A Modest Proposal to Restructure California’s State Water Project

Contractors of California’s State Water Project (“SWP”) are negotiating renewal of their SWP contracts that expire in 2037.  Rather than business as usual, California has an once in a generation opportunity to restructure the SWP along economic principles that facilitate better resource utilization, resolve lingering disputes over SWP water supply and transportation, and yield California billions of dollars.  How?  Auction the SWP’s water rights and facilities.  There are many issues to discuss.  Let the dialogue begin.

Status Quo

The State of California owns the SWP water rights and facilities.  When the project was developed, the project operator, Department of Water Resources (DWR) entered into contracts with public agencies for delivery of water.  Each agency signed up for a maximum annual quantity of water (Table A Contract Amount).  The contracts include payment provisions where SWP contractors pay DWR’s capital, operating, maintenance, energy and financing costs.

A key (and sensible) principle is that each SWP contractor’s payment obligation are the actual costs for the portions of the SWP’s facilities actually used in the delivery of water to the SWP contractor.  DWR implements this principle by dividing the project into the 74 reaches (see below).

Section of SWP Transportation


North Bay Aqueduct   Barker Slough to Cordelia Pumping Plant (4)
South Bay Aqueduct   Bethany Reservoir to Alameda-Bayside (9)
California Aqueduct
    N. San Joaquin Division   Bethany Reservoir to O’Neill Forebay (3)
    San Luis Division   San Luis Reservoir/O’Neill to Kettleman City (6)
    S. San Joaquin Division   Kettleman City to Edmonston (13)
    Coastal Branch   Avenal Gap to near Casmalia (7)
    Tehachapi Division   Edmonston to Porter Tunnel to Junction (2)
    Mojave Division   Junction to Silverwood Lake (11)
    Santa Ana Division   Silverwood Lake to Lake Perris (5)
    East Bay Branch Extension   Devil Canyon to Cherry Valley (8)
    West Branch   Junction to Castaic Lake (6)

No SWP contractor needs all 74 reaches to receive SWP water.

The SWP’s water supply is notoriously unreliable.  According to DWR’s 2011 assessment of the deliverability of SWP water supplies, a Table A contract yields, on average, only 61% of the contract amount.  For the driest hydrologic conditions considered, the Table A contract amount yields a meager 9%.  In two and four successive dry years, respectively, the Table A contract amount yields 38% and 35%.  DWR estimates that there is a 0% chance that yields will exceed 81%.

A Brief Excursion into Interstate Natural Gas Pipelines 

The successful restructuring of the interstate natural gas pipeline industry inspires this proposal.

In the 1980s, interstate natural gas pipeline companies purchased natural gas from producers and delivered natural gas to industrial customers and utilities.  When natural gas prices plunged, take-or-pay contracts with producers saddled natural gas companies with contract prices substantially above the market price of natural gas.  An economic free-for-all ensued.  Interstate natural gas pipeline companies breached contracts with producers and flirted with bankruptcy.  Gas utilities and industrial customers sought to acquire natural gas directly from producers.  Disputes arose over access and the terms of use of interstate natural gas pipeline facilities.  The pipeline companies were accused of using their ownership of pipelines to stifle economically beneficial transactions between natural gas producers and end users.

Litigation and federal regulatory rule-making transformed the industry.  There were two fundamental changes:

Unbundling: the commodity (natural gas) was unbundled from transportation (use of pipeline facilities).  Utilities and industrial customers paid separate prices for natural gas and transportation services.  Concerning natural gas, users either buy natural gas from the pipeline companies or acquire supplies from third parties (including interstate gas pipelines).

Tradable transportation rights: while pipeline ownership remained with the interstate pipeline companies, capacity use rights were defined and allocated among natural gas users.  The capacity rights included payment obligations to the pipeline companies for their capital and operating costs.

New markets developed in the natural gas industry.  Contracts for natural gas in the field became the basis for long-term and spot markets for natural gas.  The sale and lease of capacity rights generated a market for transportation services that reallocated claims to facilities as the demands for transportation services changed.  The market prices for existing transportation facilities give economic signals for investment in new transmission facilities.

The Proposal

  • Separate the SWP water right from SWP transportation facilities
  • Establish operators for water supply and for transportation facilities
  • Auction the rights to receive SWP water supply and to use SWP transportation facilities
  • Ownership of the water rights and facilities stays with the State of California.

I comment about each part.

Water Rights.  Currently, the available SWP water supply in a year is pro-rated among SWP contractors in accordance with Table A contract amounts.  If an agency has 5% of Table A contract amounts, it receives 5% of available SWP supplies.

In defining the water right available for auction, there are two options: pro-rata or tiered reliability.  A pro-rata approach follows the SWP’s current approach.  A tiered reliability approach would follow a priority system similar to surface water systems.  Divide total Table A quantities into tiers, such as the first 2 million AF, the next 1 million AF, and any water in excess of 3 million AF.  Available water within these tiers would be allocated pro-rata among the rightholders in the tier.

Another issue involves whether the operator retains use rights to SWP storage or whether SWP storage capacity is included in the use of SWP water right.  If storage rights are created, they should be tradable as well.

Transportation Rights.  Divide transportation capacity into the reaches used by DWR.  If a water user needs the first five reaches below the Delta to receive water, for example, then they will need capacity on these five reaches.  They can either move water available under their own SWP water right or water leased or acquired from others (either SWP or non-SWP water).

Operators.  The “water operator” would exercise the SWP water right and use storage facilities to make water available on an annual basis.  The “transportation operator” will schedule delivery of water to entities with the right to use transportation facilities.  See discussion below about  operators.

Auction Rules.  The proposal may take advantage of computer technology capable of administering sophisticated auctions via the internet.  Bids for a specified volume of water can be conditioned on securing a specified amount of transportation rights on designated reaches for a total payment.  If tiered reliability is selected for water rights, bids can submit specified quantities in any one or more tiers for a total payment.  Computer algorithms (fancy term for decision rules) are available that take the available bids and determine the highest bidders for each reliability tier of water and reach of transportation capacity.

The auction would be open for a stated time period (probably weeks).  The prices for water supply and transportation segments would be continuously available given the currently submitted bids.  Eligible bidders could change their bid or submit an entirely new bid and find out instantaneously the new prices of water supply and transportation capacity.

Sound complicated?  Well, Australian fishermen used such a system to bid on territorial fishing rights auctioned off by their state government.  The system worked and, with proper education, little controversy.  I trust that the California water industry is at least as sophisticated.

Maintain State Ownership.  This is not a privatization proposal.  By defining the scope of rights and obligations of the right to receive SWP water supply and use SWP transportation facilities, the state can assure that economic incentives align with public policy goals.  Through oversight of the operators, the state can assure that operators manage assets “as advertised.”

Economics of Proposal

The auction would allocate the SWP water supply and transportation capacity to the highest valued uses among eligible bidders.  As an economist, I would suggest opening up eligibility beyond existing SWP contractors and types of users.  Environmental interests could be eligible, although they may be more interested in water supply than transportation capacity.  Private sector should also be eligible.  By broadening the eligibility for the auction, this approach addresses lingering problems

  • whether smaller volumes of water should be delivered to SWP contractors to protect environmental goals
  • access to the California Aqueduct for non-project water

The water rights and transportation rights secured should be assignable through lease or sale.  As in the interstate natural gas market in the 1980s, one should expect the development of water markets and transportation capacity markets.  Water would be traded alone or in conjunction with transportation capacity.  Transportation capacity traded alone or in conjunction with water.  The flexibility in the allocation of water and transportation capacity would be enhanced considerably.  As in any market, the prices established for water and transportation capacity would give useful information about the economic value of investments in water and transportation.  For the tiered reliability structure, the prices for the different tiers would show the economic value of supply reliability.

I offer a few points on the economics of auction pricing.  The “marginal buyer” of a reliability tier of water and transportation capacity on a segment will determine prices.  Therefore, I am skeptical that large municipal water users (read Metropolitan Water District of Southern California) would drive auction prices.  Further, as we all know, the SWP project was never built out and, for the part built, there is declining availability of SWP water supplies.  Therefore, from the perspective of transportation of SWP water, there is unused transportation capacity on the SWP. (Witness DWR’s estimate that there is no chance the yield of the SWP will exceed 81%.) As a result, the demand for transportation capacity to move “non-project” water may be the driving factor in the pricing of transportation capacity,

Public Finance of Proposal

An auction, of course, would generate revenue for the State of California.  How much? What purpose?  Economics instructs the answer to the former.  Politics, of course, governs the latter.

This post is not the venue for an extensive treatise on valuation.  The Mojave Water Agency paid almost $6,000 per AF of Table A contract amount a few years ago.  The payment was for assignment of the Table A contract amount.  Mojave remains responsible for SWP charges.  Conceptually, this payment represents a valuation for both the water and transportation capacity.  Using this transaction for valuation, this means that the value of SWP water rights and right to use SWP capacity is about $24 billion ($6,000/AF multiplied by 4,000,000 AF).

As they say in the valuation business, a “haircut” is warranted.  As explained above, marginal buyers will set auction prices.  What should the haircut be? To paraphrase a line from Blazing Saddles, “Mongo says value more than $10 billion.”

What will the State of California do with more than $10 billion?  Help finance the Bay Delta Conservation Plan?  Bolster the General Fund?  Retire debt (probably not)?  I defer to the political process.

Politics of Proposal

I have been around the water business long enough to expect that (at least) the first reaction may be skepticism if not outright hostility.  SWP contractors may not like competition and having to pay for water rights and transportation capacity instead of securing them through a negotiated renewal.  There are deep legal and public policy issues including the State perfected the SWP water right with the reasonable and beneficial use of SWP contractors.  Skeptics of water markets or the role of the private sector may be concerned about the auction.  I view such reactions as an excellent exercise in “issue identification.”  As with any public policy issue, identify the issues and work through solutions.

Fear of Private Sector.  (Aside from counseling), eligibility requirements for bidders can set financial requirements and experience criteria (must be objective) to separate the “fly by nights” from responsible parties.  Right now, transfers are setting prices for water.  The auction would be a transparent mechanism.  It will also bring into the light of day the value of transportation capacity that now remains in the domain of litigation over wheeling rates.

SWP Contractors.  Give them something they don’t have.  The operators should be an entity like the ISO used in power, not DWR.  This can remove many of the problems DWR now faces about personnel retention and other issues.

The SWP Contractors will undoubtedly raises many issues of equity and the like.  If this is an issue requiring a solution, why not give them the option of acting as a “stalking horse” in the auction?  In bankruptcy auctions, a stalking horse commits to buy assets at a pre-assigned price and has the right to increase their bid in the auction.  If they are not the winning bidder, then the State would pay a negotiated “break up fee”, which could be paid out of the proceeds of the auction.  There are undoubtedly other ways to provide a SWP Contractor preference without destroying the underlying purposes of an auction.

Undoubtedly, there are other issues to consider.  Let the political process find the issues and work through solutions.

Use of Auction Proceeds.  Investing the auction proceeds in the Bay Delta Conservation Plan may provide “political grease” for the proposal.  Purchasers of water rights and transportation facilities would receive the benefit of the “state funding” of the BDCP.  This approach is akin to the use of the lining of the All American Canal and Coachella Canal in closing the Quantification Settlement Agreement.  These lining projects yielded conserved water at “bargain prices” (even before the State contributed towards construction costs).  The economic benefit of these projects provided tools for the various parties to divide among themselves as they closed the QSA.

Legislative Initiative

Ok, this “Modest Proposal” is radical in concept.  I put “modest” in the title because there is a lot of work to do to make the concept operational.  The concept must be implementable in practice and generate sufficient discussion to secure buy-in.

One way would be to have legislation establishing a Governor’s Commission to report back to the Governor and Legislature within one year addressing issues specified in the legislation.  Issues  could involve a specific recommendation about the ISOs on water supply and transportation, specifics of either a pro-rata or tiered reliability definition of water supply, term of rights auctioned, auction rules, use of auction proceeds, transition with the expiration of existing SWP contracts and other issues.  With the commission report, Sacramento will decide whether the political will exists to carry out the proposal by passing necessary legislation in the following session.  Give the entity with the authority to run the auction another six months to set up operations.  The auction for SWP water rights and transportation capacity could be held as early as 2016.

The make up of the Commission itself will need careful thought.  DWR is currently burdened with a “full plate”.  Further, a government agency should not be in charge of deciding on institutional alternatives.  Nevertheless, DWR will have an important role in assuring that the Commission has access to the necessary information about the SWP so the Commission can meet its obligations to the Governor and the Legislature.   The legislature has thought about the proper composition of a commission in many instances, such as the Bay Delta Stewardship Council.

Virtues of Change

This proposal suggests using an auction (and the related economic incentives) as an alternative to contract renewal.  Despite the virtues of the SWP (and there are many) and the important role SWP contractors have played in the project’s development, public policy should consider alternatives when they become available.  The auction mechanisms available today were not available in the 1990s (let alone the 1960s).  Before accepting “business as usual” and negotiate renewals of an approach that has its own political conflicts and controversies, should not public policy take advantage of a once in a generation opportunity to at least consider restructuring the SWP?  As true of any public policy issue, all it takes is leadership and vision.

The water sector throughout the west is at the crossroads of many historic challenges.  (Witness Southern Nevada Water Authority).  It is time for the industry to get to work, consider a broad range of alternatives, screen them and work them out.  Would not one feel better about “business as usual” if it survived a competition of ideas?