Click the link to read the article on the Water Education Colorado website (Nelson Harvey):

You might call it the great economic riddle of our time: It sustains human life, lubricates the entire economy and has no known substitute, yet a month’s supply can be delivered to your home for less than the cost of cable TV or cell phone service. It belongs to the public but the right to use it is bought and sold, and changing that use requires a pricey court approval process. It supports kayakers and anglers, trout and sparrows, and all the ecosystems in between, yet those benefits are rarely reflected in its cost. It is cheap, and yet it is priceless. What is it?

If you’re reading [Headwaters] magazine, you already know that the answer is water, and you already know that water is invaluable. What you may not know is that water’s price, according to many economists, comes nowhere near to reflecting its true value, and that blunt economic fact has consequences for the long-term sustainability of both our water resources and our water systems.

Aligning water’s price with its value is much harder than it seems. That’s because water is traded and regulated in ways that reflect its unique and irreplaceable role in our economy. Depending on who you ask, water is a private commodity or a public good, an economic input or a human right.

These varying roles affect the accuracy of water prices, and the freedom—or lack thereof—of water markets. Some examples: In Colorado, many water utilities are prevented by their charters from charging more than they need to cover their costs. This keeps water rates affordable but also prevents providers from charging customers for the current market value of their water, also called the “scarcity value,” to encourage conservation. Legal restrictions on water transfers—in place to protect other water users—make those transfers complicated and expensive, slowing the flow of water from farms to cities and helping to preserve the gap between agricultural and municipal water prices. At the same time, many non-market costs of water transfers or appropriations—“externalities” like the open space, wildlife habitat and fishing grounds lost when farmers sell their water rights to a city or a new water right is appropriated, further depleting a stream—are not typically paid for by the buyer or the seller.

Ignoring the full cost of water—and the non-market values that water provides—saves money in the short term by keeping water rates low. In the long run, however, it could prove both financially and culturally expensive. Over time, wasteful use may hasten the need for costly new water projects, and public benefits like wildlife habitat and open space are less likely to be preserved if they aren’t factored into the price of water transfers. Given the stakes, how can we value water more accurately, while preserving the legal framework that protects water users and the environment?

Supply and demand, within limits

When utilities, ditch companies and irrigation districts buy water rights to serve their populations, the price of those rights is determined in part by the basic interplay of supply—what the water costs to deliver—and demand—what it’s worth to buyers. Brett Bovee, intermountain regional director for the consulting firm WestWater Research of Fort Collins, helps clients value water rights for purchase or sale. He considers factors like a water right’s source, location, current use, historical buyers and sellers, ease of storage, and seniority, since older rights are more dependably fulfilled than those appropriated more recently.

Bovee might compare a water right to a handful of others with similar characteristics to arrive at a reasonable price, or, if the water is agricultural, he might use a technique called the income approach, calculating the yields that a farmer could get irrigating with the water compared to dryland farming yields. (A slight variation is comparing the sale price of dry farm ground to that of irrigated land nearby, then using the difference to infer a water right’s value). A final technique, the replacement cost approach, involves calculating the cost of the next-most expensive water supply option and then advising clients to pay just less than that.

“Usually the replacement cost sets the ceiling, the income approach sets the floor, and the market price is somewhere between those two,” Bovee says. “The willing seller must make more off a water transaction than he would in farming, and the willing buyer is only going to buy water if it is cheaper than alternative sources.”

Yet the economic playing field is not completely level where water is concerned, as evidenced by the vast and enduring price differences between agricultural and municipal water. As University of Arizona law professor Robert Glennon and his co-authors point out in the 2014 paper “Shopping for Water: How the Market Can Mitigate Water Shortages in the American West,” agricultural users in many parts of the West may pay just a few cents for a thousand gallons of water, while urban users pay $1 to $3 for the same amount. That’s partly because, in a strictly financial sense, urban users can earn more money with the water they consume: If you ignore the vital non-market values of agriculture like open space, wildlife habitat and food security, urban activities like manufacturing frequently generate more money per acre-foot of water than farming does. Used to grow lettuce in Yuma, Arizona, Glennon writes, an acre-foot of water might generate $6,000. Used to make microchips in California’s Silicon Valley, it would generate $13 million.

The price disparity between agricultural and municipal water is further explained by higher treatment and conveyance costs for urban water, from the chemicals that disinfect drinking water to the pumps that keep it pressurized and ready to flow from the tap. “If farmers needed really clean, pressurized water at their farm headgate on demand, the price between agricultural and municipal water may not be all that different,” Bovee says.

Agricultural water users who inherit their land also benefit from the investments their ancestors made in ditch and reservoir systems originally constructed to put the water to beneficial use. Today, they pay only the water assessments necessary to maintain or improve these systems or to make the occasional legal filings. When they sell their shares in their infrastructure or water rights, they earn the appreciated value of both, which can be substantial in areas like Colorado’s Front Range where a booming residential real estate market has kept water demand high.

Finally, federally funded irrigation projects provided a subsidy to early agricultural water users: Many of the West’s large water diversions were paid for with federal dollars between the 1930s and the 1970s. Although those federal outlays were partly recouped through a combination of cost sharing from local governments and revenues from projects’ hydroelectric features, the federal government never required full reimbursement from water users. Examples include the Colorado-Big Thompson Project, authorized by Congress during the Great Depression to provide a supplementary source of water to farmers and cities in northern Colorado, as well as earlier Western Slope projects like the Uncompahgre Project and the Grand Valley Project. “Recipients of irrigation water from federal projects will have repaid, on average, about U.S. $0.10 on each dollar of construction cost,” writes University of California, Berkeley economist W.M. Hanemann In his 2005 paper “The Economic Conception of Water.” Today, federal funds are largely unavailable to help finance water supply infrastructure.

Although they remain much higher than agricultural water prices, municipal water rates are hardly exempt from market manipulation, and for good reasons. Because water is widely considered a basic necessity for human life and economic activity, many Colorado utilities are public entities whose rates are regulated by local governments or appointed boards, and even the rates of private, investor-owned utilities are limited by the Colorado Public Utility Commission.  Many municipal utilities set their rates through “cost-of-service” pricing, which doesn’t account for the value of water itself but factors in only what it costs to run the utility—energy, water treatment chemicals, office staff—plus maintain financial reserves, make debt service payments, and repair aging pipes, tanks, reservoirs and other infrastructure. A growing number of utilities also employ “increasing block rate” pricing to keep everyday water use affordable while penalizing higher water users to encourage conservation. Yet their rates include little or no charge for water’s replacement cost or “scarcity value:” what it would cost to obtain their water on the open market today, or what they could earn by selling their water and using the proceeds to pay off debt or meet other obligations.

“For a farmer to keep a tractor, they have to be earning more by keeping it than they could make by selling it,” says Chris Goemans, an associate professor of economics at Colorado State University (CSU) who specializes in water issues. “For water rights portfolios, there is no charge to households to reflect the fact that the water could go somewhere else and earn more money for the utility.”

Failing to account for this opportunity cost encourages customers to use their water for purposes worth less to them than the cost of bringing that water to the tap, whether that’s watering the lawn or filling the swimming pool. That’s highly inefficient from an economist’s point of view. “You don’t want people using water that costs $10 per gallon to produce on applications for which they place a value of a dollar or two,” says Chuck Howe, a professor emeritus of economics at the University of Colorado, Boulder. “If the price to the consumer doesn’t cover all the costs of production, then individual customers will apply water to uses that are, at the margin, worth less than the costs imposed on society.”

Artificially cheap water saves customers money today, but in the long run will prove expensive as utilities are forced to meet growing demands by acquiring expensive new water rights or building new infrastructure. In a 2013 analysis, city staff in Westminster, Colorado, calculated that water rates would be 135 percent higher and water tap fees 99 percent higher if per-capita water demand in the city had not fallen by 21 percent since 1980. That declining consumption—driven by a combination of utility-sponsored conservation programs, conservation-oriented increasing block rate water pricing and stricter national plumbing codes—saved the city over $5.9 million on water and wastewater treatment, new water rights, and loan interest payments, which would have been passed along to residents in the form of higher rates and tap fees. Even though water rates have risen in Westminster since 1980, in part to compensate for declines in per-capita consumption, they have risen much less than they would have if per-capita consumption had stayed flat as the population grew.

Howe believes that charging customers for the scarcity value of their water could have a similarly virtuous effect on consumption—and thus on water rates—over the long haul. In an unpublished paper co-written with water attorney Peter Nichols of the Boulder firm Berg Hill Greenleaf Ruscitti LLP, Howe argues that utilities could encourage conservation by charging customers more for each 1,000 gallons of water they use, then refunding any resulting profits by reducing the fixed monthly service charges that appear on monthly water bills. By increasing the price of each 1,000 gallons of water by just $1.50, Howe and Nichols surmise, the City of Boulder could earn $20 million per year, a sum equivalent to 5 percent of its $400 million water rights portfolio. This would encourage conservation without harming ratepayers’ overall bottom lines, since higher volumetric usage fees would be offset by reductions in fixed service charges.

Love thy neighbor: Legal restrictions on water transfers

Despite the limits on what municipal utilities can charge, the gap between urban and agricultural water prices persists. That’s partly because significant legal barriers discourage those who get their water cheaply—farmers—from selling it to the cities who will pay dearly for it. Those barriers serve noble goals: Because water, unlike other commodities like land or electricity, is often used several times in succession within the same river basin, many users depend on the reliable timing and amount of return flows from their neighbors upstream. To protect those flows, legal restrictions, such as the “no harm to juniors” rule, prevent anyone who moves their water or changes its use from impacting other water users. Colorado water courts employ several other principles in regulating water trades: The beneficial use requirement is intended to discourage waste and requires water to be put to beneficial uses approved by the legislature or the courts or else abandoned, and the anti-speculation doctrine mandates that anyone changing their water use show precisely its new use, location and amount, to prevent speculators from buying water and simply holding it, unused, until prices rise.

Water courts also limit the salable portion of a water right to its “historical consumptive use,” the average amount actually absorbed by crops, retained by people and lawns, or used up by industrial processes over the water right’s history. This prevents farmers from harming other water users by selling water they no longer have to divert as a result of improving their irrigation efficiency, provided they leave irrigated acreage and consumptive use unchanged. Before the efficiency improvements, the unused portion of the water diverted and applied had served other users in the form of return flows, so Colorado law protects those historical return flows for appropriation by other users after efficiency improvements are made.

Taken together, these restrictions discourage water from simply flowing to the highest bidder. They make the process of transferring water rights time consuming and expensive, since detailed engineering studies and costly legal filings are necessary to prevent other water users from being injured without compensation. And yet, examples abound of Colorado water law flexing to accommodate changing state priorities. The nonprofit Colorado Water Trust and the Colorado Water Conservation Board (CWCB)—the only entity in the state that can hold an instream flow water right—are now seeking water court approval for the state’s first permanent “split-season” water right on the Little Cimarron River in Gunnison County. The right, acquired by the Colorado Water Trust, will permit the same water to be used for agricultural irrigation in the early summer and then for instream flows that benefit fish in the fall. Another example: Under a state law passed in 2013, farmers and municipal water providers can now enter into so-called “interruptible supply agreements” three out of every 10 years without the approval of a water court. In this arrangement, farmers fallow some of their land or reduce irrigation and then, with the blessing of the State Engineer, convey the freed-up water to cities in exchange for short-term lease payments. One such arrangement, the Arkansas Valley Super Ditch, is partway through a three-year pilot project that began in spring 2015 when irrigators on the Catlin Canal east of Pueblo leased 500 acre-feet of water to the cities of Fowler, Fountain and Security.

“It went so smoothly the first year that I don’t think we want to mess it up by changing anything,” says John Schweizer, president of the Lower Arkansas Valley Super Ditch Company and the Catlin Canal Company. Because agricultural commodity prices were low in 2015, Schweizer says, the farmers who participated earned at least twice as much fallowing land and leasing water as they would have growing corn, wheat or alfalfa on the same acreage. And they still kept at least 70 percent of their water rights in agricultural production, as required by law. Even though there are two years left in the pilot project, Schweizer says, “The City of Fountain is already talking about coming back and negotiating a longer term lease, which could mean bringing more farmers into the program.”

Ideally, these alternative transfer methods (ATMs) could give cities reliable sources of water in dry years without requiring the “buy and dry” of agricultural lands. Yet short-term leases are a relatively new concept, and because urban water providers must plan for a reliable, long-term supply they often prefer to purchase agricultural water outright. Some urban utilities then lease the water back to farmers until they need it, giving them flexibility in deciding when to begin the sometimes long and arduous process of filing for a change of use in water court.

“If you are a water [utility] manager, when you provide a water tap to a developer you are promising them water. Short-term leases are just not reliable enough right now to fulfill that promise,” says Goemans, at least not for a city’s entire water supply.

Still, reducing regulatory barriers to water leasing is likely to make it more common over time. In the South Platte River Basin, where the Colorado-Big Thompson (C-BT) Project diverts water from the upper Colorado River, owners of contracts for C-BT water are only required to obtain the blessing of the Northern Colorado Water Conservancy District board, rather than a water court, before selling or leasing their water interests, and a robust leasing market has materialized there.

According to a 2016 WestWater Research report, leases have accounted for about 80 percent of all water trades in the South Platte Basin in recent years, and most transactions have involved farmers leasing their water to cities. The value of this streamlined process is also reflected in the sale price of C-BT units—unlike a lease, a sale gives a buyer rights to the unit in perpetuity. In 2015, C-BT units changed hands 67 times and fetched an average sale price of $36,300 per acre-foot—by the second quarter of 2016 the price was above $40,000. Meanwhile area ditch shares, whose transfer requires water court approval, were traded just 23 times for an average price of $13,800 per acre-foot.

Pricing the priceless: The non-market value of water

The market for C-BT units is a compelling example of what freer water trading might look like, yet several factors make it unlikely that such a market could be replicated across Colorado. Under a 1938 contract between Northern Water and the U.S. Bureau of Reclamation, all contracts for C-BT water must be exercised within the boundaries of Northern Water’s service area. Units of C-BT water can only be used once before being allowed to flow down the lower South Platte River between Greeley and the Nebraska border, for the benefit of irrigators there. And yet, irrigators on the lower river have no legal right to claim injury if the lease or sale of C-BT units affects the return flows they rely on, since the prior appropriation doctrine—including the no-harm-to-juniors rule—applies only to native flows within a river basin, not to transbasin diversion water. This minimizes objections when C-BT units are leased or sold.

Leaving aside these complicated machinations, there is a simpler reason why most of Colorado’s water sales and leases are still regulated by water courts: Legal safeguards like the no-harm-to-juniors rule play an important role in limiting harm to third parties or the environment when water is moved. They also highlight water’s role as both a private good and a public resource with important environmental and cultural values.

Economists have devised a suite of techniques to translate those “non-market” values into financial terms so that they can be factored into cost-benefit analyses of water projects. Perhaps the most prominent technique is “contingent valuation,” where economists survey water users to gauge their financial willingness to pay for environmental benefits or willingness to accept environmental harms.

People value water’s role in the environment for a wide variety of reasons: “Use value” reflects the benefit of using a waterway for kayaking, rafting or swimming; “existence value” measures the well-being gained from simply knowing that a river exists; and “bequest value” shows the worth of knowing that an environmental good will be preserved and passed down to future generations. There is also “intrinsic value”—the notion that other water-dependent species should be allowed to exist regardless of their value to humans.

Because some of these values have an emotional component, it can be tough to give them the same weight as purely financial considerations, and many cost-benefit analyses reflect this problem. In 2011, for instance, the Colorado Department of Public Health and the Environment was considering additional limits on releases of phosphorous and nitrogen from wastewater treatment plants to comply with enforcement of the federal Clean Water Act by the Environmental Protection Agency. A state-commissioned study by the consulting firm CDM Smith weighed the costs of those new regulations—new equipment and more intensive wastewater treatment and monitoring—against benefits like reduced spending on drinking water treatment, better-tasting and better-looking drinking water, improved ecological function in rivers and streams, and increased recreation. The study found that the regulations would yield just $0.79 worth of benefits for every $1.00 spent to implement them. Yet it relied on rough estimates—derived from previous economic studies—of the financial value that people place on environmental benefits. And it did not weigh qualitative benefits like existence and bequest value, despite the fact that these values often account for half of people’s willingness to pay for environmental benefits, according to CSU environmental economics professor John Loomis.

Those same omissions have characterized, and potentially marred, other studies. A 2009 study by the Front Range Water Council, a group of Front Range water providers that has advocated for new transbasin diversions from Colorado’s Western Slope, found that the Front Range withdraws 19.4 percent of the state’s water but generates 80 to 86 percent of the state’s economic activity, while western Colorado withdraws 41 percent of the state’s water but comprises just 10 percent of the state’s economy. By that logic, the Front Range produces about $132,268 in economic output per acre-foot of water used, compared to just $7,200 per acre-foot on the Western Slope. Yet those figures fail to account for the economic costs that diverting water to the Front Range imposes on the Western Slope, along with the financial benefits of things like tourism and recreation, which rely on keeping western Colorado water in the stream. The Northwest Colorado Council of Governments (NWCCOG), a coalition of Western Slope municipal governments whose members generally oppose new transbasin diversions, attempted to address these omissions with its own 2012 study: “Water and its Relationship to the Economies of the Headwaters Counties.”

“We have struggled to convey how important having water in the river is to the economy in the headwaters region, especially in the summer,” says Torie Jarvis, co-director of the Water Quality and Quantity Committee at NWCCOG. “That study was meant to point out that there were values that studies like the Front Range Water Council’s were not accounting for.”

Some of these values, and the economic implications of protecting them, are relatively easy to quantify: The town of Winter Park, for instance, is forced to treat its wastewater to a higher standard because 65 percent of the Fraser River that once flowed through town is diverted to the Front Range, making wastewater more difficult to dilute. “We have seen an impact on the cost of wastewater treatment year-round due to the lack of dilution flows,” says Bruce Hutchins, manager of the Grand County Water and Sanitation District 1. Faced with ongoing transbasin diversions, Winter Park town leaders have also opted to curtail the town’s development to keep at least 10 cubic feet per second of water in the Fraser River at all times. That has clear economic consequences: At buildout, the town could accommodate about 9,300 single-family housing units if officials were willing to dry up the river to provide them with water. Instead, the town has capped the number of water taps it will dispense to allow for just 8,300 single-family units in order to maintain river flows.

“It’s a bit backwards from the way that other communities have done it,” says Winter Park community development director James Shockey. “We’ve put the river first, and then looked at how much we can develop from there.”

Other values compromised by transbasin diversions, like the potential effect of changes in water use on tourism, require non-market valuation in order to be expressed financially. In a March 2003 study, CSU economists Adam Orens and Andrew Seidl surveyed winter tourists in the towns of Gunnison and Crested Butte to see how changes in the area’s open space ranch landscape would affect their decision to vacation there. More than half of those surveyed said they would reconsider vacationing in the area if just 25 percent of the existing ranchland were converted to second homes or other uses. If all of the ranchland were converted, the researchers concluded that tourism in the area could drop by as much as 40 percent.

Contingent valuation surveys have also shed light on the value of water left in rivers for recreation, wildlife habitat and scenic views, which sometimes exceeds the economic benefit of diverting that same water to farms or cities. In a 2008 study, CSU Economist John Loomis surveyed a random sampling of Fort Collins residents and found that they were willing to pay an average of $352 per year to keep peak spring and summer flows in the Cache La Poudre River rather than letting agricultural and municipal users deplete them. “It appears the value of these instream flows to Fort Collins residents is of the same magnitude as the market value of the water in alternative uses,” like irrigation and municipal use, Loomis concluded. In Colorado today, there are two legal  mechanisms that Fort Collins residents could use to keep that water in the stream, and both involve the prior appropriation system. In theory, they could convince local or state government to acquire a water right on the Poudre from a willing farmer or utility, then convert it to an instream flow right (held by the CWCB) or a recreational in-channel diversion right (held by a local government) to keep its recreational and wildlife benefits intact. Such benefits are protected in some states by the public trust doctrine, a legal concept which holds that certain resources should be held in trust by the government for public benefit. Yet that concept holds no legal sway in Colorado.

“We are not a public trust doctrine state,” says retired Colorado Supreme Court Justice Greg Hobbs. “We are a prior appropriation state with a market. The Constitution provides that the water is owned by the public and is dedicated to the use of the people of the state subject to appropriation. Therefore, the public values protected by the constitution consist of the beneficial uses made by water rights owners.”

Wading through no man’s land: Accounting for social costs

There are some good examples of water users paying for the public and private costs of their diversions. Under a 2012 pact called the Colorado River Cooperative Agreement between Denver Water and 17 Western Slope entities, the Front Range utility won support for its efforts to enlarge Gross Reservoir north of Boulder in exchange for helping to fund dozens of river improvements on the Western Slope. Among them: channel maintenance and habitat improvements on the Fraser River, a catchment basin that reduces sediment in the Fraser and cuts water treatment costs for Winter Park, and a whitewater park in the Colorado River at the mouth of Gore Canyon near Kremmling.

Yet some observers argue that there should be a more formalized way to charge for the public costs of diverting water. Aside from mitigation requirements imposed on water projects by state and federal environmental laws, the existing legal mechanisms for protecting public values—instream flow rights and recreational in-channel diversion (RICD) rights—were introduced into Colorado water law relatively recently. (The legislature authorized the first instream flows in 1973 and RICDs in 2001.) That means that many instream flow rights have junior priorities and cannot be exercised when more senior rights are diverting, which can render them ineffective during dry parts of the year. As an added way to safeguard water-related public goods, the CSU economist Chris Goemans floats the idea of a public fund—perhaps financed by a tax on the buy and dry of agricultural lands—dedicated to preserving water-related public goods like open space and wildlife habitat.

“There are social values of water use that are not factored into the transaction when a farmer sells their water to a city,” says Bovee. “A farmer cannot charge a developer twice as much simply because his water is irrigating nice open land that will dry up once the water is gone. The developer will not pay extra to compensate for the loss of that public good.”

In extreme cases, in the absence of state intervention, the social costs of water diversions can undercut the economy of an entire region. A well-known example of this is southeastern Colorado’s Crowley County, where droves of farmers sold their water rights to the growing cities of Aurora, Colorado Springs and Pueblo between the 1960s and the 1980s, then took the profits, packed up and moved away. Because few of the proceeds from those water sales were reinvested in the community and the region lacked an alternative economy to fall back on, widespread unemployment ensued that persists to this day.

“If you looked at this transaction from a statewide perspective, it was a net benefit,” Bovee points out. “The revenue from moving that water to the Denver Metro area was greater than the lost income from farming in the county. But there was a spatial problem—Crowley County did not have a second and third economy to rely upon, so it was economically devastating, and there was huge poverty and social fallout. Open markets see nothing wrong with that transaction. But the state has to look out for the health of its rural populations and mitigate the downside in some way.”