Category Archives: Water resources management

How to allocate our scarce most precious resource

David Mitchell in the LA Times: As drought drives prices higher, millions of Californians struggle to pay for water

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M.Cubed Partner David Mitchell was interviewed for an article on rising residential water rates in California in this October 24 article:

Across the state, water utility prices are escalating faster than other “big ticket” items such as college tuition or medical costs, according to David Mitchell, an economist specializing in water.

“Cost containment is going to become an important issue for the sector in the coming years” as climate change worsens drought and water scarcity, he said.

The price of water on the Nasdaq Veles California Water Index, which is used primarily for agriculture, hit $1,028.86 for an acre-foot on Oct. 20 — a roughly 40% increase since the start of the year. An acre-foot of water, or approximately 326,000 gallons, is enough to supply three Southern California households for a year.

Mitchell said there are short- and long-term factors contributing to rising water costs.

Long-term factors include the replacement of aging infrastructure, new treatment standards, and investments in insurance, projects and storage as hedges against drought.

In the short term, however, drought restrictions play a significant role. When water use drops, urban water utilities — which mostly have fixed costs — earn less revenue. They adjust their rates to recover that revenue, either during or after the drought.

“So it’s not right now a pretty picture,” Mitchell said.

David Mitchell’s practice areas include benefit-cost analysis, regional economic impact assessment, utility rate setting and financial planning, and natural resource valuation. Mr. Mitchell has in-depth knowledge of the water supply, water quality and environmental management challenges confronting natural resource management agencies.

That California owns its water doesn’t mean that the state can just take it back without paying for it

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The researchers at the UC Davis Center for Watershed Sciences wrote an insightful blog on “Considerations for Developing An Environmental Water Right in California.” However one passage jumped out at me that has troubling economic implications:

The potential for abuse is particularly troubling when the State is using public funds to buy water, which technically belongs to the people of the state and which the State can already regulate to achieve the same aims.

It’s not helpful to refer to the fiction that the somehow the state can award water rights, on which entities make economic investments based on private uses, and then turn around and try to claim that the state can just take those rights back without any compensation. That’s a foolish perspective that will lead mispricing and misallocation of water use. It is reasonable to assert that the state can claim a right of first refusal on transactions or even that a rights holder can’t withhold sale of a water right to the state, but in either case, the rights holder does receive compensation. The state’s right can easily be interpreted as that of a landlord who has a long term lease agreement with a tenant, and the tenancy agreement can be terminated with compensation to that tenant.

Considerations for designing groundwater markets

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The California Water Commission staff asked a group of informed stakeholders and experts about “how to shape well-managed groundwater trading programs with appropriate safeguards for communities, ecosystems, and farms.” I submitted the following essay in response to a set of questions.

In general, setting up functioning and fair markets is a more complex process than many proponents envision. Due to the special characteristics of water that make location particularly important, water markets are likely to be even more complex, and this will require more thinking to address in a way that doesn’t stifle the power of markets.

Anticipation of Performance

  1. Market power is a concern in many markets. What opportunities or problems could market power create for overall market performance or for safeguarding? How is it likely to manifest in groundwater trading programs in California?

I was an expert witness on behalf of the California Parties in the FERC Energy Crisis proceeding in 2003 after the collapse of California’s electricity market in 2000-2001. That initial market arrangement failed for several reasons that included both exploitations of traits of internal market functions and limitations on outside transactions that enhanced market power. An important requirement that can mitigate market power is the ability to sign long-term agreements that then reduces the amount of resources that are open to market manipulation. Clear definitions of resource accounting used in transactions is a second important element. And lowering transaction costs and increasing liquidity are a third element. Note that confidentiality has not prevented market gaming in electricity markets.

Groundwater provides a fairly frequent opportunity for exploitation of market power with recurrence of dry and drought conditions. The analogy for electricity is during peak load conditions. Prices in the Texas ERCOT market went up 30,000 fold last February during such a shortage. Droughts in California happen more frequently than freezes in Texas.

The other dimension is that often a GSA has a concentration of a small number of property owners. This small concentration eases the ability to manipulate prices even if buyers and sellers are anonymous. This situation is what led to the crisis in the CAISO market. (I was able beforehand to calculate the minimum generation capacity ownership required to profitably manipulate prices, and it was an amount held by many of the merchant generators in the market.) Those larger owners are also the ones most likely to have the resources to participate in certain types of market designs due to higher transaction costs that act as barriers.

2. Given a configuration of market rules, how well can impacts to communities, the environment, and small farmers be predicted?

The impacts can be fairly well assessed with sufficient modeling with inclusion of three important pieces of information. The first is a completely structured market design that can be tested and modeled. The second is a relatively accurate assessment of the costs of individuals entities to participate in such a market. And the third is modelling the variation in groundwater depth to assess the likelihood of those swings exceeding current well depths for these groups.

Safeguards

3. What rules are needed to safeguard these water users? If not through market mechanisms directly, how could or should these users be protected?

These groups should not participate in shorter term groundwater trading markets such as for annual allocations unless they proactively elect to do so. They are unlikely to have the resources to participate in an usefully informed way. Instead, the GSAs should carve allocations out of the sustainable yields that are then distributed in any number of methods that include bidding for long run allocations as well as direct allowances.

For tenant farmers, restrictions on landlords’ participation in short-term markets should be implemented. This can be specified either through quantity limits, long term contracting requirements or time windows for guaranteed supplies to tenants that match with lease terms.

4. What other kinds of oversight, monitoring, and evaluation of markets are needed to safeguard? Who should perform these functions?

These markets will likely require oversight to prevent market manipulation. Instituting market monitors akin to those who now oversee the CAISO electricity and the CARB GHG Allowance auctions is potential approach. The state would most likely be the appropriate institution to provide this service. The functions for those monitors are well delineated by those other agencies. The single most important requirement for this function is a clear authority and willingness to enforce meaningful actions as a consequence of violations.

5. Groundwater trading programs could impact markets for agricultural commodities, land, labor, or more. To what degree could the safeguards offered by groundwater trading programs be undermined through the programs’ interactions with other markets? How should other markets be considered?

These interactions among different markets are called pecuniary externalities, and economists consider these as intended consequences of using market mechanisms to change behavior and investments across markets. For example, establishing prices for groundwater most likely will change both cropping decisions and irrigation practices, which in turn will impact both equipment and service dealers and labor. Safeguards must be established in ways that do not directly affect these impacts—to do otherwise defeats the very purpose of setting up markets in the first place. People will be required to change from their current practices and choices as a result of instituting these markets.

Mitigation of adverse consequences should account for catastrophic social outcomes to individuals and businesses that are truly outside of their control. SGMA, and associated groundwater markets, are intended to create economic benefits for the larger community. A piece often missing from the social benefit-cost assessment that leads to the adoption of these programs is compensation to those who lose economically from the change. For example, conversion from a labor intensive crop to a less water intensive one could reduce farm labor demand. Those workers should be paid compensation from a public pool of beneficiaries.

6. Should safeguarding take common forms across all of the groundwater trading programs that may form in California? To the degree you think it would help, what level of detail should a common framework specify?

Localities generally do not have either the resources, expertise or sufficient incentives to manage these types of safeguards. Further the safeguards should be relatively uniform across the region to avoid creating inadvertent market manipulation opportunities among different groundwater markets. (That was one of the means of exploiting CAISO market in 2000-01.) The level of detail will depend on other factors that can be identified after potential market structures are developed and a deeper understanding is prepared.

7. Could transactions occurring outside of a basin or sub-basin’s groundwater trading program make it harder to safeguard? If so, what should be done to address this?

The most important consideration is the interconnection with surface water supplies and markets. Varying access to surface water will affect the relative ability to manipulate market supplies and prices. The emergence of the NASDAQ Veles water futures market presents another opportunity to game these markets.

Among the most notorious market manipulation techniques used by Enron during the Energy Crisis was one called “Ricochet” that involved sending a trade out of state and then returning down a different transmission line to create increased “congestion.” Natural gas market prices were also manipulated to impact electricity prices during the period. (Even the SCAQMD RECLAIM market may have been manipulated.) It is possible to imagine a similar series of trades among groundwater and surface water markets. It is not always possible to identify these types of opportunities and prepare mitigation until a full market design is prepared—they are particular to situations and general rules are not easily specified.

Performance Indicators and Adaptive Management

8. Some argue that market rules can be adjusted in response to evidence a market design did not safeguard. What should the rules for changing the rules be?

In general, changing the rules for short term markets, e.g., trading annual allocations, should be relatively easy. Investors should not be allowed to profit from market design flaws no matter how much they have spent. Changes must be carefully considered but they also should not be easily impeded by those who are exploiting those flaws, as was the case in fall of 2000 for California’s electricity market.

Why Californians aren’t meeting the state’s call for more water conservation

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Governor Gavin Newsom called for a voluntary reduction in water use of 15% in July in response to the second year of a severe drought. The latest data from the State Water Resources Control Board showed little response on the part of the citizenry and the media lamented the lack of effort. However, those reports overlooked a major reason for a lack of further conservation.

The SWRCB conservation reports data shows that urban Californians are still saving 15% below the 2013 benchmark used in the last drought. So a call for another 15% on top of that translates to a 27% reduction from the same 2013 baseline. Californian’s have not heard that this drought is worse than 2015 yet the state is calling for a more drastic overall reduction. Of course we aren’t seeing an even further reduction without a much stronger message.

In 2015 to get to a 25% reduction, the SWRCB adopted a set of regulations with concomitant penalties which pretty much achieved the intended target. But that effort required a combination of higher rates and increased expenditures by water agencies. It will take a similar effort to move the needle again.

California’s water futures market slow to rise as it may not be meeting the real need

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I wrote about potential problems with the NASDAQ Veles California Water Index futures market. The market is facing more headwinds as farmers are wary of participating in the cash-only markets that does not deliver physical water.

Their reluctance illustrates a deeper problem with the belief in and advocacy for relying on short-run markets to finance capital intensive industries. The same issue is arising in electricity where a quarter-century experiment has been running on whether hourly energy-only markets can deliver the price signals to maintain reliability and generate clean energy. The problem is making investment decisions and financing those investments rely on a relatively stable stream of costs and revenues. Some of that can be fixed through third-party contracts and other financial instruments but the structures of the short term markets are such that entering or exiting can influence the price and erode profits.

In the case of California Water Index futures market, the pricing fails to recognize an important different between physical and financial settlement of water contracts: water applied this year also keeps crops, particularly permanent ones such as orchards and vineyards, viable for next year and into the future. In other words, physical water delivers multi-year benefits while a financial transaction only addresses this year’s cashflow problem. The farmer still faces the problem of how to get the orchard to the next year.

Whether a financial cash-settlement only futures market will work is still an open question, but farmers are likely looking for a more direct solution to keeping their farming operations viable in the face of greater volatility in water supplies.

A new agricultural electricity use forecast method holds promise for water use management

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Agricultural electricity demand is highly sensitive to water availability. Under “normal” conditions, the State Water Project (SWP) and Central Valley Project (CVP), as well as other surface water supplies, are key sources of irrigation water for many California farmers. Under dry conditions, these water sources can be sharply curtailed, even eliminated, at the same time irrigation requirements are heightened. Farmers then must rely more heavily on groundwater, which requires greater energy to pump than surface water, since groundwater must be lifted from deeper depths.

Over extended droughts, like between 2012 to 2016, groundwater levels decline, and must be pumped from ever deeper depths, requiring even more energy to meet crops’ water needs. As a result, even as land is fallowed in response to water scarcity, significantly more energy is required to water remaining crops and livestock. Much less pumping is necessary in years with ample surface water supply, as rivers rise, soils become saturated, and aquifers recharge, raising groundwater levels.

The surface-groundwater dynamic results in significant variations in year-to-year agricultural electricity sales. Yet, PG&E has assigned the agricultural customer class a revenue responsibility based on the assumption that “normal” water conditions will prevail every year, without accounting for how inevitable variations from these circumstances will affect rates and revenues for agricultural and other customers.

This assumption results in an imbalance in revenue collection from the agricultural class that does not correct itself even over long time periods, harming agricultural customers most in drought years, when they can least afford it. Analysis presented presented by M.Cubed on behalf of the Agricultural Energy Consumers Association (AECA) in the 2017 PG&E General Rate Case (GRC) demonstrated that overcollections can be expected to exceed $170 million over two years of typical drought conditions, with the expected overcollection $34 million in a two year period. This collection imbalance also increases rate instability for other customer classes.

Figure-1 compares the difference between forecasted loads for agriculture and system-wide used to set rates in the annual ERRA Forecast proceedings (and in GRC Phase 2 every three years) and the actual recorded sales for 1995 to 2019. Notably, the single largest forecasting error for system-wide load was a sales overestimate of 4.5% in 2000 and a shortfall in 2019 of 3.7%, while agricultural mis-forecasts range from an under-forecast of 39.2% in the midst of an extended drought in 2013 to an over-forecast of 18.2% in one of the wettest years on record in 1998. Load volatility in the agricultural sector is extreme in comparison to other customer classes.

Figure-2 shows the cumulative error caused by inadequate treatment of agricultural load volatility over the last 25 years. An unbiased forecasting approach would reflect a cumulative error of zero over time. The error in PG&E’s system-wide forecast has largely balanced out, even though the utility’s load pattern has shifted from significant growth over the first 10 years to stagnation and even decline. PG&E apparently has been able to adapt its forecasting methods for other classes relatively well over time.

The accumulated error for agricultural sales forecasting tells a different story. Over a quarter century the cumulative error reached 182%, nearly twice the annual sales for the Agricultural class. This cumulative error has consequences for the relative share of revenue collected from agricultural customers compared to other customers, with growers significantly overpaying during the period.

Agricultural load forecasting can be revised to better address how variations in water supply availability drive agricultural load. Most importantly, the final forecast should be constructed from a weighted average of forecasted loads under normal, wet and dry conditions. The forecast of agricultural accounts also must be revamped to include these elements. In addition, the load forecast should include the influence of rates and a publicly available data source on agricultural income such as that provided by the USDA’s Economic Research Service.

The Forecast Model Can Use An Additional Drought Indicator and Forecasted Agricultural Rates to Improve Its Forecast Accuracy

The more direct relationship to determine agricultural class energy needs is between the allocation of surface water via state and federal water projects and the need to pump groundwater when adequate surface water is not available from the SWP and federal CVP. The SWP and CVP are critical to California agriculture because little precipitation falls during the state’s Mediterranean-climate summer and snow-melt runoff must be stored and delivered via aqueducts and canals. Surface water availability, therefore, is the primary determinant of agricultural energy use, while precipitation and related factors, such as drought, are secondary causes in that they are only partially responsible for surface water availability. Other factors such as state and federal fishery protections substantially restrict water availability and project pumping operations greatly limiting surface water deliveries to San Joaquin Valley farms.

We found that the Palmer Drought Stress Index (PDSI) is highly correlated with contract allocations for deliveries through the SWP and CVP, reaching 0.78 for both of them, as shown in Figure AECA-3. (Note that the correlation between the current and lagged PDSI is only 0.34, which indicates that both variables can be included in the regression model.) Of even greater interest and relevance to PG&E’s forecasting approach, the correlation with the previous year’s PDSI and project water deliveries is almost as strong, 0.56 for the SWP and 0.53 for the CVP. This relationship can be seen also in Figure-3, as the PDSI line appears to lead changes in the project water deliveries. This strong relationship with this lagged indicator is not surprising, as both the California Department of Water Resources and U.S. Bureau of Reclamation account for remaining storage and streamflow that is a function of soil moisture and aquifers in the Sierras.

Further, comparing the inverse of water delivery allocations, (i.e., the undelivered contract shares), to the annual agricultural sales, we can see how agricultural load has risen since 1995 as the contract allocations delivered have fallen (i.e., the undelivered amount has risen) as shown in Figure-4. The decline in the contract allocations is only partially related to the amount of precipitation and runoff available. In 2017, which was among the wettest years on record, SWP Contractors only received 85% of their allocations, while the SWP provided 100% every year from 1996 to 1999. The CVP has reached a 100% allocation only once since 2006, while it regularly delivered above 90% prior to 2000. Changes in contract allocations dictated by regulatory actions are clearly a strong driver in the growth of agricultural pumping loads but an ongoing drought appears to be key here. The combination of the forecasted PDSI and the lagged PDSI of the just concluded water year can be used to capture this relationship.

Finally, a “normal” water year rarely occurs, occurring in only 20% of the last 40 years. Over time, the best representation of both surface water availability and the electrical load dependent on it is a weighted average across the probabilities of different water year conditions.

Proposed Revised Agricultural Forecast

We prepared a new agricultural load forecast for 2021 implementing the changes recommended herein. In addition, the forecasted average agricultural rate was added, which was revealed to be statistically valid. The account forecast was developed using most of the same variables as for the sales forecast to reflect similarities in drivers of both sales and accounts.

Figure-5 compares the performance of AECA’s proposed model to PG&E’s model filed in its 2021 General Rate Case. The backcasted values from the AECA model have a correlation coefficient of 0.973 with recorded values,[1] while PG&E’s sales forecast methodology only has a correlation of 0.742.[2] Unlike PG&E’s model almost all of the parameter estimates are statistically valid at the 99% confidence interval, with only summer and fall rainfall being insignificant.[3]

AECA’s accounts forecast model reflects similar performance, with a correlation of 0.976. The backcast and recorded data are compared in Figure-6. For water managers, this chart shows how new groundwater wells are driven by a combination of factors such as water conditions and electricity prices.

The State Water Board needs to act to start Flood MAR pilot projects

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I recently presented to CDWR’s Lunch-MAR group the findings for a series of studies we conducted on the universe of benefits from floodwater managed aquifer recharge (MAR) and the related economic and financing issues. I also proposed that an important next step is to run a set of pilots to study the acceptability of on-farm floodwater recharge projects to growers, including how do they respond to incentives and program design, and what are the potential physical consequences.

The key to initiating these pilots is getting a clear declaration from the State Water Resources Control Board that excess floodwaters are surplus and available. Unfortunately, the Water Board has not provided sufficient clarification on how these projects can take “advantage of seasonal or occasional flood waters that overtop the banks of a stream and are then directed into a designated recharge area.” Instead, the Board’s website says that such diverted floodwaters cannot be stored for future beneficial use–which obviates the very purpose of retaining the floodwaters in the first place.

The Board should be at least issuing temporary use permits for floodwaters above certain designated levels as being available for pilot projects on the basis that non-use of those floodwaters constitute a surrender of that right for the year. Then those agencies interested in flood MAR can design projects to experiment with potential configurations.

Is the NASDAQ water futures market transparent enough?

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Futures markets are settled either physically with actual delivery of the contracted product, or via cash based on the difference in the futures contract price and the actual purchase price. The NASDAQ Veles California Water Index future market is a cash settled market. In this case, the “actual” price is constructed by a consulting firm based on a survey of water transactions. Unfortunately this method may not be full reflective of the true market prices and, as we found in the natural gas markets 20 years ago, these can be easily manipulated.

Most commodity futures markets, such at the crude oil or pork bellies, have a specific delivery point, such as Brent North Sea Crude or West Texas Intermediate at Cushing, Oklahoma or Chicago for some livestock products. There is also an agreed upon set of standards for the commodities such as quality and delivery conditions. The problem with the California Water Index is that these various attributes are opaque or even unknown.

Two decades ago I compiled the most extensive water transfer database to date in the state. I understand the difficulty of collecting this information and properly classifying it. The bottom line is that there is not a simple way to clearly identify what is the “water transfer price” at any given time.

Water supplied for agricultural and urban water uses in California has many different attributes. First is where the water is delivered and how it is conveyed. While water pumped from the Delta gets the most attention, surface water comes from many other sources in the Sacramento and San Joaquin Valleys, as well as from the Colorado River. The cost to move this water greatly varies by location ranging from gravity fed to a 4,000 foot lift over the Tehachapis.

Second is the reliability and timing of availability. California has the most complex set of water rights in the U.S. and most watersheds are oversubscribed. A water with a senior right delivered during the summer is more valuable than a junior right delivered in the winter.

Third is the quality of the water. Urban districts will compete for higher quality sources, and certain agricultural users can use higher salinity sources than others.

A fourth dimension is that water transfers are signed for different periods and delivery conditions as well as other terms that directly impact prices.

All of these factors lead to a spread in prices that are not well represented by a single price “index”. This becomes even more problematic when a single entity such as the Metropolitan Water District enters the market and purchases one type of water which they skews the “average.” Bart Thompson at Stanford has asked whether this index will reflect local variations sufficiently.

Finally, many of these transactions are private deals between public agencies who do not reveal key attributes these transfers, particularly price, because there is not an open market reporting requirement. A subsequent study of the market by the Public Policy Institute of California required explicit cooperation from these agencies and months of research. Whether a “real time” index is feasible in this setting is a key question.

The index managers have not been transparent about how the index is constructed. The delivery points are not identified, nor are the sources. Whether transfers are segmented by water right and term is not listed. Whether certain short term transfers such as the State Water Project Turnback Pool are included is not listed. Without this information, it is difficult to measure the veracity of the reported index, and equally difficult to forecast the direction of the index.

The housing market has many of these same attributes, which is one reason why you can’t buy a house from a central auction house or from a dealer. There are just too many different dimensions to be considered. There is housing futures market, but housing has one key difference from the water transfer market–the price and terms are publicly reported to a government agency (usually a county assessor). Companies such as CoreLogic collect and publish this data (that is distributed by Zillow and Redfin.)

In 2000, natural gas prices into California were summarized in a price index reported by Natural Gas Intelligence. The index was based a phone survey that did not require verification of actual terms. As part of the electricity crisis that broke that summer, gas traders found that they could manipulate gas prices for sales to electricity generators higher by simply misreporting those prices or by making multiple sequential deals that ratcheted up the price. The Federal Energy Regulatory Commission and Commodity Futures Trading Commission were forced to step in and establish standards for price reporting.

The NASDAQ Veles index has many of the same attributes as the gas market had then but perhaps with even less regulatory protections. It is not clear how a federal agency could compel public agencies, including the U.S. Bureau of Reclamation, to report and document prices. Oversight of transactions by water districts is widely dispersed and usually assigned to the local governing board.

Trying to introduce a useful mechanism to this market sounds like an attractive option, but the barriers that have impeded other market innovations may be too much.

“What are public benefits of conveyance?” presented to the California Water Commission

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Maven’s Notebook posted a summary of presentations to the California Water Commission by Richard McCann of M.Cubed, Steve Hatchett of Era Economics, and David Sunding of the Brattle Group. Many of my slides are included.

The Commission is developing a framework that might be used to identify how shares of conveyance costs might be funded by the state of California. The Commission previously awarded almost $3 billion in bond financing for a dozen projects under the Proposition 1B Water Storage Investment Program (WSIP). That process used a prescribed method including a Technical Guide that determined the eligible public benefits for financing by the state. M.Cubed supported the application by Irvine Ranch Water District and Rio Bravo-Rosedale Water Storage District for the Kern Fan water bank.

How to choose a water system model

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The California Water & Environmental Modeling Forum (CWEMF) has proposed to update its water modeling protocol guidance, last issued in 2000. This modeling protocol applies to many other settings, including electricity production and planning (which I am familiar with). I led the review of electricity system simulation models for the California Energy Commission, and asked many of these questions then.

Questions that should be addressed in water system modeling include:

  • Models can be used for either short-term operational or long term planning purposes—models rarely can serve both masters. The model should be chosen for its analytic focus is on predicting with accuracy and/or precision a particular outcome (usually for short term operations) or identifying resilience and sustainability.
  • There can be a trade off between accuracy and precision. And focusing overly so on precision in one aspect of a model is unlikely to improve the overall accuracy of the model due to the lack of precision elsewhere. In addition, increased precision also increases processing time, thus slowing output and flexibility.
  • A model should be able to produce multiple outcomes quickly as a “scenario generator” for analyzing uncertainty, risk and vulnerability. The model should be tested for accuracy when relaxing key constraints that increase processing time. For example, in an electricity production model, relaxing the unit commitment algorithm increased processing speed twelve fold while losing only 7 percent in accuracy, mostly in the extreme tail cases.
  • Water models should be able to use different water condition sequences rather than relying on historic traces. In the latter case, models may operate as though the future is known with certainty.
  • Water management models should include the full set of opportunity costs for water supply, power generation, flood protection and groundwater pumping. This implies that some type of linkage should exist between these types of models.