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Huffington Post: Why California’s Drought Policies Are Wrong-headed and Won’t Work

huff-post-greenMuch has been written, a good deal of it on the front page of the San Diego Union Tribune and some even in the review section of the New York Times about California’s four-year drought, the shortages it will cause, and what to do about it. Much of it is not particularly sensible. But they’re only reporting what the policy makers have determined.

According to economic theory, you cannot have a ‘shortage’ of something unless the price of the item is artificially constrained. The market facilitates price increases until supply equals demand. However, because water is a regulated commodity whose price is supposed to reflect its average cost, then it is by definition not priced at marginal cost, and shortage is the theoretical result. This doesn’t matter when the price of new supply is the same as the price of existing supply, which it has been until recently. But with rain and snow, the cheapest supply source, suddenly uncooperative, there has been an unpleasant change in the options and their cost. Unless dramatic changes in policy and pricing are made, or the weather suddenly turns very damp, further shortages are the inevitable result.

There are six policy alternatives for the political system to meet commodity shortages of widely distributed goods:

Prayer and wishful thinking – probably El Nino will come along and save us with a wet winter. After all, it happened before.

Voluntary appeals – take fewer showers, save shower water and use it in your garden, flush toilets less often, convert gardens to succulents, stop watering your lawn because we don’t live in England.

Regulate consumption by prohibiting specific activities–water two days a week, not three; no personal car washing and no sprinklers throwing water into the road. There are, of course, an infinite number of ways to “waste” water and it is hard to prohibit all of them. It is even harder to enforce such prohibitions.

Regulate consumption by across the board reduction: use 25% less compared to some base period — June-September of 2013 is the one selected. As we will see later the “base period” matters enormously, and the more discrete the restrictions become the more it matters.

Create additional supply–especially infrastructure–drill wells, increase volumes recycled to potable standard; refine additional non-traditional sources (fracking wells); use desal on brines or sea water.

Raise prices (for customers and for purchases of the commodity from suppliers) to the market clearing level.

California water officials, collectively, appear to be applying these tools in the order listed above. All have pluses and minuses, but the final option of raising prices and letting the market “clear” is by far the most efficient and fair. And it will stimulate new supply, which is the ultimate answer. But we’re clearly not there yet.

Are there lessons from the past that could be helpful?

The Arab oil embargo of 1973-1974 was a huge shock to the U.S. energy system. It exposed a real gap in how much the government and the country knew about energy in general and oil use in particular. There was fear, rumor, misinformation and shoot-from-the-hip policy making. And no one could be sure when it would end.

I had the pleasure of working in the federal government, in the Office of Management and Budget at the time and was quickly directed to join the task force working on the crisis. The quick summary of what happened: We immediately froze prices which, in essence, created the shortage. We went through prayer and specific restrictions – the 55 MPH speed limit for example. We settled on reductions from a base period of consumption.

But this approach requires large amounts of data, just to pick the right reduction level. However, we didn’t know how much oil we had used historically, in any detail. We didn’t have data on current consumption, we didn’t know by how much the supply was reduced, and we wrote rules that might have allocated 125% of what we had, or 75% of what we had. What you got depended on who your supplier was.

The best estimate of the shortage of supply was of 5 to 7%. This should have been easily manageable but we had no plans and no institutions to do such management.

It was agreed that we should immediately increase domestic supply, but the exact nature and amount of current U.S. supply was unclear. It was clear that increasing it would take time (unknown) and policy tools to do so were uncertain. Plus the price freeze discouraged additional supply. Inventories were not known, not consistently defined and not reported, and consumption was generally not reported. If reported the numbers were not comparable across the states.

The capability of each refinery to switch outputs among refined product i.e., maximize gasoline, was technically unknown, even by oil industry insiders, and our ability to order such changes was unclear.

Domestic consumption was a mystery, both as to amount and uses -for example, diesel and diesel #2 heating oil were the same product, but had different distribution channels and different prices.

The ability to fuel switch, i.e. substitute natural gas for oil, was only applicable to utilities and large industrial users, and was unknown, and we did not believe we could just order this to happen. It was thought that almost all switching took time, but how much was also unknown.
There was an unbelievable clamor and extraordinary pressure for the government to DO SOMETHING. So we did.

Prices were frozen; supplier/customer links were frozen. You were no longer free to shop for a new supplier. This applied to everything but gasoline and over the road diesel, where it was impractical.

Voluntary appeals were made, with specific suggestions–turn down thermostats, inflate tires, insulate attics. But precise data on the impact of doing such things was non-existent.

Some few specific behaviors were prohibited — 55 MPH speed limit, every other day gasoline availability at stations. But enforcing the speed limit significantly strained police departments. It was not popular.

If you freeze prices, then price signals don’t work to allocate the scarce resource. You have to put in place an alternative system. We chose historic consumption as the basic determinant of current allocation, but with a haircut. These rules were implemented, mostly as across the board supply limitations to customers, but implemented by suppliers. There were three levels:

1. 100% of needs (military, hospitals, some agriculture/food production uses) — we didn’t know how much this was.

2. 100% of base period volume, with base as 1972 annual consumption — home heating principally. We didn’t know how much this was.

3. 80% of base period volume, but applied proportionately to remaining supplier volume. This was mostly industrial use including electric utilities. Since supplier/customer links were frozen, suppliers with more class 1 customers and class 2 customers would end up with smaller volumes for Class 3 customers. Given the notes on 1 and 2 above, we were completely clueless as to how much (or little) this was.

None of this worked well, and it worked not at all for gasoline and diesel. A gasoline rationing system which, unlike the WWII arrangement relied on tradable coupons was formulated, with each person with a driver’s license to receive the same number of coupons per month. The coupons themselves were printed. The liquid nature of the coupons was a back door way to use price to allocate gasoline supplies. So was hiring someone to stand in line with your car for you while waiting in a long line for gasoline. Fortunately, the embargo ended before we were forced to implement the rationing scheme.

The allocation system based on a percent of historic use created huge implementation problems:

Data was terrible, and really didn’t exist–this had never been necessary to collect before, certainly not on a consistent national basis. But it was also terrible at all levels, because how much fuel a person or entity had used in 1972 was, in the normal course of things, useless historic information and so no one had it.

There was significant unfairness, real or perceived. For example, if you were a big user during the base period, you still ended up with a larger gross amount of fuel than your neighbor. Which meant to some that the system rewarded richer customers, or those who had conserved less. However, a system allocating exactly the same amount to each customer was never really considered, and would have triggered the same claims of unfairness.

There were anomalies without number:

–I didn’t own this house in 1972, why am I stuck with this base period?

–I got married to a woman with three teenage daughters at the end of 1972, this allocation does not recognize that.

–I was on a foreign assignment for six months of 1972 and the house was vacant. So my base period volume is way too low.

–This house was built at the end of 1972, so what is my base period volume?

–My supplier went bankrupt so now who is supposed to supply me?

–I used less last month than my allocation. Can I carry over that amount to this month?

–My neighbor has a big tank full of heating oil that he bought last year, but he’s still getting his full allocation even though he doesn’t really need it–that’s not fair.

–You didn’t read my meter at the end of the month, you read it five days late, so you haven’t made an accurate calculation of what I am entitled to.

An entire “hearings and appeals” process had to be set up from scratch to deal with these sorts of problems.

The parallels with the California water system and its reduction goal should be obvious.

The Arab oil embargo ended in March of 1974. Had it continued much longer, the allocation system would have simply broken down under its own weight, and gasoline rationing implemented. Prices would have had to be “unfrozen” as the allocation system simply could not reasonably deal with the millions of transactions a day that the market dealt with, relatively efficiently. And even with retail prices frozen, the base price of oil had risen from $3 per barrel to $12.

It seems likely that the 410 local water distribution entities with no experience in regulating consumption, no systems, and limited data will have the same problems. And it’s not their fault; an across-the-board reduction system based on historic consumption, and applied to 38 million customers is simply not manageable.

Look for my upcoming articles:
–How much water is there in California? How much will it take to end the drought?
–Who owns the water in California? Does this matter?
–New supply options are proven, cost effective and available.

RF Hemphill is a former CEO of a multi-billion dollar global electric power and distribution company and is the author of Dust Tea, Dingoes & Dragons: Adventures in Culture, Cuisine & Commerce from a Globe-Trekking Executive.

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