Scarcity Rents for Water: A Valuation and Pricing Model

Abstract

For most natural resources, the existence of scarcity and the extent of the scarcity rent can be readily determined, at least conceptually. That portion of the resource price in excess of extraction costs signals scarcity and defines the value of the resource in situ. Drawing on Hotelling's (1931) treatment, Heal (1976), Pindyck (1978), and Hanson (1980), among others, have used various forms of this relationship to analyze efficient extraction and consumption of natural resources. Given clear ownership, no externalities, and the existence of viable markets, competitive market processes will establish the efficient level of this rent and, thus, the efficient time path of extraction and consumption. In the absence of clear ownership rights and markets, however, scarcity value frequently goes unrecognized. Water resources provide an important example of this phenomenon, given the growing apparent shortages in both urban and agricultural uses. Government agencies typically own the resource or otherwise have free access to it and need only cover extraction, treatment, and distribution costs. Ignoring scarcity rents in water pricing means that water prices are too low, thereby inducing excessive extraction, capacity investment, and consumption. Even if water utilities were aware of the concept and importance of scarcity rent, the absence of marketdetermined water prices makes the valuation of scarcity rents very difficult. Most water supply utilities obtain water from sources that have a recognized, finite capacity. This occurs where the withdrawal rates exceed the current rate of recharge. A similar situation exists when utilities approach their legal entitlement to some given water source, such as California water authorities now face with respect to their Colorado River rights. The anticipated higher cost for water implies a scarcity rent (Howe 1979, 78ff) on use of existing cheaper water sources today. The usual lack of markets in water makes this rent implicit, but it exists just as with oil or diamonds or any scarce natural resource. This c st is completely distinct from outlays for exploration, development, transmission, treatment, and distribution which, as out-ofpocket costs, readily become embedded in conventional water prices. Scarcity rent could arise with or without economies or diseconomies of scale in extraction or distribution. It