It was miserable weather in Melbourne again today – cold and wet – and further rain is expected over the weekend. To whinge a bit more: 6 the last 7 times I’ve played golf I’ve got drenched and it was a repeat on Saturday and today (updated).
I’ve been reading about the 1997-2009 drought – the Millennium Drought – which many believe to be the most severe drought in our history. It was not the most intense each year that it operated but it lasted a very long time and, over several years, covered most of the country. River red gum forests died in the Murray-Darling Basin and large tracks of hardy dry country Brigalow died in central Queensland. The drought, of course led to governments splurging out about $13b on desalination plants which have come on stream since 2006.
In 2010 and 2011 back-to-back La Nina events gave us two of the wettest years in the nation’s recorded history. It is a remarkable turnaround and an illustration of the extraordinary variability of the Australian climate.
Stupid criticisms of the desalination investments see them as a foolish endeavour because the rains did come – of course it is easy to be wise after the event. Smarter criticisms say that the desalination schemes provided insurance against further drought but that the premium was too high. The most obvious criticisms are that alternative much cheaper sources of water such as rural-to-urban water trades and the use of “scarcity pricing” (charging more for water when storages have low supplies) would have enabled us to delay or permanently defer these massive investments.
Analytically one can study these problems using option pricing methods and stochastic dynamic programming – I have been doing this for the last couple of years. The simplest lessons are however easy to state without recourse to high tech maths. Have the blueprints and planning procedures for desalination drawn up in advance and you can delay construction by at least a couple of years giving flexibility in making these large investments. Retaining modular expansion options and initially building small scale plants also adds to flexibility. And of course taking advantages of short term efficient sources of water (cheap rural water, recycling etc), using scarcity pricing and even using relatively inefficient procedures (such as water restrictions) all add to investor flexibility.