Free Market Solutions To Fix India’s Water Crisis

Water costs money. Sooner citizens realize this and policy makers allow private participation in the sector, better our chances to tackle the water crisis. 

In more than sixty years of independence, India has courted several welfare measures, ranging from subsidies to price control and even rationing, in an attempt to provide the country’s burgeoning population with a steady access to clean water. These measures have shown abysmal results as is evident in the recent data shared by the country’s ministry of water resources.

From 1947 to 2011, water availability per person in India decreased by as much as 75 percent – from 6042 cubic metre to 1545 cubic metres. It is further expected to reduce to 1,340 cubic metres by 2025 and to 1,140 cubic metre by the year 2050. A study by the management consultancy McKinsey and Co. predicted India’s water demand would grow to almost 1.5 trillion cubic metres by 2030. The current water supply is approximately 740 billion cubic metres, less than half the forecasted demand.

Such gaping imbalance between present supply and potential demand calls for a sincere reconsideration of old methods of addressing water challenges. Particularly, given the lamentable track record of the state in managing crucial national resources, including water, there is a need to institute greater role for the free-market.

Traditional methods employed by the State have been particularly ineffective in managing water crisis owing to their populist nature; they are directed at appeasing certain class of voters at the cost of causing severe groundwater depletion, widespread shortage, and financial loss to the exchequer. Subsidizing water, for example, is politically palatable as it helps keep the actual prices far below the costs of extraction, treatment or transportation.

What most voters seldom realize is that subsidization must inevitably lead to scarcity, as artificially maintained low price causes demand to rise irrationally. And since water is a limited resource, there is no way for the State to fulfil this increased demand. Those fortunate enough to get access to subsidized water – which includes most people in urban areas – now have greater incentives to waste it while others, who do not form a substantial vote bank, continue to suffer from shortage.

As economists Terry Anderson and Pamela Snyder explain in their book ‘Water Markets’, “What is seen as a waste or inefficient water use in rural or urban areas is simply the users’ rational response to low water prices.” The key word to note here is “rational”, since the only response to artificially created low prices, keeping other factors constant, is to buy more of it regardless of actual usage.

In response to scarcity, the government then imposes restrictions on us in the form of rationing. Regular water outages in various parts of the country are not uncommon. A recent government study showed that 22 out of 32 major Indian cities suffer from daily shortages. By providing water only for limited hours per day and on specific times, the state effectively decides how we should use water, in what quantity, and when. This is not unlike a totalitarian state where consumers’ choices are routinely sacrificed at the arbitrary whims of bureaucrats in the name of “public interest”.

I say “arbitrary whims” because it is beyond the means of the state to know the right price of water or of any other resource absent the market forces of demand and supply. It is these forces – guided by our individual preferences and choices – that determine how much a good is worth in the market. Greater demand translates into higher price and, conversely, lower demand into lower price. The state, by virtue of not having access to information about our complex and dynamic preferences, ends up distorting incentives and begetting scarcity.

Consider the alternate scenario: that the state does not subsidize water, allowing its price to respond freely to the forces of demand and supply. People would then pay as per usage, and they would have greater incentives to conserve water.

Private companies are better placed to facilitate conservation, since they their chief revenue stream is user charges that incentivizes people to consume water efficiently.

Another reason for water scarcity in India can be attributed to the classic problem of “tragedy of commons” that results when national resources are publicly owned. Milton Friedman, dealth with this problem in his 1980 book ‘Free to Choose’. While reflecting on the decrepit condition of public housing in the Soviet Union as well as United States, he wittily remarked, “When everybody owns something, nobody owns it, and nobody has a direct interest in maintaining or improving its condition.”

This statement appears to be a searing indictment of the ramshackle condition of publicly owned water resources in India. The virtue of conservation in the subsidy-culture of our country only gets lip service because, as Friedman beautifully explained, “nobody has a direct interest” in economizing consumption.

We like to rely on activists and NGOs – besides of course state-imposed rationing – to create awareness about the need to save water. Well intentioned as they may be, these activists are hardly initiated in the economic underpinnings of scarcity. Instead, they continue to rely on the inherent goodness in human nature as the panacea for wastage. To be sure, the role of awareness cannot be overrated. But it may be best regarded as a fringe solution, as it fails to account for a fundamental aspect of human nature: individual self-interest. Even if a responsible consumer may be inclined to economize water usage, he may think, “Of course I want to save water. But what would my picayune saving amount to when compared to collective consumption?”

The “you first” instinct prevents us from voluntarily reducing water wastage just as it prevents us, collectively, from having our vehicles inspected for pollution in regular intervals. It also explains why an otherwise responsible citizen would nonchalantly throw a smoked cigarette or a used wrapper on the street, thinking that his one-time littering would not make substantial negative difference to the environment. This instinct, of course, is not unique to Indians. It constitutes basic human nature and is therefore universal.

Rather than ignoring or trying to correct our natural, human tendency to pursue “self-interest”, we would do well to create institutions that leverage it to the benefit of the society. That’s exactly where the role of privatization and free market system in water management assume significance.

Following the economic liberalisation of the 1990s, India witnessed the merits of privatization in airline, telecom, automobile, banking and a host of other industries that were earlier strictly controlled by the State. Competition among private companies resulted in greater consumer choice and plummeting prices.

A privatization drive in water systems may similarly help bring much-needed efficiency to the sector. But care must be taken that the transition is smooth and transparent lest it lead to unfavourable outcomes that weaken rather than promote free-market.

The water sector, unlike many others, involves substantial yet very specific risks that may make the co-operation of private enterprises more complicated. Water projects are capital intensive and may also involve high initial investments. The infrastructure is fixed, very specific and cannot be used for other purposes – and since most of it is underground, it may also involve high maintenance costs. If operators are foreign companies, then they could be exposed to foreign exchange risk as well. These challenges are enough to deter most private companies from entering the water sector. Absence of sufficient private bidders can undermine competition, which is a crucial component of the market-system.

These risks notwithstanding, there are several ways in which we can encourage competition in water sector. A 2009 report from the Organization For Economic Co-operation and Development (OECD) titled’ Private Sector Participation in Water Infrastructure’, suggested important steps that developing countries could take to ensure that all artificial barriers restricting competition are eliminated. For example, we could remove barriers to entry that may restrict companies below a specified level of capital or size from venturing into the water sector.

Oftentimes, state-owned water operators are provided monumental subsidies by the government. They are also allowed to issue tax-exempt debt in order to attract funds. To make the playing field equal, we could phase out subsidies and rationalize tax treatments across international and domestic companies, state-owned and private enterprises, and small and large players. This will prevent some players from gaining undue advantage over others.

We could also encourage transparency and smooth information flow so that certain water companies do not take advantage of insider information to gain undue lead over their rivals. A system of performance benchmarking could be introduced to compare operational efficiencies between organisations. This would put competitive pressures on water operators, thereby inducing them to perform better.

Freeing up the water sector from artificial barriers is only half the step towards ensuring smooth functioning of privatisation. Like in any sector, we should also consider the role of regulations in ensuring that companies do not flout rules and that competition stays fair. These regulations may be aimed at maintaining water quality, protecting the consumer in cases of fraud, and preventing rent seeking behaviour among companies and public officials. Governments should take care, however, that these regulations are not cumbersome upon businesses. Ideally they should minimize both costs and market distortions, promote innovation through proper incentives and are compatible with competition.

Critics say that water is too important a resource to be left to private players. It will lead to higher prices that will ultimately hurt poor the most. This is a valid concern. In a free-market, the prices are bound to fluctuate with the forces of demand and supply. Yet, the truth is that free fluctuation allows water to be reallocated to its highest valued use. If the market price of water is high, for example, I have an incentive to conserve water – use it only for purposes that I value the most – and sell the remaining water to users that need it for their most valued uses.

This market pricing mechanism makes scarcity virtually non-existent. If the groundwater depletes substantially, then prices will increase just enough to reflect the low supply of water underground. Water will still be available, but at higher prices that truly reflect groundwater availability. Market prices will then prompt users to reconsider their water use. For example, farmers in certain areas may realise that they would earn more from selling water than from using it in agriculture.

Take the case of Punjab, where rice production is not a very profitable endeavour. Paddy fields typically require three times more water than the total rainfall Punjab gets every year. Instead of extracting ground water and depleting it in the process, farmers can import water from eastern areas which get ample rainfall (thereby enriching eastern farmers, both big and small, that sell excess water). Or, if importing does not make economic sense given the costs, then they could switch to producing other high valued crops such as fruit, vegetable, and meat, and dairy. 

Whatever options the farmers ultimately choose, their decisions would rest on the market prices of water and not on artificial prices set by the state through subsidies. This true pricing will enable water to be allocated to its highest valued use and will therefore prevent scarcity.

An essential requirement for water markets to run efficiently is to create defined, enforceable, and transferable property rights. In the United States, for instance, water markets in many western states emerged out of the prior “appropriation doctrine” or first-ownership-to-first-user, which recognised rights to the use of water rather than to the water itself. Water rights could be defined in terms of water volume or a share of water flow or availability in a given place. Absence of water rights does not necessary mean water markets would not exist, but that they may exist informally as has been the case in Tamil Nadu.

Informal water trading is practiced in this state by selling the land adjacent to a river to people who would pump water from underground, either from a well or directly from the river. This practice, of course, is illegal for two reasons: (1) these people have no rights to the river water and (2) they often use electricity that is legally provided only for agriculture purposes (not for pumping water). The well owners sell water to the truckers who then deliver it to urban consumers at more than 10 times the price of subsidised water provided by the state.

Despite high prices and illegality of water markets, users continue to buy water from truckers owing to severe scarcity. These consequences could be reversed simply by legalising water markets and giving transferable rights to users so they can sell it without adverse legal implications. As Stanford law professor Barton Thompson observed, “By providing the legal infrastructure for water markets and actively encouraging such markets, the government can help reduce the harm from uncertainty in water rights and deliveries.”

Just as the solution to crimes does not lie in imposing curfews but in strengthening law and order, and the solution to traffic congestion does not lie in banning all cars but rather in planning towns better, so also the solution to water crisis rests not on rationing or price control or subsidisation, but in transforming India’s informal, unregulated, and spontaneous water markets into formal trade that is well enforced through protected property rights.

“The available supply of every commodity is limited,” wrote the great economist Ludwig von Mises in his book Human Action. “If it were not scarce with regard to the demand of the public, the thing in question would not be considered an economic good, and no price would be paid for it.” For India to tackle its future water needs, it must break free of sordid, socialist activism that is bereft of any genuine understanding of the economics of scarcity and provide the free-market a chance.