July 6 (Bloomberg) -- An American trucker barreling down Interstate 95 bemoaning the high price of diesel fuel might never imagine that one of the things driving up his bill is the way water in China is being mispriced. But the truth is, water shortages are indirectly causing increased use of diesel generators for electricity in China, and that, in turn, is helping raise diesel prices in the U.S.

Smarter pricing could help China -- and the rest of the world -- avoid further problems allocating water resources, and mitigate some of the side effects.

Coal plants generate most of China’s electricity. Hydropower is the second-biggest source. Water is clearly essential for hydropower, but a lot of it is needed for coal power, too -- to mine the raw material, to process it and then to cool the power plants that burn it. In 2010, coal-fired electricity in China used more than 30 trillion gallons (114 trillion liters) of water, or about 20 percent of the country’s total consumption. And over the coming decade, roughly 40 percent of the nation’s increase in water demand will be associated with coal power, China’s Ministry of Water Resources says.

This development is exacerbating an already severe shortage in China. The country accounts for about 15 percent of the world’s consumption of fresh water. Yet its supplies are limited, and pollution is a significant hazard.

According to the World Bank, the amount of water per capita in China is only one-quarter of the global average. Furthermore, about 80 percent of the total supply is south of the Yangtze River, while only about half the Chinese population lives there. So the north is chronically short. The North China plain, which encompasses both Shanghai and Beijing, contains more than 40 percent of the national population, but less than 15 percent of the water. In this region, the per-capita amount is only about one-quarter the level considered the minimum for people to live on.

Pollution Hurts

Widespread pollution exacerbates the situation. About 90 percent of the aquifers underneath major cities in China are polluted. More than 300 million Chinese lack access to safe drinking water, according to the World Bank.

In addition to these challenges, there is a severe drought this year, which is the worst in half a century, according to some estimates. Rainfall is 40 percent to 60 percent lower than normal, which means less power from hydroelectric dams and too little water to support some coal-fired plants. The Chinese have, therefore, had to lean more heavily on diesel generators to help power the electricity grid. That, in turn, has led officials to ban exports of diesel fuel.

And that raises costs for the trucker on I-95.

So what can be done? Broadly, three things.

The first is to reduce China’s water pollution and, globally, address the threat of climate change. Some scientists say climate change is already increasing the pressure on China’s water supply by disrupting normal patterns of rain- and snowfall.

The second is to increase the supply of usable water in the places in China that lack it, through desalination and by redirecting water from south to north. In the Tianjin-Binhai development zone, on the western shore of the Bohai Sea, China has built a 12 billion-yuan ($1.9 billion) desalination plant, using the latest Israeli technology. In addition, the nation is embarking on the world’s largest water-diversion project, to re-route part of the Yangtze along three channels to the north.

Raise the Price

But what is perhaps most promising is the third solution: better pricing of existing water resources. Water is Earth’s most valuable commodity, and yet in most countries it is given away free -- as if it had no value at all.

In Oman, a Middle Eastern desert country where water is scarce, it is understood to be more valuable. There, farmers trade water rights. As Peter Brabeck-Letmathe, the chairman of Nestle SA, has pointed out, farmers are in the best possible position to know water’s value. Pricing it through tradable rights or other mechanisms “is an extremely strong incentive to use water efficiently,” Brabeck-Letmathe said in an interview with the McKinsey Quarterly.

The academic literature bears out his point. In a July 2007 study, Sheila Olmstead of Yale University and Robert Stavins of Harvard University concluded that using prices to manage water demand was more cost-effective than conservation programs not linked to price, such as restrictions on watering the lawn and subsidies for low-flow faucets.

Yet many critics of higher prices for water say low- and moderate-income households will be unfairly affected. So the most promising way to price water -- in China as well as in the U.S. and elsewhere -- would be to provide, at no cost, a base amount per day for normal activities, such as cooking and cleaning, and then charge for water used above that threshold at rates that rise with the increased amount consumed.

The Chinese people are willing to pay more for water, the World Bank reports, “as long as the quality of the service is good and the tariff level acceptable.” And yet prices in China are still much too low to ensure that the water is used efficiently enough to sustain the supply. Higher prices would persuade people to both reduce waste and improve the allocation of water across all its possible uses (including in the energy sector). It would also encourage more investment in desalination and other measures to increase supply.

If China moved more aggressively to price water in a manner that reflected demand and supply, it could teach the U.S. a lesson in using market economics to address environmental issues. As a colleague of mine at Citigroup Inc., the analyst Deane Dray, has written, “water has never been priced efficiently.” In the U.S., water is generally heavily subsidized, and prices aren’t adequately linked to usage levels.

Just as we need to price carbon in order to avoid a climate crisis, we need to price water to avoid a water crisis. Market forces can work wonders for the environment, but only if we have the political courage to create them.

(Peter Orszag, vice chairman of global banking at Citigroup and a former director of the Office of Management and Budget in the Obama administration, is a Bloomberg View columnist. The opinions expressed are his own.)

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To contact the author of this column: Peter Orszag at orszagbloomberg@gmail.com

To contact the editor responsible for this column: Mary Duenwald mduenwald@bloomberg.net