In November 2013, voters from around Texas overwhelmingly approved a referendum that would allocate $2 billion from the state’s Economic Stabilization (Rainy Day) Fund to start water projects already included in the Texas Water Development Board’s State Water Plan. Many interested parties, including legislators and environmental groups, believe that the real work lies ahead. Where is this money going to go? And which projects are ultimately going to be funded? Andy Uhler spoke with the LBJ School’s own natural resource economist, Dr. Sheila Olmstead, to discuss the implications of this referendum, in a larger sense, for Texas public policy. 

Andy Uhler: I think the prevailing attitude from a lot of folks in favor of this legislation was: If we put money towards these projects, then we’re just going to inherently be better off. Is that necessarily true?

Sheila Olmstead: There are economists who have written about returns to public investments in infrastructure in terms of private economic activity, and those things definitely generate some sort of growth. There is certainly some link there. The public sector has been the funder and provider of dams, levees and other kinds of water infrastructure for a long time. That’s in part because you build those things and there is a very diffuse, large population of beneficiaries who, in the absence of the public role, may not have pooled their resources to provide the good because we can all free-ride on other people’s investments. So, it’s not an unusual thing. The public sector has directly funded and managed those infrastructure projects for a long time. This strikes me as something where you’re not relying entirely on the private market, but you do inject some of that competitive pressure to make sure that a project has a good rate of return.

AU: Is it accurate that federal, state and local government wasn’t investing in water projects heavily over the last fifty years? That was certainly part of the story many Prop 6 supporters and water funding advocates have hung their hats on.

SO: You’d really have to go back and look at the historical data on infrastructure investments. Nowadays, we do more benefit-cost analysis, and we have a better understanding of what some of the downside impacts of those projects were. As beneficial as they were for the intended recipients of the amenities – like farmers’ irrigation water or whatever that happens to be – they had some pretty significant costs that often weren’t on the ledger. Now, we’re more conscious of those things. People value some of those opportunity costs higher, like less access to untapped rivers. So it’s a mix. It’s true there’s been a lull in those kinds of investments, but you also have to consider the context of what has happened with government-funded projects as a whole. We’re in an era of tighter budgets, especially recently.

AU: Is there anything to be learned from what other states or other countries have done in setting up something of a permanent fund for water projects?

SO: It’s difficult since what we know about how these systems work and what their benefits and costs are changes over time. In some ways California is a great example because we had huge investments in moving water from the northern part of the state down south where the cities are and now we’ve realized, ‘Oh, wow, look what’s happened to the Bay Delta – this is a mess. Maybe we might have anticipated it a little bit.’ Some of this learning happens once the big project is there, and once the big project is there it’s not going away, or it takes a very long time before you can think about taking away those entitlements to water and dealing with the infrastructure. For example, there are dams in the U.S. that could probably be destroyed and there would be net benefits to doing that, but the process of doing that is extremely expensive and contentious. It’s one of those problems that isn’t irreversible once the investments are made, but it’s hard to reverse those decisions. And you often don’t know some things about the outcomes until decades after the infrastructure is there. You can’t really experiment with infrastructure. You can, but it’s really expensive and you’re changing a lot when you install this kind of infrastructure. But that doesn’t mean you don’t have net benefits. There are downsides, but a lot of these projects provide a lot of good, too.

AU: Does it make sense to equate the sort of funding that we’re doing with transportation and, historically at least, the funding of roads to the sort of thing that we’re talking about doing with water projects? Or is this more like the establishment of a toll road system?

SO: There are many benefits to the extent that you can inject some of that payment for services and those kinds of funding mechanisms. It’s not just that they’re a self-sustaining way of funding the project, but it helps to ensure that the amenities provided by the project are governed by prices. You want to inject that into the process. You should think of the government as providing the infrastructure because it’s not going to be provided by the private market, or it’s going to be under-provided by the private market. Yet there are a lot of benefits to having the private market provide stuff, so the government has to be that proxy. It has to take on that role in terms of the capital piece, the financing piece and the pricing piece.

AU: But, historically, in Texas, folks don’t like the government doing things like that, right? How is this any different?

SO: We don’t often know exactly what the government does. I suspect even in arid parts of Texas, if you ask people, they might not know how heavily subsidized some of their water infrastructure is. While there may be some resistance to government intervention, I suspect if you worked it out with pencil and paper, most Texans are the beneficiaries of government largess with some of it related to water infrastructure. So, it’s a role that the government has served before and doesn’t seem out of step with how governments have funded water infrastructure in the past.

AU: But this method of funding is a bit out of the ordinary, right?

SO: Historically, the public sector has used tax revenues of some kind to create these large infrastructure projects, so this is a little different. What you’re talking about is providing financing at what sounds like basically market rates. So, the key thing will come down to, ‘What’s the counterfactual?’ If the government had just outright funded those projects, then we would expect to see investments that might not have passed the bar for a private bank. Again, that’s an efficiency cost, but you might have a social goal other than efficiency that you’re trying to achieve and make that trade-off. But, generally, we think of that as being not as efficient as private investment, because of the free-riding problem. However, in this case, it sounds like we’re trying to inject some of that competitive market pressure in decision making about which projects are going to get funded, and that can only be a good thing relative to the earlier model. Ultimately, this doesn’t sound like the same old, same old. It’s somewhat different.

AU: Do you think the connection between oil and gas revenues and the funding mechanism for this water funding is compelling to voters?

SO: It’s a rainy day fund. Texas has made the decision that it’s there for things we might need during a downturn. It’s an interesting and  fine way of thinking about how to use those funds. You could also think about it in the sense of, ‘Well, we’ve got lots of oil and gas development and we anticipate that increasing in the future with the shale revolution, so we think that’s going to require some additional water resources, particularly in some really arid regions. So one thing that we could do, in a very reasonable sense, is take some of that investment that has been built up over time, some of that capital that is in that fund, and put money toward fixing that problem.’ That would seem to be, just from an economic perspective, a really great use of those funds because you’re stocking money away from the depletion of oil and gas to do something about the depletion of oil and gas.

AU: Why do you think referendums like this one are able to pass with such a considerable percentage of the vote?

SO: It helps that the voter is not being asked to pay out of pocket. I would think next to a referendum that’s actually going to involve a local tax increase, people would be much less likely to vote for the latter, just because of the problem of free riding and willingness to pay. Here, they can think, ‘Well, the money is already there. Sure, let’s use it for something like this.’

AU: Other economists have expressed concern that the influx of money to the water development plan is just going to start building things without scrutinizing the viability of certain projects. Do you think that the public nature of this water infrastructure funding will affect the selection of the projects that will ultimately be chosen to receive this money?

SO: You would usually think of the private market as being the selector of the best projects, or those projects with the highest rate of return. But, you could make an argument that there are other public purposes that aren’t going to generate market return that still have value. As a result, you might expect the private market to underfund these sorts of things. One way to think about funding these kinds of things is that the best way to fund them is locally, because local returns drive the local investment and infrastructure. But, to the extent that something has broader regional benefits, maybe you could imagine the state stepping into that role. It’s also true that once you have these sorts of funding pools, you do have an open access problem, a race to take advantage of it. In the private market, what’s going to weed out the good projects and the bad projects is the competitive pressure. Every bank wants to fund the best project. The government has to play that role. If it’s going to manage the funds, then it has to take on the critical responsibility of picking the winners.

Economic policy expert and LBJ School professor, Dr. Sheila Olmstead, knows what she’s talking about when it comes to effective environmental and energy policy. Before joining the LBJ School this year, Olmstead was a Senior Fellow at Resources for the Future in Washington, DC, as well as an Associate Professor of Environmental Economics at Yale’s School of Forestry and Environmental Studies. Her current research projects examine the environmental externalities associated with shale gas development in the United States and regulatory avoidance under the U.S. Safe Drinking Water Act, among other issues. She has worked extensively on the economics of water resource management, focusing on water demand estimation, water conservation policy, and access to drinking water services among low-income communities.