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

By Wayne Lusvardi and Charles Warren -- February 20, 2014

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

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

KERN & KINGS COUNTY FARMS PAID 100% for their State Water Allocation but only received 35% in 2008 40% in 2009 50% in 2010 0% in 2014 updated Farmers Lost Over $200 million on Water Not Delivered! (up to 2010) WaterForAll.com – Families Protecting the (Central) Valley.com

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

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

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

Where Water Goes in California	Wet Year (1998)	Average Year (2000)	Dry Year (2001)
Urban Uses	7.7 MAF (8%)	8.8 MAF (11%)	8.6 MAF (13%)
Agricultural Uses	27.7 MAF (28%)	34.3 MAF (42%)	34.1 MAF (52%)
Environmental Water	62.1 MAF (64%)	39.4 MAF (47%)	22.4 MAF (35%)
Source: California Dept. of Water Resources (MAF = million acre feet) (acre foot = 2 urban households per year or 0.33-acre irrigated crop land per year). Developed water: Water that is produced or brought into a water system through the efforts of people, where it would not have entered the water system on its own accord. http://www.ext.colostate.edu/pubs/crops/04717.html

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

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

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

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

Unintentional Regulatory-Created Markets

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

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

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

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

What Price Environmental Water? ?

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

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

“The fair market value of the water made available,

The cost of compensatory environmental actions, or

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

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

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

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

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

The Project Influence Rule

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

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

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

Compensate Whom?

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

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

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

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

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

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

Implications for Hydropower Market

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

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

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

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

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

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

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

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