Cut and Dry: What California’s Water Restrictions Mean for Risk Management
For the first time in modern American history, severe drought conditions combined with essentially unfettered demand have led an entire state to implement mandatory ongoing restrictions on the use of water. California Governor Jerry Brown issued an Executive Order in April 2015 mandating a 25% reduction of urban water usage from 2013 levels over a nine-month period, a savings of roughly 424 billion gallons—enough to fill more than 640,000 Olympic-size swimming pools. The move followed a failed year-long effort to achieve a voluntary 20% reduction in water usage, with statewide conservation results averaging between just 7% and 12%. Early returns suggest that residents are starting to get the message: The State Water Resources Control Board reported that water use in May had dropped by 29%.
The mandate requires that local water agencies and suppliers determine for themselves how to achieve their goal, which is weighted based on each area’s current water usage. To reach the 25% goal, local conservation requirements actually range between 8% and 36%. Crucially for California’s vast agriculture industry, local entities can effectively ignore agricultural usage.
In terms of the impact on other businesses, California state-level regulators have been careful to note that they have not targeted any industry or sector for specific cuts. Instead, the State Water Resources Control Board explained, “Water suppliers will determine locally the actions that they will take to ensure that their commercial, industrial and institutional sectors are contributing to meeting these requirements and in what amounts.” In other words, if a business uses a significant amount of water, it may well end up on the local water agency’s target list for water reduction.
Although California is the first state to employ such drastic measures, it is unlikely to be the last. In a 2014 report, the U.S. Government Accountability Office (GAO) found that 40 of the 50 state water managers expect freshwater shortages in some portion of their states by 2023 under average water conditions, with 24 of those states anticipating shortages to impact entire regions. If there were drought conditions, all 50 state water managers foresee water shortages. Furthermore, the GAO cited research from the National Drought Mitigation Center that predicts ongoing climate change will result in more widespread and severe droughts across much of the United States. In anticipation of increasing water scarcity nationwide, businesses should carefully observe the impacts of the water restrictions in California.
Industries at Risk
Much of California’s regulatory framework and the resulting public discussion have primarily focused on the water usage of residential consumers, with previous regulations prohibiting the use of potable water to wash sidewalks, driveways and cars, and to maintain excessive outdoor landscaping in the state’s hot climate. But homeowners and businesses with large, lush lawns are not the only heavy users of water in California.
For most of the country, water has been a ubiquitous and inexpensive resource for so long that it can be difficult to remember how critical it is to so many different industries. Several trade groups and individual businesses from a range of industries submitted comments on California’s proposed regulations. The California Construction and Industrial Materials Association noted that many of its members are required to use significant amounts of water to control dust in compliance with the Federal Clean Air Act as well as local requirements. The California Hospital Association emphasized that acute healthcare facilities must remain operational 24/7, 365 days a year, and that water usage for many critical purposes such as sterilizing instruments and patient hygiene simply cannot be cut without threatening public health and safety. The California Manufacturers & Technology Association and similar trade groups called for regulators to recognize that water is crucial to industrial operations and to exempt so-called “process water” from the reduction regulations.
There are very few industries for which water is not a crucial resource, and cutbacks could have a significant impact in any sector of the economy. As the California League of Food Processors stated in its comment letter on the regulations, “Mandatory reductions in water may equate to an equivalent reduction in economic output and could result in significant job loss.”
In the face of economic losses caused by outside events, businesses most often turn to insurance as a means of risk transfer. For even the most well-insured business owner, from the sole proprietor to the largest corporation, there are some key questions to ask if the water supply dries up. Operationally, the business must quickly determine when the water will return and what to do in the meantime. In terms of insurance coverage, however, the only question that really matters is “why?”
Depending on the answer, the business losses that stem from lack of water can indeed be compensated. Typically available as an endorsement to basic business interruption coverage, utility service interruption insurance is designed to protect businesses from lost income caused by utility outages. Such coverage, however, only applies if the utility outage itself is caused by a covered cause of loss. If, for instance, the water stops because of a lightning strike or fire at a far-off pumping station, a business can recoup the lost income if its operations suffer. If, however, a business’s pipes go dry because the government has mandated across-the-board water reductions, insurance coverage is simply not available.
Insurers have long held that regulatory risks are uninsurable for much the same reason that businesses cannot insure against the likelihood a competitor will come up with a better product or service: While such insurance could be possible to provide, it would be priced so exorbitantly that no business could afford it. Without the ability to transfer the financial risk of water restrictions, businesses in California and anywhere else facing similar regulations must consider other risk management strategies.
Water Scarcity Mitigation
Until the fundamental causes of water shortages are addressed, no business will be immune to significant downside risk from water scarcity.
There is no question that many businesses in California face a near-term risk of financial loss as a direct result of the mandatory water cuts. An economic impact analysis prepared for the State Water Resources Control Board estimated that total direct costs may reach between $1 billion and $1.3 billion through January 2016. This theoretically includes the lost profit from businesses that may have to cut back production, although the report’s authors readily admit such estimates are extremely imprecise.
Beyond the limitations of the economic impact analysis, reality is more complex. Dr. Bonner R. Cohen, an expert in environmental and energy policy and senior fellow with the National Center for Public Policy Research, said that “nothing short of a well-run police state” could effectively enforce the regulations. If the mandate were actually enforced, Cohen believes many water-intensive businesses would try to avoid the resulting risk by leaving California altogether. Risk retention, in this situation, would amount to accepting higher costs and possibly less supply of water. This would only make sense for a business that can maintain acceptable levels of profitability given the restrictions. This strategy, however, includes significant risk of the unknown: If California’s drought continues for several more years, more severe regulations may be imposed at even higher economic costs.
In terms of risk reduction, businesses anticipating regulatory water restrictions in California or elsewhere have two general approaches: reducing their own demand for water, or addressing the broader public policy that led (or may lead) to water restrictions. It is possible that many businesses could achieve substantial water use reductions through measures like auditing their current usage, replacing outdoor landscaping with drought-resistant plants, or installing more water-efficient appliances and equipment. Such techniques are certainly much easier for an individual business to control than public policy is, but ultimately may not be enough to truly mitigate the long-term risk. Until the fundamental causes of water shortages are addressed, no business will be immune to significant downside risk from water scarcity.
The Tragedy of the Commons
While it is possible that every individual consumer will invest in water efficiency measures to stave off disaster, history and economic theory suggest that is extremely unlikely. The concept of the “tragedy of the commons” says that individual consumers tend to maximize their own usage of shared resources to meet their needs even if the combined effect of all users doing so ultimately depletes or destroys the resource. Unfortunately, considering that California’s initial attempts to achieve voluntary reductions in water usage were ineffective, it appears the state is at risk of experiencing a tragedy of the commons regarding water—there simply is not enough to meet everyone’s wants or needs. Other states and municipalities could someday follow.
Cohen characterized California’s current water crisis as a man-made disaster, arguing, “The drought came to us from Mother Nature, but the crisis came from political decisions.” He noted that the risk of drought is entirely predictable, as California has suffered through at least eight severe droughts in the 20th century alone. Equally foreseeable, growing populations and expanding economies continue to demand additional public resources such as water, but public policies have failed to keep up with the correlating demand. Worse, he argued, governments have imposed rules, regulations and policies that make it difficult, if not impossible, to devise workable solutions for shortages.
For example, Cohen cited the enactment of renewable portfolio standards in most U.S. states, which mandate that a certain percentage of electricity generation come from renewable energy sources over a defined timeframe. Unfortunately, as states and municipalities have struggled to meet these requirements, the cost of electricity has dramatically increased. Indeed, some estimate that California’s energy prices may increase by 47% by 2030 in part because of renewable portfolio standards. As such, even though California sits on an ocean, it cannot effectively utilize desalinization to produce additional fresh water since the process is energy intensive, and thus cost-prohibitive. Partially in response to these energy cost increases, states like West Virginia and Ohio have already undone these regulations, and others may follow. Water restrictions could face similar difficulties.
California and other states also have not adequately invested in necessary water infrastructure, including reservoirs. The American Water Works Association estimates there are 240,000 water main breaks annually, resulting in tremendous waste. For the American economy to grow, improved water infrastructure is a necessity. Unfortunately, Cohen said, individuals and businesses are now paying the price for these failings of public policy.
California may be the first state to impose mandatory water restrictions, but it is unlikely to be the last. Businesses in all industries rely on cheap water and may have previously taken it for granted. As that changes, individual conservation or efficiency efforts are only part of the risk management strategy required to ensure that needed water supplies remain available and cost-effective. Although many businesses may be wary of getting involved in public policy debates or lobbying efforts, an era of water scarcity may make such involvement a necessary long-term risk-reduction technique. As Cohen warned, “What we’re seeing now in California, we’re going to see again.”