The economics of Water

Why do we worry about water so much? Even in the UK we talk about droughts a lot – just to get news on historic floods a day or month later. Isn’t water really a regional issue or should we trade water cross border thus water rich countries helping water scarce economies? We are positive that many people have never really thought about whether water is tradable like any other commodity. And, is it?

Who owns the right to water: the government, companies, or land owners? Generally speaking, governments own the rights to water. But water is tradable and the market distinguishes three levels of water permits. Below we will investigate what it means with respect to the pricing of water and how we can benefit as financial investors.

Source: ADB, 'Water rights and Water Allocation', 2009

Source: ADB, 'Water rights and Water Allocation', 2009

The three levels are tradable water abstraction rights, tradable rights to water-based resources and tradable water pollution rights. We kick off the article by assessing both how water is priced and which factors need to be considered. Before we start, we hope that our readers can generally agree that “water should have a price in order to achieve two objectives, namely recovering the cost of providing the particular water service and giving a clear signal to the users that water is indeed a scarce good that should be used wisely” (Van der Zaag, P. and Savenije, H.H.G. (2006) ‘Water as an economic good: The value of pricing and the failure of markets’).

Water Pricing in the EU
The European Environmental Bureau published a report on the pricing structure of water back in 2001. The EEB report opens by saying that “60% of European cities over exploit their groundwater resources. Along the coastlines in Southern Europe and on many islands, seawater is already intruding into the depleted underground aquifers, making them unusable as drinking water.” The issue of pricing water focuses on what to include in the total cost of water. The concept of Full Cost Recovery (FCR) includes various factors but ensures that (i) Operation and Maintenance Costs, (ii) Capital Costs, (iii) Opportunity Costs, (iv) Resource Costs, (v) Social Costs, (vi) Environmental Damage cost as well as (vii) Long-Run Marginal Costs (LRMCs) are included, at least in theory. Further, the ‘Polluter Pays Principle’ (PPP) ensures that it is the one who pollutes pays instead of the society as a whole. That way it is possible to create incentive structures for polluters to reconsider whether to pollute or to enhance the discharge to minimize pollution. So far the theory.

Fact is water is non-substitutable and irreplaceable which makes the calculation, in practice, challenging. For example, calculating marginal costs could be solved, or at least addressed, by smart metering although it would be near impossible to achieve a 100% service ratio.

How does the EU assess water pricing then? Essentially three levels persist: tariff structures and levels, charges and subsidies. Those are then applied across three sectors (a) households, (b) industry and (c) agriculture. Tariff structures enable utilities to collect a relatively stable revenue base and thus minimize their business risk. It probably does not inspire ‘market’ forces and the need for innovation is somewhat arbitraged away as revenues are surely coming in. Further, the issue of regional monopolies may impact the pricing behaviour of municipalities and utilities. We can distinguish between two charge systems: abstraction charge and pollution charge. The former collects payment at point of abstraction and aims to demonstrate that by minimizing leakage money can effectively be saved and the ecological benefit is obvious. Some countries trade in water abstraction rights (FAO, 2006). The latter does what is says on the tin: it charges a price for polluted waters. Germany is leading the initiative but many other European countries have adopted a similar concept. It is the closest to the Polluter Pays Principle. Subsidies prevail on many levels but the most obvious is tax reductions for new water treatment plants et al. Although the cost-benefit analysis is difficult, the water sector generally charges below its FCR principle.

Tradable Water Pollution Rights
In an report (2004) published by the Inter-American Development Bank the authors Andreas Kraemer, Eleftheria Kampa and Eduard Interwies conclude that “[e]xperience with tradable permits for water pollution control is accumulating primarily in Australia and the US, which are both advanced economies with long regulatory history in water management and pollution control. The introduction of trade for water pollution control has benefited in these cases from solid scientific understanding of the pollution problems in question, existing monitoring infrastructure and enforcement capacities”.

However, the market is still relatively young and the authors admit that it is too early to know whether the economic benefits can be explained systematically.

Conflict Potential
We are not in the position to comment on the various conflicts associated surrounding water rights. However we point out that whenever cross-country/cross regional water flows tangent on various jurisdictions, conflict is pre-programmed especially in water scarce regions. We suggest this paper by the Munk Center for International Business in Canada on issues surrounding the US-Canadian relationship on water. Other prominent research has been conducted around the River Nile and the water abstraction issues from countries further upstream. A very good report was published by the Asia Development Bank.

Further reading: