down for by the threat of legal actions or environmental mitigation costs.  Market value is defined in California as where “there is no pressure on either party in a transaction to buy or sell.”

“Fixed, Negotiated Fees?”? Likewise, a “fixed or negotiated fee established by the regulatory agency” would be so one-sided that, again, this would not reflect market value but a fiat price. A fiat price is a price ordered by the fiat or dictate of government, not a free market. The usual example is pricing in the old Soviet Union where titanium was used to build submarine hulls because nobody knew how costly it was.  Food and other necessities were priced very low, but for that reason always in short supply.  Waiting in line also cost the buyer.

A better alternative would be to lease Refuge Water to farmers during a drought as they already do in Montana. A drawback to water leasing is that water flushed to the sea can’t be leased-back to farmers because it has already been wasted.

The Project Influence Rule

There is a rule in eminent domain appraisal called the “Project Influence Rule.”

Under this rule any artificial inflation or depreciation in the value of property that occurs on account of the public project for which a property is being acquired by eminent domain cannot be considered. This rule has relevance to the market context of the proposed Drought Environmental Water Market whereby a shortage of water was partly created by the San Joaquin River Restoration Settlement Act in California’s Central Valley.  We believe this rule is relevant despite there is no use of eminent domain in this case.

Buying agricultural water in a market with drastically reduced supply due to an environmental project to restore river salmon runs is a market condition created by a public project, not the market. The way appraiser’s control for such “project influence” when valuing land for redevelopment projects is that they have to find comparable sales data outside the project area.

Water Auctions in Vogue

Not mentioned in the U.C. Davis-PPIC proposal is the currently popular alternative of water auctions advocated by former U.C. Davis water economist David Zetland. A recent auction of 12,000-acre feet of irrigation water in Kern County resulted in “sky high” prices due to drought conditions.  Bids came in around $1,200 per acre-foot of water for 200-acre-feet of water or more.  This is about three times the typical going price of $400 an acre-foot cited by the U.C. Davis team in their article.  The market data from this small quantity of water suffers from the small sample size problem inherent in statistics and markets.  This makes it difficult to extrapolate such “sky high” prices to an entire market that uses from 27.7 to 34.1 million acre-feet of water depending on a dry or wet year. Moreover, we don’t know what the buyer motivations were: to buy “spite water” to remove water from competitors, to prop up the local finances of the water district due to fewer water sales resulting from environmental water diversions, or what?

Zetland proclaimed on his Aquanomics.com blog on Feb. 6, 2014, after the auction: “Now THAT’s a market!”  But is it Fair Market Value?  We don’t think so for reasons that will be elaborated upon below. It may be gratifying to those with a political agenda that farmers finally have to pay the so-called real, unsubsidized market price of water. But once again, the tight market conditions that produce such inflated prices are due to a public fish restoration project not entirely the market. Zetland never explains why if so-called subsidized water prices distort markets why don’t artificially inflated prices do the same?

Of course while farmers might be able to pay that price once or twice for a small amount of water, if anything approaching that became the average price for water, agriculture in California would become uneconomic.  And farmers and agricultural appraisers know that irrigation water would be valued as a residual of the expected market price of the crop, the type of crop, the anticipated crop yield per acre, the cultivation costs, land rental, and profit. Agricultural markets do not generally value water on an across the board price per acre basis regardless of crop type, orchards, or grazing land.

A close proxy to the market value of agricultural water might be The Metropolitan Water District of Southern California’s drought land fallowing program with the Palo Verde Irrigation District along the Colorado River (a program one of the authors was involved with). A test of the program from 1992 to 1994 fallowed 20,215 acres of farmland thus saving 186,000 acre-feet of water.  Land lessees or landowners were paid $620 per fallowed acre per year on a voluntary basis only during drought years, equating to $135 per acre-foot of water. The water was stored in Lake Mead instead of released to farmers. Additional administrative costs for the program equated to $8 per acre-foot of water. This comes nowhere near the $1,200 per acre-foot of water indicated by the Kern County auction.

IMAGE: Insert graph from David Zetland, “The Water Shortage Myth,” Forbes, July 15, 2008
http://images.forbes.com/media/2008/07/15/omm-chart_400x351.jpg

The U.C. Davis-PPIC proposal did not call for water auctions, but such auctions would likely affect the market price of a so-called “drought water market.” Water districts with curtailed water sales due to environmental court orders and policies could likely be tempted to sell surplus water for three times the going price to recover their fixed operational costs. Municipalities with water banks in agricultural areas could also be tempted to reap a windfall for deficit-plagued pension funds.  Public universities such as U.C. Davis looking for a pot of blue gold to perpetually fund their environmental programs would likewise be prone to devising “rent seeking” policies from farmers.

At some point we have to ask how farmers would pay such a rent (i.e., monopoly price).  It could and probably would be reflected in reduced land value, which could, ironically put farmers “underwater” on their mortgages and farm credit loans.  It undoubtedly would be reflected in food prices. Only the most water self-sufficient farms would remain.  Food supply would have to be met by imports.  World supply would diminish proportionately to the withdrawal of California production and prices would rise.  Meantime, the grandiose visions of limitless revenue would prove chimeric.

Are drought environmental water markets or water auctions markets?  Or are they metaphorical bureaucratic piranha feeding frenzies at the expense of farmers?  Real estate and commodity appraisers have to evaluate the motivations of both buyers and sellers to estimate Fair Market Value.

Such inflated prices brought about by the crowd psychology of auctions are advocated by water economists such as Zetland who believes that if water prices are set high enough this will encourage conservation.  But is it an economist’s proper role to promote “sky high” water prices to accomplish public policies, or is that the role of legislatures? Who elected environmental economists and water economists to structure water markets to accomplish public policy?

Markets are social mechanisms to produce the lowest priced goods or services, given that their highest use is the same (agriculture, urban, industry, wildlife refuge).  For there to be a public environmental water market the buyer has to have a competitive choice or there is only a captive market for Monopoly Value.  The choice of not buying water is a non-market.

Additionally, water markets structured by environmental economists who are openly hostile to crop subsidies without disclosing such a bias would present a potential conflict of interest that could disqualify an independent appraiser.  Such crop subsidies are not entirely “crony capitalism” but public policy to assure farms don’t go in and out of business due to the volatility of farm commodity markets. Moreover, there is no “free water” provided to Central Valley farmers in California even for proprietary groundwater rights, contrary to the claims of some environmental water economists.

To an impartial real estate appraiser the above-reported inflated auction prices do not reflect Fair Market Value, but are a hostage price due to a fish restoration project-created shortage of water.

Farmers Would Have to Pay Sellers Twice

Moreover, the whole drought market proposal would result in farmers having to buy-back water they already paid for in their water rates. Central Valley farm water rates include a premium for paying off the bonds for the federal Central Valley Project.

In the main it is farmers, not taxpayers that are paying the $1.3 billion original cost for the construction of the Central Valley Project financed by government bonds. They are also paying a significant share of the cost to restore salmon runs in the San Joaquin River. They may be provided with “cheap” water as a matter of public policy but that is not a policy for water or environmental economists to unilaterally correct with inflated water market prices to conform to their agendas.   Repayments of the CVP costs have lagged since 1990 when courts and regulators took 58% of agricultural water for fish restoration.  The resulting fewer water sales due to environmental water diversions has resulted in farm repayments falling in arrears.

Additionally, Central Valley farmers have already paid $180 million into the San Joaquin River Restoration Fund up to 2014 to restore salmon runs through higher water rates. Thus, the proposed price for environmental water would be what is called an environmental surtax (an additional tax on something already taxed) more than it would be a market price.

Moreover, the deep negative impacts to Central Valley farmers perhaps could have been lessened or entirely avoided if the $102 million set aside for construction of replacement of lost farm water in the San Joaquin River Restoration Act had been implemented.  The 2014 California Central Valley farm drought has been partly caused by a failure to adhere to a fail-safe planning principle to build replacement water facilities first before taking farm water for fish restoration.

Compensate Whom?

Another problem we had was the proposal’s reversal of which party would require compensation for the so-called purchase of environmental water.  According to the U.C. Davis-PPIC proponents:

“Creating such a drought environmental water market would help limit the reductions in environmental river flows, while ensuring that such reductions receive some compensation.”

But how can farmers be shaken down to pay compensation to environmental agencies and consultants for water that they already paid for?  Shouldn’t compensation be the other way around, to farmers, not possibly self-serving environmental bureaucracies who want an unending source of funding? In a drought perhaps water bill rebates for the overcharges for environmental restoration might be considered.

The U.C. Davis proposal to establish an environmental water market partly induced by environmental regulatory drought does not hold water.  And we find pricing environmental water sales by auctions to reflect inflated non-market prices derived from the “project influence” of inducing a water shortage as a result of the San Joaquin River Restoration Settlement Project of 2009 (U.S. Senate Bill 246 – Sen. Dianne Feinstein, D-California).

Nonetheless, we welcome the opportunity to open up a discussion of how markets might alleviate drought hardship on farmers and, wherever possible, on the environment.

The proposed Drought Environmental Water Market would not conform to the definition of an open and competitive market and any water sales by auction, by water prices set by potentially biased water economists wanting to further environmental agendas loaded in the pricing structure of water, by the avoided Cost of Compensatory Legal Actions, or by Fixed Negotiated Fees would not reflect Fair Market Value.

Implications for Hydropower Market

About $192 million per year, reflecting 19% of all electricity and 5% of all energy used in the state goes for pumping water from the Sacramento Delta over the Tehachapi Mountains to Los Angeles. This doesn’t count the $49 million annual hydropower pumping costs from Hoover Dam to convey imported water from the Colorado River over the Mojave Desert mountain chains to Los Angeles.

Over 800,000 acre-feet of federal Central Valley Project water and 453,000 acre-feet of Trinity Lake water were flushed to the sea in 2012 and 2013 respectively for fish restoration. Additionally, the U.S. Bureau of Reclamation reduced agricultural water allocations to zero for 2014 in California’s Central Valley due to the third consecutive year of light seasonal rainfall inadequate to replenish reservoirs.  Wildlife Refuge water flushed to the sea does not end up turning hydroelectric turbines along the federal Central Valley Project or the State Water Project.

Fitch Ratings has warned that the combination of regulatory and meteorological drought could put financial pressure on public power entities in their ability to service bonded debts. Revenues from water auctions or bureaucratic water sales, even at inflated prices, are unlikely to offset financial losses to water districts caused by environmental water diversions.

[1] U.C. Davis-PPIC associated water experts:

Prof. Jay Lund, Director of Environmental Engineering at the U.C. Davis Center for Watershed Sciences
Ellen Hanak, PhD, economist for the Public Policy Institute of California
Barton Buzz Thompson, J.D./MBA, the Robert E. Paradise Professor of Natural Resources Law at the Stanford Law School
Brian Gray, Professor of Law at Hastings School of LawJeffrey Mount, PhD, and Professor Emeritus of Paleoclimatology at U.C. Davis
Katrina Jessoe, PhD., Environmental and Natural Resource Economics at U.C. Davis.

Wayne Lusvardi is former chief real estate appraiser for a large regional water district in California specializing in land, easement, pipeline corridors, and water-related properties and rights of ways.  He served on the 2001 California Energy Crisis Task Force for the same water agency.  He currently reports on water and energy policy for the Pacific Research Institute, a free market think tank in San Francisco, on their news service Calwatchdog.com.  He also reports on California energy policies at MasterResource.org, a free market energy website sponsored by the Institute for Energy Research in Washington, D.C.  His professional articles on water rights, land and easement valuation have been published in the Appraisal Institute’s Appraisal Journal, the journal of record for the public utility industry Public Utilities Fortnightly, the Counselors of Real Estate Journal Real Estate Issues, New York University Real Estate Review, American Society of Appraisers Journal of Property Economics, Environmental Claims Journal, Reason Public Policy Institute Privatization Watch Journal, the U.S.C. Journal of Planning and Markets, and the International Right of Way Association “Right of Way” quarterly journal.  He is co-author with Charles B. Warren of the textbook What’s It Worth? The Valuation of Limited and Non-Market Properties (2008).   

Charles B. Warren, MRICS (Member Royal Institute of Chartered Surveyors), ASA (Urban-Real Property-The American Society of Appraisers), is a real property valuation consultant in northern California with over 30-years of experience in litigation support, property tax assessment, institutional lending appraisal, computer-assisted mass valuation, and a qualified expert witness in Superior, Federal and Bankruptcy courts.  Warren formerly taught real estate finance as Visiting Professor at Istanbul Technical University, Turkey.  He has been published in the journals Valuation, Business Geographics, Real Property Digest, New York University Real Estate Review, and the U.S.C. Journal of Planning and Markets.  He is a U.S. Coast Guard Master and FAA Private Pilot. He is co-author with Wayne Lusvardi of the textbook “What’s It Worth? The Valuation of Limited and Non-Market Properties (2008). 

Keywords: California Drought Environmental Water Cap and Trade Market, Hydroelectric Power, Utilities, Environmental Policy, Water, California, Drought, Regulatory Drought, San Joaquin River Restoration Settlement Act of 2009, Water Market Value, Water Auctions, California Water Bond Ratings, David Zetland, Charles B. Warren, Wayne Lusvardi