Making risky decisions – Is it wise to invest in desalination plants for drinking water?

A recent and welcome news release informed us that, following several years of severe drought in California, water supplies had recovered to the extent that state officials suspended state-wide restrictions on water use. Regulation of water use reverted to local authorities. During the drought, there had been repeated suggestions that hard-hit localities (San Diego was one) might consider investing in desalination plants. A common response was that California might be wise to take a hard look at Australia’s experience with large-scale desalination during its long-lived “millennium drought” several years earlier. John C. Bergstrom and Alan Randall explain.

The millennium drought was unusually severe and long-lived – from roughly 2004 to 2010 – and Sydney water customers watched uneasily as the water level in Warragamba Dam continued to fall. Warragamba is a huge reservoir with a large catchment and storage capacity equivalent to about six years’ supply for Sydney. Managers had imposed restrictions on water use, and these restrictions became more severe as time passed without a break in the drought. Planners developed a contingency plan for a $2 billion desalination plant to augment supply, and recommended that the plant be built in the event the water level fell below 30 per cent of capacity.

By 2007, the long-running drought was showing no signs of letting up. Residents were tolerating the severe water restrictions fairly well, but becoming fearful that things might get worse. Given the huge capacity of Warragamba, it could be expected to provide adequate water even in an extremely long drought. Engineers routinely calculate the 100-year drought and the 500-year drought (ie, the worst drought with probability 0.01 and 0.002, respectively), and those numbers suggested that running out of water in Warragamba was very unlikely. Nevertheless, as the length of drought began exceeding expectations, people began to question the strategy of waiting-out the drought. Some commentators began speaking of drought as “the new normal”.

Was Sydney just experiencing an unlikely run of bad luck, or was the weather system really changing as the climate scientists had been warning?

There is a powerful reason to delay a big-bang solution, such as a $2 billion desalination plant, as long as possible – for example, if it rains in time, the problem goes away. State government officials started to feel the heat as the water level in storage dropped below 40 per cent of capacity, and officials do not like to be accused of fiddling while Rome burns. In due course, the state government succumbed to the “we have to do something” impulse and authorized construction of the Sydney desalination plant (SDP) in 2007, when the dam level was still a few percentage points above the planners’ trigger. The plant began operation in 2010 for a two-year proving period, after which it would be governed by rules calling for full-scale operation when the dam level falls to 70% of capacity, and return to stand-by mode when storage returns to 80%. Ironically, the drought had broken while the SDP was under construction, and Warragamba was near full capacity for much of the proving period. Water restrictions were eased and, as it turned out, demand did not recover to its pre-drought level – it turned out people had learned ways to live just as well while using less water.

In retrospect the evidence suggests that the unprecedented low inflows in the 2000s really were just a run of bad luck, but we can sympathise at least a little with the embattled decision makers in 2007.

In May 2012, the newly-elected state government, which had opposed construction in 2007 when it was in opposition, sold the plant to a consortium of institutional and corporate investors led by the Ontario, Canada, teachers’ pension plan. The purchase price was $2.3 billion (just enough to cover the initial cost plus the transactions costs of the sale), and Sydney Water entered into a 50-year contract with the buyers requiring guaranteed payments of $190 million annually when the plant is in stand-by mode, plus substantial shut-down and start-up payments, all inflation-adjusted. Sydney Water committed to purchasing any water produced by the plant, at rates set by the independent regulatory authority to allow the new owners a 6.7% return on investment. SDP was duly put on stand-by in July 2012 and, given the current water level in Warragamba, it is unlikely to be needed again before 2020. Optimists point out the SDP provides some insurance against a future drought, but realists argue that desalination technology is progressing so fast that SDP will be too inefficient and expensive to use in the event it ever is needed.

So, a major investment was made in order to forestall a potentially devastating but quite unlikely water shortage; in the end, this investment turned out to be unnecessary, it has little salvage value; and, while the water authority got its money back, its customers are saddled with substantial payments to the SDP’s new owners for fifty years beginning in 2012. There is much to be learned from this story – chapter 7 of our new book ‘Risk and uncertainty: how do we assess risk and make risky decisions involving natural resources and the environment’ explores in more detail.

Our forthcoming blog pieces will take a closer look at risk management and the politics and economics of privatizing public facilities.

Resource Economics: An Economic Approach to Natural Resource and Environmental Policy, Fourth Edition, John C. Bergstrom, The University of Georgia, Athens, US and Alan Randall, The Ohio State University, US and The University of Sydney, Australia

This textbook is available on inspection for courses.