Guest Column | May 15, 2015

California Is Not Running Out Of Water, It Is Running Out Of Cheap Water

By Ory Zik, VP of Analytics at Lux Research

The ongoing water crisis in California has generated some dire predictions about the state's future. But California isn’t running out of water. It’s running out of cheap water. The drought damage is estimated as $2.2 billion, which is significant, but hardly the "end of growth" for California’s $2.2 trillion economy. The problem for businesses, however, is that cheap water jeopardizes their water security. Executives need visibility into the issue and strategies to manage it, but unfortunately, the slow policy response and inconsistent price signals slow adaptation and innovation.

It starts with a very basic problem of ‘metrics’. How do we measure water? Since agriculture accounts for the majority of the water usage, around 80%, the attention naturally focuses on this sector. In the absence of good metrics, the conversation drifted to esoteric metrics such as “gallon per nut” (for almonds) to compare almonds and alfalfa. These two are the most frequently discussed crops; they occupy similar land acreage in the state. An acre of almonds consumes about 1,140 kgal of water per year while an acre of alfalfa consumes about 30% more. But there are real economic differences: Almonds generate about $6,000 of revenue per acre per year, compared to alfalfa’s $1,000. Therefore, the economic value of almonds is about $5.3 per kgal of water and alfalfa is only about $0.7 per kgal – almonds are eight times more valuable than alfalfa per unit of water.

There is even a more basic issue. Water is measured (and charged for) by volume. But the value of a gallon of water is highly dependent on location. In California, the difference is extreme. The typical difference in annual total rainfall between northern and southern California is fifty-fold – 100 and 2 inches, respectively. Clearly a gallon of water in the north has different value than the same gallon of water in the south, but how can this be quantified?

The most logical proxy to use to sort out the geographic and economic differences in the value of water is energy. There is no shortage in water for those who are willing to pay for the energy to treat, convey, distribute and collect it after use. This is why California is not running out of water. It already ran out of cheap water. But water needs to be regulated to make sure that withdrawal does not lead to depletion, and is priced in a way that captures the value of the energy and environmental externalities.

When we price water as energy, we gain visibility. The energy intensity of water in California can be as low as 2 kWh per kgal or as high as 37 kWh/kgal (including desalination and conveyance). Assuming an electricity price of $0.15/kWh (to create a “value of water” benchmark), the energy price of water will range between about $0.3 per kgal and $6 per kgal. Almond farmers can easily pay for the low-end (which is less than 10% of resulting crop value), which is what they have been doing until recently. They cannot pay for the high end. Alfalfa farmers can pay for neither, and the popularity of the crop in the state depends on the fact that the state's byzantine system of water rights means that water can be virtually free for some agricultural users. In some locations, however, today’s drought prices are as much as $3 per kgal and driving an outcry among farmers. In the absence of clear and consistent water pricing, econometrics that use energy as a proxy can provide decision makers with visibility into the value of water.

This analysis highlights the challenges California faces in deploying what should be its greatest asset in addressing water issues: innovation. The lack of clear pricing has led to a lack of interest by Silicon Valley entrepreneurs and investors. New pricing mechanisms and regulations may change this situation, but the track record of government is not encouraging. Last year, finally, the governor signed a bill to regulate groundwater extraction – but the regulation is set to be fully implemented only in 2040, and until then, farmers that have the money to drill deeper for water can suck aquifers dry, while regulators that focus on the residential sector, may move some guilt, but California residents cannot conserve their way out of the crisis.

The Israeli experience may be relevant. From the water perspective, Israel is like a "miniature California": It is 60% desert, had a seven-year drought between 2004 and 2010 and the driest winter on record in 2013-2014. It has one big surface water reservoir (the Sea of Galilee) and ground water aquifers that need to be protected, and relies on desalination plants for additional water. Fresh water is expensive, so farmers minimize use and when possible use brackish water. Even so, agriculture is 2.4% of GDP (compared to 2% in California) – Israel even exports carrots to Russia. Like California, it's an entrepreneurial hub, and there the price of water helps drive thriving water innovation: Promising start-ups include Desalitech, which builds improved reverse osmosis systems that farmers can use.

How should business executives respond to the water crisis? They cannot wait for policy makers. They have to acquire the right data and determine the internal value of water to decide what technology can be effective where. For example, Nestlé uses an internal ‘shadow price’ of water to assess innovations and proposals for new equipment.

As California runs out of cheap water, and as the regulators are moving too slowly, companies have to distill complex information into crisp decisions. They should use data and analytics to determine the value of water, using the energetic price as a starting point. This will boost innovation and select the innovations that can provide value.