Expanding Water Markets in the Western United States: Barriers and Lessons from Other Natural Resource Markets
Abstract
This article identifies key barriers to the expansion of surface water markets in the western United States and examines the lessons learned from the development of market-based management of other resources. We argue that the most salient barriers to water market development are conducting and verifying trades of environmental goods and services and the challenges associated with the political economy of defining, altering, and transferring property rights. We review the extensive economics literature on markets for fishing rights, air pollution abatement, and water quality; discuss the lessons learned from experience with these markets; and suggest specific reforms for increasing the role of markets in water resource management, including minimizing the cost of trades and implementing strategies to address political opposition.
Introduction
On February 12, 2017, communities below the Oroville Dam near Sacramento, California, were evacuated due to concerns that flooding could cause the dam—the tallest in the United States—to fail. Yet four days earlier, the California State Water Board extended its existing water conservation regulations, noting that much of the state was still experiencing severe drought conditions that had persisted for years.1 This apparent contradiction underscores the new reality facing water managers in an era when climate change is predicted to shift the timing, location, and amount of precipitation in the western United States (Solomon et al. 2007). Demographic trends indicate that arid regions will face increasing demands for water supplies that will become increasingly difficult to manage (Olmstead 2010).
The efficient allocation of water among competing agricultural, municipal, and environmental uses (e.g., in-stream flows for fish habitat) presents a critical policy challenge for local, state, and federal governments in the United States. In the early twentieth century, major public investments in water reclamation infrastructure were undertaken to increase supplies. However, large-scale supply augmentation is not likely in the modern western U.S., not least because it provides perverse incentives for water-intensive development (Stavins and Jaffe 1990; Chong and Sunding 2006; Olmstead et al. 2016). Thus resource managers, policymakers, citizen groups, and the popular press are increasingly considering water markets as a tool for managing water, particularly in the western United States (Easter and Huang 2014).
Economists have long discussed the potential efficiency gains and transaction costs associated with surface water markets (Hartman and Seastone 1970; Burness and Quirk 1979; Vaux and Howitt 1984; Saliba and Bush 1987). Voluntary trading between willing buyers and sellers directs water resources to their highest valued use and provides information on relative values, which is key for making tradeoffs between competing uses or assessing the costs of imposed trade-offs or restrictions. However, by reducing the gains from trade, transaction costs (i.e., the costs of defining, exchanging, and enforcing water rights) can prevent widespread use of markets to allocate water.
In reality, water markets are highly localized and often controversial (Brewer et al. 2008). Although there are isolated markets for surface water in certain regions of the United States, Australia, and Chile, these are the exception rather than the rule, and where water trading does occur, it tends to be within irrigation districts (Grafton et al. 2011; Olmstead, Fisher-Vanden, and R. Rimsaite 2016). Given the large potential gains from water trading, trades between sectors or across basins are more limited than economic theory would predict, suggesting that transaction costs are high (Brewer et al. 2008; Donohew 2009; Libecap 2011). Unfortunately, the data and the empirical literature on water markets are limited, focusing more on diagnosing problems than offering solutions. Although water markets are constrained by unique transaction costs and institutional barriers, market-based policy responses to other natural resource problems have faced similar challenges.
The relative strength of surface water rights in the western United States, coupled with the mixed success of the markets there, provides a rich setting for studying how the unique features of water combine with political economy factors to create barriers to the further development of water markets. This article examines the barriers that prevent welfare-enhancing water trading from occurring in the western United States, which may offer insights into how water markets might be developed more effectively around the world. We also identify lessons from other markets that may be applicable to water markets by examining the successes and failures of market-based environmental policy for fishing rights, air pollution abatement, and water quality management—both in the United States and elsewhere. We then suggest specific institutional reforms to increase the role of markets in water resource management.
We begin in the next section with a review of the literature on surface water rights to highlight the two most important barriers to water market development in the United States: the costs of conducting and verifying trades of environmental goods and services and the political economy of defining, altering, and transferring property rights. This is followed by a brief overview of the other environmental markets we examine. Then we discuss efforts to address the key barriers in these markets and the extent to which such efforts have been successful. The final section presents a summary and conclusions, including suggestions for policy reforms.
Surface Water Markets: Institutions and Barriers
Water markets are rare and, when they do exist, institutions for trading water vary widely. Informal markets for groundwater have emerged throughout Asia, particularly in India. However, formal markets for water are not widely used in the developing world (Hadjigeorgalis 2009). Markets exist in China and South Africa, but most formal trades of water occur in Australia and in the western United States, where property rights are more fully defined (Brewer et al. 2008). This section discusses the issues associated with water rights in the western United States, where policymakers are increasingly considering the use of markets to address mounting water shortages.
Defining Property Rights
The starting point for developing any market is defining property rights to the assets that are to be traded. Property rights set the terms of use, exclusion, and exchange for scarce resources by specifying what may be owned and by whom and under what conditions ownership may be transferred. Property rights to water are defined the most clearly in the western United States, where the prior appropriation doctrine allocates rights to surface water.2 Prior appropriation grants the right to divert a specified quantity of water from a specific location for preapproved “beneficial uses” (e.g., irrigation, municipal supply) on an annual basis, as long as senior claims—those that were established earlier—are satisfied first. This “first in time, first in right” system results in priority-based reductions during drought, meaning that senior users may face no reductions while junior users receive no water.
Prior appropriation rights (also called appropriative rights) are not tied to the ownership of riparian lands (i.e., lands directly adjacent to streams). This is an important feature for both the initial development of irrigation in the West and the transferability of water rights because it broadens the set of landowners who can potentially own a water right (Leonard and Libecap 2017). Prior appropriation forms the basis for regionally isolated water markets, comprising thousands of trades from 1987 to 2005 across Arizona, California, Colorado, Idaho, Montana, New Mexico, Nevada, Oregon, Texas, Utah, Washington, and Wyoming (Brewer et al. 2008).
Mobility of Water and Externalities
The fact that some portion of most agricultural diversions eventually reenter streams as “return flow” through runoff, coupled with the sequential nature of prior appropriation claims, has resulted in a system of overlapping rights whereby multiple individuals hold rights to the same molecule of water (Barzel 1997; Hanemann 2006; Donohew 2009). If upstream users transfer their rights, they may impose external costs on stakeholders who benefit from the existing distribution of flows, such as downstream users whose water rights often rely in part on return flows. The various institutions (e.g., case law, irrigation district rules) that have evolved due to concern about these “third-party effects” make trading costly and politically fraught because numerous stakeholders, including downstream users and community members, can block trades (Chong and Sunding 2006; Brewer et al. 2008; Bretsen and Hill 2009).
Some issues associated with return flow externalities can be avoided by allowing sellers to transfer only their “consumptive use” (total diversion minus return flow) of water, which minimizes impacts on other users by more carefully tracking the ownership of each molecule of water (Johnson, Gisser, and Werner 1981; Brewer et al. 2008). Defining transfers in terms of consumptive use provides a theoretical solution to the physical externalities of water use by accounting for return flows, but it creates its own challenges. Because prior appropriation rights are defined and enforced in terms of the amount of water that can be diverted from the stream, the consumptive use associated with each diversion must be determined before it can be transferred, which requires both hydrologic and legal expertise to estimate what proportion of a diversion returns to the stream, and where.3
Transaction Costs and the Scope of Water Markets
The transaction costs associated with determining what portion of a right is consumptive use and how that use may vary across different basins, jurisdictions, or sectors increase as the size and complexity of trades grow (e.g., transfers between different uses). For example, the return flows associated with agricultural runoff are quite different from residential use. This means that transferring water from one use to another requires careful measurement of the consumptive use of sellers, who are often farmers (Colby, Jones, and O’Donnell 2014). Some researchers have suggested that the increasing transaction costs associated with more complex trades is one reason that such trades are relatively rare (Barzel 1997; Olmstead 2010). However, there is a lack of empirical analysis of the extent to which hydrological third-party effects are a barrier to trade.
Measurement issues
Appropriative rights are more clearly defined than riparian water rights and most groundwater rights, but there are discrepancies between the legal definitions of rights and actual water use (Hanemann, Dyckman, and Park 2015). This gap between legal and actual water rights is driven by the lack of on-the-ground measurement and verification of diversions, known as adjudication.4 Some states such as Colorado adjudicated rights early and, as a result, they have a relatively complete record of actual water use (Hanemann, Dyckman, and Park 2015). Other states, such as California, have yet to completely adjudicate surface water rights, which creates uncertainty about how the legal transfer of “paper” water rights will affect hydrologically connected users (Hanemann, Dyckman, and Park 2015). Where adjudication has not taken place, each potential sale of water requires empirical measurement and verification of the rights that may be transferred; this increases the transaction costs and reduces the net gains from water trading. The implications of these increased transaction costs are clearly illustrated in California, where Hanak and Stryjewski (2012) find that water market activity remained largely flat, even during drought conditions, when the potential gains from more efficient water allocation are high.
Local water markets
Despite these measurement issues, Brewer et al. (2008), Olmstead (2010), and others note the existence of well-developed local water markets. Why do verification issues hamper large-scale trades but not small ones? The answer depends on the extent of hydrologic externalities in surface water use (return flows) and the institutions for mediating disputes. Transfers within a given basin or irrigation district are less likely to inflict externalities on third parties because the water stays in the same hydrologic system, thus limiting the extent to which either primary stream flows or return flows can change (Barzel 1997).
It is also important to note that transfers of water within agriculture will induce smaller hydrologic changes than transfers to municipal and urban applications, which have higher consumptive use and thus may impair more downstream uses (Chong and Sunding 2006). This is important because third-party effects can be directly addressed when the number of parties involved is relatively small, but the transaction costs of addressing potential externalities can quickly exhaust the potential gains from trading when the number of parties involved becomes large (Coase 1960). Moreover, ditch companies and irrigation districts were designed to solve allocation problems within, but not between, their memberships, further complicating the transaction costs of trading either out of basin or with urban and environmental users who are not members of irrigation organizations (Bretson and Hill 2009).
Studies of water markets in the western United States indicate that their success hinges on developing institutions for mediating public opposition and adequately addressing transaction costs. The existence of local water markets across the West suggests that appropriative rights themselves are not an insurmountable barrier to markets. Rather, the issue is whether current institutions can be “scaled up” to allow markets to span jurisdictions and sectors (Goemans and Pritchett 2014). High-volume trades, agricultural-to-urban transfers, and transboundary markets offer the largest potential efficiency gains (based on existing price differentials), but these are precisely the transfers that involve high transaction costs and invite political and regulatory opposition (Brewer et al. 2008; Olmstead 2010).
The lack of observed large, cross-jurisdiction water transfers, coupled with comparatively robust local water markets, suggests that the transaction costs of trading water in the West rise more rapidly than the benefits (Olmstead 2010). Identifying and mitigating these transaction costs is essential if markets are to play a role in promoting the efficient use of increasingly scarce water in the western United States.
Security of property rights, uncertainty, and beneficial use provisions
Uncertainty about the security of appropriative rights themselves constitutes another significant barrier to expanding the scope of water markets. Appropriative claims are usufruct rights; that is, states have the legal right to rescind or restructure rights under the public trust doctrine, which says that the government holds water resources in trust for the benefit of the public (Bretson and Hill 2009). As noted earlier, appropriative rights also typically include a beneficial use provision—referred to as the “use it or lose it” rule—which says that water must be put to a prespecified beneficial use, thus making the legal status of conserved water unclear. For example, if a water user adopts more efficient practices to make some conserved water available for sale, certain interpretations of the beneficial use requirement could void that portion of the water right (Bretson and Hill 2009).
Beneficial use provisions have been a barrier to transfers between consumptive and environmental or “in-stream” uses (i.e., flows for fish habitat) in particular (Donohew 2009). Many states, beginning with Oregon, adopted legislation designating in-stream flows as a beneficial use; nevertheless, transaction costs and political factors surrounding changes in water use continue to hamper market-based provision of environmental flows (Garrick and Aylward 2012). One reason is that legislative reductions in water rights (under the public trust doctrine) appear increasingly likely in the face of shrinking water supplies and growing residential and environmental demands (Libecap 2011). The potential for such legislative changes reduces the incentive for users to make investments in securing additional water supplies through markets, thus limiting the scope of existing transactions.
The regulatory uncertainty concerning the legal definition of U.S. water rights, especially the public trust doctrine and its potential interpretations, compounds the underlying uncertainty about stream flows faced by water rights holders. The usufruct nature of rights creates a broad scope for administrative action to affect users. States have historically respected appropriative rights, but increasing demands for environmental flows, coupled with declining reservoir and aquifer levels, make the future of appropriative rights uncertain. This uncertainty is compounded even further in areas where rights have not been fully adjudicated (Hanemann 2006).
Uncertainty about the future security of appropriative rights also reduces the use of water markets. There are several reasons for this. First, the expected duration of a right affects its value—rights that have less secure tenure are not as valuable to farmers, and so the gains from trade are suppressed and fewer trades occur. This is particularly likely in the case of high-value trades across local political boundaries, where uncertainty is likely to be greatest due to possible variation in district-, county-, or state-level policy. Second, the possibility of future expropriation may reduce rights holders’ willingness to offer their water for sale. This is especially likely in light of the beneficial use requirements that accompany appropriative rights.
The Political Economy of Surface Water Rights
Efficiency-enhancing changes in the way property rights are defined or allocated can create losses for users, causing individuals or groups to oppose potentially welfare-enhancing reforms (Grainger and Parker 2013). Heterogeneity in the location, priority, and size of water rights creates conflicting perspectives on the potential impacts of expanding water markets. The fiercest political opposition to water markets arises due to the potential reallocation of water toward urban and environmental uses and away from the local farm economies that depend on the current distribution of water use.
Heterogeneity in benefits and costs
Because prior appropriation rights holders are heterogeneous, they have different expectations about the potential benefits and costs of expanding water markets across sectors and basins. In addition to (and perhaps because of) the differences in their exposure to stream variability arising from differences in the priority of water rights, irrigators select cropping patterns that differ in their water intensity, profitability, and drought tolerance. For example, alfalfa growers, who can easily fallow land, have greater ability to adapt to scarce water supplies than orchard keepers, whose trees (which are a capital investment) require a minimum threshold of water each season to survive. These users are likely to have different sensitivities to potential return flow externalities and other possible adverse effects of water transfers.
In areas where water market transfers are limited, farmers subject to beneficial use requirements have not historically faced the true opportunity cost of their water because they lack the options to sell. Many farmers may find that their current crop mix and irrigation techniques are not profitable relative to selling their rights on a competitive market. On the other hand, farmers and cities that typically lack reliable access to water stand to benefit from increased access to additional water supplies via market transactions. The ten-fold price difference between agriculture and urban water uses (Brewer et al. 2008) in many areas of the western U.S. suggests the possibility for mutually beneficial exchange, even net of the considerable transaction costs of transporting water. Such trades will necessarily increase the opportunity cost for farmers who previously did not have a feasible option for selling their water (Brewer et al. 2008). Although the sale of these rights is a net gain on paper, some irrigators perceive the transition away from farming to be a significant loss (Haddad 1999; Hanak 2003; Libecap 2009). Thus there are a variety of factors that limit the political acceptability of water markets.
Social implications of water use
In addition to the profitability concerns of water rights holders, the broader economic impacts of major changes in water use can generate vocal opposition. Water transfers from agricultural to urban and in-stream uses and across political and hydrologic boundaries threaten to reduce the demand for a variety of farm-related goods and services. Social concern over pecuniary externalities—adverse effects on other participants in farm economies—presents another important barrier to water markets. Farm laborers, landowners, agricultural processors, and input providers all rely on the existing distribution of water use but do not hold water rights (Howe, Lazo, and Weber 1990). Hence farming communities have traditionally opposed transfers of water to both municipal and environmental uses. Currently these groups’ concerns are generally addressed through case-by-case administrative approval of trades, which often involves heated political debate (Hanak 2003). Moreover, the legal doctrine known as the public interest standard allows states to sue to block trades on behalf of third parties even if there are no protesting third parties (Bretson and Hill 2009). These nonmarket institutions are one of the primary impediments to expanding water markets and should thus be a focus of policy reform.
Parallels with Other Resources
In this section we present an overview of air pollution, water quality, and fishery markets to provide background for our discussion of lessons for expanding water markets. We highlight the essential features that each resource shares with water.
Air Pollution Markets
Markets for air pollution abatement, or “cap and trade” systems, are designed to help meet emissions goals at the lowest possible cost. These regulatory systems set an overall cap on the level of emissions for a given pollutant and then allocate permits to emit that pollutant to regulated firms and allow trading of permits. Firms must hold permits to cover all units of the pollutant that they emit; if a firm’s emissions exceed their permits, they must either purchase additional permits or reduce their emissions.
Cap and trade systems for carbon have been implemented in the European Union (EU), New Zealand, and at the subnational level in the United States, Canada, and Chile (Newell, Pizer, and Raimi 2013). Carbon markets were proposed but not implemented at the federal level in the United States, which has a (largely defunct) federal cap and trade program for sulfur dioxide (SO2) and nitrogen oxide (NOx) under the Clean Air Act Amendments of 1990 (Newell, Pizer, and Raimi 2013). China has announced its intention to develop a cap and trade program; if implemented, China’s carbon market would be the largest in the world.5 Experience with air pollution markets has been mixed, which provides an opportunity to identify lessons about effective design strategies for resource markets facing supply reductions.
Water Pollution Markets
Markets have also been used to abate water pollution. As with air pollution markets, water quality trading (WQT) markets impose a cap on the total amount of a pollutant that may be released into a waterway and allocate tradable permits to polluting firms. These markets are usually defined at the lake, river, or drainage basin level, with permits assigned for particular pollutants. As of 2009, 57 WQT markets were in place or under development worldwide, primarily in the United States (Selman et al. 2009). These markets have generally struggled to bring together farmers, who often improve water quality through changes in fertilizer use, and polluting firms, who are the primary purchasers of permits (Selman et al. 2009). The underlying hydrologic challenges and constraints facing water quality markets reflect those of water markets more broadly and thus may offer lessons for surface water markets, including addressing the challenges of linking agricultural and urban water users.
Fisheries Markets
The primary property rights approach used to manage fisheries is the individual transferrable quota (ITQ).6 This is similar to a cap and trade system in that ITQs set a total allowable catch (TAC) each year and allocate tradable property rights (usually defined as shares of the TAC) to fishers. ITQs have been used for a variety of species worldwide, accounting for about 5 percent of global fisheries (Costello, Gaines, and Lynham 2008),7 but covering about 25 percent of global fish catch (Arnason 2012). ITQs have been shown to increase economic efficiency in fisheries while reducing the probability of stock collapse (Grafton, Squires, and Fox 2000; Costello, Gaines, and Lynham 2008). Fish, like water, are a renewable resource whose availability varies from year to year. Fisheries markets have faced political opposition from fishers and other affected parties, whose individual rents may decline even though markets improve overall efficiency (Deacon, Parker, and Costello 2013; Grainger and Parker 2013), thus providing lessons for water markets, which have faced similar types of opposition.
Lessons from Other Environmental Markets
Next we discuss how key barriers, including transaction costs, uncertainty, and political and legal challenges, have been addressed in water pollution, air pollution, and fisheries markets and the extent to which these efforts have been successful.
Addressing Transaction Costs in Water Pollution Markets
The transaction costs faced by users in water pollution markets are perhaps most similar to those faced by surface water users. The size of a water quality credit is adjusted to account for various factors, including the location-specific impacts of nonpoint and point source pollutants along a waterway, differing ecological effects of various uses (e.g., fertilizer runoff versus effluent from a manufacturing plant), and the uncertainty stemming from natural variability in stream flows (Selman et al. 2009; Stephenson and Shabman 2017).8 Often, the costs of measuring actual effluent for nonpoint source polluters (mostly agricultural producers) are so high that they are exempted from regulation, hampering incentives for market exchanges (Breetz et al. 2005). Moreover, the difficulty of measuring and verifying pollution credits makes farmers reluctant to generate rights while prompting regulated point source polluters to prefer costly upgrades, which are more directly under their control than market transactions (Selman et al. 2009).9 Stephenson and Shabman (2017) note that complex and overlapping regulatory requirements can also limit the demand for effluent credits.
Regulatory agency involvement in verification, public funding for measurement efforts, and technological development have proven to be helpful for addressing the transaction costs of trading water pollution rights in the United States and elsewhere (Selman et al. 2009). For example, formal endorsement and promotion of water quality trading programs by the U.S. Environmental Protection Agency, coupled with federal funding for establishing markets, is viewed as the primary reason for there being more WQT markets in the United States than other countries (Selman et al. 2009). Nevertheless, WQT markets in other countries have also been successful. For example, the Hunter River Salinity Trading Scheme in New South Wales, Australia—considered to be the most successful WQT in the world—utilizes an online trading platform to minimize transaction costs and bring together willing buyers and sellers (Shortle 2013). The use of online marketplaces and third-party clearinghouses has been a successful strategy for reducing transaction costs in several WQT markets, including those in Maryland and West Virginia (Selman et al. 2009).
The use of hydrologic modeling software in WQT markets has reduced the transaction costs of measuring and verifying each trade individually.10 These software tools incorporate site-specific parameters such as fertilizer application rate, slope, and soil type to deliver estimates of nutrient losses and reduction from nonpoint sources and are used in the Maryland Water Quality Trading Program, Pennsylvania Water Quality Trading Program, Great Miami River Watershed Trading Pilot, and Gun Lake Tribe Trading Initiative (Selman et al. 2009). Although the upfront costs of developing these tools cannot be ignored, they reduce the transaction costs of individual trades in WQT markets, thus helping facilitate a more efficient distribution of effluent abatement liability than a market where transaction costs constrain each potential trade.
Addressing Transaction Costs in Air Quality Markets
The transaction costs associated with air quality markets, particularly international systems such as the EU Emissions Trading System (ETS), are driven by the challenges of finding willing buyers and sellers and confirming the validity of offsets (i.e., emissions credits generated by a nonregulated party). The use of centralized institutions has reduced these costs. Several centralized permit exchanges—Nordpol in Norway, EEX in Germany, and the European Climate Exchange in London—account for the overwhelming majority of trades in the EU (Ellerman, Marcantonini, and Zaklan 2016). In addition, the Clean Development Mechanism, initiated under the Kyoto Protocol, monitors and enforces carbon offsets in order to reduce the transaction costs and liability of relying on such offsets (Newell, Pizer, and Raimi 2013). There continues to be skepticism about the validity of some carbon offsets and concern about their tendency to compete with domestic permits and suppress prices. To address this issue, some markets, such as the Regional Greenhouse Gas Initiation (RGGI) in the United States, place caps on the use of offsets and require that the offsets be generated within RGGI states (Newell, Pizer, and Raimi 2013; Böhringer 2014).
Air pollution markets illustrate the importance of the ability to transfer rights across political boundaries. The 1990 Clean Air Act Amendments (CAAA) in the United States established an allowance trading program for emissions of SO2 from regulated facilities that at one point was considered to be a model for market-based pollution abatement reduction (Stavins 2003). However, several policy changes between 2005 and 2011 resulted in source-specific state-level emissions caps that essentially ended interstate trade in permits and caused the market to collapse (though it still exists nominally) (Schmalensee and Stavins 2013).
In contrast to the abrupt collapse of the SO2 trading program in the United States, the EU ETS was built from a series of national emissions markets that were then integrated, or “linked,” to form an EU-wide market that ultimately grew into a robust trading program (Ellerman, Marcantonini, and Zaklan 2016). Each participating nation was able to develop its own domestic policy within a set of general guidelines that facilitated linking of the markets, and the EU system is now considering linkages to other non-European countries, such as Australia (Ellerman, Marcantonini, and Zaklan 2016).
Addressing Uncertainty in Fisheries and Air Pollution Markets
In several countries, uncertainty is embedded in the definition of property rights in ITQ fisheries. In the United States and Canada, for example, fishery resources (much like water) are regarded as “common” property owned by the people and the crown, respectively. This means that ITQ rights are technically a privilege that can be revoked at any time.11 In contrast, fishing quotas in New Zealand are a secure asset that cannot be revoked and can be used as collateral for loans (Grainger and Parker 2013). Grainger and Costello (2014) find that the dividend:price ratio for a quota—a measure of the riskiness of the asset—is significantly higher in the United States than in New Zealand.12 These results suggest that uncertainty about the security of a property right can significantly reduce the market value of that right, potentially deterring further market activity.
The emissions market for particulate matter pollution in Santiago, Chile, offers an extreme example of the impact of regulatory uncertainty on the effectiveness of markets. Under this program, each transfer of permits is subject to regulatory approval and can take up to ten months to complete (Coria, Löfgren, and Sterner 2010). There is also regulatory uncertainty concerning sanctions, which, if enforced, could cause some firms to shut down. As a result, regulated firms hold permits rather than trading to hedge against risk (Coria, Löfgren, and Sterner 2010). The lack of trading has hampered the effectiveness of the program, which is characterized by noncompliance by some firms and overcompliance by others (Coria and Sterner 2008).
Addressing Political and Legal Challenges in Other Markets
Cap-and-trade systems provide insights for handling heterogeneous users, while market-based fisheries reform and markets for water quality can provide insights for dealing with both the economic and social sources of opposition to water markets. Cap and trade systems and market-based fisheries reforms have had to grapple with heterogeneous responses to the prospect of market mechanisms that enhance overall efficiency but have potentially adverse impacts on some users. Although neither emissions control nor fisheries management has to deal with the issue of property rights existing prior to the programs, they do create formal property rights to natural resources where none previously existed. This can effectively expropriate informal claims to rental streams from those resources, prompting fierce opposition to what otherwise appears to be an efficiency-enhancing approach to resource management (Leonard and Libecap 2015; Grainger and Costello 2016). However, designers of both emissions markets and ITQ fisheries have adjusted their implementation to reduce the opposition that arises from the heterogeneity of existing resource users.
Property rights and fisheries reforms
The issue of heterogeneity as a source of opposition to efficiency-enhancing, market-based policy has been studied the most in the context of property rights–based fisheries reform. Although the efficiency gains of ITQs are relatively well understood and documented (Grafton, Squires, and Fox 2000; Reimer, Abbott, and Wilen 2014), there is often fierce opposition to ITQs, particularly from high-skilled fishermen who are well adapted to open access or limited access fishing conditions (Heaps 2003; Grainger and Costello 2015; Leonard and Libecap 2015). One of the key sources of controversy is the initial allocation of fishing quotas among fishers, which affects the expected changes in rents associated with fishery reform.13
In the same way that opening up water markets threatens to reduce rental streams to users who benefit due to their current priority, location, or crop mix, highly skilled fishermen consistently voice opposition to ITQs as a tool for reforming fisheries due to perceived threats to their ability to earn economic rents. Small fishing communities in coastal towns that serve as home ports for many of the world’s fisheries are sociologically similar to farm economies in that participation holds cultural as well as economic significance (Karpoff 1985; Acheson 1988). Reductions in total fishing, fleet consolidation, and changes in the demand for fresh versus processed fish associated with the implementation of ITQs create pecuniary externalities for nonfishers by changing the structure of the industry and potentially reducing employment (Abbott, Garber-Yonts, and Wilen 2010; Newell, Sanchirico, and Kerr 2005; Grafton, Squires, and Fox 2000). Stakeholders affected by these pecuniary externalities have been a vocal source of opposition to fisheries reform and their concerns have played a role in crafting policy (Grainger and Parker 2013).
Schemes for allocating fishing quotas, which we discuss later, have been designed to help overcome opposition. These approaches, which have also worked well in the air pollution context, provide potential models for making water markets more acceptable to incumbent rights holders. For example, by allocating quotas to processors and other community members, fisheries schemes give key stakeholders valuable assets that depend on the health of the resource. In addition, by making quotas tradable, these schemes increase efficiency.
Addressing profitability concerns in air pollution markets
Markets for air pollution abatement also provide important lessons for addressing profitability concerns when transitioning to a more efficient distribution of resource use. Just as irrigators exposed to expanded water markets may see the real or implied price of their water increase, firms covered by a new cap and trade scheme will suddenly be faced with a cost for their carbon dioxide emissions. Moreover, because firms’ air pollution abatement costs are heterogeneous, the distribution of costs and benefits from the imposition of cap and trade is complex (Mendelsohn 1986; Newell and Stavins 2003). Although in some cases (e.g., the United States) firms have mounted fierce opposition to cap and trade, this has not been a significant factor in others (Newell, Pizer, and Raimi 2013). As with fisheries, the initial allocation of property rights is crucial for reducing political opposition and addressing the concerns of heterogeneous users.
Securing stakeholder support in water pollution markets
Markets for water pollution abatement provide the most direct lessons for addressing the sociological dynamics of water use in farming communities. Just as agricultural-to-urban water transfers often involve the fallowing of land, so too does the generation of effluent credits. In fact, as of 2005, at least one-third of the water quality trading schemes in the United States included agricultural sources and the majority of the credits involved the movement of land out of agriculture (Breetz et al. 2005; Stephenson and Shabman 2017). As with water markets more broadly, farmers have been reluctant to participate in these markets despite the potentially large economic benefits of doing so, with a distrust of regulators and “outsiders” being the primary obstacles to participation (Breetz et al. 2005).14 Selman et al. (2009) note that opposition from the broader farming community has caused many water quality trading schemes to languish by creating obstacles through local governments.15 Successful water quality markets have required significant investment to secure support from stakeholders in the farming community (Shortle 2013). These strategies used to achieve support from highly resistant local farming communities can provide important lessons for expanding surface water markets.
Securing Political Support
Political factors have constrained the development of environmental markets, but policymakers pursuing fisheries reform and market-based air and water pollution abatement schemes have achieved some success through strategies that include carefully tailored allocation of new property rights, slow phase-in of reductions in overall use, side payments to stakeholder groups, and trade-offs between efficiency and equity concerns.
In both ITQs and air emissions cap and trade schemes, “grandfathering” shares of the cap has been effective in reducing political opposition by highly skilled fishermen and high-emitting firms whose rental streams may be the most impacted by reductions in overall use.16 Grandfathering allocates shares based on either historical catch (fisheries) or historical emissions (air pollution abatement). In air pollution markets, grandfathering has been coupled with a gradual phase-in of the emissions cap itself (often the cap is not even binding initially) in order to allow firms to adjust slowly and minimize losses from abatement costs (Newell, Pizer, and Raimi 2013; Ellerman, Marcantonini, and Zaklan 2016).
Policymakers have developed additional tools to secure political support for market-based fishery reforms. For example, some ITQ schemes place limits on the amount of quota that can be held by any one vessel and/or impose restrictions on the ability of nonfishers to own and lease quotas. Although these restrictions reduce the potential efficiency gains of markets by prohibiting certain mutually beneficial exchanges, they have helped to reduce opposition that would otherwise hinder market-based reforms (Grainger and Parker 2013). Thus these second-best approaches seek to strike a balance between first-best theoretical policy instruments and the complex realities of the political economy of defining and allocating property rights.
Other features of fisheries reform and water pollution markets are aimed more directly at securing political support from third-party stakeholders. For example, some ITQ fisheries have allocated quota to processor firms or set aside a “community development quota” that is owned by local communities or governments (Grainger and Parker 2013). These in-kind quota allocations can be leased to fishers, providing communities with both a rental stream and a political voice in the market (Grainger and Parker 2013). Similarly, working with existing social organizations and institutions has been an important component of successful water quality trading schemes in the United States (Breetz et al. 2004, 2005). By working directly with institutions such as irrigation districts, where farmers already interact with the broader community, policymakers were able to alleviate doubt and mistrust from these stakeholders.
Summary and Conclusions: Lessons for Water Markets
Water markets exist in the United States, but their development is constrained by political and legal barriers at the local, state, and federal levels that increase the costs of transacting. Environmental markets for other resources have been designed to overcome barriers to trading that share essential features with water markets. Our examination of the successes and failures of market-based policies in these other markets suggests several important lessons for expanding the use of environmental markets in the future. We summarize these lessons here and discuss how they might be applied to increase the scale and scope of water markets in the western U.S.
The Importance of Clarifying Property Rights
The value of water rights as a market commodity will increase if the long-term security of those rights is assured. Given current institutions, high-value trades that transfer water to new uses are subject to the most uncertainty. Alleviating this uncertainty will encourage the expansion of water markets by increasing the number of potential sellers and by connecting them to new sources of demand for water.
Government purchases of permits were an important early driver of market activity in successful water pollution markets. Markets for air pollution abatement and ITQs would not function if government did not first create clearly defined property rights. The challenge for surface water is to clarify existing rights rather than to create new ones. Currently water rights in the western U.S. are usufruct and hence potentially subject to expropriation by the government without compensation. Moreover, many rights have not been adjudicated and so remain uncertain until physically verified. Finally, beneficial use requirements make the potential impacts of efficiency enhancements unclear.
Experience in other markets has shown that government involvement in the market as a buyer creates confidence in the security of existing rights by validating the right and by providing a signal that conservation goals will be met through purchase rather than expropriation of those rights. In the case of surface water, the reallocation of water from consumptive agricultural uses to in-stream environmental uses could, in principle, be accomplished through the application of the public trust doctrine in conjunction with legislation such as the Endangered Species Act, rather than through markets (Bretson and Hill 2009). However, evidence from other markets suggests that rather than threatening to expropriate rights that have been observed for more than a century, it would be helpful for state and local governments to commit to pursuing reductions in water use through market mechanisms.
Up-Front Investments to Reduce Transaction Costs
Technological and institutional investments in measurement, verification, and online clearinghouses could reduce transaction costs for trading water in the same way that such investments have facilitated trading in other markets. For example, standardization and the use of software were a boon for markets for water quality and air pollution abatement. Ex ante adjudication of surface water rights would reduce the need to adjudicate rights on an ongoing basis, thus reducing the transaction costs of trading and increasing the potential gains from trade. For example, Donhowe (2015) finds that surface water adjudications in Oregon increased land values for downstream and senior rights holders, reflecting the value of increased certainty about the property rights. Moreover, investments in standardized modeling software that could be applied broadly would reduce the costs of measuring and estimating consumptive use and potential third-party effects (Colby, Jones, and O’Donnell 2014).
As we have discussed, centralized clearinghouses and third-party aggregators helped to facilitate trade in both air pollution and water quality markets. Developing exchanges and clearinghouses for water rights would reduce transaction costs by providing information about prices and available supplies of water to farmers, municipal water providers, and the environmental sector. These investments are costly. However, just as major investments in physical infrastructure were necessary to develop water use in the arid West in the early twentieth century, investments in institutional infrastructure will be necessary to sustain it into the twenty-first century (Anderies, Janssen, and Schlager 2016).
Consider Efficiency Trade-offs to Secure Stakeholder Buy-In
Although they may have reduced efficiency, free permit allocation, slow phase-in of mandated reductions, and restrictions on trade were essential components of successful fishery ITQs, air pollution markets, and water pollution markets. Policymakers should consider similar concessions when trying to expand the scope of water markets, striking a balance between the potential efficiency gains of larger and more ambitious transfers and the need to secure support from important stakeholders. Scaling up the use of water markets requires mechanisms to address the concerns of increasingly large groups of stakeholders. Ultimately, designing “second-best” markets that can accommodate both the concerns of heterogeneous users and affected third parties is likely to be more efficient than policies that incite political opposition that may undo water market reforms altogether.
There are several strategies to secure political support for cross-jurisdictional water transfers and transfers to nonagricultural uses. Irrigation districts, counties, and states could place ex ante restrictions on the total water available for transfer. Third parties’ objections often focus on reductions in demand for farm-related services. Restrictions on transfer-related fallowing of land could help to alleviate concerns about large-scale “buy and dry” water acquisition schemes that have historically created a negative stigma around transfers of water away from agriculture (Libecap 2005; Colby, Jones, and O’Donnell 2014). Slow phase-in of large transfer programs, possibly paired with trial periods, is another strategy for securing political support.
Finally, the creation of community development funds to compensate affected parties directly could help prevent political backlash. For example, fallowing restrictions, a trial period, and direct side payments to the local municipality were key features of the largest agricultural-to-urban and out-of-district water transfer to date between the Palo Verde Irrigation District and the Metropolitan Water District in California.
Concluding Remarks
As the American West continues to face a decreasing supply of water, the ability to transfer water longer distances, across political borders, and between uses will become a crucial component of water management policy. It is these more ambitious transfers that are hindered by the current institutional climate. Efforts to promote broader water market development should focus on institutional reforms to reduce transaction costs while addressing the concerns of important stakeholders in farm economies. In this regard, experience with successful reforms in other environmental markets, especially concerning the careful design of property rights, offers important lessons for water markets.
Ex ante investments in policy reforms aimed at reducing transaction costs, regulatory uncertainty, and potential opposition from stakeholders could reduce the costs associated with individual trades in the future (Easter and Huang 2014). Lowering the marginal costs associated with each trade would increase the number of net-beneficial transfers, allowing markets to function more smoothly and facilitating price discovery and other important forms of learning among participants (Olmstead 2010; Easter and Huang 2014). Moreover, reductions in transaction costs make short-term leases and fallowing arrangements that generate smaller per-transaction gains more viable, reducing the need to rely on more controversial permanent transfers (Hadjigeorgalis 2009; Colby, Jones, and O’Donnell 2014).
The trade-offs associated with the high up-front costs of establishing market institutions that lower the marginal costs of subsequent trade are not unique to water markets. To function well, any market needs clearly defined and enforced property rights, and establishing and clarifying these rights is a costly process. Market-based environmental policy in particular has had to find ways of lowering transaction costs, reducing uncertainty, and handling stakeholder opposition (Anderson and Libecap 2014).
Notes
1 See https://www.theatlantic.com/national/archive/2017/02/how-did-the-oroville-dam-get-so-bad/516429/ and https://www.waterboards.ca.gov/board_decisions/adopted_orders/resolutions/2017/rs2017_0004_corrected_version_with_regs.pdf.
2 The prior appropriation doctrine is used in Arizona, Colorado, Idaho, Montana, New Mexico, Nevada, Utah, Wyoming, and parts of California, Kansas, Nebraska, North Dakota, Oklahoma, Oregon, South Dakota, Texas, and Washington (Leonard and Libecap 2017).
3 New Mexico, where rights are defined in terms of consumptive use, is an exception.
4 Adjudication is the basin-wide process of physically measuring and verifying legal property rights to water, which sometimes requires multiple parties to agree to reduce their water use when there is not enough water to satisfy all paper claims.
5 See https://www.scientificamerican.com/article/china-will-start-the-world-s-largest-carbon-trading-market/.
6 ITQs are also called individual fishing quotas (IFQs).
7 Territorial use right fishers (TURFs) are another property rights–based tool for managing fishers. TURFs allocate spatial property rights to fishermen for relatively sedentary species such as sea snails.
8 Point source pollutants enter the stream from a specific location, such as a pipe. Nonpoint source pollutants enter the stream as runoff from agricultural fields or other dispersed locations.
9 As nonpoint polluters, farmers may be reluctant to reveal the level of their baseline emissions if they fear regulatory retaliation.
10 The OVERSEER program in New Zealand and the Nitrogen Trading Tool, the Region 5 model, and the World Resource Institute’s NutrientNet in the United States are the most widely used models (Selman et al. 2009).
11 In the United States, quotas cannot be used as collateral and, in many cases, cannot be owned by individuals who do not participate in the relevant fishery. Canada’s quota rights are slightly more complete (Grainger and Costello 2014).
12 In New Zealand, dividend:price ratios fell (and hence asset values increased) in response to the resolution of disputes between the government and tribes regarding the distribution of fishing rights (Grainger and Costello 2014), suggesting that reducing the risk of expropriation makes rights more valuable.
13 The consolidation of fishing fleets and the potential for absentee ownership of quotas by “armchair fishermen” are also common objections to ITQs (Grainger and Parker 2013).
14 One concern of farmers, especially those who distrust outsiders and regulatory agencies, is whether revealing the baseline level of their unregulated nonpoint pollution will expose them to regulatory sanctions (Breetz et al. 2005).
15 This has played out at the national level in New Zealand, where a well-organized farm lobby created significant hurdles to a national air pollution abatement scheme that threatened to significantly impact the agricultural sector (Bullock 2012).
16 See Anderson, Arnason, and Libecap (2011) for an argument for the efficiency of grandfathering in a dynamic setting.
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