The Western U.S. is dealing with its water crisis in a variety of ways, but the most promising solutions, and the least draconian, involve the creation of water ownership rights and markets in which they can be traded. This recent Vox interview with John Fleck, author of “Water Is for Fighting Over“, emphasizes the dramatic reductions in usage that have taken place over the past few decades. Unmentioned, however, is that without correct price incentives, much of this adaptation involves unnecessary costs. Many users are forced to restrict water use via coercive rules. Even when conservation entails the installation of relatively simple technologies like low-flow toilets and less water-intensive landscaping, mandates do not encourage water to flow to its highest-valued uses. Mandates force conservation on all uses regardless of the efficiency with which it can be accomplished, leading to higher costs. Of course, droughts induce changes in agricultural usage as well (and reduce yields), but those changes are always suboptimal to the extent that real price incentives for a crucial input are absent.

Fleck is highly supportive of a few cases of water trading within and between certain irrigation districts. Despite these cases, however, water is priced too low in most jurisdictions to reflect its actual scarcity, and the adjustments that do occur are generally indiscriminate in terms of economic efficiency.

The only way to bring rationality to water use is for all parties to have an interest in its long-term sustainability. Markets can do that much better than collective action or forms of regulation instigated by the state. But for markets to work, traders must have a secure right in the thing being traded. Water rights are controversial, to say the least. Some basics of water rights are discussed briefly in this review of a book called “Water Capitalism: The Case for Privatizing Oceans, Rivers, Lakes, and Aquifers“, by Walter Block and Peter Nelson.

First, the riparian system, which works only when water is plentiful:

“‘The concept is that ownership of the adjacent land includes the riparian zone [the water frontage zone, i.e. shore] … typically to the centerline (unless he has holdings on both sides …) as well as the water [itself]. Pure riparian ownership gives the proprietor the privilege of drawing water … as long as there is any [to draw]’“

The in-toto system requires that any body of water, or any independent source of water, be owned by one entity, whether that is an individual, a cooperative, or a corporation. In such a world, owners of water assets would have an economic interest in good stewardship, and would charge rates that would effectively limit drawdowns to a sustainable flow. That is the only way to preserve the long-term value of their asset. However, the idea of an “independent” source of water is often problematic or even superfluous, as many or even most sources of water are dependent on others to one degree or another.

The prior appropriation system of water rights is described by Peter Nelson in this quote:

“‘This type of ownership both involves the water and measures it. The first user constructed the device(s) necessary to utilize and/or divert what he needed. In so doing, he mixed his labor with a natural resource. But what exactly does he own? It is not geometric in nature. The flow of water is what he possesses.’“

In some respects, prior appropriation is similar to the concept of squatter’s rights. However, the author of the book review linked above, Ryan Griggs, claims that ownership in a rate of flow, a usage right, is fundamentally different than a property right. I disagree. There are other forms of property that constitute claims to future flows of income, such as shares of stock or bonds held in perpetuity, and those flows are valued and traded as property. In any case, I’m not sure why ownership in a rate of usage is problematic from the perspective of the resource allocation problem at hand.

Prior appropriation is a convenient way of addressing the problem of vesting users with rights. Those rights would necessarily be attached to the land or area on which usage occurs, rather than portable for users, but I will continue to refer to “users” in what follows, rather than “places”. To simplify, suppose that each user owns an annual allotment of water as a percentage of total availability. If total availability fluctuates, some users will find it easier than others to adjust their usage. Individual users would receive their allotments based on prior use. They would pay a fee for the infrastructure and technology needed to extract and distribute water to them, and they would pay an additional rate per unit for water used above their allotment. If they use less than their allotment, they receive a rebate at the same rate per unit (or a “feebate“, a term sometimes used in conservation circles). Thus, users are given a conservation incentive.

In a low-water year when total availability is down, the price of usage will rise as users requiring more water than allotted bid on the available supplies. Those able to adjust their usage downward might find it profitable take “feebates”, in effect selling part of their allotment to other users. In this sense, water will flow to those uses in which its value is highest. The price of these trades will reflect the actual scarcity of the resource, and the higher price leads to more intensive conservation efforts. In fact, depending on the going rate, it’s possible for a user to become a net water seller, in term of monetary value, in a given period. It is also possible to arrange trades of longer-term water transfers, future water transfers, and even contingent water transfers.

The initial allotments are relatively easy to measure, though the details surrounding the measurement of historical usage must be agreed upon. However, future adjustments must be based on changes in total availability. How is that measured? A first step is to determine the extent to which total water supply is above or below a range deemed acceptable from a natural perspective. This, in turn, depends upon the annual rate at which the stock is recharged or replenished from natural sources. These data allow the calculation of a flow of usage each year that is consistent with moving toward the acceptable range for the water level. Depending on initial conditions, the allotments might require adjustments in usage in subsequent years, but that depends on the type of water source and the response of usage to the new conservation incentive. The path to “sustainable” allocations might have to be gradual, requiring several years. This might also require water authorities to purchase flows from other basins to bridge the gap, with the cost passed on to users in the marginal water rate (and reflected in feebates to the suppliers).

This might sound suspiciously like a “cap and trade” system because that’s exactly what it is. The determination of the initial allotments is a relatively benign exercise. The process for determining later adjustments is described above as a strictly technological problem, but in truth, it would be fraught with controversy, requiring a series of of political compromises. Battles over changes to allotments are likely to recur during periods of severe drought. This has been the case in Australia, for example, where the development of water markets is at a fairly advanced stage.

Australia succeeded in developing extensive water markets in response to the severe scarcity faced by farmers and other users in certain water basins. The National Water Commission published this report on water markets in 2011, which provides something of a blueprint for their system. These markets are primarily for water used in irrigation. The details of allotments in Australia are discussed in the report. No feebate system as described above is mentioned. Their water markets are now overseen by the Department of Agriculture and Water Resources. There are water brokers and exchanges to facilitate trading. WaterExhange and Waterfind provide on-line platforms for water trades. This Reuters article from September 2015 is of interest for its description of how water markets can become highly politicized under certain circumstances. This recent Bloomberg piece makes essentially the same point.

Regardless of the political complexities, the growing scarcity of water in the American West demands innovative new approaches to conservation. Creating secure rights in water flows and allowing users to engage in mutually beneficial trades of water gives them the right incentives for rational water management. Traditional approaches such as usage restrictions, mandates, and large water storage infrastructure projects are all costly and do not promote the  efficiencies that come naturally by way of market solutions.

Further reading: A recent report from The Nature Conservancy is strongly supportive of markets to deal with water scarcity. This Hamilton Project paper on water markets is worth reading as well. Two previous posts on Sacred Cow Chips dealt with water markets: “Scarcity Scarcity Everywhere, And Water Pricing Stinks” and “Can Water Markets Drive the Nuts From California?”