1st Quarter 2005 • 20(1) A publication of the CHOICES American Agricultural The magazine of food, farm, and resource issues Economics Association The Evolving Western Water Markets Richard Howitt and Kristiana Hansen

Expanding population and environmental protection the A worldwide survey of existing markets makes it clear world over are placing additional demands on existing that gains in efficiency can occur even in the absence of water supplies. Meeting these demands by traditional theoretically perfect markets (Saleth & Dinar, 2004). The structural supply augmentation is dogged by increasing efficiency gains are achieved by moving water to higher environmental and fiscal costs, which leave excess water value uses. To achieve these gains, many states west of the demand to be met largely by conservation and reallocation Mississippi River have implemented legislation to facilitate of existing supplies. Water trading clearly has a role in real- water trading within their borders. However, because locating supplies and stimulating conservation by provid- water has both private and public good characteristics, it ing a clear measure of its value for conservation and a has often been developed with some degree of public voluntary self-compensating mechanism for reallocation. financing or subsidies. Hence, its reallocation generates Despite these advantages, traditional markets have been heated controversy—especially when potential profits are slow to evolve in the western United States for institu- involved. tional and hydrologic reasons. However, even when insti- tutional, political, and physical impediments prevent Water Market Determinants textbook water markets from developing, significant gains What factors determine whether and how markets in efficiency can result from relaxing restrictions on own- develop? Why is trading heavier in some states than in ership, use, and transfer. Most water markets in the west- others? The importance of water’s physical characteristics ern United States fall between the two extremes of cannot be emphasized enough. In many parts of the West, textbook markets in which, on the one hand, price is the water supply is uncertain; there is tremendous tempo- determined by unfettered market forces, and on the other, ral and spatial variation in rainfall. Furthermore, supply there is an outright legal prohibition of trading. and demand peaks do not generally coincide within the Three fundamental reasons probably cause the slow water year. For example, when snow pack melts in the evolution of water markets in the West. First, water has spring, it is stored in surface reservoirs until late summer many public good characteristics, benefiting not only the when farmers’ irrigation demand peaks. These fundamen- owner of a water right, but also the public at large. Public tal characteristics of precipitation make water market interest in water is supported by the fact that most western development all the more desirable, but they hinder the states retain the ultimate property right to water; individ- creation of markets in the first place. Transportation and ual water rights are more akin to use rights than private storage facilities have been constructed throughout the property rights. Second, fluctuations in water supply result West, largely at public expense, to convey water across in periodic “thin” markets with few participants. Third, time and space. Not surprisingly, water markets have water transfers often require significant costs, in terms of tended to develop in locations where the Bureau of Recla- both institutional costs and the cost of physically trans- mation and state water projects have invested resources in porting the resource. Even in the presence of willing buy- creating an infrastructure to facilitate the transportation ers and sellers, trades of permanent water rights are often and storage of water. not approved by regulators because they would result in Yet obstacles remain. Even though water garners sub- significant externalities—physical impacts on parties not stantial political attention and controversy, its economic involved in the transaction—and in third party financial value at the margin is actually quite low relative to the cost impacts to the exporting region. of conveyance. For example, the option purchase price for

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1st Quarter 2005 • 20(1) CHOICES 59 water in a 2002 transaction between of losing their right to the water in tal resource. Reduced or altered flows Glenn-Colusa Irrigation District in the longer term. Further, permanent on a waterway affect water quantity northern California and the Metro- transfers of water rights under prior and quality downstream. Drawdown politan Water District serving the appropriation have usually been in an underground aquifer affects Los Angeles area was $110/acre-foot. costly and time-consuming. Perma- neighbors’ pumping costs. Such The cost of transport (including a nent transfers and leases have externalities may be positive or nega- mandatory 20% environmental miti- recently become easier, as state laws tive. When they are negative, there is gation requirement and 300-mile have changed to facilitate market a role for regulatory agencies to transport and pumping fees) is transactions. ensure that nonmarket values placed approximately $143/acre-foot, for a One water market in the West on the waterways by society are taken total delivered cost of $253/acre-foot. where property rights are clearly into account. The absence of ade- Such high transaction costs reduce defined, enforceable, and transferable quate protections for those adversely the number of trades that are finan- is a Bureau of Reclamation project on affected by negative externalities may cially viable and the geographical the eastern slope of the Rocky Moun- result in trade volume that exceeds scope of markets. tains: the Colorado-Big Thompson the socially efficient level. On the Water’s mobility also makes prop- (CBT). Water rights in the CBT are other hand, these concerns have tra- erty rights enforcement a challenge. correlative; shares fluctuate annually ditionally been handled through Property rights are easier to monitor in response to water conditions, and lengthy court procedures, which may in some settings than others. For all shareholders benefit or lose each discourage socially beneficial trad- example, annual fallowing transfers year in like manner. The shares are ing. Over time, regulatory agencies from rice growers in the north of entirely homogeneous, and transfer should develop procedures to address California to urban users in the south occurs with minimal fees and paper- these issues in a less costly manner, of California are relatively easy to work. However, the CBT system has perhaps through the development of monitor. If the fields are fallowed, the the great advantage of using water a body of precedent cases to guide water must still be in the river and imported from another watershed, water traders and through the stan- presumably flows to the purchasers. thus freeing it from the impacts of dardization of environmental impact In contrast, monitoring sales of water reduced or altered flows on down- reports. saved by more efficient field applica- stream users or externalities that Although water trades may tion methods requires the detailed complicate water trades along natural increase overall efficiency within a assessment of current and past irriga- rivers. In contrast, California water market, there can be negative finan- tion technologies as well as the level rights are far from homogeneous. cial impacts on third parties in the of implementation. California continues to recognize area of origin through local loss of For trades to occur easily, prop- riparian rights (water rights that are income and employment and erty rights must be clearly defined, attached to the land adjacent to the through impacts on neighboring enforceable, and transferable. In waterway) alongside appropriative groundwater users. Trades are more most western states, water property rights, which makes defining water likely to occur where impacts on rights are governed by prior appro- rights with sufficient precision to sell third parties in the area of origin are priation, whereby the first to claim them costly and litigious (Carey & minimal (perhaps because the water the water in a waterway for beneficial Sunding, 2001). Furthermore, in does not leave the watershed in use has first priority to the water, and many parts of California (as else- which it originates) or where state a water right not exercised for a where in the West), federal owner- law does not recognize them. Stan- period of some years is relinquished. ship of developed water resources dard economic theory does not usu- When appropriative rights were codi- complicates market development. ally consider these third-party fied into state laws in the late 19th The differential in water values financial losses to be legitimate. and early 20th centuries, state law- between current owners and poten- However, many trades do provide makers did not envision widespread tial buyers is often great enough to some compensation to third parties, leasing and permanent transfers of stimulate potential trades. However, often to appease public opinion. This water rights. As a result, western another complexity is the physical concern for third-party financial rights holders have historically been and environmental externalities losses results from fundamental water reluctant to lease water out, for fear intrinsic to trading an environmen- property rights. In most of the west-

60 CHOICES 1st Quarter 2005 • 20(1) Table 1. Volume and volume-weighted prices for reported water transactions, 1999–2002. Volume (thousand acre-feet) Price ($/acre-foot, in 2004 dollars) State Lease Sale Total Lease/sale ratio Lease Sale AZ 1,371 24 1,395 53 73 894 CA 3,127 227 3,354 14 80 1,207 CO 74 242 316 0.3 22 3,451a ID 692 1 693 692 10 201 KS 4 0.2 4.2 20 51 — MT 5 — 5 — 5 — NM 338 10 348 34 66 1,233 NV — 49 49 — — 2,572 OK 10 — 10 — 59 — OR 532 38 570 14 283 1,045 TX 877 322 1,199 3 81 864 UT 6 3 9 2 6 870 WA 68 13 81 5 53 513 WY 105 — 105 — 40 — Total 7,211 929 8,140 8 86 1,299 a CBT sales omitted. If included the average sale price is $7,801. Source: Data from the Water Strategist. The authors acknowledge Adams, Crews and Cummings (Georgia State University) for generously providing us with their database of Water Strategist transactions; and Alex Lombardi for assistance. ern states, the ultimate owner of the What Do Existing Water Markets sales comprise approximately 10% water is the state itself, which is Look Like? and leases 90% of the volume traded, bound to protect the welfare of its although it is important to remember We were unable to find public source citizens. that a permanent water rights sale of consistent data on western water Externalities and third-party only appears once, whereas a lease is trading, so we compiled a summary damages are likely to become more often an annual contract that must of trading from fourteen western important as a greater volume is be renewed each year to reflect the states for 1999–2002 from back traded. Thus, we expect that these same quantity of water over the long issues of the Water Strategist. pressures will induce a higher per- term. Although the Water Strategist may centage of leases relative to perma- A majority of the trades reported not record all the trades in western nent sales, as negatively affected in the Water Strategist are from agri- water, it is the only comprehensive parties exert political pressures in reg- cultural sellers to urban buyers who source of water trade information. If ulatory arenas to limit permanent are grappling with projected increases there is a selection bias in the transfers. Examination of columns in demand. In Colorado and New reported trades, it should be consis- four and five in Table 1 suggests that Mexico, municipal agencies are pur- tent across states and thus not influ- states where more volume is traded chasing permanent rights and leasing ence the comparisons. We classified have a higher lease-to-sale ratio. This them back to the irrigators from the trades as sales and leases. In a per- tension between the benefits to trad- whom they purchased in the first manent sale, the right to the water ing partners and the negative effects place until needed to meet antici- for all time is transferred. Lease trans- on third parties is likely to be the pated future demand. The Water actions involve short-term trades of dominant influence on future trading Strategist data suggest that water pur- water; the underlying property right patterns. chases for municipal and industrial remains unaffected by the transac- use trade at higher prices than water tion. Table 1 shows that water leases for agricultural or environmental use. dominate the market in terms of Market purchases for environ- water volume traded. Permanent mental use have increased in recent

1st Quarter 2005 • 20(1) CHOICES 61 years. In California, for example, nia, have rates close to 6.6%, whereas chase a specific quantity of water in direct purchases such as those made low-volume states exhibit tremen- the spring, should the water year turn by state and federal entities to com- dous variation in their implicit capi- out to be dry. By paying the option ply with federal environmental regu- talization rates. The variation is likely cost, the buyer manages supply risk lations (primarily augmenting stream due in part to thin markets with few by avoiding last-minute spring con- flow to enhance fish runs) accounted buyers and sellers. tract negotiations for water, which for one third of traded volume in may no longer be available at a rea- 2001. By contrast, municipal buyers Permanent Sales, Leases, and sonable price. Buyers can further only accounted for about 20% of Options decrease transaction costs by negoti- market activity (Hanak, 2002). This One striking aspect of the descriptive ating long-run, multiple exercise trend is repeated elsewhere in the statistics provided in Table 1 is the options. The benefits of options are West. In the Pacific Northwest, for dominance of leases in 12 of the 14 twofold. example, water market development states. Permanent trading is only First, the water remains in the has been driven by the need to clearly dominant in the dry states of basin of origin during average and acquire water for environmental pur- Nevada and Utah, where diversions wet water years, lowering third-party poses (Smith, 1995). and permanent trading have always financial impacts and making it more The sale prices reported in the been an integral part of settlement likely that regulators will approve the Water Strategist in Colorado, Nevada, and development. transfers. Options undertaken due to and New Mexico over the survey In the presence of supply uncer- the burdensome regulatory require- period are markedly higher than in tainty, many water agencies in the ments of permanent transfers are sec- other states, probably reflecting the West seek to purchase water only in ond best from an economic efficiency relative scarcity of the resource in dry years when their own supplies are perspective, but are preferable none- these locations. Financial theory inadequate. This may explain trading theless to no trades at all. Second, would suggest that the price of a behavior in Idaho, Oregon, and given supply and demand circum- right would exceed the capitalized Washington, where most water trans- stances in California, this is an effi- value of a lease for two reasons. First, fers are leases for environmental and cient arrangement of property rights the purchase of a right eliminates the (to a lesser extent) agricultural use. and uses. In California, a typical risk inherent in relying on future Such leases may be in response to trade might be between small water lease markets. Second, given the annual water year conditions. A rights holders in the North with low- uncertainty of the value of future water rights transfer would be an value agricultural use and a large water rights, rational sellers would appropriate response to permanent municipal water agency in the South require a premium or hurdle rate in shortage rather than the year-to-year with relatively high-value use. addition to the capitalized value of supply uncertainty which often pre- Because the municipal agency has a current leases to consummate the vails. In short, leases are common relatively high-value use but suffi- deal. A counterpoint to the risk argu- because temporary transfers of one cient developed supplies during wet ment is that leases are more likely to year or less face significantly fewer and normal years, the water is most be concentrated in years of greater environmental regulations, the costs efficiently allocated to the municipal scarcity, whereas the return from the of defining rights sufficiently to sell user in dry years and the agricultural sale of a right should be averaged over them permanently are often prohibi- farmers in wet and normal years. all types of water year. tive, and the presence of sufficient Who should own the water to The lease-to-sale price ratios in supply in wet years makes permanent best ensure efficient allocation Table 1 give us the implicit capitali- transfers unnecessary and costly in between dry and wet years? If we zation rate over an infinite planning many cases. assume for simplicity that the trans- horizon, which averages 6.6%. This A specific type of leasing—the action costs are the same regardless of is below the standard commercial option agreement—is gaining cur- who owns the water, then the water capitalization rate of 10%, but it rency in California. Under an option right should remain with the low- seems a reasonable rate given the risk agreement, the purchaser pays an value agricultural use, so that transac- reduction from permanent sales. It is option cost in the fall before the win- tion costs are a lower proportion of also worth noting that high-volume ter precipitation for the right to pur- the buyer’s final sale price. If transac- states, such as Arizona and Califor- tion costs vary depending on who

62 CHOICES 1st Quarter 2005 • 20(1) possesses the water right (small buy- continue to be issues with which water_workingpapers/2004- ers may collectively face higher bar- developing markets must contend. 004.pdf. gaining costs than a single large These institutional impediments to Carey, J., & Sunding, D. (2001). buyer), this further strengthens the water transfers, combined with the Emerging markets in water: A case for low-value users to retain their uncertainty of water supply, will comparative institutional analy- water rights. probably lead to a proportional sis of the Central Valley and Col- An option agreement negotiated increase in the number of lease trans- orado-Big Thompson projects. in advance of the water year helps the actions relative to permanent sales of Natural Resources Journal, 41(2), municipal agency manage its supply water rights. In particular, the risk- 283-328. uncertainty. If the difference in value sharing characteristics of option Hanak, E. (2002). California’s water between the buyer and sellers is larger agreements correspond precisely to market, by the numbers. Public than the transaction costs, the agri- the need for flexibility in those Policy Institute of California. cultural rights holders can be suffi- instances where supply risk is shared Saleth, R. & Dinar, A. (2004). The ciently compensated for this dry-year by both parties or where it is possible institutional economics of water: A option contract. To the extent that to sell risk between parties. cross-country analysis of institutions western states will have to increase and performance. Cheltenham, water trading to balance demands, For More Information UK: Edward Elgar Publishing and third-party pressures increase, we Adams, J., Crews, D., & Cummings, Limited. expect the proportion of option con- R. (2004). The sale and leasing of Smith, R. (1995). Annual transac- tracts to increase. water rights in western United tions review. Water Strategist, States: An update to mid-2003 9(1), 16. Water Markets in the Future (water policy working paper Markets as a mechanism for water #2004-004). North Georgia Richard Howitt is a professor of Agri- allocation are gaining traction in the Water Planning and Policy Cen- cultural Economics at the University of California, Davis. Kristiana western United States. However, con- ter. Available on the World Wide Hansen is a graduate student in the cern over environmental and eco- Web: http:// Department of Agricultural and nomic externalities and third-party www.h2opolicycenter.org/ Resource Economics at the University impacts in exporting regions will pdf_documents/ of California, Davis.

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