Design of Efficient Water Pricing Policies Integrating Basinwide Resource Opportunity Costs

Abstract

By ignoring the opportunity cost of water use, water is undervalued, which can lead to significant errors in investments and water allocation decisions. The marginal resource opportunity cost (MROC) varies in time and space, as resource availability, demands, and users’ WTP vary. This spatial and temporal variability can only be captured by basinwide hydro-economic models integrating water demands and environmental requirements, resources, infrastructure, and operational and institutional restrictions. This paper presents a method for the simulation of water pricing policies linked to water availability, and the design of efficient pricing policies that incorporate the basinwide marginal value of water. Two approaches were applied: priority-based simulation and economic optimization. The improvement in economic efficiency was assessed by comparing the results from simulation of the current system operation and the pricing schedule. The difference between the benefits for the simulated current management and the upper bound benefits from optimization indicates the maximum gap that could be bridged with pricing. In the application to a synthetic case, a storage-dependent step pricing schedule derived from average MROC values led to benefits that capture 80% of the gap of net benefits between management without pricing and the economically optimal management. Different pricing policies were tested, depending not only on reservoir storage but also on previous inflows. The results show that the method is useful for designing pricing policies that enhance the economic benefits, leading to more efficient resource allocations over time and across the competing uses.