Demand Management, Privatization, Water Markets, and Efficient Water Allocation in Our Cities

When water is plentiful, we tend to take it for granted and overuse it. Once water becomes scarce, our neglect changes to pleas for new supplies. In other words, when water demands exceed the supply at existing low prices, shortages emerge and we appeal for an increase in supply. Yet expanding domestic water supplies has become much more difficult and expensive. This is because we have already developed the low cost sources of supply and face growing environmental constraints due, in part, to our increased awareness of the many instream services undeveloped water resources provide. The cost of developing new sources includes both the explicit financial cost of infrastructure and the opportunity cost of using water consumptively, rather than for instream or nonconsumptive services. Although nonconsumptive uses, by definition, do not involve water consumption, they can change the timing and location of water flows (hydropower), increase water temperature (cooling), or pollute (boating) the water. In addition, these instream (or nonconsumptive services) such as sewage dilution, recreation, and a healthy aquatic habitat may require increased water supplies. Balancing all these demands is a challenge and requires us to recognize that our supplies of clean, fresh water resources are quite limited. Simply increasing the supply is no longer the easy option. We must now emphasize using the water we have more wisely.

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13.1 Introduction

When water is plentiful, we tend to take it for granted and overuse it. Once water becomes scarce, our neglect changes to pleas for new supplies. In other words, when water demands exceed the supply at existing low prices, shortages emerge and we appeal for an increase in supply. Yet expanding domestic water supplies has become much more difficult and expensive. This is because we have already developed the low cost sources of supply and face growing environmental constraints due, in part, to our increased awareness of the many instream services undeveloped water resources provide. The cost of developing new sources includes both the explicit financial cost of infrastructure and the opportunity cost of using water consumptively, rather than for instream or nonconsumptive services. Although nonconsumptive uses, by definition, do not involve water consumption, they can change the timing and location of water flows (hydropower), increase water temperature (cooling), or pollute (boating) the water. In addition, these instream (or nonconsumptive services) such as sewage dilution, recreation, and a healthy aquatic habitat may require increased water supplies. Balancing all these demands is a challenge and requires us to recognize that our supplies of clean, fresh water resources are quite limited. Simply increasing the supply is no longer the easy option. We must now emphasize using the water we have more wisely.

In this chapter we will explore different institutional arrangements and mechanisms that will encourage consumers to reduce their water use, particularly those mechanisms and arrangements that will facilitate “demand management”. We will also consider ways to improve water management and make better use of our existing supplies through “privatization” of water utilities. We will then consider water markets and the role they might play in allocating urban water supplies. Finally, we see how water charges and markets can help reduce water pollution.

13.2 Demand Management

With the growing demand for water in urban areas and our increased concern regarding the environment, we have to develop and use institutional arrangements and mechanisms to reduce the growth in water demand. Implementing such arrangements and mechanisms has become known as demand management. More specifically, demand management primarily involves three general types of institutional arrangements: (1) water pricing, (2) water quotas-rationing, and restrictions on specific uses (watering lawns), and (3) water subsidies for technologies that use less water (low flow toilets) or legislative restrictions that only allow the purchase of these water saving technologies.

Water pricing tends to be the mechanism one thinks of when you talk about demand management. In fact, most urban water users, who are supplied water by a public utility, pay a water price (or charge) unless it is included as part of their apartment or house rent. Most urban homeowners and commercial water users have meters that measure the amount of water they consume. A few municipalities (Sacramento, California, for example) and a number of small towns do not have meters, and users are charged a fixed fee. In such cases the charge is primarily used as a way to cover the cost of supplying water to community users. It is like a land tax and sometimes it may vary by type of business or number of people living in the household. In cities with meters and where water has become scarce, water pricing has been used to help reduce water consumption by giving consumers an incentive to conserve water.

The water demand (or use) will vary by household and industrial characteristics such as income, landscape, family size, products produced and technologies used, as well as climate and season of the year. For example, households in hot, dry climates tend to use more water for garden and lawn irrigation. United States household consumption varies from about 76,000 gallons/household per year to as high as 284,000 gallons/household per year (Fig. 4.1 in Chapter 4). Outdoor water use in the United States varies from about 10 to 75% of the total household water use while indoor use averages about 70 gallons/capita per day. One key in effective demand management is to know household and industrial characteristics and use them in structuring a water management and pricing system. Reducing demand will likely require the use of more than water pricing if water supplies are low relative to the demand. However, with the appropriate pricing procedure in place, the cities’ job of meeting growing demands will be much easier.

There are number of different pricing methods that can be used but each provides users different incentives to reduce water use. These methods include: (1) a fixed charge per month or quarter, (2) a constant rate per unit of water used, (3) a decreasing block rate per unit of water used, (4) an increasing block rate per unit of water used, (5) a two-price method which includes a fixed charge plus a charge per unit of water used, and (6) peak load or seasonal pricing. As discussed above, the fixed charge is found mostly in small towns and provides no incentive to reduce water use. It is generally set to cover the costs of operations and maintenance plus a capital charge for the infrastructure, and does not change with quantity used by a business or household. An example would be a $25 per month charge for a household which would only change annually based on changes in the cost of supplying water.

The constant rate means that water users pay the same price per unit of water no matter how much they use in a given time period. For example, if the rate or price per 1,000 gals is $2 and you use 15,000 gals/month, then your monthly bill is (15 × $2) $30 (line A in Fig. 13.1). The advantage of such a pricing method is that it is easy to understand and it gives you a constant incentive to conserve water because the more you use the more you pay. Each 1,000 gals of water has the same price. Therefore, the marginal cost to the consumer is constant no matter how much is used (marginal cost is $2).

Fig. 13.1

Decreasing, constant and increasing water pricing schedules

The decreasing block rate means that water users pay a lower rate or price, the more they use, which provides little incentive to conserve water. An example would be to pay $2/1,000 gals for the first 5,000 gals used per month but only $1/1,000 gals for the next 5,000 gals used that month and $0.40/1000 gals for all water used per month above 10,000 gals (line B in Fig. 13.1). If the user consumes 15,000 gals/month, the monthly bill would be only ($2 × 5 + $1 × 5 + $0.40 × 5) = $17 or about half of what the constant rate user would pay. Decreasing rates are generally used by towns to encourage firms to build or expand plants in their town. It favors large water consumers such as wealthy homeowners with big lawns and swimming pools, and business enterprises. Since the water charge drops as more water is used, the marginal cost to the consumer also drops as does the incentive to conserve water (marginal cost is $0.40 for water use per month over 10,000 gals). St. Paul, Minnesota has a decreasing rate that drops by $0.10 per ccf after 100,000 cf (100 cubic feet (ccf) = 748 gallons) are consumed.

The increasing block rate or price is just the opposite of the decreasing rate. It provides an increasing incentive to conserve water and is used by cities that are serious about reducing water consumption per capita. An example of increasing block pricing would be a price for the first 5,000 gals used per month equal to $2/1,000 gals while the price for the second 5,000 gals used per month would be $3/1,000 gals; and for water use over 10,000 gals per month, the price would go to $4/1,000 gals (line C in Fig. 13.1). Thus, when a user consumes 15,000 gals/month, the monthly water bill would be ($2 × 5 + $3 × 5 + $4 × 5) $45. Clearly, users facing this increasing rate would have a much greater incentive to conserve water than users facing either the declining or constant rate. The price for the last block in our increasing rate example ($4/1,000 gals) is double the constant rate and ten times the declining rate example. The increasing rate should provide heavy water-using industries with a clear incentive to recycle water which can dramatically cut water use. The marginal cost of water to large water consumers increases and reaches $4 for consumption of more than 10,000 gals/month. In some cases cities have as many as five blocks, such as Irvine, California. Their block charges start out at $75 per ccf and go up to $7.28 per ccf in the fifth block.

If there is a desire to assure cost recovery and maintain an incentive to conserve water, a two-price method can be used. The first price is like a fixed service charge per month for anyone connected to the water system, and is thus not really a price. You pay the fixed charge whether you use water or not, and it is generally designed to cover the fixed costs of operating and maintaining the water system. The fixed charge also helps eliminate the need for very high prices to cover costs during periods of low water use and low water sales. The second price is a charge per unit of water used per month or quarter. This can be an increasing, constant, or decreasing rate and is designed to cover all the variable costs (costs that vary by the volume of water delivered). If water conservation is important, the variable charge will either be an increasing or a constant rate. To maintain efficient water allocation and conserve water, the variable rate can be set at the long-run marginal cost to the water utility of obtaining new water supplies (or the opportunity cost of water). If an increasing block rate price is used, then the highest block price used would be set at the long-run marginal cost of obtaining new water supplies.

Two other pricing concerns face many urban water managers. The first is the seasonal variability of water supplies and demand. The second is the concern that low income families will have a difficult time getting access to and paying for water. For seasonal variability, peak load or seasonal pricing can be used. In this case the prices or charges per unit would be raised during periods of high water demand and/or low supplies. For the United States this tends to mean high rates in the summer and low rates in the winter. For example, the rate might be only $1/1,000 gals in the winter, $4 in the summer, and $2 in the fall and spring. It might also be set lower for part of the spring season since in northern climates this is usually a period of high rainfall and snow melt. In Phoenix, Arizona, a city in the dry southwest, they charge $1.65 per ccf from December through March; $1.97 for April, May, October, and November; and $2.50 from June through September.

The concern about low income families is best handled by a system with increasing block rate pricing. The first price can be set low and the quantity cutoff point for the first or low price set so that a low income household of four or five people would receive enough water to meet their basic domestic water needs at the low price (see Fig. 13.2). This “basic minimum supply” would exclude water needed for lawns, washing cars and filling swimming pools since poor households generally do not have these water uses. The second price would be higher for all water used above the “basic minimum” per month and would be set high enough so that total collections would cover the cost of operating and maintaining the water system plus a capital depreciation charge. With this pricing system, water utilities have three instruments they can use to achieve three separate objectives: (1) recover costs from water users, (2) protect low income families from high water charges, and (3) provide an incentive for water users to conserve water. Utilities can raise or lower the two prices ($1 and $2) and they can change the “basic minimum” amount of water at which the higher price starts. For example, if they are not collecting enough money to cover costs, they can raise one or both prices by $0.25 or move the starting point for the higher price from 5,000 to 4,000 gals/month or some combination of the three. If water conservation is a big concern, they can just raise the highest price by $1, which will help achieve both the cost recovery and conservation objectives. Another advantage the two-price approach offers is flexibility in adjusting to different supply and demand conditions over time. In a sense this gives the pricing mechanism resilience. You just have to shift one of the prices, or the cutoff quantity up or down, to meet the changing water conditions. (See Hall, 2000, for an example of this type of pricing system used in the Los Angeles area).

Fig. 13.2

Pricing schedule for domestic water use

Since the demand curve for many domestic water users (drinking and cooking) tends to be quite steep (demand is inelastic), large price changes bring about only small changes in quantity used, particularly for those families with higher incomes. This case is illustrated with steep demand curve, A, in Fig. 13.3 where higher prices have little impact on the quantity consumed. Demand curve B is not as steep and is more representative of the demand for water to wash cars and water lawns. This suggests that using only higher water prices may not achieve the water conservation needed. A more effective approach would be to use a combination of demand management strategies. An example of such a strategy would be higher water prices combined with subsidies for the adoption of selected water saving technologies, such as low flow toilets and drip irrigation for landscapes. During drought periods, restrictions on certain water uses such as car washing and lawn watering could be an additional strategy. In California’s drought of the 1990s, a study of two towns in southern California showed that unless a water pricing policy is combined with other demand management mechanisms, low income families would bear a larger proportion of the reduction in water use (Renwick and Archibald, 1998). This was because the water bill for poor households was a much larger share of their income than it was for the higher income families. This was true even though the higher income families used more water per capita. Renwick and Green (2000) found that, for moderate (5–15%) reductions in demand, modest price increases combined with public information campaigns, work. However, for larger reductions in demand (greater than 15%) relatively large price increases or restrictions on water use (no lawn watering) or some combination of the two are needed.

Fig. 13.3

Demand for water

Table 13.1 Privatization options found in the United States

13.3 Privatization

Another concern in the water sector that is closely related to the water scarcity concern is the low quality of service provided by some water utilities, particularly in developing countries. In such systems you find interrupted service, lack of maintenance, overstaffing, leaky pipes, and large financial deficits. To help address these problems and to involve new entities in the supplying of water service, private firms have been asked to become more involved in the operation and management of such water utilities. This process has been referred to as the privatization of water services.

One of the key steps in this privatization has been the decoupling or unbundling of the services provided by the public utility. This decoupling allows the water utility to have private firms manage or operate different functions within the utility all the way from bill collecting and meter reading to constructing new water treatment plants. Table 13.1 lists some of the different functions private firms have performed for public water utilities in the United States. In most cases ownership stays with the public utility. Only in a few cases has there been private acquisition of water systems and this generally includes a contract for supplying water to the city. Acquisition usually occurs when a government or city is trying to raise capital to invest in the water sector. Concerns about raising capital are likely to accelerate since a growing share of U.S. water and wastewater infrastructure needs to be upgraded or replaced in the very near future (Jacobs and Hoe, 2005). Even before this recent interest in privatization, private firms have been employed to construct most of the public water infrastructure outside the old communist block of countries. Thus, a private firm providing services in the water sector is really not new. What is new is the management functions they are privatizing. In the United States most of the privatization of management has been in the smaller urban communities who want to take advantage of some of the extra services the private firms can provide, such as better laboratory facilities for water testing and more extensive technical expertise.

One of the important ideas behind privatization, besides getting more entities involved, is to introduce competitive pressures in the water industry. When contracts are offered for bid to perform different water services, the idea is that competition among private firms will lead to lower cost bids. The contracts also include performance criteria the firms have to meet. The end result, hopefully, is higher quality service provided at a lower cost than those provided by the public utility.

There are three different methods of introducing competitive pressure into the water utilities market. They are (1) product-market competition, (2) competition to supply inputs, and (3) yardstick or comparative competition. Since installing a competitive water delivery network is generally not a serious option for product-market type competition, we are limited to two other types of strategies in product-market competition. The first strategy is to allow different firms to compete to deliver water on the existing delivery network. However, opening up the water distribution network for different firms to use may create water quality problems. Water standards must be established and closely monitored to make sure that one of the competing firms does not try to cut treatment costs and introduce contaminants into the water delivery network. In actual practice, there are few cases where competing firms have been on the same network, other than in the United Kingdom (Dosi and Easter, 2003).

The other strategy is to set up competition for water concessions or agreements to manage all or part of a water utility. The water concession has become one of the most common forms of competition in the provision of urban water supplies. To make them work, it is critical that public authorities maintain regulatory pressure on the private water company during the life of the concession. However, it may be difficult to expel a poorly performing firm because of the contractual power arising from the firm’s provision of essential water services. Thus, short-term contracts (5 years) are generally preferable but may not be attractive to many firms. An alternative might be a long-term contract (20 years) that must be reviewed and reapproved, based on the firm’s performance, every 5 years. This would give the private firm a longer-run investment framework, as long as it maintains a satisfactory level of service.

Competition to supply inputs such as billing, revenue collection, and infrastructure maintenance is an attractive alternative that has been used in several countries. It is part of the unbundling process. This means the public utility can focus on what it does best and then contract out competitively for the other services. In Santiago, Chile, they established a “public” water company that is financially autonomous from government: It owns and manages the city water system. Since the company is financially autonomous, it has to cover all its costs with the water charges collected from its water users. As a result the water company contracted out for different services such as water billing, bill collection, and the replacement and repair of old damaged and leaking pipelines. This not only raised cost recovery levels but saved water, which was then, in turn, sold to new water users, again enhancing cost recovery. They also reduced illegal connections and broken meters.

Finally, yardstick competition can be important where there is not enough competition from private firms. In such cases the regulatory authority needs to be able to introduce a comparison of performance among firms working in different water systems and different locations. To be effective, comparable information on water charges, collection rates, and service levels must be available for a number of firms (public and/or private), including the ones being evaluated. This will only work if there are comparable firms or utilities that are providing good quality service.

Two interrelated factors seem to have stimulated United States interest in privatization. First, was the problem of financial pressure, particularly in many smaller systems and in older systems, where they faced major costs in upgrading their infrastructure. Second, the introduction of new health and environmental quality standards for domestic water supplies has raised costs. Water utilities had to meet these new stricter requirements for the removal of a range of contaminants. For example, when the new arsenic standard was introduced in 2001, about forty small communities in Minnesota failed to meet the standard the first year. Even after 2006, some of these same communities still could not regularly meet the new standard.

In 1997, a survey of 261 U.S. cities found that 40% of them had some form of private/public partnership and another 14% were considering proposals. The most common activity was the private design and construction of infrastructure, particularly water treatment plants (Callahan, 2000). Private ownership of water systems is discouraged by law, which exempts municipal debt from taxes but not private debt. There are also political concerns about private ownership partly because of the potential for local monopoly power, since the firm, usually, would be the only water supplier for a given municipality. Consequently, most water facilities in the United States are designed and constructed by private firms but are managed and owned by municipalities after completion. This model appears to be less efficient (costs more) than the design, build, operate, and transfer (ownership) model, which gives the private firm more control, particularly over how the plant is operated once it is built. Siedenstat et al. (2000) argue that the design-to-transfer model will reduce construction costs by about 25% and operating costs by 20–40% as compared to the design and build model. The Tolt River Project in Seattle, which fits the design-to-transfer model, is estimated to have had cost savings of 40% compared to the conventional model of private construction, followed by public management.

Despite the growing interest in privatization, it is likely to experience only modest future increases in the United States. It will fit some communities’ needs but not others. To be effective, privatization decisions will need to be open and transparent, with public participation and periodic third-party review (Wolff and Hallstein, 2005). Clearly, the need for more funding, combined with public officials reluctant to accept the political consequences of raising taxes or fees, will maintain a continued public interest in the use of the private sector to cut costs (Jacobs and Howe, 2005).

Another area where private water development has been widespread is in the use of groundwater for irrigation as well as for commercial and domestic uses. With the development of low-cost pumping technologies, private wells have spread around the world, particularly in Asian countries such as India, Pakistan, China, and Bangladesh as well as in the U.S. Great Plains. Although much of the private well development has been for irrigation, the irrigation wells also are used extensively as a domestic water source. In Bangladesh many rural households now have low cost pumps. Although this private well development has supplied large quantities of water, it has, in some cases, caused serious problems of overdrafting of groundwater. This is particularly true in irrigated areas with limited groundwater recharge and unclear property rights for water. Since groundwater in many cases is an open access resource (no clear water rights), users do not take into account the impact of their pumping on their neighbors. In areas with small-scale farms, farmers soon realize that if they do not use the groundwater, their neighbors will. This occurs because, in most cases, owning the land gives landowners the right to pump but does not limit the amount that can be pumped. Since water is mobile, too much pumping for irrigation will extract water from under their neighbor’s land and may compete with rural towns. For example, most towns in Minnesota depend on groundwater for their water supply. In cases where overdrafting occurs, the state needs to set up limits, both on the number of wells and the pumping rates. High charges for electricity may be one method to help reduce pumping rates, although such charges have proven very hard to enforce and collect in developing countries such as India.

13.4 Water Markets

Almost the same types of concerns have been raised about water markets as have been raised about privatization: Monopoly power and access of consumers to water at reasonable prices. Currently, there have been few attempts to set up markets for municipal water, although several have been proposed (see Haddad, 2000, for proposal for a water market in Monterey, California). Of course, there is a very extensive private market for bottled water used for drinking and, in some cases, food preparation and cooking. Water markets also exist in some farming areas for irrigation water but trading is primarily among farmers (see Easter et al., 1998). For urban water use the major role water markets have had, and is likely to have in the near future, is as a mechanism for transferring water among different sectors of the economy, such as from agriculture to urban communities, or from one urban community to another (Brewer et al., 2008). So far, most governments have not used markets as a tool to transfer water, except in the western United States and some other countries such as Chile and Australia. In all of these cases markets were used in response to droughts or growing urban populations, which suggests that in the future we will likely need to use markets in this manner as urban water demands continue to grow relative to supplies.

If we want to use water markets within urban areas, the task becomes more difficult. The big problem in setting up such water markets is establishing private water rights or use rights and distributing them fairly among urban users. These rights could be in terms of volumes or shares of water available. Establishing water rights and their allocation are key to setting up water markets within cities. Who should get the water rights and how much they should have to pay for them, if anything, must be decided. The right could be based on past use, size of landholding, or family size. Since these decisions will be difficult to agree on, it is not likely that water markets will see much use within U.S. cities until water scarcity becomes much more severe. Even the water scarce Monterey Peninsula failed to introduce a proposed water market during the 1990s drought (Haddad, 2000). Yet the use of markets to reallocate more water to our growing cities does not face the same restrictions.

The advantage of using water markets for water transfers among sectors is that past users are compensated directly. It also helps improve water use efficiency by reallocating water to its higher valued uses. The problem that must be guarded against is the unintended effects or external impacts of water transfers on downstream users and the environment. When water is transferred out of a region or from agricultural to urban uses, return flows of water are reduced. In the case of downstream users of return flow, they will likely have to be compensated for any water losses caused by water trading upstream. The water trading could also be restricted to just consumptive use and the return flow would have to stay in the system. For irrigators that would mean they could only trade about half of their water rights (approximately 50% of irrigation water delivered returns to the surface flow or groundwater). The water trading issue gets a little more complicated when it comes to environmental damages. In such cases the potential environmental damage may limit the amount of water that can be transferred for urban uses and force a city to use other higher cost sources of water, which may in some coastal cities even include desalinization.

13.5 Sustainability of Water Use

The economic toolkit – including water pricing, water markets, and privatization – can play an important role in helping sustain urban water systems faced with growing water demands. Effective water pricing and selected privatization can improve the financial sustainability of water utilities by improving cost recovery (cover costs including investment costs). Of course, for water pricing to be effective in cost recovery, users must receive a level of service from the water utility they think is worth the price being charged (Easter and Lin, 2007). This will be difficult if the city faces a continued water supply constraint. Under such conditions water markets can help. Since domestic water use tends to be one of the highest valued uses of water, markets for water can be an effective way to help increase and sustain water supplies for urban areas. For example, the purchase of water rights from farmers has been an important source of reasonably priced water for the city of La Serena in northern Chile. Similarly, Phoenix, Arizona and cities in the Phoenix metropolitan area have purchased agricultural land and its associated water rights, and leased water from Arizona tribes as cost-effective ways to meet their growing water demands (Colby and Jacobs, 2007). The water market in Arizona would be more efficient if water rights were separate from land rights, as they are in other U.S. western states, such as Colorado, New Mexico, and California.

While water pricing and water markets can help assure cost recovery and water supplies, privatization can help improve the operation and maintenance of some urban water systems. If done right, privatization will complement cost recovery efforts by providing and maintaining a level of water delivery for which water users are quite willing to pay. Effective private management can also hold down costs, which will again make cost recovery easier. Finally, private firms will have a real incentive to reduce water losses and water theft because if they do, they have a larger effective supply. The large supply means more water can be sold, again, helping raise cost recovery and possibly allowing water prices per unit to be lowered. Thus, in cases where a public utility is not effectively managing its water resources, the use of selective privatization may be one answer. Through privatizing management, incentives can be changed so that they are consistent with providing a more sustainable water service.

13.6 Water Quality and Incentives

Above, we discussed how pricing, privatization, and markets can help improve water management by changing incentives. These incentives can also play an important role in managing and improving water quality. For example, selected privatization of wastewater management in urban areas can in some cases help hold down costs and improve our wastewater treatment. Much like the design and construction of water supply facilities, the private sector has played a major role in the design and construction or waste water treatment facilities. The private sector has also played an important role in installing storm drains and wastewater collection facilities.

Cities can make greater use of prices as a way to encourage firms to discharge less wastewater into the city sewage system. The price or charge would need to be based on the quantity and quality of water a firm discharges. The quantity-based charge would be similar to the ones discussed above for the purchase of city water and should be a constant, or increasing rate, per volume discharged. The quality-based charge would be a little more complicated, but should rise as the concentration of pollutants, such as phosphorous, nitrates, etc., increase. Many of the more toxic pollutants are banned. In Minnesota, the Metropolitan Council has a “strength charge” for waste water discharge based on total suspended solids, chemical oxygen demand, and volume discharged.

Markets could also help reduce the amount of pollutants discharged into our urban water ways. The United States, for example, has through regulation reduced point source pollution discharge of pollutants such as phosphorous and nitrates. Point sources are primarily factories, towns, and cities with small towns being the major point source still dumping raw sewage in our water bodies. As many as 100 small towns in Minnesota discharge raw sewage. We have had even less success in reducing the discharge of some of these same pollutants from nonpoint sources such as agriculture and urban runoff (nitrates and phosphorous).

It is possible that we can use market mechanisms, not only to reduce these nonpoint source pollutants but also to reduce the cost of pollution control in urban areas from point sources. So far, the use of markets to reallocate the right to discharge pollutants has been quite limited, but it is likely to grow in the future. The basic idea is to establish a set number of permits for key pollutants such as phosphorous, nitrates, etc., and not allow any water discharge containing those pollutants without a permit. The first step is to decide the maximum amount of a pollutant that can be discharged into a stream or river during a given period of time. Once this is established, permits can be issued and then allocated or sold to those discharging the pollutants. The maximum number of permits issued would be set to equal the maximum discharge allowance as determined by a public pollution control agency, such as the U.S. Environmental Pollution Control Agency (EPA) at the federal level, or the Minnesota Pollution Control Agency (MPCA) at the state level. The number of permits issued would be less than the amount of pollution being discharged. Consequently, those firms not obtaining enough permits to cover the amount they discharge would have to reduce their level of pollution discharge, unless they could buy more permits.

Thus, markets come in as a means to reduce the pollution load at the lowest possible cost by allowing firms to buy and sell permits (Hall and Raffini, 2005). Once the permits are made tradable, the firms with high pollution control costs will buy permits at a price below their cost of control while those with low costs of control will sell permits. Trading could also be done between point and nonpoint sources if stricter regulations were established for nonpoint sources, such as agriculture. Currently, there are only a few such point–nonpoint source trades since nonpoint sources do not have a strong incentive to participate. So far nonpoint sources have not been required to meet set discharge limits, primarily because of the large number of nonpoint source polluters and the difficulty of measuring and attributing actual discharges, which are highly dependant on rainfall events (Fang et al., 2005).

To illustrate how the market for pollution permits would work to reduce pollution control costs, let’s use the example of two firms discharging one pollutant, phosphorous, into the Minnesota River. The firm with the highest marginal cost (MC) of pollution control (emission reduction) is B while firm A has a lower MC (see Fig. 13.4). Assume each firm discharges 25 units of the pollutant into the river and that the pollution control agency wants total discharges to be only 25 units in total. This means there needs to be a reduction in discharge by 25 units. The first question is how should the 25 unit reduction be allocated between the two firms? Assume the two firms are about the same size and that for equity reasons both are required to cut discharges to 12.5 units. This will be quite costly for firm B (see Fig. 13.4). In contrast, firm A has a lower MC of reducing pollution levels and can do it more cheaply. The difference in cost with each firm emitting 12.5 units is the distance x–y in Fig. 13.4. This is where a market can help reduce the cost of pollution control. If firm A sells 2.5 pollution permits to firm B at a price above A’s MC of pollution control but below firm B’s MC of pollution control, both firms gain. Firm B now only has to reduce its pollution load by 10 units while firm A cuts its load by 15 units. Firm B now can discharge 15 units while firm A can only discharge 10 units of the pollutant. The only debate will be over the price of the permits. The last permit would sell at price z, where MC_B = MC_A and the cost of saving from the sale of 2.5 permits is equal to the area abc in Fig. 13.4. These cost savings from permit trading are savings of real resources that are no longer needed to meet the water quality standard (cut emission by 25 units) because pollution levels are reduced more cost-effectively.

Fig. 13.4

Permit trading for pollution control

13.7 Summary and Conclusions

What are some of the key ideas to remember from this chapter? First, economics provides those persons managing urban water utilities with some tools that can make them more effective in serving their customers. They will also find that as water scarcity increases, they will be called upon to make good use of these economic tools in demand management including the effective use of water pricing. Yet to really reduce per capita water use, utility managers may need to combine water pricing with other demand strategies, such as subsidies for the purchase of water conserving technology.

Privatization can be an effective way to change management incentives and raise the level of services provided by water utilities. As in the past, the private sector will continue to play a major role in the design and construction of new water treatment facilities. Furthermore, the private sector is likely to play a larger role in the day-to-day management of urban water utilities, particularly in small communities that want to take advantage of the cost savings provided by private management of selected management functions. The key point being that we need to unbundle the service utilities provided and determine where the private sector can provide cost savings and/or improved service.

Although water markets are not likely to be used to allocate water within most urban communities, they can help at the next level. Water markets can be a means through which urban areas obtain water supplies from other sectors such as agriculture. In areas where agriculture is currently consuming 80–85% of a region’s water, reallocating water to the urban sector may be the key to sustain urban water service. In most cases this reallocation will involve not more than 5–10% of agriculture’s water. The advantage of using water markets is that they compensate agricultural water users directly and can improve the allocation of water among farmers. However, the transfer must be closely monitored to make sure that there are no negative impacts on return flows in the area selling water. If there are, those being damaged will likely have to be compensated.