Optimal Water Portfolios and Non-discretionary Consumption

Abstract

Non-discretionary water consumption is an important component of the ag- gregate demand for water and in the determination of optimal water supply portfolios. To capture these features an intertemporal optimization model is de- veloped to generate an optimal water portfolio, which weights alternative sources of water according to the uncertainty of inows, supply costs and stochastic habit formation. The model is calibrated to the city of Taoyuan, Taiwan, which, despite experiencing rainfalls at three times the world average, is nonetheless subject to water shortage problems and a good example of the widespread nature of the water crisis. We show that habit has a significant effect on the optimal wa- ter supply portfolio. In the case of purely discretionary water consumption the optimal water supply portfolio consists primarily of reservoir water. Allowing for habit formation results in greater reliance on manufactured water, but less so when habit formation is sensitive to the shocks in water supply. This has important implications for policies that target water consumption behavior. In addition to reducing water demand, these policies enable the realization of long run water supply portfolios that are more cost-effective as they rely less on the costly, riskfree sources of water.