Paper 4 Water as an economic resource

J. T. Winpenny

Overseas Development Institute, London

Summary: The growing scarcity of water and the increasing environmental costs entailed by its provision, use and disposal are aggravated by a failure to treat it as an economic commodity. Traditional attitudes, based on supply-orientation and reliance on non-market controls, have contributed to the problem and cannot cope with the problems ahead. Although the obstacles are recognised, it is argued that what is needed is a combination of measures at three levels - the creation of enabling conditions, providing incentives and encouraging markets, and direct project interventions. Various suggestions are made for making the reforms more acceptable to the public.

Water as a commodity

Water may be a gift of nature but it is also a commodity. In the economic sense, this is a good or service exhibiting scarcity; unlimited amounts are not available at zero cost. Even where water is plentiful it has to be treated and distributed, and wastewater has to be safely disposed of. These activities use up economic resources. In many - perhaps most - countries at all stages of development, water is scarce and is rapidly getting scarcer. In many cases, the limits of existing supplies are being approached. More frequently, new supplies are only available at sharply increasing costs. In a recent review of projects in the water sector, the World Bank estimated that the cost of a unit of water from "the next project" was often two to three times the cost of a unit from the "current project" (Bhatia and Falkenmark, 1992). These costs are carried by water utilities and their sponsoring government agencies, the majority of which are in poor financial condition and unable to contemplate the large investments envisaged on current extrapolations: $ 10 billion is currently being invested annually in improving water supply and sanitation in developing countries. Even at current costs it would take five times this amount to provide universal reasonable services by the year 2000. Internal cash generation financed only 10% of the cost of World Bank-funded water projects in 1991 (World Bank, internal estimates).

The environmental costs of growing supply and consumption of water are mounting and in many quarters becoming unacceptable. The construction of dams and reservoirs, inter-basin water conveyances, the depletion of natural lakes, and the drawing-down and contamination of aquifers are all causing serious environmental concern. Many agencies have all but suspended aid for large hydro schemes and major water conveyance projects are coming under the closest scrutiny. Pollution from effluent, wastewater and sewage is another source of environmental cost from water use, in this case an 'externality' forced onto third parties. It amounts to using up the finite assimilative capacity of the aquatic environment, leaving none spare for other users and forcing high cost treatment on the public services. Alongside the mounting cost of supplying growing populations and servicing the rising proportion of urban dwellers is the large and growing backlog of services to the poor. Despite the achievements of the UN's Drinking Water and Sanitation Decade, over 1 billion people still lack access to safe water and 1.8 billion to proper sanitation (World Bank, 1992).

These symptoms all lead to water stress and user conflicts as interested parties contend for limited water supplies or for the preservation of threatened environments.

"..a large irrigation project in India does not operate because water has been diverted to the rapidly growing city of Pune. In China industries are having to reduce their production due to water shortages even though they are surrounded by paddy fields. In California selenium salts leached by irrigation are killing wildlife. [World] Bank irrigation projects in Algeria are now competing with Bank urban water supply projects for the same water, and many proposed irrigation projects and most hydro project proposals are on hold because of environmental concerns” (Rogers, unpublished).

Outmoded approaches to planning and provision

Water is universally scarce yet the majority of societies do not treat it as such. A commodity should be priced so as to cover its cost of production and to ration its use to those placing the highest value on it. Commodities are bought and sold in markets. Private agents are active in supply and distribution. In a well-functioning market, the benefit attached to the use of the marginal unit of the commodity (the last one to be sold) is the same for all consumers. These conditions are evidently not those in which water is supplied and used in most cases. The water sector is typified by supply-oriented provision, reluctance to make active use of pricing, allocation by non-economic means, the persisterce of low-value usage in important sectors, and the minor role played by private enterprise.

In most countries, the automatic response to water stress is to consider supply augmentation. The equivalent of the Hippocratic Oath for water engineers is to promise to meet all reasonable needs for water without question by enlarging and improving supplies. Prices are rarely used to allocate water supplies or to manage demand actively. Water pricing is usually seen purely as an aspect of cost recovery and in many cases (e.g. agriculture) does not even achieve that. The resulting paradox is that an increasingly scarce resource is subsidized, discouraging conservation or the reduction of waste. The average tariff in World Bank-financed water projects - probably a better-than average sample - is only about one-third the average incremental cost of supply. Most authorities respond to scarcity by non-price devices, such as rationing, prohibited uses, exhortation, or cutting-off supplies. Although these can be effective, they can also be costly and inconvenient to users, and do not take account of the relative value of water in different applications.

The benefits from using water typically vary widely from one sector to another as well as within sectors. Variations up to a factor of 10 or more are common in comparing the value of water for different uses within the industrial and agricultural sectors and similar differentials apply in comparing municipal and agricultural use values (Gibbons, 1986; Bhatia and Falkenmark, 1992). This is a sign that total benefit could be increased from reallocating supplies. Another sign of the under-development of markets is the minor role played by private enterprise in bulk supply and distribution. It is no accident that privatisation has made least headway in the water sector and, except in the UK, it has largely taken the form of concessions and management agreements rather than full-blooded ownership.

Why is a scarce resource underpriced and undervalued?

There are a number of reasons why water is not treated as other commodities and why water markets are so poorly developed. Why does water differ from electricity or bread?

· Customary attitudes are a primary obstacle in many cases. The idea that water is a gift of God is cited as an obstacle to pricing in some societies (it is less clear whether a dam, a treatment plant, a distribution pipe, or a tap are also due to divine providence). It is understandable that consumers used to getting free water from traditional, unimproved, sources (wells, streams) may resist paying for improved supplies, just as unmetered consumers resist paying proportionately for metered supplies. Whatever their justification, popular attitudes to water constitute a political hurdle to rational pricing. Because water is universally used, the inflationary effects of introducing pricing also need to be considered.

· The fact that water supply is in many circumstances a natural monopoly explains why public agencies are predominant. Difficulties of regulating private monopolies (e.g. in the UK) also account for the limited progress made by full privatisation. Public agencies can and do behave like private enterprises, but mostly don't. In general, water utilities fall far short of normal commercial behaviour.

· Institutions in the water sector have evolved to enable their employees to be rent seekers. Wholesaling water at below its market value to intermediaries and retailers is profitable to the parties involved (though not to the consumers reliant on vendors, who are amongst the poorest urban dwellers). The gains from monopoly power are shared in various anti-social ways. Transaction cost analysis has also produced insights into why the water sector resists market processes (Nickum and Easter, 1991). In certain towns in Ghana a political party extracts half the revenue from charges on the use of public toilets (Lovei and Whittington, 1991).

· Strong vested interests dependent on cheap water conspire to preserve the status quo. Irrigated agriculture and industries reliant on large volumes of water or cheap hydro-power can exercise great political influence.

· The physical barriers to developing a more integrated water market are often crucial. There may be no practical method of transferring water which is surplus to one sector - or used wastefully - to another which could make more economic use of it. In Beijing, surplus agricultural water would need to be collected from groundwater wells and pumped uphill to the city. This sets a limit on how much could be transferred (East-West Center, 1988).
· The physical barriers to the development of water markets are often underscored by legal obstacles, e.g. the existence of long-term entitlements to cheap water, ambiguity over the ownership of water, etc. The rights of third parties in water transfer cases is another consideration and, indeed, is a necessary part of recognising and 'internalising' environmental concerns into the transaction.

· Shifting water onto a more market-oriented basis entails transitional costs which can be heavy. Metering involves a heavy resource cost, which has to be weighed against expected water savings. Industries may need to spend sizeable amounts on recycling equipment or even introducing an entirely new water-efficient process. In households, campaigns to promote water-efficient devices are costly and time-consuming. Socially, ensuring the transfer of water from one sector to another may be disruptive (e.g. may lead to a decline in irrigated farm communities).

Notwithstanding the force of all the above factors, possibly the fundamental obstacle to treating water as a commodity is a lack of faith in the efficacy of economic instruments. It is widely believed that the price elasticity of demand is simply too low for water pricing to do an effective job in restraining demand and reallocating supplies.

Turning water into an economic resource

The interrelated problems described earlier call for action to recognise water as an economic (namely, scarce) resource, and to promote market-oriented reforms in the way it is supplied, used and disposed of. Action is called for at three levels: the creation of enabling conditions; setting incentives and promoting markets; and direct interventions and spending programmes (Winpenny, 1992).

Enabling conditions

In this context, the Enabling Environment comprises institutional and legal changes, the reform and privatisation of utilities, and sector-wide economic policies.

· Legal reforms may be necessary to remove ambiguities over the ownership of water and the conditions under which it can be transferred. Planning for the development of water resources - usually dominated by the projection of fixed 'requirements' and the inevitable rise of 'gaps' - needs to adapt to demand management and allow for the operation of markets and, even, the entry of private operators.

· Water utility reforms would require them to behave more like commercial undertakings. This will require them to adopt more active pricing, metering and tariff restructuring, improved cost-recovery, and greater self-finanang. This will often entail managerial and organisational reforms. Drawing up corporate plans ('con/rats-plans') with the government has been shown to be useful in some cases. Privatisation is appropriate in some instances, though it can take many forms and full private ownership is an extreme - and rare - variant. The French model of concessions and lease contracts has influenced a number of developing countries, e.g. Morocco, Cote d'Ivoire, Guinea, Thailand and Malaysia. Regulated private companies also operate in Santiago de Chile and Guatemala City (Roth, 1987).

The best intentioned and designed reforms in the water sector will be frustrated if key economic signals prove to be countervailing. The more rational pricing of irrigation water will be negated by artificially high farm-support prices. Penalising wasteful industrial water use by pricing and effluent charges will be nullified by high protection on the output of heavy industry and 'soft' budget constraints enabling parastatals to pass on increased water charges and fines to their sponsoring ministries. Hence in those countries where water is becoming the scarce factor of production, action in the water sector should be consistent with other key economic signals.

Incentives, market creation and non-market inducements

The permissive effects of enabling conditions may be sharpened by the creation of incentives for the more rational use of water. These may be positive or negative, market or non-market. They will be categorized below as: tariffs; pollution charges; water markets; and non-market inducements.

Tariffs: Although water tariffs are in widespread use in countries at all stages of development, they are usually seen as a means of cost recovery rather than a way of actively managing demand. The principles of economic tariff setting are well established and accepted, and are similar to those in use in the power sector. They can be summarized as setting prices according to Long Run Marginal Costs. This usually entails adjusting the structure of tariffs to include a fixed and variable element, with the latter rising for successive increments ('progressivity'). There is evidence of enough elasticity of demand in the household sector to make tariffs an effective instrument for water demand management. A consensus is emerging from a variety of empirical studies that the price elasticity of demand for water by households falls in the range -0.3 to -0.7, implying that a 10% increase in prices leads to a fall in demand of between 3% and 7%. (Boland, 1991; OECD, 1987; Gibbons, 1986).

A pre-condition of economic tariffs is metering which is not always feasible or sensible. It is also difficult to apply to groundwater users - though there may be good environmental reasons for levying some charge on groundwater extraction.

Pollution charges: Setting economic charges for water may also be the best way of discouraging industrial water pollution by penalising excessive water intake. For example, in two private Indian fertilizer companies of a similar size, the one paying a high price for its municipal water achieved a unit water consumption per tonne of nutrient production only 40% of that in the other company, which depended partly on its own wells and partly on low-priced public supplies (Gupta and Bhatia, Unpublished).

The application of pollution charges proportional to the volume and quality of effluent is more rare, but has been shown to be effective in reducing water intake as well as discharge. In three industries in Sao Paulo, Brazil, the introduction of an effluent charge led within two years to a 40 60% reduction in water consumption (Miglino, 1984).

Water markets: There are various types of water markets. Their common feature is that water can be bought and sold, thus enabling it to find its highest value use. Groundwater markets are long established and widespread in certain parts of the Asian sub-Continent, e.g. Gujerat, Bangladesh. Farmers sell water surplus to their requirements to those in deficit. Surface-water markets exist in some Western states of the USA and Eastern, Australia, principally to transfer water from low-value irrigated farming to urban consumers. Sometimes the transfers are semipermanent arrangements, e.g. the efforts of the Los Angeles MWA to acquire long-term water rights from its agricultural neighbours.

Less well-known are the fledgling industrial water markets in India, whose existence depends on growing supply uncertainty and/or higher costs, together with variations between companies in the feasibility and cost of tertiary treatment of wastewater. In Jamshedpur, India, an integrated steel plant (TISCO) sells water at cost to other Tata firms in the area, as well as to a Birla subsidiary (Bhatia et al., In press).

Water auctions, although unusual, are well-established in parts of Spain and have been tried in Australia. Water banking has also been tried: as a response to the recent drought, the state of California bought up water rights to farmers to hold in reserve for urban and industrial use (and most of the stock was drawn down for these purposes).

Non market inducements: Despite the emphasis in this paper on the value of economic instruments in managing water resources there will always be a role for non-market devices, often working in tandem with economic measures. Education and publicity campaigns can help to convert the public to the need for water conservation, though the message will be powerfully underlined by the use of tariffs. In water pollution, some contaminants are so dangerous that they should be banned - pollution charges are not enough. The only feasible response to shortterm emergencies may be to ration supplies and ban wasteful uses.

In authoritarian societies the combination of prescriptive norms, approximating 'best practice' or reasonable usage in each case, and penal charges for users exceeding these norms, can be effective. In Tianjin, China, for example, norms are set for industrial consumers based on regular detailed water audits, and users who exceed their quotas pay a penal water charge of up to 50% the normal level (Bhatia et al., In press).

Direct interventions and projects

The lowest level of the tier consists of direct intervention by the government or water utility to bring about the necessary conservation without further ado. This category of measure usually entails public spending and absorbs administrative and technical resources. Many of these interventions can be thought of as projects. Examples include: canal lining; programmes to reduce unaccounted-for-water (UFW); and the dissemination of improved household appliances. For public enterprises, the analogous action would be spending on recycling equipment.

Overcoming the objections; the art of reforming the water sector

It is safe to predict that turning water into a commodity will be controversial and call upon every ounce of a government's goodwill with its citizens. Governments should, however, seek every opportunity to remind their citizens of the alternative - which in many cases will be a grim scenario of growing and eventually disastrous water stress.

The following can facilitate public acceptance of the necessary reforms:

· Exploit complementarities and create synergy between the different elements in a reform programme; create virtuous circles

The profitability of UFW programmes is increased if tariffs are set at realistic levels. Consumers will more readily espouse water-efficient appliances if tariffs are at economic levels. Consumers will be more ready to pay higher tariffs if they see evidence of improved services. Industrialists are more ready to pay pollution fines and charges if the funds are earmarked for visible environmental clean-ups. A vigorous public campaign stressing the value of water and the dire consequences of allowing present trends to continue should form part of any reform programme.

· Create gainers as well as losers

The most effective way of doing this is to promote water markets. Farmers who decide to sell their water instead of using it on low-value crops are doing themselves, as well as society, a favour. There are many interests to be mobilised in favour of pollution penalties and reduced industrial water use: one firm's effluent is someone else's intake.

· Make the reforms socially equitable

In developing countries the poor are among the worst victims of existing systems. They regularly pay prices per unit for their water (from private vendors) many times higher than those paid by wealthier people with their own connections. Any reform that raises charges, improves cost recovery and generates funds for expanding and improving the system promises to be socially equitable, even if charges to piped consumers are raised. The structure of tariffs can further promote distributional goals by offering low 'lifeline' rates for minimum levels of consumption.

· Exploit environmental benefits

The better management of demand will postpone, or even obviate, the need for investment in new supply - with its attendant environmental costs. Reduced water stress will also alleviate user conflicts - between municipalities and farmers, power utilities and fishermen, industrial polluters and recreationists, as well as between nations. A reformed water sector confers environmental, as well as economic and financial, bonuses.

· Enlist private resources

Government has dominated the planning, supply, distribution and disposal of water. This has happened for a mixture of motives, both noble and ignoble. Outright privatisation is not feasible or even desirable in every case, though it is a way of deflecting heavy future costs - and public obloquy - onto the private sector (e.g. the UK). Privatisation stopping short of a transfer of ownership (e.g. concessions, management contracts, contracting out) can combine the advantages of public ownership with private management. The more active use of tariffs and effluent charges will encourage many more firms to invest in conservation and recycling, leaving less of a disposal problem for the public agency. Promoting water markets and raising tariffs decentralises the task of matching demand with supply, and mobilises every party behind solving the problem. Nothing less would seem to suffice.

References

BHATIA, R., CESTTI, R. and WINPENNY, J. (In press) Policies for Water Conservation and Reallocation: Good Practice Cases in Improving Efficiency and Equity. World Bank.

BHATIA, R. and FALKENMARK, M. (1992) Water resource policies and urban poor: innovative thinking and policy imperatives. Paper presented to the Dublin International Conference on Water and the Environment, January 1992.

BOLAND, J. (1991) Legislative and Economic Approaches to Water Demand Management. United Nations, New York.

EAST-WEST CENTER (1988) Water Resources Policy and Management for the Beijing-Tianjin Region. Joint Summary Report of the Chinese and East-West Center study teams. Honolulu, Hawaii.

GIBBONS, D. C. (1986) The Economic Value of Water. Resources for the Future. Washington, DC.

GUPTA, D. B. and BHATIA, R. (Unpublished) Water Conservation through Pricing and Pollution Control: a Case Study of Two Fertilizer Plants in India. Unpublished paper.

LOVEI, L. and WHITTINGTON, D. (1991) Rent Seeking in Water Supply. Discussion Paper, Report INU 85, Infrastructure and Urban Development Department, World Bank, Washington, DC.

MIGLINO, L. C. (1984) Industrial Wastewater management in Metropolitan Sao Paulo. PhD Thesis, Harvard University.

NICKUM, J. and EASTER, W. (1991) The Application of Transaction Cost Economics to Asian-Pacific Metropolitan Water Use Issues. Regional Development Dialogue, 12/4, Winter.

OECD (1987) Pricing of Water Services. Organisation for Economic Co-operation and Development, Paris.

ROGERS, P. (Unpublished) Concept Paper for World Bank Comprehensive Water Resources Management Policy Paper. Harvard University. July 19.

ROTH, G. (1987) The Private Provision of Public Services in Developing Countries. World Bank/Oxford University Press.

WINPENNY, J. T. (1992) Where No Water Is: the Economic Management of a Scarce Resource. A Development Policy Study, Overseas Development Institute, London (For publication late 1992).

WORLD BANK (1992) World Development Report, 1992, Development and the Environment.

Discussion

In response to a question on poverty alleviation, it was said that studies had shown a willingness on the part of the poor to pay for water supply. This seems surprising, but they would save a lot compared to buying from water vendors. So projects should look at wider coverage and fewer public standpipes. Customary attitudes to water supply are exaggerated as an obstacle, particularly by politicians. There are plenty of examples of supposed taboos being broken. It was pointed out that in California and Israel, water is very highly subsidised but very efficiently used. At the other extreme, in Bangladesh, farmers cannot even pay the cost of meters, let alone water. Models of water resources management were discussed; the privatised British water industry was compared with the French system, where ownership is retained but the market opened up; companies bid to manage. This does not throw up the problems of regulation which the UK has acquired. The ancient Roman system was also discussed; but it was suggested that these systems had deleterious environmental effects in the Middle East. It has been observed that subsidised water for farmers is a way of making farmers think that the government cares for them. In discussion it was said that, increasingly, resources are concentrating on the cities; this provides the dynamic for many of the problems which we see (despite the political weight of farmers). Raising the price of water to farmers would create food insecurity. But Egypt, for instance, is wasting precious water on low-productivity outlets. In addition, there was comment on the horrifyingly high percentage of water supply systems now out of use; this shows both lack of consultation and a failure to think through cost recovery.