A Free-Market Energy Blog

California’s Cap-and-Trade Water Proposal: A Planner’s ‘Market’ (Part II: Sky high water auctions)

By Wayne Lusvardi and Charles Warren -- February 21, 2014

“The real problem is that the price of water in California, as in most of America, has virtually nothing to do with supply and demand…If water was priced to reflect scarcity, a decrease in supply would lead to an increase in price, and people would demand less… My system is designed to reduce demand rather than cover costs.” – David Zetland, The Water Shortage Myth (Forbes, 2008)

In Part I of this series we discussed how a proposed Drought Environmental Water Market does not meet the criteria of a market nor would the prices produced from such a system reflect Fair Market Value. The proposal for an environmental water market by a group of experts from the University of California, Davis, the Public Policy Institute of California and law schools at the University of California and Stanford (the “U.C. Davis-PPIC Proposal”) would end up double charging farmers for water they already paid for, including $180 million in river restoration fees.

In this second part of the series we discuss the implications of wholesale water auctions currently in vogue in California, ostensibly as a drought relief mechanism.

We previously discussed the eminent domain property appraisal rule called the “Project Influence Rule.” This rule means that any increase or decrease to property values due to a public project must be excluded from any appraisal for Fair Market Value. This rule is typically applied in redevelopment project areas where the upzoning, road improvements and utilities brought about by redevelopment have to be excluded from any property valuation. Appraisers usually control for project influence by searching for sales data outside the defined project area.

Below we will compare agricultural water sales prices from outside the Central Valley to cross check if there is any premium in water prices caused by government withdrawing over half of the supply of farm water to restore “fish flows.” In general, government does not have to pay for an enhancement of private property value it created. This rule should work in reverse when government wants to sell back to farmers water at environmentally-inflated prices.

We believe application of this rule in any sales of environmental water back to farmers to alleviate drought should exclude any price premium created by “project influence” of fish restoration projects; and from any “auction fever” of “All-In Water Auctions” currently in vogue in California.

We conclude that pricing environmental water sales by auctions reflects 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 161 – Dianne Feinstein, D, San Francisco). This is all-important to the analysis and discussion of environmental water re-sales back to farmers and water auctions that follows.

Water Auction Resulted in 3x Going Water Price

“All-In Water Auctions” by water agencies and irrigation districts, advocated by former U.C. Davis water economist David Zetland, have become in vogue in California.

A recent auction of 12,000-acre feet of irrigation water in Kern County resulted in “sky high” prices partly due to historic drought conditions. Bids came in around $1,200 per acre-foot of water for 200-acre-feet of water or more. This is about three times the $400 an acre-foot cited by the U.C. Davis team in their article as the Market Value of wholesale water in Central California.

A prior water auction by the Chino Basin Watermaster in Southern California of 36,000 acre-feet of water for $800 to $1,000 of treated, retail water in 2009, worth perhaps $36 million, was postponed over how the water was to be stored and recovered. No mention was made whether the Metropolitan Water District of Southern California had agreed to a water wheeling fee in advance to convey the water through their pipeline system.

After the Kern County water auction, Zetland proclaimed on his Aquanomics.com blog on Feb. 6, 2014: “Now THAT’s a market!” But is it Fair Market Value? We don’t think so for reasons that will be elaborated upon below.

The market data from the sale of this small quantity of water suffers from the small sample size problem inherent in statistics and markets. This makes it difficult to extrapolate such “sky high” prices to an entire market that uses from 27.7 to 34.1 million acre-feet of water depending on a dry or wet year.

An economic reality check would also be needed. Let’s say Elk Grove, California, which is infamous for overdrafting its aquifer, bought water for $1,200 per acre-foot. Would they then have to price all their water at $1,200? Could they raise consumer prices that much, by, say, five times or more (5x or 10x)?

Moreover, we don’t know what the buyer motivations were:

* To save valuable agricultural improvements like orchards and vineyards?
* To buy “spite water” to remove water from competitors?
* To prop up the local finances of the water district due to fewer water sales resulting from environmental water diversions?
* To submit over-priced water auction bids to influence the future water price of groundwater rights held by farmers?
* To inject water into an underground aquifer to arrest land subsidence caused by groundwater pumping due to flushing water to the sea along the San Joaquin River to create salmon runs.
* To dump an excess supply of water that would have otherwise been wasted.
* To buy water for crop irrigation purposes for market-based agricultural production.

The answers to such questions can only come from third-party appraisers not economists.

“Auction Fever” Creates Water Pricing Bubble

One of the authors of this article has conducted land sale auctions, which sometimes did not reflect Fair Market Value sales prices. Based on that experience, it is not untypical to find inflated prices brought about by the crowd psychology of auctions. Water economists such as Zetland believe that if water prices are set high enough this will encourage conservation. But would that reflect market pricing, a manufactured pricing fever or bubble, or policy pricing?

Under a Public Utility Model, water is priced to recover the costs to construct, finance, operate, repair, and manage the water system. But to farmers water also has to be economically feasible to produce a crop, feedstock, or livestock. Once the fixed price of water is established the economics of crop yield per acre, cultivation costs, any land rents, and profit are calculated. Thus, the price of government supplied agricultural water has to be set based on a reasonable lowest and worst use factoring in droughts, not highest and best use as in real estate. Otherwise, large cities or wealthy farmers could only afford to buy water. Small urban cities and unincorporated farm towns would be priced out of the market, as is perhaps now emerging in California’s Central Valley which may soon run out of drinking water.

“All-In Auctions” conducted under the duress of drought, high water prices induced by withdrawing more than half of the agricultural water supply resulting in higher water prices, and the “fever psychology” of auctions, all combine to create a water pricing bubble. When bubbles occur the checking forces of markets are typically not allowed to work.

IMAGE: Insert graph from David Zetland, “The Water Shortage Myth,” Forbes, July 15, 2008

Extracting the Environmental Price Premium from Bubble Water Prices

A close proxy to the market value of agricultural water might be The Metropolitan Water District of Southern California’s drought land fallowing program with the Palo Verde Irrigation District along the Colorado River (a program one of the authors was involved with). A test of the program from 1992 to 1994 fallowed 20,215 acres of farmland thus saving 186,000 acre-feet of water. Land lessees or landowners were paid $620 per fallowed acre per year on a voluntary basis only during drought years, equating to $135 per acre-foot of water. The water was stored in Lake Mead instead of released to farmers.

This comes nowhere near the $400 per acre-foot of water suggested by the U.C. Davis-PPIC environmental water market proposal or the $1,200 per acre-foot of water indicated by the Kern County auction.

The Central Arizona Groundwater Replenishment District has a voluntary farmland fallowing program that pays farmers $750 per acre of land per year or roughly $167 per acre-foot of water.

A tentative hypothesis is that the price difference between $135 per acre-foot of agricultural water in Imperial County and $400 to $1,200 in the Central Valley is due to the project influence of withdrawing over half of the water supply for “fish flows” and the inflationary sales method of “All-In Auctions.”

Thus, an indicated environmental premium from $265 to $1,065 per acre-foot of water is loaded into Central Valley water rates that would be inadmissible in an eminent domain action; and should also be prohibited for re-sales of any environmental water back to farmers.

The above is not a certified, appraised opinion of a government-manufactured value premium for water, but a preliminary indication that would require further accumulation of data, analysis, and testing. It should be made clear we are not rendering an opinion of value here that meets appraisal standards. The magnitude of value premium above is for public policy discussion purposes only and not for the valuation of any water trades as is loosely being propounded online by environmental water economists.

Of course, removing over half the project water under the guise of the environment wasn’t compensable to the farmers at all as long as it was regulatory-based and the farmers had no adjudicated rights to the water. But with a sale-back market of environmental water farmers should not have to pay an environmental premium caused by a manipulated lower supply of water. Environmental water economists can’t have it both ways.

Water economists Ellen Hanak and Elizabeth Stryjewski of the Public Policy Institute of California report that high water prices may have reduced farmers’ incentives to transfer water during recent droughts. They believe the difference between high water prices in the Central Valley and elsewhere are due to crop subsidies, not loss of supply of irrigation water caused by environmental flushing of water to the ocean. Hanak also asserts that environmental water is an “undervalued resource.” She omits any consideration that fish restoration projects may have on the price of that environmental water.

Embedding Public Policy in Sky High Auction Prices

It is one thing for Zetland to oppose crop subsidies and disparities in water costs. However, it is another thing to advocate correcting that with what Zetland calls “markets” that create “sky high” prices to accomplish public conservation policies. Once again, that is not market pricing.

The method that Zetland propounds of “All-In Auctions” is inflationary. So is his omission of considering how public fish restoration projects reduce water supply and thus raise prices. Is it an economist’s proper role to promote “sky high” water prices to accomplish public policies, or is that the role of legislatures and water agencies? Failure to disclose and avoid such biases would disqualify an independent appraiser but not elite environmental water policy advocates masquerading as water economists.

According to the U.S. Comptroller General, farmers receiving water from the State Water Project (built in the 1960’s and 1970’s) must pay the full cost of the water, while Central Valley Project (built in the 1930’s) farmers may pay half that amount. But this price disparity is mainly because the initial cost of the Central Valley Project was lower. And, according to no less then the U.C. Davis Center for Watershed Sciences, farmers have already paid for any subsidies through higher land values, property taxes, and sales and use taxes.

According to Zetland, “farmers want more free water to make more money” (David Zetland, The End of Abundance: Economic Solutions to Water Scarcity, 2011, p. 107). However, there is no “free water” provided to California farmers in California anywhere of which we are aware. Even farmers must pay the costs associated with pumping, gravity flow irrigation ditches, drainage, and desalting costs of their own groundwater. Zetland has so many self-contradictory views on water pricing that he can defend his views any way he wants. But in general his view is that farm water is free or priced too low and that “All-In Auctions” better reflect the true market value of agricultural water. There is no such thing as free water with your free lunch in California.

Project-Influenced Water Auctions Are Ruinous to Agricultural Economy

Of course while farmers might be able to pay the $1,200 per acre-foot price once or twice for a small amount of water, if anything approaching that became the average price for water, agriculture in California would become uneconomic.

At some point we have to ask how farmers would pay such a rent (i.e., monopoly price). It could and probably would be reflected in reduced land value, which could, ironically put farmers “underwater” on their mortgages and farm credit loans. It undoubtedly would be reflected in food prices. Only the most water self-sufficient farms would remain. Food supply would have to be met by imports. World supply would diminish proportionately to the withdrawal of California production and prices would rise. Meantime, the grandiose visions of limitless water re-sales revenue for environmental projects would prove chimeric.

We are historically reminded that Communism in the old Soviet Union produced infamous repeated famines as well as droughts manufactured by Joseph Stalin to destroy those seeking independence from his rule.

Zetland admits his “sky high” water auctions are not geared to merely recover costs of operating the huge water hydraulic system in California as the present Public Utility Model does. When the hyper-inflated dreams of revenues from environmental water markets don’t materialize California may end up like Europe where green power mandates have resulted in such low electricity prices that they can’t cover the costs to operate the energy grid. The dreams of environmentalists of free energy have come nearly true in Europe to the detriment of their economy.

Conversely, in California the dream of environmentalists and water policy elites is “sky high” agricultural water prices but with the same eventual result of undermining California’s agricultural economy.

Nobody likes Fair Market Value, but it is the basis of our economic system. It is no surprise that countries with the highest water prices in the developed world are Socialist, where a mixed economy can’t separate out the market price from the policy premium any longer.

“All-In Water Auctions” in California’s Central Valley would not reflect “uninfluenced” or “unenhanced” market prices from the public fish restoration project that has reduced farm water supply by more than half.

Do fish restoration project-influenced “All-In Water Auctions” result in fair market water pricing? Not so far as we can see.

In conclusion, neither the proposed Drought Environmental Water Market, nor the currently in vogue “All-In Water Auctions” would conform to the definition of Fair Market Value. Any water market with prices set by water policy elites to further conservation or to “avoid giving fish flows away for free in a drought” by market water prices inflated by public fish restoration projects that reduce water supply and thus raise prices, would not reflect Fair Market Value. Neither would the avoided Cost of Compensatory Legal Actions or Fixed Negotiated Fees reflect Fair Market Value advocated by the U.C. Davis-PPIC environmental water market proposal.


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, Utilities, Environmental Policy, Water, California, Drought, Regulatory Drought, San Joaquin River Restoration Settlement Act of 2009, Water Market Value, All-In Water Auctions, California Water Bond Ratings, Water Pricing Bubble, Palo Verde Irrigation District Land Fallowing Program, Central Arizona Groundwater Replenishment District Land Fallowing Program, David Zetland, Ellen Hanak, Elizabeth Stryjewski, Charles B. Warren, Wayne Lusvardi

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