Water rights and water markeng Michael Hanemann Arizona State University It’s about water rights

• The larger context is improved management, allocaon and use of water. • But that depends, in turn, on the property rights to water. • Water rights are typically part of the problem. • The problem can be that exisng water rights have not been comprehensively determined (adjudicated). • It can be that water rights are not enforced. • It could also be that exisng water rights seem poorly suited to contemporary condions, generang some need to modify or revise them. • In these cases, ushering into existence a beer defined or more comprehensive set of water rights, or a more flexible set of water rights, or a new set of water rights, may be a key building block towards creang an improved water management system. What economists think (Op-ed in Wall Street Journal) In the context of the 2014-2016 California drought

3 4 This makes two implicit assumpons about property rights 1. Farmers own the water they use (just like they own the land they farm). So, they should be free to sell it. 2. There is no right or regulatory obligaon to instream use or protecon of fish or aquac habitat. If the government wants these things to occur, and needs water for this, it should pay the market price of that water.

• Both assumpons are dead wrong. • The farmers who use water in California do not actually own that water. • As specified in the California Constuon, all water is owned by the people of California. • The farmers have a right to use the water, subject to certain condions, which can be modified retroacvely. • Including modificaon to meet public trust needs. • In many cases, the right to abstract water is owned by the water district that supplies the farmers, not by the farmers themselves. • Efforts to take that right from districts and give it to individual users failed. • The general welfare requires that the water resources of the State be put to beneficial use to the fullest extent of which they are capable. • Mulple uses are favored; reserving water for a single-purpose use is disfavored. • The California water rights agency is expressly directed to determine whether proposed water transfers will have unreasonable effects on fish, wildlife, or other instream beneficial uses.

6 The property right to water: key disncons • Disnguish the property right to divert water from the contractual right to receive water from a water supply organizaon. • About 20% of the water used in California is obtained through supply contracts with the two large water projects in California, the federal Central Valley project and the State Water Project. • Contractual rights are governed by commercial law. • Disnguish surface water from groundwater, since they are subject to different legal regimes. • The right to abstract water is a usufructuary right. It is a right to use water from a water source. It does not convey ownership of the water resource. • The water in California is owned by the state of California in the interest of the people of California.

7 The property right to water is different than that to land • “Water rights are a unique form of property, because the property right in water is limited (or rendered less certain) by a variety of factors, both physical and legal, that seldom affect real property and other property rights.” Physical features that make water different

• It moves around – it flows, seeps, percolates • The same molecule of water can be used sequenally by different people. • Return flow • The same molecule can be used simultaneously for mulple purposes by mulple people. • Water flowing in a river provides drinking and irrigaon water, hydropower navigaon, recreaon, aquac habitat. • It funcons as both a private good and a public good. • This argues for some sharing of the right to use water, rather than exclusive individual ownership. Physical features, connued • Precipitaon and streamflow are highly variable in me. • The difference between recorded minimum and maximum annual streamflow can be an order of magnitude. • This, too, argues for sharing of the right to divert water rather than exclusive individual ownership. • If there is abundant streamflow and I was the sole owner, most of it would run to waste in the ocean. • The variability of supply makes the property right problemac. • To what do I have a right? A fixed amount or a share? • In the case of riparian rights, I have a right to an unspecified share. Riparian rights are like tenants in common. • Under appropriave rights, there is a fixed amount. But, what amount? • An average amount of diversion? NO • A minimum amount of diversion? NO • A maximum amount? YES. But that makes the actual amount you can get uncertain. Compare water with land

• Two owners cannot simultaneously use the same piece of land – they cannot each locate a building on the same piece of land.

• A plot of land is a discrete resource with given boundaries. • For this reason, a property right associated with land – the right of first possession – works poorly for water (see below).

11 Economic features that make water different • Key differences between surface water and ground water: • Economies of scale play a crucial role in surface water supply • Surface water is transported from source to user over much larger spaal scales than groundwater. • With groundwater, users oen have their own individual wells. With surface water, the storage and conveyance infrastructure are collecvely provided. • The recipients of surface water typically share the delivery infrastructure. • And, they share the financial obligaon to pay for its financing. • Typically in developed countries the surface water infrastructure goes beyond what individual farmers can construct with their own labor. It required capital to hire an engineering company for the construcon. • The users lost their individual ownership of the water rights and were collecvely obligated to pay the debts incurred in construcon. • This led to formaon of water districts and mutual water companies.

• Almost no scope for modularity in surface water development. Essenally the enre system – storage, diversion, transmission, treatment, & local distribuon – has to be in place before a single drop can be delivered to users. • Unlike groundwater, which can be developed one well at a me. • But capital has to be raised up front before construcon can start. Interest has to be paid before a single cent of revenue comes in.

13 Cost structure complicates financing • The capital intensity and longevity of physical capital create problems of cost allocaon and make financing hard. • Financing is the Achilles heal of water supply • If the costs were mainly operang cost it would be very simple to rely on “the user pay principle” and pay-as-you-go financing. • As it is, the capital intensity and capital longevity mean make it very hard to have “user pay.” • One ends up relying heavily on transfers: • between one group of users and on other • between one generaon and another • between non-users (the developed countries) and users. 14 Legal features that make water different • Water is essenal for life. In olden mes, rivers were the only means of long-distance transfer. • Water was thus the ulmate merit good and the ulmate public good. • In Roman law, water in a stream could not be privately owned – what could be owned was the right to take water from the stream and put it to use (usufructuary right). • “Unlike almost every other form of property, water has always been viewed as something in which the community has a stake and which no one can fully own” (Sax, 2008). • In the sixth century, the emperor Jusnian declared that “by natural law” air, running water, the sea and the seashore are “common to all.” • This is sll a common view. The no-injury rule in water law • Because of return flow, the use of water (especially in agriculture) generates an externality. How to manage that externality? • A Coasean would assert that bargaining among the pares should fix the problem. But that is highly impraccal in most case. • A Pigouvian might argue for a tax of subsidy to internalize the externality. But that, too, is not praccal. The externalies are spaally specific, so a uniform tax/subsidy rate would be wrong. • Western water law, generally, eschews a balancing between the costs and benefits of disrupon of return flows caused by a water transfer. • Under prior appropriaon, the main approach is the no injury rule that requires a change in the place or type of use to avoid causing any harm to the use of water by other water rights holders. • Determining whether there is injury and how much it must be abated oen involves ligaon and generates significant transacons costs. Water is an entangled commodity

• This occurs because of externalies associated with the use of water. • It occurs because of the legal property right. • “Unlike almost every other form of property, water has always been vied as something in which the community has a stake and which no one can fully own.” (Sax, 2008) • It occurs because the supply of water (especially surface water) involves shared infrastructure that is jointly financed. Water as a source of contenon • The fact that mulple uses, and mulple users, can benefit from the same stream is an abundant source of conflict. • Also, over me, new uses of water emerge. Oen, the populaon that would like to exploit a water resource grows over me. • Conflict over water, and property rights to water, is endemic in human society. • Conflict is more endemic with water than with land. • Much of the disagreement over water is disagreement over what the property rights are, or what they should be. • Resolving these property rights dispute is oen polically fraught. 18 Economic (efficiency) objecves • Water markets can: • Promote re-allocaons of water use required for the long run • E.g., agricultural to urban transfers • Provide short-run flexibility for water users • E.g., short-run leases • Provide a way for small-scale actors to supply water without the need to finance large-scale, centrally-operated infrastructure • E.g., a large farmer drills a well and sells groundwater to some of his neighbors • When we look at actual markets, we can ask which objecve(s) they fulfill, and how well. When are water transfers simple?

1. The pares are connected so that moving water between them is physically easy. • Within an irrigaon district. • Within the service area of a wholesale supply system (e.g. CAP, the Central Valley Project, etc) 2. Externalies are minimized. • The no injury rule does not apply • They have well-defined and relavely un-entangled rights.

Otherwise, NOT • Is there a goal to prevent the usage of water (aquifer depleon, streamflow depleon) from increasing? • Is the goal that the usage of water (aquifer depleon, streamflow depleon) should be reduced

• If so, this goal has to be layered on the economic objecves. • How well will a market achieve this? • “Markets bring pares with conflicng interests together to confront tradeoffs and arrive at soluons where a broad range of benefits and costs have been considered.” (Jonathan Wood, PERC)

• Is this true? • Is the opposite true? Could the inability to resolve disagreements among pares with conflicng interests be a major impediment to the creaon of water markets? The hardest part in seng up a market system • The hardest part is securing agreement on how to allocate rights to the resource. • And what type of right • Share/absolute amount • Constant over me vs changing Some quesons • Before a market is opened, does there have to be an agreed cap set on the total volume of water used? • Before a market is opened, does there have to be an agreed allocaon of the total cap among individual users (in effect, an adjudicaon)? • Does there have to be an agreed mechanism for changing (i) the allowed total level of use or (ii) the individual allocaons if this subsequently proves necessary? • Does water withdrawal have to be measured? • These are maers of governance. They involve bargaining among pares with opposed or at least conflicng interests. Without an outside higher-level authority, there may be no ready soluon. • For example, Imperial Irrigaon District has been wrestling with the queson of how to allocate water among growers in the event of shortage since 2003. There is sll no agreement on this. Before a market is opened, does there have to be an agreed cap set on the total volume of water used? Before a market is opened, does there have to be an agreed allocaon of the total cap among individual users (in effect, an adjudicaon)?

• If you have to wait for these to be resolved, it may greatly delay the opening of a market. • But, if you forge ahead without a cap on total diversions or without an adjudicaon, there are some risks • People selling “paper” water • “Sleeper” water rights • If the goal is to reduce total diversions, this might not be met • If there are too many paper water rights, while this may not harm aainment of the flexibility objecve, this may frustrate the goal of aaining a long-run redistribuon of water In reality, a diversity of water market arrangements • Thus, there can be markeng of water without a determinaon of property rights.

• There can also be a determinaon of property rights without water markeng (instead, impose a quanty limit on water use).

• There can be markeng of water without the measurement of actual water diversion.

• There can be water markeng without allowance for profit to be made – transfers where the buyer pays the seller’s cost, with no profit markup.

• DOES THIS MATTER? WHAT IS THE LOSS OF EFFICIENCY? Another queson:

• Is a market the only policy instrument? • What about levying a charge on diversion instead? • This may require a lesser degree of collecve agreement, since it avoids the need to create an allocaon of water rights. • This what has happened in some cases with groundwater in California. • If there ever were a river basin authority that might be part of its powers. Market parcipaon: who is in the market as a seller? Could this change? How? • At any given point in me, is every holder of a water right a likely seller, if the price is right?

• In California, since 1980, ~250 enes have sold surface water. But there are perhaps several thousand holders of surface water rights, perhaps more.

• In Australia, the data for the Murray-Darling Basin are quite striking (Graon and Wheeler, Annual Review of Resource Economics, 2018) 29 • My hunch is that the surface water market in California looks like this • What explains this? • Extreme drought • Major policy changes Gains from trade with paral market parcipaon • Exisng simulaon analyses of the scope for water markeng assume that every water user would parcipate in a water market, selling or buying water if the price is right. • There are sll some gains from trade with paral parcipaon, but they are smaller. • How much smaller is an empirical queson. It depends on the paern of seller parcipaon. • For example, if the seller parcipants are disproporonately large farming operaons, as opposed to small operaons. • Or if parcipants represent a representave sample from the whole universe. • How does this affect aainment of goals? • Flexibility objecve is sasfied. • But long-run re-allocaon of water uses may be impeded? Internal trading – a form of limited parcipaon

• One feature of markets can be a form of internal trading: an enterprise with mulple locaons takes advantage of the opportunity to shi the resource (water, CO2 emissions) among those locaons. • With SO2 trading, the EPA disnguishes between “economically significant transacons, i.e., between economically unrelated pares) and “transacons between related enes” • 46% of the SO2 transacons were transacons between related enes. • Moreover, 60-70% of the total emission reducon were internal to the plant that was regulated (i.e., occurred outside the market). • In Australia, in the beginning almost all the water trading was transacons between related enes. • That proporon declined as the market broadened. • What fracon of the gains from trade were lost with internal trading? Why do sellers/buyers stay out of the market?

• They see it as risky • Price risk – fear of punive price spikes • Does the market need some price dampening mechanism? • Risk to their water right • IF they sell temporarily, will that set a precedent and prejudice their water right • How can one guarantee this. • The decision to parcipate is analogous to the make vs buy decision.