TEMPORARY WATER TRANSFERS FOR DRY-YEAR WATER SUPPLY

WATER RESOURCES BULLETINVOL. 29, NO.2 AMERICAN WATER RESOURCES ASSOCIATION APRIL 1993

TEMPORARY WATER TRANSFERS FORDRY-YEAR WATER SUPPLY'

John R. Clark and Steven R. Abt2

ABSTRACT: Temporary transfers of water for dry year water sup-ply are analyzed for cost and operational feasibility. The temporarytransfer is implemented as part of a water rights option agreement(WROA) between a lessor and a lessee. First, engineering analysisdetermines the technical feasibility and operations plan under theColorado doctrine of prior appropriation. The cost of the WROA to awater utility is estimated. Other considerations in the agreementare discussed. The WROA is compared to other dry-year supplyalternatives using a water system simulation model to obtainexpected cost and operational performance characteristics.(KEY TERMS: water management; water transfers; water options;drought; interruptible supply; water law.)

INTRODUCTION

A methodology is needed for the analysis of tempo-rary water transfer agreements for use by a waterutility as a dry-year water supply. The temporarywater transfer may require a change in point of diver-sion, a change of type of use, and a change in locationof use. This reallocation process is sometimes referredto as water optioning, interruptible supply, or droughtinsurance. The concepts presented are developedwithin the doctrine of Prior Appropriation inColorado. This paper presents the essential elementsof a research project conducted and documented byClark (1992).

THE WATER-RIGHT OPTION MODEL

A water right option agreement (WROA) is a long-term contract to temporarily transfer water during adry year and to compensate the water-right owner.

The scope of the agreement is determined by theneeds of the lessee (water user), lessor (water-rightowner), and water administration agencies such as aditch company and the State Engineer's Office (SEO).The lessee has the "option" of using the water undercertain stated conditions. The water transfer in theWROA should be approved for execution within theadministrative system, either by court decree orthrough a substitute supply plan approved by theState Engineer's Office.

The model WROA is composed of three compo-nents: a water transfer plan, a financial analysis, anda contract document. The first component, the watertransfers operations plan, requires rigorous engineer-ing analysis and, most likely, will include severalwater rights. The historical irrigation practices andcropping patterns are determined as part of the anal-ysis to estimate consumptive use. Assume that analy-sis of the agricultural water right in Figure 1 resultsin a 1:50 year yield of 1000 acre feet (af') at theheadgate; i.e., annual diversions are a minimum of1000 af in 98 percent of the years of record.Transferable consumptive use is estimated at 552 af.A "transfer factor" of 552/1000 = 0.552 is thereforeapplied to the example transfer.

Location of the existing use relative to the proposedtemporary use determines the return flow require-ments and impacts of the transfer on other parties.The deep percolation returning to the stream systemis accounted for in a delayed return flow schedule.Details for stream depletion analysis are given byRice (1986). Additionally, the physical facilities need-ed to deliver the water to the lessee must be identi-fied. Construction, rehabilitation, and the addition ofmeasuring devices are usually required.

iPaper No. 92092 of the Water Resources Bulletin. Discussions are open until December 1, 1993.2Respectively, Project Manager, Gronning Engineering Company, 12050 Pecos, Suite 100, Denver, Colorado 80234; and Professor,

Department of Civil Engineering, Colorado State University, Fort Collins, Colorado 80523.

249 WATER RESOURCES BULLETIN

Clark and Abt

FINANCIAL ANALYSIS

The second component of the WROA includes awater market analysis, financial calculations, and acompensation plan. Agricultural economic analysis ofthe WROA is developed by Michelsen (1988) and isadapted to this research. In the analysis, the cost topurchase the water right is estimated first becausethe cost of ownership of the water right (WRPC) is theprimary variable in estimating the WROA cost (OC).Calculations are presented in Table 1. The transac-tion cost (TRC) is necessary to determine cost of own-ership to the potential buyer. TRC is quite variableand depends upon many factors; it must be estimatedby the analyst. In the example, Equation (1) of Table1 is used to estimate transaction cost of the owner-ship. An example market price of irrigation ditchcompany water in northern Colorado is $600/af (con-sumptive use). The transferred quantity of 552 af isestimated to have an ownership cost (WRPC) to thepotential buyer of $2,136/af. Transaction costs andallowance for return flows effectively increase themarket price of the water right to the potential buyer(the utility) by a factor of $2136/$600 =3.6.

The computed cost of a WROA (OC) is presented inTable 2. OC is a total present value cost made up of:

• cost of ownership (WRPC),• an amortized change in market value over the

contract,• costs for analysis and negotiation (TRC) of the

WROA,• an initial payment to the lessor (CP) at inception

of the contract (either lump sum or annual), and• an option payment (Ex) at the time of the option.

WATER RESOURCES BULLETIN 250

The WROA contract will have two payments to thewater right owner, OP and Ex, computed per af.Probability of actual exercise of the option can be esti-mated by stochastic analysis; however, it is assumedhere to be 1:10. Choice of probability (p) will havevery little influence on the final cost.

WRPC * 1,020/552 $1,156 * 1.848 — $2,136/sfpresent value cost of the water right.

Of particular note is the choice of the value for CRIt is obtained by break-even analysis in whichEquation (2) and Equation (3) are solved simultane-ously. Using all of the assumed values previouslynoted and a discount rate of 4 percent over inflation,CP = $134.83/af; at this value, present values of own-ership and lease agreement are equal. The chosenvalue of OP represents the incentive for the irrigatorto enter into the contract. In Table 2, one-half thisvalue is used to compute a value of OC.

The value of Ex is obtained from Michelsen'sresearch on the value of water as a factor in agricul-tural production and includes net annual income plus

MODEL OF WATER RIGHT DIVERSIONFrom Analysis of Diversion Record

May June July AugMonth of Record

TABLE 1. Cost to Purchase Water Rights: Example.

J Consumptive Use [J Surface Return Flow Grd Mr Return Flow

Figure 1. Model of Agricultural Water Right.

I. Compute example transaction cost TRC (referring tohowe et al., 1990) using Equation (1):

TRC = 428.48— 124.5*ln AF + 750.79*ONO + 4.25PD (1)

where:

AF = 552 af, net transferred water;ONO = 1, "yes" to anticipated objectors, which generally

raises the cost;PD = taken as zero; not of sufficient significance; andTRC = 428.48 — 124.5tln(552) + 750.79 +0 = $393/af.

U. Compute purchase cost WRPC using Equation (2)(Michelsen, 1988):

T

WRPC=(WRC+TRC)+Mt*d (2)

where

WRPC =WRC =mc =T =r =Mt =d =

water right purchase cost to the buyer;market price = $600/afconsumptive use;$393/af; Section I above;planning horizon =20 years;interest rate over inflation =4.0 percent;annual company assessment =$12/af; anddiscount factor; since Mt is constant, use presentworth series = 13.59; and

WRPC = 600 + 393 + 12*13.59 = $1,156/al.

Ill. Compute cost of delivered water:

Temporary Water Transfers for Dry-Year Water Supply

fixed capital costs for the entire season in which thewater is taken by the utility and lost to crop produc-tion. The value for Ex in Table 2 is determined byresearch of local farm income per acre foot, by negoti-ation with the lessor, or by selection from Table 3(northern Colorado, 1954-1987 crop prices, 1988 dol-lars). The present cost of the example WROA is$1,218/af of delivered water. The resulting presentvalue advantage to the utility of a WROA over pur-chase of the water right is $2,136 — $1,219 = $917/af,due primarily to savings in transaction costs and nothaving to purchase an equity position in the waterright.

TABLE 2. Cost of a Water Rights Option Agreement (WROA).

TABLE 3. Annual Agricultural Water Value Per Acre Foot(1988 constant dollars) (Source: Michelsen, 1988).

CornGrain

PintoBeans Alfalfa

MaltBarley

A. Water Applied(af/ac'yr)

2.28 1.87 3.32 1.73

B. Crop Water Value/OptionExercise Cost**

Perennial (average)Seven Year LowSeven Year High

$ 95.3128.89

149.65

$105.3168.47

144.95

$52.3736.6463.21

$109.38109.38109.38

*Malt barley under sales contract.tAnnual water values assuming average, low, and high crop

prices.

I. The same water right as described in Table 118 used.The WROA will have transaction Costs. Equation (1) inTable 1 is not appropriate because TRC computes c 0.Actual costs to the city of lease purchase agreementsbetween the City of Greeley and local irrigators areused:

$10,4005,0005,000

$20,400 or $20/af(at 1,020 al)

II. Compute present value option cost (OC) per af of waterwith Equation (3) (Michelsen, 1988) using the followingassumptions:

TOC = WRA*d + TRC* 2+ [(Ex* p) + CPt]* d (3)

t=o

where

WRC = current market price = $600; assume appreciationrate of market price =2.0 percent APR;

WRA = appreciation in price over the period=600* (1+.02) '2O —600 = $292;

TRC *2 = double the TRC to cover the renegotiation of WROAin 20 years;

Ex = $95faf corn, Table 3;p = probability of exercise = 1:10 = 0.1;CP = estimated annual cost; see text

= $ 134.83/2 = 67.42/ailyr;T = contract term =20 years;r = interest rate over inflation = 4.0 percent;d = discount factor = ]J(1+.04) A20 = 0.4564; because

all variables remain unchanged in the summationfor this example, present worth annual series maybe used instead of d for the summation;

D = present worth annual series @4.0 percent for 20years = 13.59; and

OC = 292.4564 + 20*2 + [(95*.1) + 67.421*13.59=$1,218/afpresent value cost of the WROA.

WATER OPTION CONTRACT DOCUMENT

The third component of the WROA is the legal con-tract which defines the responsibilities of the waterutility and the water-right holder. The contract willcombine policy, definitions, technical data, compensa-tion arrangements, and administrative elements intoa workable operating plan. Key provisions of theoption contract were developed by research in Clark(1992) and are listed in Table 4. The influences ofpotential objectors to the water transfer, the wateradministration officials, and others impacted by thewater transfer should not be underestimated.Supporting documents relative to quality, quantity,and administration should be included in the WROAas attachments.

Research into existing and proposed WROA sug-gest that the "description of property" clause and the"first right of refusal" clause in Table 4 are of particu-lar interest. Water rights are considered real propertyin Colorado subject to line of title and encumbranceson equity through debt. Sorting through the equitypositions on farm properties can be complex. In recentcases of WROA proposals, numerous constraints onthe seller (owner) have been added to the contract toprotect the interests of the buyer. One example is therequirement placed upon the seller to execute a limit-ed Deed of Trust to his water rights in favor of thelessee. The constraints are indications of the risk per-ceived by the buyer (lessee) that the right to the waterwill not be available when time is at hand to exercisethe option. From the perspective of the lessor, theWROA represents another encumbrance on his prop-erty and may limit his ability to gain benefit fromfuture transactions such as opportunities to sell.

Professional ServicesIn-House Staff TimeOther Costs

TOTAL TRC

Note: The cost does not include equity in the water right.


Clark and Abt

TABLE 4. Option Agreement Terms and Provisions.

1. Names of the Parties

2. Responsibilities of the Parties:Prior to transferSubsequent to transfer

3. Description of the Property:Water right equity legalLand legalEncumbrances of equityCrop cover(attachments: specifications)

4. First Right of Refusal to PurchaseRight of Lessee to Purchase, PricePurchase May Include Land, PriceLessor to Provide Substitute Supply, Conditions

5. Option Price:First cost, per unit, totalExercise cost, per unit, totalCost escalation clause, index

6. Quantity:Shares, yield, acres dried up, covenantsPriority and appropriation date(Engineering attachments)

7. Water Quality:Minimum standards for acceptance

8. Requirements for Notice to Exercise OptionThggering MechanismAllowance for Late NoticeSpecification of Service of Notice

9. Renegotiation Clause:Conditions, terms, triggers

10. Force Majeure:Allowances for temporary breach of contract

11. Contract Term and Renewal Date(s)

The "first right of refusal" clause allows the lessorto bring a bona fide offer to the lessee as proof of suchan opportunity. The lessee must then act on the offerby purchasing the water right or terminate theWROA. Thus, the two clauses are linked in that bothclauses, i.e., property description clause and refusalrights clause, have the function of protecting the equi-ty interests of one party while placing constraintsupon the other party. These are important legal mat-ters and currently are disincentives to enter a WROA.Interviews with water resources professionals suggestthat these two issues may present more barriers tothe WROA than any technical or administrative ele-ments, once the technical feasibility of the proposedwater transfer has been established.

Item 8 of Table 4, which addresses notice toexercise the option, will have both operational and

administrative elements. Clearly, intent of the city toinitiate the temporary transfer is not the same asproviding notice of the intention to the lessor due tothe degree of commitment involved for each party.Research indicates that irrigators desire early noticewhile the city's water utility wishes to delay the deci-sion to exercise the option until the annual yield ofthe traditional water supply is more certain. From theoutset, each party to the WROA should consider thetiming, triggering, and notice requirements of thearrangement. Refer to Hrezo et al. (1986) for anoverview of triggering mechanisms.

WATER SYSTEM PERFORMANCEAND DESIGN DROUGHT

Several tools were developed to illustrate the anal-ysis of alternative dry-year water supplies. The analy-sis and tools are briefly summarized in this section.

Dry year water supply alternatives, including theWROA, were studied by application of a simulationmodel of water system operations over a critical peri-od. Frick et al. (1990) developed the concept of a"design drought" which is used to set dry year watersupply requirements. Such a design drought eventhas three parameters: the duration (consecutivemonths of less than average water supply yield),cumulative deficit in acre feet (af) over the duration,and return period in years. In the present example, a40-year record of calls was obtained on 11 waterrights in the Upper South Platte River basin. Therecord contained a critical period 1953 through 1958with a cumulative deficit of 50,428 af from the 40-year average over 47 consecutive months. This eventwas designated a design drought with a probability ofnonexceedance of 1:40 and is illustrated in Figure 2.The critical period is comparable to long-term precipi-tation shortages reported by McKee et al. (1991) forseveral areas of Colorado. The design drought eventwas input to the simulation model together with amonthly municipal demand pattern for a populationof 62,500 and 40,000 af of useable storage, a configu-ration not unlike several east slope Colorado cities.Performance of reservoir storage under stress of the1:40 event is presented in Figure 3.

In the water system simulation, system failure isdefined as: delivery D less than demand (D>Q).Shortage is defined as (D—Q). Using the record of theabove design drought in simulation, the following sys-tem failures occurred: (a) Fl failures: deficit to 80 per-cent of demand, 16 months out of 47 months; (b) F2failures: deficit to less than 80 percent but more than100 percent of demand, one month out of 47 months;



(c) F3 failures: no water delivered, two months out of47 months.

As a component of the simulation, a loss functionwas developed to estimate the expected cost of theshortages. Expected costs to the customers E[CS] ofthese events were determined using customer surveydata from California and Colorado cities, such asHowe et al. (1991), and probability data of failures Fl,F2, and F3 above. These surveys assessed customers'willingness to pay for increased reliability and will-ingness to accept system shortages in dollars/tap!month. The resulting E[CS] from the simulation was$3.78 per tap for any month of the drought, spreadover the 25,304 taps, or $95,650. Expected cost of lostrevenues to the water utility E[LR], using a billingrate of $613.58/af ($1.88/bOO gallons), resulted inrisk of lost income to the utility of $65,560 in anydrought month. Total expected cost of the drought dueto water shortage is:

CUMULATIVE ANNUAL DEFICIT

1953 1954 1955 1956 1957 1958

ci)*3)

U-*3)

C)

a)

0C,)

I.-wLii

—(0C0(00

öbLIuJ

Figure 2. Cumulative Annual Deficit of Design Drought.

RESERVOIR VOLUME45. ——

40 __....—.-.———_..-._....-.- ——...'——

35.., . ......

ADDITIONAL WATER30 REQUIRED

25- .•.

20-——-— ---'-- . ..__ ..15 - —.-

10-j. -

5 ..

0— I I I . I

0 10 20 30 40 60 70 80Months

Figure 3. Reservoir Volume Under Design Drought (simulation).


U)

Cc'U)

0F-

Clark and Abt

E[L(D—Q)] = (E[CS] + E[LR]) * 47 mo * (1:40)= $189,420 for any year in the given record.

Thus, the theoretical annual cost (damages) of a 1:40drought, and the justified amount to invest to preventdamages, is $189,420/yr in current dollars. Total CSplus LR costs for the entire 1:40 event were estimatedto be about $7.5 million. This damage level is the firstcolumn in Figure 4. The remaining data in Figure 4are results from simulations using alternative dry-year water supplies, presented in the next section.

SUMMARY OF DRY-YEAR SUPPLYSCENARIO ANALYSIS

Several augmented supply scenarios were simulat-ed over a six-year period containing the critical event.The scenarios included short-term seasonal lease at$300/af, water rights purchase using Table 1 costs,

Damages Lost Rev

water right option agreement (WROA) using Table 2costs, and construction of additional storage. Costs ofall of these alternatives were estimated at sufficientlevels of additional water or addition of storage capac-ity to eliminate F2 and F3 shortages in the simulationmodel. For the WROA alternative, water option con-tracts totaling 2,000 af were exercised in the spring ofthe third year and again in the fourth year.Additional storage did not improve water availabilitybecause the protracted shortage reduced inflows tothe extent that no amount of storage could compen-sate. Purchase of additional water was, therefore,added to the additional storage alternative.

Cost results are summarized in Figure 4. Residualdamages in all of the supply scenarios are from theremaining Fl failures and may be ignored for a morereasonable comparison. To obtain a true comparison,expected cost is preferred to the six-year results inFigure 4. The total cost (TC) of implementation ofeach alternative is annualized at a 4 percent discountrate for the water right option and water right pur-chase scenarios, and the expected value results are

Water Cost Facilities

Figure 4. Summary of Analysis: Dry-Year Supply Costs.


SUMMARY OF ANALYSES: DRY-YEAR SUPPLYSIMULATED COST FUNCTIONS

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ACKNOWLEDGMENTS

The research project was sponsored by the Cities of Aurora,Denver, Greeley, Boulder, and Grand Junction, Colorado.Appreciation is also extended to Ms. Nancy Munns, James A.Ferentchak, RE., and Dr. Ari Michelsen.

LiTERATURE CiTED

Clark, J. R., 1992. Temporary Water Transfers for Urban WaterSupply During Drought. Doctoral Dissertation, Colorado StateUniversity, Fort Collins, Colorado.

Frick, D. M., D. Bode, and J. D. Salas, 1990. Effect of Drought onUrban Water Supplies, I and U. J. of Hydraulic Engineering,ASCE 116(6):733-764.

Howe, C. W., L. Bennett, C. M. Brendecke, J. E. Flack, R. M.Hamm, L. Rozaklis, M. G. Smith, and K. Wunderlick, 1991.Incorporating Public Preferences in the Optimization of UrbanWater Supply Reliability: Planning Procedures and SurveyTechniques. Institute of Behavioral Science, University ofColorado-Boulder, Boulder, Colorado.

Howe, C. W., C. S. Boggs, and P. Butler, 1990. Transaction Costs asDeterminants of Water Transfers. University of Colorado LawReview, University of Colorado Law School, Boulder Colorado,61(2):393-405.

Hrezo, M. S., P. G. Bridgeman, and W. R. Walker, 1986. ManagingDroughts Through Triggering Mechanisms. JAWWA 78(6):46-51.

McKee, T. B., N. J. Doesken, and J. Kleist, 1991. DroughtMonitoring in Colorado. In: Drought Management andPlanning, D. Wilhite, D. Wood, and P. Kay (Editors).Proceedings of Workshop, Institute of Agriculture and NaturalResources, University of Nebraska-Lincoln, Lincoln, Nebraska,IDIC Report 9 1-1, pp. 73-80.

Michelsen, A. M., 1988. Economics of Optioning Agricultural WaterRights for Urban Water Supply During Drought. Dissertation,Colorado State University, Fort Collins, Colorado.

Rice, L., 1986. Engineering and Hydrologic Issues in ChangingWater Issues. In: Tradition, Innovation and Conflict: Per-spectives on Colorado Water Law, L. J. MacDonnell (Editor).Proceedings, Natural Resources Law Center, University ofColorado, Boulder, Colorado, pp. 163-173.

1. The WROA appears superior to additional stor-age under the assumed conditions due to reducedcosts and because it can deliver water after carryoverstorage is exhausted.

2. The WROA can be characterized as less costly,either on a present value basis or on an annual basis.The WROA is less sensitive to the time value ofmoney than the purchase of water rights or the con-struction of additional storage.

3. Within the assumptions, the WROA is a feasiblealternative for dry-year water supply.


presented in Figure 5. Ignoring residual damages ofFl failures in Figure 5, purchase of water rights costmore per year by ($228,630 —$144,540 = $84,090), or58 percent, than optioning the same water rightsunder a WROA agreement. Figure 5 illustrates thatthe WROA has brought the WROA scenario costs andthe no-action damages to approximate equilibriumwhile maintaining water right ownership with theagricultural sector.

EXPECTED VALUES IN $/YEAREFL(D-O)) + EITCI ANNUALLY

C/)0

LUI.—

I-U)w

Damages Water

Figure 5. Expected Values in $/Yr.

The model also tracked the performance of the fivealternatives over the period. With the purchase ofadditional water rights, spills in the normal yearsincreased 140 percent; no spills occurred with theWROA. Otherwise, both option and purchase per-formed similarly. A comparison of the five dry-yeardrought scenarios in Figures 4 and 5 result in the fol-lowing conclusions:

OponSCENARIO

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TEMPORARY WATER TRANSFERS FOR DRY-YEAR WATER SUPPLY