Yichun Huang, Department of Economics and The Water Institute, University of Waterloo
Margaret Insley, Department of Economics and The Water Institute, University of Waterloo
The natural resource extraction industry uses large amounts of water, and competition for water supplies may put industry operations into conflict with local communities. Protection of the public interest requires that governments around the world specify limits on water withdrawals and enforce legal and regulatory requirements regarding water access rights. Regulatory responses vary across jurisdictions, depending on the state of water supplies, the nature of other competing uses, as well as the existing political, legal and regulatory frameworks. Competition for water supplies and constraints on water usage is of increasing concern for firms involved in natural resource extraction industries around the world, including Canada.
The objective of this research is to demonstrate a rigorous approach, using stochastic optimal control, for examining the cost of environmental regulations for a firm. The research undertakes a systematic analysis of the cost of water regulations imposed on a particular resource extraction activity, namely mining of the oil sands in Alberta, Canada. In the early 2000s, forecasts of ongoing increases in oil sands production combined with a declining trend of the river flow in the Athabasca, the second largest river in Alberta, resulted in significant public concern about the impacts of water withdrawals. While collective water withdrawals constitute only a tiny percentage of the river flow, river flows vary significantly between seasons. In water short seasons, there are risks that the withdrawals will damage aquatic habitat. Further, there is considerable scientific uncertainty over how much water can be safely diverted from the river without harming the aquatic ecosystem. In addition, the river sustains the livelihood and culture of First Nations and Metis communities in the area, and low flow hinders navigation on the river.
The Alberta government drafted a river management plan for the Lower Athabasca River to limit withdrawals according to river conditions. Phase 1 of the water management plan was imposed in 2007 and identified, among others, instream flow needs to maintain fish habitats. A revision to the water regulations in Phase 2 released in 2015 imposed a finer classification of water flow conditions, but is otherwise similar to the Phase 1 regulation. This research examines the economic cost of the regulation, using the details of the Phase 1 specification.
The research devises a model of a firm's decisions regarding the optimal choice of bitumen production over time, given available oil reserves, the firm’s license agreement with the government for bitumen extraction, and regulations regarding water usage. The firm's objective is to maximize the expected present value of cash flows from its oil sands operation, with the firm’s decision specified as a stochastic optimal control problem. The model is parameterized for a hypothetical oils sands mining operation in Alberta, which draws water from the Lower Athabasca River. Regulatory restrictions on water withdrawals vary depending on river conditions. Possible responses by the firm to stricter water constraints include reducing oil production in the short term, or installing water storage facilities as a longer term solution. Bitumen production, and hence water use, is affected by volatile oil prices determined in world markets. Oil prices are modelled by a stochastic differential equation calibrated using data on oil market futures. Water restrictions are modelled as a jump process, calibrated for various different possible river conditions in the Lower Athabasca River.
A stochastic dynamic programming approach is implemented to determine the difference in value and optimal controls for the oil-producing asset, with and without water restrictions. The model is used to estimate the increased cost to the firm of imposing stricter regulations on water withdrawals. These cost estimates are an important input to regulatory design, as these can be compared to the potential benefits of stricter regulations.
The most important outcome of the research is that Alberta's Phase 1 water management plan did not impose a large cost on firms, given historical river flow conditions of the Athabasca River. The cost of restrictions has fallen since the regulations were first implemented, as firms made investments to improve the efficiency of their operations. The costs remain low even under assumptions of much drier conditions. The option to install technology that improves water use efficiency, such as water storage, reduces the marginal cost of water restrictions even further. This indicates the importance of considering potential technological investments in response to regulations.
There is, however, considerable uncertainty about how much water can be safely diverted from the river without harming the aquatic ecosystem. Given the low marginal cost estimates, this analysis reveals that there is scope for adopting stricter regulations if there is a desire to provide added protection for in-stream river flows.
An outlook for a lower long run average oil price increases the cost of restrictions as a percent of the mining operation value. This is an important consideration given worldwide commitments to reduce oil consumption to limit carbon emissions, which would put downward pressure on oil prices. Nonetheless, the recovery in oil prices in 2022 indicates that oil sands production may remain economical for the short to medium term.
Failure to understand the costs of water regulations to large water users increases the likelihood that water restrictions will be set at an inappropriate level and may represent a missed opportunity to improve ecosystem protection at lowest cost possible. In this study, the cost of the imposed restrictions in the Lower Athabasca River is estimated to be quite small given historical river flow conditions. However, the cost is shown to increase under drier conditions and in the long run given expectations about future river conditions and oil prices. As oil price volatility increases, water storage becomes more valuable to the firm, making it more likely that the firm will undertake an investment in storage. This conclusion would also apply to other types of technology designed to improve water use efficiency. Alternatively, a determination that restrictions are very costly to firms points to the need for a process to respond appropriately to ameliorate those costs.
Huang, Y., & Insley, M. (2021). The impact of water conservation regulations on mining firms: A stochastic control approach. Water Resources and Economics, 36, 100185. https://doi.org/10.1016/j.wre.2021.100185
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