Lecture 7: Water Economics

Question 1

What is the diamond water paradox?

Answer 1

Water: essential for life and low value/price

Diamond: non-essential for life and high value/price

Question 2

Explain the concept of marginality

Answer 2

what matters is the value of an
additional unit of a good, regardless of the value of the
previous unit

Question 3

Explain the concept of scarcity

Answer 3

The value of a good is thus also determined by its scarcity
(determined by the relation of supply and demand)

—> A reversal of diamond and water prices may occur once
the marginal water uses are essential uses

Question 4

What are characteristics of water?

Answer 4

Essential, needed for survival
Finite and non-substitutable
Mobile, fugitive, a flux
A system
 any use of water affects the whole water cycle
Varying availability and quality
—> spatial and temporal variability (climate variability, land
use, human interference…)

Specific characteristics of water (2)
Bulky
—> difficult to store
—> limited transportability (or only within limits)
Use may create externalities
—> dependencies between users (e.g. upstream and downstream users)
Various uses/users, so water market is not homogenous

Question 5

What are the different users of water?

Answer 5

Households —> drinking water, household water
Industry, Construction, Mining —> production processes
Agriculture —> irrigation water
Transport sector —> oceans, rivers, but also ballast water
Energy sector —> hydropower, other energy sources
Tourism —> recreation, swimming, water sports

Question 6

What are the implications of the characteristics and uses of water?

Answer 6

Everyone should have access to water needed for survival
—> basic water supply for free because it is essential?
There is not only one water market but markets for each type of use
The value of water differs between different uses (more and less essential uses of water)
We need to manage competing uses
We need to take into account system-effects of water use
We cannot trade water as any other good (only virtually)

Question 7

How is water supplied?

Answer 7

 Water is mostly supplied by a single provider (water utility)
 Specialized to serve one user group, e.g. provider of urban water services, provider of irrigation water for agriculture
 Goal: Handle raw, unprocessed or natural water from a surface watercourse or an underground aquifer —> transform the water into the retail water that is received by the clients

Question 8

What are the costs of water supply?

Answer 8

High initial capital investment needed (fixed cost)
Variable costs include, e.g. costs for pumping, purification, decontamination, transportation to client, administrative, management cost etc.
Costs of water supply increase with amount of (retail) water that is delivered

Question 9

What is the efficient supply of water?

Answer 9

Supply curve equals marginal cost curve —> marginal-cost pricing

Question 10

Explain the water demand curve

Answer 10

 Different demand curves for different uses and types of water
 Marginal benefits function determines water demand curve of
single user
 Market demand: aggregate marginal benefits function of all users

Question 11

What is the price elasticity for residential water demand?

Answer 11

Price elasticities for residential water demand are typically in
the range of -1.3 to 0.1 with the average elasticity around
- 0.4 —> rather inelastic demand

Question 12

What are the instruments of public water management?

Answer 12

 Quotas – setting upper limit to water use for a certain purpose
 License to use – issuing licenses for withdrawals or discharges
 Subsidies, grants – subsidizing water-saving appliances and infrastructures
 Penalties – financial and legal enforcement incentives (fines and premiums)
 User charges – pricing of water services
 Tradable water rights – creation of a water market where users can buy and sell water rights Instruments of public water management

Question 13

What are the primary goals of water pricing?

Answer 13

Economic efficiency: economically efficient allocation of existing supplies
Environmental sustainability: reducing consumption, conserving water resources (for future generations)
Equity / Affordability: equitable treatment of water users, universal access
Generation of revenues / Financial sustainability: generation of adequate revenues for the operation, maintenance and expansion of the water system (cost recovery)

—>Challenge: to keep the different goals in balance

Question 14

Explain water in a narrower sense

Answer 14

Water price: volumetric price placed on metered water
Water rate or water tariff: entire package of charges applied by a water supplier
Charges dependent on amount used: per-unit charges
Charges not based on amount used: connection fees, irrigated acreage charges

—> Typically: different water prices for different types of water and different uses

Question 15

What are the three structures of water pricing? And which one is the most efficient?

Answer 15

Uniform Rate Structure

Increasing Block Rate Structure —> Most efficient

Decreasing Block Rate Structure

Question 16

What are different household water tariffs?

Answer 16

Flat tariff —> fixed payment
Volumetric tariff —> pay per use
Tiered tariff —> rates that change
depending on time or amount of use
- dual rate for peak- and off-peak-demand
- Increasing block tariffs or a stepped tariff
—>Highest value use (essential water use) is priced lowest
—> Lowest value use (non-essential water use) is priced highest
Two part tariff —> fixed charge that is independent of the consumed amount and variable charge that depends on the consumed amount

Question 17

Mention different types of irrigation tariffs

Answer 17

Flat tariff
Volumetric rate —> constant rate per cubic meter
Rising block tariff
Two-part tariffs: fixed charge per area plus volumetric rate
Per area prices
—> charges are related to the irrigated area
—> Sometimes contingent on the crops grown and/or the
season

Question 18

What are wastewater tariffs and pollution charges?

Answer 18

Charges to treat and manage wastewater
In OECD countries: often two part tariff, fixed and a volumetric rate

Additional role of wastewater tariffs: pollution prevention
—> “Polluter pays principle”: higher charges for users that release more pollutants into the water

Question 19

Explain the goal of Cost recovery and sustainable financing

Answer 19

Cost recovery is a prerequisite for equitable and universal access to basic water supply
Free water dilemma: Water provider will not be able to adequately maintain the system —> unsafe water for poor, while richer people can afford buying from other sources
Sustainable cost recovery is often based on affordable water
tariffs and other sources of funding (taxes, transfers)
In EU: cost recovery of variable costs is generally high for household water supply, but government subsidies are often needed for capital investments
In many low income countries cost recovery is not achieved

Question 20

Explain the goal of Increasing water use efficiency

Answer 20

Volumetric tariffs are more effective than flat tariffs in
achieving water use efficiency
Block tariffs or a stepped tariff system can ensure universal
access:
- Highest value use (essential water use) is priced lowest
- Lowest value use (non-essential water use) is priced
highest

Question 21

Explain the goal of reducing consumption

Answer 21

If water demand exceeds supply, then the price is too low
Efficient pricing is usually equivalent to marginal cost pricing
- Connection charges should reflect the marginal costs of connections
- Cost of (metered) water use should reflect marginal costs of supply
Additional measures to reduce water demand may be needed (e.g. education, non-price measures, technical measures, nudges, etc.)

Question 22

Explain Supply-demand cycles and reservoir effects

Answer 22

Building dams/expanding reservoirs as
supply enhancement strategy to cope with droughts and water shortages can be problematic
 Supply-demand cycles: increasing water supply enables higher water demand
—> additional supply enables agricultural, industrial or urban expansion

 Reservoir effects: overreliance on reservoirs increases vulnerability
—> reduced incentive for adaptive actions on other levels

 Often better solution: demand management

Question 23

What are the conditions for well functioning water markets?

Answer 23

 Well defined and administered water rights embedded in law
 Large number of potential buyers and sellers
 Sales and water use is monitored and enforced
 Low transaction costs (administrative complexity, trading fees)
 Exchange is easy

Question 24

What is essential for the functioning of water markets?

Answer 24

 Application of the market mechanisms
 Assign property rights to (quantity of) water and allow trade
 Market puts a price on water
 Often implemented in very water-scarce countries or areas such
as
- Australia (e.g. Murray Darling Basin)
- Western parts of the US (e.g. California, Colorado)

Question 25

Explain Water markets goal: Re-allocating water between
users

Answer 25

Different uses of water create different added value
Initial allocation of rights to use water is an administrative procedure
Price mechanism can be used to re-allocate water between users, e.g. from users with lower added value to users with higher added value
—> tradable water rights

Question 26

Explain Water markets (markets for tradable water rights)

Answer 26

 Setting an optimal price is difficult
—> We don’t know MBs
—> So exchange of water rights between buyers and sellers
 Government or community limits (caps) water use within a freshwater source and defines water rights that are traded among users —> often caps fluctuate with availability
 Tradable water permits: allocated permits or water rights, openly traded among users
 Users with highest value for water will have highest willingness to pay for water permits
—> economic efficiency
 Incentivizes investments in water use efficiency