Franklin Appeals Stockton Bankruptcy Confirmation

Franklin filed an appeal of Stockton's bankruptcy confirmation this week.  I hope that my previous prediction that Stockton's plan would be rejected in Court will continue to be wrong. 

Franklin claims that Judge Klein's ruling included 4 errors:

1. It incorrectly interpreted the Best Interest of Creditors Test.

2. The classification of Creditors was discriminatory and unlawful.  [The City's plan grouped Franklin's claim "class 12" with the retiree health plan claim.]

3. The plan was proposed in Bad Faith.

4.  The City has not adequately disclosed payments and fees related to the case.

 

I find the second argument most compelling, and it is a big reason why I originally thought the Court would reject the plan.  Of course, I am not a lawyer.  According to Judge Klein, Stockton's classification scheme does not discriminate illegally, and the appellate court may agree.

 

Below is an excerpt on this topic from Franklin's appeal.

 

"Disparate And Discriminatory Classification And Treatment. Franklin also established that

the Plan’s classification scheme – in which Franklin’s unsecured claim was classified together with

part of the claims of City retirees (health benefit claims but not pension claims) and separately from

the claims of all of the City’s other bondholders – had only one purpose: to enable the City to avoid

the “cramdown” requirements of section 1129(b)(1) of the Bankruptcy Code. By improperly

gerrymandering Franklin’s unsecured claim into a class whose other members (the retirees) had

committed to vote to accept the Plan due to the promise of unimpaired pensions, the Plan violates the

strictures of section 1122(a) of the Bankruptcy Code. In re Barakat, 99 F.3d 1520, 1525 (9th

Cir. 1996) (plan violates section 1122 where “the classifications are designed to manipulate class

voting”) (quoting In re Holywell Corp., 913 F.2d 873, 880 (11th Cir. 1990)). The Court erred in

concluding otherwise.

The Court also erred in disregarding the disparate treatment of Class 12 claims and creditors

holding Class 12 claims. Specifically, the Court turned a blind eye to the direct linkage under the

Retirees Settlement between the retirees’ recovery in Class 12 and the City’s agreement to leave the

retirees’ pensions unimpaired. While nominally providing a sub-1% recovery to all claims within

Class 12, the Plan actually provides retirees with a recovery of somewhere between 53% and 70%

 

due to the fact that, as quid pro quo for the sub-1% “settlement” of Retiree Health Benefit Claims,

the City agreed to pay pensions in full. As many cases cited by Franklin establish, that treatment

violates section 1123(a)(4), which requires that claims and creditors in the same class receive the

same treatment. The Court erred by disregarding that authority.

Finally, the Court erred by failing to consider the undeniably unfair discrimination against

Franklin’s unsecured claim. Had the Court properly rejected the City’s gerrymandered classification

and disparate treatment of Franklin’s unsecured claim, it would have concluded that the sub-1%

payment on that claim unfairly discriminated against Franklin in comparison to the Plan’s 50%-70%

payment of retiree claims and 52% to 100% payment of other City bonds, including the wholly unsecured Pension Obligation Bonds. This legal error is likely to lead independently to reversal."

North San Joaquin Valley Regional Assessment Conference, November 19 in Modesto

On Wednesday November 19, the Business Forecasting Center is organizing a forum in Modesto to share the results of a project we have been working on for the past year with regional leaders and the general public.  In addition, to Dr. Pogue and myself with Powerpoints of data on the regional economic system, there will be panel discussions with leaders from inside the region, and some guests from the Bay Area and Sacramento to discuss how the North San Joaquin Valley fits within the mega-region and how collaboration between counties can work for economic development.

The half day event is free, but you must pre-register.  Click here for more information and registration.

Also, the Modesto Bee published a Q&A with me this morning related to the event.

Regional Differences in Valley Air Pollution Could Drive Changes in Regulatory Approach

The Fresno Bee article linked below features an important regional environmental-economic issue that is often under the radar.
Clovis and Bakersfield, with dirtiest of dirty air, complicate Valley’s pollution battle

Read more here: http://www.fresnobee.com/2014/11/08/4223458_clovis-and-bakerfield-with-dirtiest.html?rh=1#storylink=cpy

The article talks about air pollution hot spots that cause the entire Valley to be out of attainment with federal standards, and how air pollution regulators are looking to focus on pollution "hot spots".   The graph below, borrowed from a regional data brief from California Forward, illustrates the regional disparities.

Overall, the North San Joaquin Valley (San Joaquin, Stanislaus, Merced) has less than 1/3 the number of unhealthy air days as Fresno, Tulare, and Kern, and is actually better than Sacramento, and far better than LA and the Inland Empire.

The NSJV complains about the regulatory costs and poor image that comes from being associated being grouped with the South.  The South Valley complains that much of their pollution isn't local, but is blown in from the North.

Some clips from the Fresno Bee article

“If those places do not attain the standard, the Valley won’t attain,” district executive director Seyed Sadredin said. “We’re not talking about backing off on the pollution reduction in other parts of the Valley. But we’re seeing that these two hot spots need more attention.”To focus on Clovis and Bakersfield, officials will need to deal with regional politics, doubts from air activists and probably state and federal air agencies...

Historically, the politics have involved the Valley’s northern tier of counties — San Joaquin, Stanislaus and Merced. Their air is cleaner than counties to the south, but they feel they need to speak up for their share of the $150 million in federal and state grants the district gets each year.

The money helps replace diesel engines, fireplace inserts, gasoline-powered lawnmowers and pay for many other incentive-based cleanup programs. Thousands of old diesel engines and diesel-powered vehicles have been replaced with this kind of money.

Stanislaus County Supervisor Bill O’Brien, an air district board member, defends the northern counties.

“We can’t just take the money from one area and give it another,” said O’Brien, whose family owns O’Brien’s Market, based in Modesto. “If the hot spot is around Fresno or Bakersfield, then we might want to talk about different rules and different ways of raising money in those areas to spend there.”

Stockton Bankruptcy Plan Approved!

I can't recall the last time I was this happy to be wrong.  I should stick to predicting the economy as I have a poor track record predicting judges.

It seems the judge was being very practical, and recognized the precarious public safety situation in Stockton and the risk of some very negative outcomes, especially in the short-run, if he were to reject the plan.

I am still a little surprised that he approved a plan that treated Franklin so severely (12% overall repayment, less than 1% on unsecured debt) - not just when compared to the City's retirees - but the other unsecured bond creditors who had settled.  That doesn't mean I am sympathetic to Franklin, they loaned the City money in 2009 without adequate collateral when the economic and financial crisis of the City was obvious.

It's time to move forward.  I am very happy for Stockton today.

Stockton's Bankruptcy Ruling Is Tomorrow: I expect the judge will reject Stockton's plan

According to today's Stockton Record article, it appears that there is no imminent settlement between the City of Stockton and Franklin Investment.  In addition, the City spokesman said they have not amended their plan that pays Franklin less than 1% on their more than $30 million in unsecured debt.

Thus, I expect the Judge will reject Stockton's plan, as I discussed in my earlier post reacting to the October 1st ruling.

It seems to me that Judge Klein has been doing everything he can to nudge the sides to settle over the past few months.  I believe delaying the confirmation ruling from October 1 to October 30 was to give them one last chance for a deal or for Stockton to come forward with an amended plan.

I hope I am wrong about this.

Bankruptcy Judge Delays Stockton's Decision until October 30. If City does not improve its offer to Franklin, rejection of its exit plan seems likely.

I expected the Judge to reject Stockton's bankruptcy plan of adjustment today, because it unfairly discriminates against Franklin.  However, he delayed a ruling on the plan until October 30th and reportedly said it was still "open season" on a negotiated settlement or for Stockton to amend their plan's treatment of Franklin.

While the delays in this case have been painful and costly for the City, I think he did them a favor here by giving them one last chance to avoid a rejection of their plan.  I think the Judge recognizes that rejecting the plan will be destabilizing to the City, but I doubt he is willing to confirm a plan that pays Franklin less than 1% on its unsecured debt and about 12% on its total debt when other creditors - both retirees and bondholders - are receiving so much more.

I also expected the Judge to make some sort of finding that CalPers pensions could be impaired by the City, and he did.  Since the City does not want to impair pensions, the ruling may seem to be of little practical importance to Stockton.  However, I do think that finding turns up the pressure for the City to improve its offer to Franklin and potentially make a last minute deal.

Below is an excerpt from what I wrote about the case in the most recent California and Metro Forecast.  I did not predict a rejection of the plan, but speculated at what the City would do if he does.

Judge Klein may confirm Stockton’s plan on October 1, but what happens if he does not?  The Judge could find that the City’s plan discriminates unfairly against Franklin, and he may also reach a conclusion that opens the door for Stockton to reduce pensions but he can’t compel the City to go through that door.  Even if the Judge gives Stockton an opening to impair pensions, City leaders have made it clear that they have no desire to go in that direction.  It is most likely that the City would simply amend its plan to offer Franklin a repayment of around 50%, roughly proportional to the recovery from fixed payments in the City’s settlement on its over $100 million in unsecured pension bonds.  The City would have a strong case that such an offer is fair, and would hopefully be able to still avoid a long and costly court battle over the pension issue.

While the judge did not reject the plan today, I expect he will unless the City produces something that is reasonably close to the settlement on the unsecured pension bonds announced last October. (The terms of the pension bond settlement essentially precludes the City from offering anything better.) Franklin also said today that it wants to be a "partner" in the City's recovery, which I believe is the same language that Assured Guaranty and the City used in describing their pension bond settlement last fall, because that deal provides a higher repayment if the City's future revenues exceed their current projections.

In my view, the City's argument for its harsh treatment of Franklin is illogical and inconsistent with its treatment of other creditors.  Sticking to that argument until October 30 seems like it could be a losing strategy. The City's plan hinges critically on being able to classify retiree's claims against the city for medical benefits and pensions into separate classes. The City's plan defines the medical claims as unsecured and sticks them in the same class as Franklin's unsecured claim for its bond debt, and the City puts the pension claims into a separate class. Since the retiree health care benefits were essentially eliminated by the bankruptcy plan, the City argues that the 1% recovery for Franklin's unsecured claim is fair since it is proportional to the treatment of retiree healthcare that it has placed in the same class. However, in ruling today that the pensions could be impaired and the $1.6 billion termination liability could not be enforced, it seems that the Judge views pensions as an unsecured retiree claim as well - at least they are not as protected as the City and CalPers claims. And at least to my non-lawyer brain, that suggests to me that it is highly unlikely that the judge will accept the City's classification scheme and agree with Franklin's argument that they are unfairly defining the classifications in order to impose a low recovery on them. I would also point out that the City considered separate secured claims from the same creditor (Assured Guaranty's secured bonds on the 400E Main building and unsecured pension bonds) as a package in describing the fairness in the settlements, so it seems to me that they are not being consistent here either. So I expect a settlement or adjustment to the plan in the next few weeks. I haven't made any serious attempt to estimate the cost of an adjustment on the City's budget, but it seems that the worst case would be $1 million per year over the next 30-40 years. While that hurts, it is much less painful for the City than having their plan rejected by the judge.

Disclaimer:  I am not a lawyer, and this is my immediate reaction to today's hearing.  As a non-lawyer, my opinion is based on my personal view of the logic and fairness behind the arguments and whether the business case and economic analysis supporting the arguments is sound.  I have been following this class closely, and have read all the briefs submitted by both sides leading up to the case, and have reviewed the City's financial projections in the past.

Will the City of Stockton Ever Be Able to Hire the 120 Additional Police Officers Promised in the Measure A Tax Increase?

As pointed out in today's Stockton Record (also see Michael Fitzgerald blog post), the City of Stockton has yet to hire any additional police officers with Measure A funds.  Officer attrition is high, and hiring is slow.

I was a notorious fence-sitter during the Measure A debate, upsetting a lot of people because I was waffling for and against the tax.  It was a close call, and the City dropped blockbuster creditor settlements and a new bankruptcy exit plan in October that greatly changed the situation.  I ultimately gave Measure A a very tepid endorsement, but many of my concerns about the unrealistic promises made to promote Measure A are now being realized.

Since the City unveiled Measure A, I have warned that my review of the City's financial projections made me doubt whether the City could live up to all the promises made in the Measure A campaign: namely that it would a) finance a bankruptcy exit, b) add 120 new police officers, and c) sunset in 10 years.

The City broke its promise about the 10-year sunset even before the election by assuming a permanent tax increase in the bankruptcy exit plan it filed with the court.

After Measure A passed, I wrote in the January 2014 forecast "it is clear that the City will have extremely tight budgets for the foreseeable future and hiring all of the promised 120 police officers will prove difficult, especially if new employee contracts include restoration of raises and cost of living increases."

These news reports of the struggles in hiring and retaining police seems to be setting the stage for higher compensation in future contracts.  In addition, the bankruptcy exit is already costing the City more than it projected - the offer to Franklin has increased by $4 million and the City is still paying high-priced bankruptcy lawyers when it had projected it would leave bankruptcy before the middle of 2014 if Measure A passed.

Back in the May 2013 forecast, even before the City proposed Measure A, I projected that the city would need a 1/2 cent sales tax increase just to finance its bankruptcy exit if it didn't hire any additional cops, and that there would only be 1/4 cent available to increase police staffing, enough to perhaps hire 50-60 police officers.  This was in major part of my argument against the Mayor's "Safe Streets" half cent tax proposal dedicated to public safety because it was unrealistic and would make it impossible for the City to finance its bankruptcy exit.

Measure A proponents headed off the Safe Streets proposal by promising 1/2 cent to pay for cops and 1/4 cent to pay for bankruptcy exit, and even gave voters an advisory Measure B to express this desire.

Now, it appears that arithmetic will ultimately prevail and Stockton voters may only receive half the police they were promised as bankruptcy and pension costs mount, and pressure increases for employee raises.

I am not surprised or disappointed in these developments as it is where I thought things were inevitably headed all along, and there wasn't and isn't necessarily a better financial plan for the City.  I am disappointed in the process, although it is not unusual for government officials to promise more than they can deliver and passing Measure A may have prevented an even worse outcome.

But it will further erode Stockton voters' trust in City Hall, and the voters should hold City leaders accountable for keeping costs down and doing everything they can to deliver the services promised to them.

I'm happy the Legislature and Governor have agreed on a new water bond, but I will probably still vote against it.

The most important benefit of approving the new $7.5 billion water bond last night for the fall ballot is that it repeals and replaces the terrible, $11.1 billion bond leftover from the 2009 water package.  The 2009 bond was seen as unlikely to pass, but it had a chance with the drought deepening, and that would have been the worst outcome of all.

From my initial read, the new bond is a significant improvement in two major areas:

1. It is nearly $4 billion smaller, and some of the more egregious "pork" spending items are gone.

2. While the bond may not be 100% Delta tunnels neutral, it cuts $2 billion in direct funding for Bay Delta Conservation Plan (BDCP) habitat from the 2009 version.  It seems to me that this is a major blow to the already unlikely prospect that the BDCP/tunnels can develop a credible financial plan sufficient to gain regulatory approval of the project.  

While I will withhold making final judgement until I know more about the details, I don't think these improvements are enough to switch me from a position of opposing to supporting a water bond.  

My main objection is that many if not most of the projects supported by this bond, even good and worthy projects, could and should be paid for with water rates instead of General Obligation Bonds that take money directly away from education, health and public welfare programs and are repaid with income and sales tax revenue. Funding for the safe drinking water crisis in the San Joaquin Valley is a relatively small part of the bond, and it should be funded as a stand-alone measure outside of the bond package.  

My second objection is the $2.75 billion in "continuous appropriation" for surface storage projects that have highly dubious public benefits, small water yields, and a very poor return on investment.  As I have discussed elsewhere, the Temperance Flat dam feasibility study is woefully deficient and the mammoth project is simply a bad investment.  My understanding is that Sites reservoir is a better project, but I have not yet reviewed it in depth.  If it is a good project, then the "continuous appropriation" is unnecessary and it should be able to compete against other storage projects and priorities.  [Update: I am told that the storage funding will be allocated by California Water Commission in a competitive process, and could go to something other than these dams.  I have heard major doubts of whether these dams are viable even with state funding support from the bonds.  There will be lots of political pressure on the CWC to fund reservoirs even if they are non-competitive as that is what many of the bonds supporters think they are voting for.]  

Another objection is the issue Restore the Delta is raising about the bond authorizing $485 million to be spent buying water upstream of the Delta to augment Delta flows - even as the state pushes the Delta tunnels that will reduce Delta flows.  I don't know anything more about this then what RTD keeps sending to my inbox, and if it is illegal as they say then I won't worry too much.  

I should also state that I am bothered that the water bond appears to have elbowed a school bond off the ballot.  Public schools are free and can't be financed with user fees like water infrastructure (although new schools can be financed with impact fees), thus it is an appropriate use of a GO bond.  More importantly, California's woeful support of education is a far greater problem to its economy and long-run prosperity than water.  The Governor has his priorities backwards on these bond issues.

Thus, I'm happy the Legislature and Governor have agreed on a new water bond to remove the beast from 2009 from the ballot, but I will probably still vote against it.  I suspect some of the legislators who voted overwhelmingly for putting the new bond on the ballot feel the same way and will not be campaigning for it.

The Fictional Scenario Behind BDCP Jobs Claims

The LA Times and now some other sources have quoted me criticizing the BDCP's claim of a million jobs protected by building the tunnels, because it is based on a "fictional scenario."  These press reports do not explain why I said it is a fictional scenario, so I will do it here.

The jobs claims from BDCP are divided into 2 parts, as shown in this BDCP infographic.

The first part are those created by the direct spending on implementing the BDCP (building the tunnels and habitat).  This part of the analysis is well-done and estimates 155,090 years of employment, primarily from construction.

The fictional scenario is the second part: the claim of nearly 1 million jobs (years of employment) from water supply reliability.  The calculation depends on 3 far-fetched assumptions, all of which must be true to generate the level of water shortages that drive this kind of job impact.

1. Water agencies don't invest in any new alternative water supplies for the next 60 years beyond what is under construction today, and there is virtually no increase in active conservation beyond current levels.  The Brattle Group says alternatives are speculative.  I guess it is speculative to assume that water agencies would do anything crazy like actually follow their own board-approved investment plans!  Metropolitan's own long-range plan specifically lays out what they would do over decades to ensure no water shortages even if there is no Delta solution and environmental regulations cut water supplies further.  It only takes this one ridiculous assumption to make it a fictional water shortage scenario, but wait there's more.
2. Water demand in Southern California urban areas grows by 20% over the next few decades, even though there has been no growth in demand for the past 20 years.  This projection uses outdated and inflated population growth forecasts instead of following California law and using the Department of Finance population forecast as is required for state level planning activities.  Population growth is expected to be slower and development more dense in the future than it has been in the past 20 years of flat demand.  These types of water demand growth forecasts have been made by the water industry for decades to rationalize big projects and they have always been wrong.  This one is no different.
3. Increased environmental regulation reduces Delta water exports by another 25%, as soon as 2025.  I guess they think the Environmental Water Caucus or Restore the Delta will be running the State Water Project control room in a decade.  Of course, the shortage wouldn't happen even if the state implemented these advocates' "Responsible Exports Plan", because their plan calls for large investments in alternative water supplies and conservation with the money not spent on BDCP (see assumptions 1&2 above).  Although I increasingly think this "Responsbile Exports Plan" is the best plan on the table, it is wildly speculative to assume that is the current direction of policy.  The current, much less protective levels of regulation are under attack in Congress and the courts, often by the same interests promoting the BDCP.     

Finally, I will note that the good part of the analysis that estimates 155,090 jobs (years of employment) is not very impressive given the cost.  If you divide by the $25 billion cost of BDCP, that amounts to only 6.2 jobs per $1 million of public spending.  Anyone familiar with employment multipliers should recognize that is an incredibly low total of employment for that level of spending.  The bottom line is that spending billions on imported tunneling machines and converting farmland to marsh just doesn't produce that much job bang for the buck.

BDCP Cost and Yield Deception

Last week, BDCP released what it describes as "cost and yield information,"  although I didn't see any new information in the glossy newsletter summary with the pretty bird. The newsletter makes 2 main claims: 1) BDCP provides reliable water for $5 per month, and 2) BDCP is cheaper than the alternatives.  Both of these claims are deceptive and are based on invalid comparisons and inaccurate assumptions.

I'll start with the second claim, BDCP is cheaper than alternative water supplies, which is illustrated in the BDCP glossy with this graphic.

I see six major problems with these comparisons.

1. Subsidized BDCP costs are compared to unsubsidized alternative costs.  However, the proposed water bond subsidizes both BDCP and these alternatives.  According to BDCP, water agencies would pay 68% of BDCP's estimated $25 billion cost, and most of the rest would be paid by state water bonds.  While the agencies would pay all the cost of the Delta tunnels, the public subsidy of BDCP includes things essential to securing an endangered species "take permit" for the Delta tunnels, including billions for habitat construction projects and purchasing water from upstream sources to augment Delta freshwater in-flows which would be greatly reduced by the tunnels.  My understanding is that the current water bond proposal has more public funding for these alternative water supplies like recycling and groundwater cleanup than BDCP projects.  Thus, if the costs of BDCP to water agencies are displayed assuming water bond subsidies, then the alternative costs to water agencies should also reflect subsidies that would result from the same water bond(s).
2. BDCP costs are reported as the change to the average cost of a large system with existing projects (i.e. State Water Project) whereas alternative costs are reported at the project level.  A consistent comparison to the alternatives requires BDCP costs per acre foot to be calculated at a project level (i.e. marginal costs), which means looking at the increase in water supplies from implementing the project.  The BDCP cost figure deceptively averages the cost over all State Water Project supplies - including those that would be provided without the BDCP.  Dr. Rodney Smith has an excellent example of a correct calculation of BDCP costs for comparing to alternatives on this blog post.  Dr. Smith states that "Under alternative “no tunnel” scenarios, the best case for the cost of BDCP water would be well over $1,000/AF for a non-firm water supply.  There are some scenarios where the BDCP investment may yield even a lower water supply.  In those circumstances, the BDCP investment in tunnels would become the “bridge to nowhere” in waterworld."  It should be noted that Dr. Smith's "well over $1,000" is untreated water at the Tracy pumps and does not include the cost of treatment and pumping hundreds of miles over mountains to southern California cities.
3. Uncertain BDCP costs and yields are compared to alternatives with known or much more certain costs and yields.  The alternative costs in the chart are based on projects that are already built, under construction, more advanced in design and/or use existing technology.  There is a lot more certainty about the costs of these alternatives.  In contrast, the BDCP tunnels are only at 10% design and it is a unique project that presents enormous engineering challenges.  Furthermore, the BDCP water yield is not known and is given as a range.  BDCP cost estimates assume no cost escalation and optimistic yields.  Thus, BDCP is much riskier than these alternatives.   
4. Alternatives are more reliable than BDCP.  Unlike BDCP, these alternatives are relatively drought proof, whereas BDCP provides no additional water in dry years.  For BDCP to generate comparable reliability, you would have to include significant costs of new storage which would raise the per-acre foot cost of BDCP water.
5. Lower-cost alternatives are ignored.  The comparison chart picks the high-cost, high-capital alternatives under the assumption that most of lower-cost alternatives like conservation have already been implemented or will be implemented anyway. Many experts, such as those at the Pacific Institute, disagree with this pessimistic assessment of conservation.  It should also be noted that this comparison only looks at urban alternatives, when most of the BDCP water supplies go to agriculture. The simplest alternative for agriculture is to fallow lower-value crops, an action which is generally estimated to cost about $150 per acre foot.  
6. Ignores technological advance in alternative water supplies.  While I don't fault the BDCP for not wanting to speculate about the cost of future technologies, it should be noted that the cost of these alternatives is dropping and there is a lot of technological innovation in the pipeline on water supply alternatives.

As for the first claim, $5 a month for water supply reliability.

• $5 a month per household assumes that farmers pay the majority of the tunnel costs, which is widely known to be infeasible and this cost allocation issue is the main reason that even a draft BDCP finance plan is years overdue.  There are also some unrealistic assumptions about no cost escalation, delays and financing terms embedded in this.  I expect urban household costs to be about 3 times what BDCP estimates.
• BDCP water is not that reliable.  Given the current drought, I think most people would not view a $15 billion piece of water infrastructure that is idle in drought years as substantially increasing reliability.

The Baseline for Drought Impacts: Valley agriculture has expanded a lot in the 5 years since the last drought.

The economic losses from the drought is the hottest topic in the Valley right now.  It is clear that the 2014 drought impacts will be larger than the 2009 drought, but how much larger?  A significant challenge in making comparisons is accounting for the remarkable changes in Valley ag over the past 5 years.  What is the right baseline for measuring fallowing and lost production?

For the 2009 drought, 2007 was arguably the best year to use for the baseline because there were already some modest drought impacts in 2008 leading up to 2009.  Although we don't have complete 2013 data yet, it is still probably best to use 2012 data as a baseline for 2014 impacts for the same reason.  Thus, I have compiled some key indicators for 2012 and 2007 for the 8-county San Joaquin Valley to see how things have changed.  The overall picture is an industry that is expanding in response to strong crop prices, revenues, and profits.

Farm Jobs in the San Joaquin Valley:
According to California EDD, there were 197,000 agriculture jobs in 2012, a 10,000 job increase (5%) from 187,000 in 2007.  Average wages increased from $10.46/hour in 2007 to $11.82/hour in 2012, an increase of 13%.

Preliminary data for 2013 shows employment was slightly higher than 2012, and wages increased nearly $1 an hour.  Farmers have complaining louder than ever about labor shortages, but total farm employment is at its highest level in over a decade.  However, farm wages have also seen significant gains in both 2012 and 2013 which supports the idea that labor is becoming more scarce.  Simultaneous increases in both employment and wages point to increasing demand for workers.  That is a sign that the industry is expanding, and the acreage data points to rapid expansion.

Irrigated Acres in the Valley:
I compiled total harvested acres for the 3 main crop types: field crops (excluding rangeland and unirrigated pasture), fruit and nut crops, and vegetable crops.

Total harvested acres in the San Joaquin Valley increased by 387,000 acres between 2012 and 2007, an increase of 7% to 5.824 million acres in the 8 counties in 2012.

Field crops increased by 72,000 acres, +2%.
Fruit and nut crops increased by 386,000 acres, +21%.
Vegetable crops decreased by 72,000 acres, -12%.

All counties expanded total harvest acres except Kern County, but Kern County had the highest increase in fruit/nut (permanent) crops at 102,000 acres in 5 years.

I have mixed feelings about this and the Valley economy.  On one hand, the strength and growth of the agricultural sector has been especially welcome in the context of a depressed overall economy.  The recent growth in agricultural wages is particularly encouraging.  On the other hand, there are good reasons to question the sustainability of this industry growth.  Many people were questioning the sustainability of over 5.4 million irrigated acres in the San Joaquin Valley back in 2007, even before an additional 400,000 acres were brought into production.  The total amount of key resources such as land and water has not increased.  I have heard a lot of comments from people inside and outside the industry about permanent crops that are planted on marginal, poor quality land, seriously overdrafting groundwater or both.

The immediate question is what is the baseline from which to measure the impacts of the 2014 drought, and how to compare the 2009 and 2014 events.  In 2009, there were about 250,000 fallowed acres compared to the 2007 baseline.  In 2012, not only were the 250,000 acres fallowed in 2009 back in production, an additional 387,000 acres of mostly permanent crops were added to the baseline level of production and are now competing for an even lower supply of water.    While it is probably best to use the more recent 2012 baseline for measuring the immediate impact of the drought, it is important to understand that this industry expansion fueled by growing plantings of permanent crops also plays a role in drought impacts.

New PPIC Report on the Cost of Water From the Tunnels

After a quick initial read, my impression of the new PPIC report, Paying For Water, is mostly positive.  It provides a good overview of funding options and challenges in key areas.

Of course, I am always interested in what the PPIC has to say about the Delta tunnels.  There is only a brief discussion of the tunnels on page 26-27, and it correctly focuses on the major challenge of agricultural users affording the tunnels without endorsing or rejecting the tunnel proposal.  However, I do not believe it accurately characterizes the cost of water through the tunnels, and it incorrectly attributes a per acre foot cost estimate to Dr. Rodney Smith (of Hydrowonk fame).
   

BDCP puts the implicit additional water supply cost of new conveyance, based on current cost estimates, at $302 to $408 per acre-foot at the Delta.39 Additional costs would accrue for transmission, treatment (for urban users), and distribution, which could add as much as several hundred dollars to the price paid by urban water users. Others that have examined BDCP put the likely cost much higher, with estimates ranging from $500 to $1,000 per acre-foot. fn40

Footnote 40 attributes the $500-$1000 per acre-foot estimate to Dr. Smith's blog post, but this is what Dr. Smith actually said in that blog post.

Over the past couple of weeks, I have heard about alternatives to the no BDCP scenario defined by DWR.  What proves true will have a substantial impact on the cost of BDCP water.  Under alternative “no tunnel” scenarios, the best case for the cost of BDCP water would be well over $1,000/AF for a non-firm water supply.  There are some scenarios where the BDCP investment may yield even a lower water supply.  In those circumstances, the BDCP investment in tunnels would become the “bridge to nowhere” in waterworld.

I don't know how Dr. Smith's very clear and bold statement can be interpreted as $500-$1000 af.  I have joined Dr. Smith in estimating the cost of BDCP water as well over $1,000 af., and would be over $2,000af in very plausible scenarios.

The PPIC's brief discussion of the tunnels' cost continues...  

Still, for most urban water users, Delta exports in this price range would remain competitive with most other new sources of supplies. In contrast, this price increase could be prohibitive for many agricultural activities. Among the many open questions is whether water users could agree to a cost-sharing formula with lower payments by agriculture, potentially in exchange for lower reliability, or to a smaller project (lowering both future exports and costs, and using the savings to develop more local supplies in urban areas).

This is a reasonable assessment if you think the costs are under $1,000 af.  My take is a little different, and simply reflects my view that the costs are higher. 

For urban agencies, I believe the costs are on the high-end of their current alternatives.  So it is affordable but marginal investment for urban agencies if you assume a proportional cost distribution with farms.  But the costs are absurd/nonsensical/crazy (I have used all these adjectives) for agriculture, and the majority of the water exported from the Delta is used by agriculture.  Any attempt to shift the costs from agriculture to urban users make the tunnels a very bad investment for the urban users as well.  And the PPIC's other suggestion, that the cost shift be done in exchange for lower reliability for agricultural water supplies - has significant economic and social implications in a dry year like this - the financing plan for the tunnels could be the real "man-made" drought for the Valley.

New Temperance Flat Feasibility Study Claims Salmon Benefits and Delta Earthquake Risk Reduction Justify the New Dam and a Big Taxpayer Subsidy

I spent a good part of the afternoon reviewing the new feasibility study for the Temperance Flat dam and compared it to the one released in 2008.  The Bureau of Reclamation's claimed benefit-cost ratio in the new feasibility study is much higher than the one from 2008 that infamously found a B-C ratio of 1.0 to 1.06 despite the fact that the estimated water yield is lower.

Some observations about the benefit-cost estimates.

1.  Estimated construction costs of the dam dropped by nearly $1 billion (new estimate is about $2.5 billion compared to original of about $3.5b), even though the current estimate is in 2013 dollars and the old one was in 2006 dollars.  I am told the cost reduction is attributed to a change in the hydroelectric mitigation required.  Apparantly, it isn't true that estimated construction costs always go up.

2.  The new feasibility study justifies the dam for its ecosystem benefits to salmon.  It values the ecosystem benefits 2-10 times higher than the water supply benefits.  In addition to economically justifying the dam, this finding also is convenient for justifying a much higher taxpayer subsidy of the dam than proposed in 2008 (more on that later).  These multi-billion dollar ecosystem benefits (annual benefit estimates ranged up to $500m per year) result from the report's estimate that the dam will increase long-run average abundance of salmon from between -0.7% and 4.9% per year.  I'm not a biologist, but that doesn't seem like a huge benefit to me for a river that is projected to have relatively small salmon populations.  This recasting of the dam as a salmon project is very surprising to me as I am not aware of any environmental groups or fishery experts pushing Temperance Flat dam as a priority, and there are even some environmental groups who are opposed.

3.  The report is quite honest that the traditional water supply, flood control, hydropower, and recreation benefits that are associated with dams are not nearly high enough to justify the construction costs of this project.  And that's even after the report inflates these traditional benefits...

4.  In the "best" scenario, the report estimates $19 million in annual agricultural water supply benefits from an average increase to ag. water supply of 41,000 af.  That's a healthy $461 af in current dollars, a value that is about 3 times higher than typically used for incremental ag water in benefit-cost assessments.  Given the special role of agriculture as the economic base of the Valley, I have sometimes argued for using a more generous economic development measure that includes multiplier effects.  Like many of these assessments, this feasibility study also calculates the economic development value in a separate section.  In Table 5-12, the report estimates this annual value at $10.8 million for agriculture, which seems about right for 41,000 af of annual yield.  The strange thing is that this economic development value is lower than the value used in the benefit-cost estimate, and it is usually the other way around.  This seems to confirm my suspicion that the $19 million value associated with ag. water supply reliability is an error.  Bottom line, the agriculture water supply benefits are overestimated by a factor of 2-3, at least $10 million per year.  [Update:  I have now seen the technical appendix, and it turns out that this huge agricultural value results because the model they are using allocates the majority of new agricultural water produced by Temperance Flat to recharge groundwater where it has a much higher economic value than growing crops. This is an interesting finding and if it accurately measures the value of recharging groundwater and/or the external cost of pumping groundwater on other users of the aquifer, it makes a powerful argument for regulation of groundwater.]

5.  Delta earthquake and flood protection benefits.  The feasibility study estimates $25 million in annual benefits from emergency water supplies Temperance Flat would provide in the event of a catastrophic Delta flood.  This benefit is inflated due to ridiculous assumptions about levee failure probabilities among other issues.  As a point of comparison that shows the foolishness of this number, it is almost identical to the risk-reduction benefits the BDCP estimates for the Delta tunnels which are thought to preserve several million acre feet of water exports in the case of these catastrophic events.  [The BDCP estimates 50 years of this benefit has a present value of $364m to $460m, use the present value formula to solve for the annualized value and it is in the neighborhood of $25 million annually.  This Temperance Flat study allocates over $400m of construction costs to taxpayers due to this benefit.]   

6.  The benefit-cost analysis uses annual costs and benefits.  It annualizes capital costs over 100 years with a 3.75% discount rate.  That is a very generous assumption, and it understates the annual costs.

Some observations about the proposed cost allocation for Temperance Flat.

1.  Only 26% of the cost of the dam would be allocated to water users (12% ag, 14% municipal/industrial).  In contrast, the 2008 study of the dam allocated the majority of costs to water users.

2.  About 73% of the cost of the dam would be paid by federal and state taxpayers.  The 73% allocation can be broken down into three general categories of claimed public benefits: 49% ecosystem, 8% recreation/flood control, and 17% emergency water supply benefits from a Delta flood (see #5 above).  This 73% share is only direct construction costs, and does not count the subsidy in the Bureau's 0% financing of agricultural users contribution.

So that is about $1.25 billion in taxpayer dollars towards dam construction for claimed salmon benefits (direct costs, this doesn't count interest costs on the water bond that would finance the state's share).  I wonder what a salmon expert would do if you gave them $1.25 billion of taxpayer funds and said spend this to improve salmon habitat.  

In addition, it allocates 17% of the dam's costs (nearly $500 million) to state/federal taxpayers due to the Delta flood risk reduction benefits (see #5 above).  Taxpayers might prefer to spend $500 million in Delta risk reduction would be better spent directly on Delta levees themselves - providing flood protection benefits for water supplies and protecting property, other infrastructure and lives in the Delta. 

Some observations about financial feasibility calculations for water users.

  

Unlike BDCP, this report correctly proposes a cost allocation before making any conclusions about financial feasibility. 

1.  Agricultural water supply is allocated $264 million of construction costs.  Assuming 40 year repayment period with no interest, and operating costs comes to $8.7 million per year.  The report estimates the cost of the incremental water supply to the agricultural users is $212 af.  That's a hefty cost for agricultural water, and note that this is the cost even with the Reclamation's generous no-interest financing and taxpayers picking up 73% of the estimated construction cost of the dam.

2.   Municipal and industrial water supply is allocated $362 million of construction costs.  The report assumes a 40 year repayment of capital costs and 5.37% interest.  Principal, interest, and operating costs come to $27.4 million annually, and the incremental water supply cost to M&I users is $1,305 per acre foot. That's a pretty expensive municipal and industrial water supply, even with taxpayers picking up 73% of the estimated cost of the dam.

Overall, it's not a very convincing feasibility study, and I don't believe it provides strong economic justification for Temperance Flat dam.  It's disappointing, because I believe in the value and need for storage and I would like to be able to support storage projects in the Valley.  But there are better uses of taxpayer dollars for these and other purposes, and the water it is still an expensive option for water users even with the large taxpayer subsidies.  

What's the value of water to agriculture?

Over the past month, lots of people have been emailing me the $1,100-$1,200 per acre foot price for price irrigation water is selling for in a Kern County auction.  It is indeed an incredible price for agricultural water.  It shows that this drought is very severe and likely will impact some high-value permanent crops, and it tells us what orchard owners are willing to pay for one year to keep an orchard alive when they have few other alternatives.

But what does this data point tell us about the value of water to agriculture in California?  What is the value of agricultural water that should be used for major policy analysis - such as evaluating infrastructure investments such as Delta tunnels, new reservoirs, alternative agricultural water supply investments (like solar powered groundwater desal), or intra-regional conveyance to facilitate more local transfers between Valley farmers?

I would caution people from over-interpreting the $1,100 per acre foot price.  In fact, the same article in the Bakersfield Californian that reported the $1,100af auction, also reported this...

Buena Vista plans to use part of the proceeds from the auction to pay for a land fallowing program within its district. It has offered to pay farmers $400 per acre not to farm this year to reduce demand on the aquifer.
It had hoped to be able to fallow 4,000 to 5,000 acres.
The district ended up getting applications for 11,000 acres, Etchechury said.
After weeding through all the applications, he said, it looks like about 7,500 acres are eligible for the fallowing program, which could cost the district $3 million.

Thus, in the same county where farmers are willing to pay $1,100 per acre foot, a 50,000 acre water district on the west side of the Valley has 7,500 acres (about 15% of the district) accepting $400 per acre to forgo planting. Assuming 3-4 feet of water to grow a crop, this second data point suggests the marginal value of water in agriculture on the west side of Kern County is about $125 per acre foot.  [Data on irrigated land rental rates from the California Department of Food and Agriculture (see page 2) imply a similar value.  CDFA reports irrigated cropland rents for an average of $340 per acre in 2012, and non-irrigated land rents for $40 an acre, a difference of $300 per acre.]

This $1,000 af difference in agriculture water values in the same year in the same area shows large gains could come from local trades, and that there would be considerable value to infrastructure and market institutions to support local, intra-county and intra-basin trades between farmers.  It seems that these sorts of investments could make a lot more financial sense for the San Joaquin Valley than the $15 billion tunnels under the Delta.

Comparing Immigration Proposals for Detroit and the Valley

This is an interesting proposal.

Michigan Governor Rick Snyder unveiled a proposal on Thursday that calls for the U.S. government to allocate 50,000 special visas over the next five years to lure highly skilled immigrants to live and work in the bankrupt city of Detroit.

The theory is that attracting a critical mass of high-skill, high-education immigrants to Detroit would create many jobs by attracting talent-seeking employers as well as stimulate entrepreneurship and new businesses founded by the immigrants.

Here in the Valley, political leaders are pushing for a different program that would provide green cards to immigrants after 5 years of low-paid farm labor.

Detroit and the Central Valley are two places in the U.S. struggling with economic woes and municipal bankruptcies.  The Governor of Michigan, with the endorsement of Detroit's mayor, wants to use immigration to stimulate entrepreneurship, attract new industries and change the local economy.  In contrast, Valley leaders are looking for immigration reforms to attract a low-paid labor force to help its largest and most-profitable existing industry.

The contrast is interesting, special visa programs can be seen as a way to create a new economy or preserve an existing economy.  Immigration is complicated and involves much, much more than economics, so this shouldn't be seen as an endorsement or rejection of either proposal.

Should there be regulation of economic activity in drought zones?

There is widespread recognition that historical federal policies such as flood insurance have encouraged undesirable development in areas that predictably flood, and have increased the cost of flood disasters.  Public policies are changing to address this issue.  The policy changes and proposals at both federal and state level include:

• significantly reduced subsidies for flood insurance
• stronger requirements to purchase insurance
• limitations on new development in flood plains
• requiring flood-proofing investments

These changes in flood zone policies are phased in over time and have to be sensitive to historic communities in these areas, and are often opposed in the communities in flood zones that bear an increase in costs.  The overall thrust of policies is change behavior in ways that reduce risk to predictable hazards.

Similarly, high fire hazard areas have seen changes to regulations; including stricter building codes, increased fees, and changes to insurance that add costs to living in fire hazard areas and are unpopular in these areas.

Today, California is facing the prospect of substantial drought impacts on the agriculture economy for the second time in five years.  These severe drought events are predictable, occurring at least once per decade and they have a significant economic and human toll on the areas where drought impacts are most concentrated in California, the west side of the San Joaquin Valley.

And similar to historical policy towards flood zones, historical water policies such as the Central Valley Project have encouraged increased investment and growth of vulnerable populations in areas where the risk of drought are greatest (see chart below).  Similar to the treatment of floodplains, is it time to think of policy changes to reduce the economic risk and suffering from future droughts?  Climate and water experts predict these shortages may become more common with climate change.  Here are a few initial ideas for reducing economic risk in "drought zones":

• Restrictions on investment in permanent crops that harden demand for water  (I once heard a fisherman call this tree limits, similar to catch limits and regulations governing fisheries)
• Mandatory contributions of farmers in these areas to social insurance funds that are tapped to help unemployed workers and local communities in drought years.  This would reduce economic risk of drought-induced fallowing in two ways, 1) direct assistance to individuals affected by drought-induced unemployment, and 2) encourage the cultivation of less labor-intensive crops or the introduction of more capital-intensive and less labor-intensive production methods.
• If not mandatory, policies could reduce subsidies for farms that do not participate in voluntary drought-risk reduction programs, just as the CVP has a higher full cost rate for water for some farms that exceed acreage limits.

Just like changes to flood zones and fire hazard areas, I have no doubt that policies like this would be vociferously opposed by farmers in drought hazard areas like the west side of the San Joaquin Valley.  But when economic disasters repeat themselves in predictable ways, it is time to look for new ideas to reduce risk.  There may be better ideas than my initial suggestions, and I encourage others to develop them.

Postscript:  Unemployment rates on the west-side of the San Joaquin Valley since the Central Valley Project began delivering water to the region in 1968.