The transformative role of water markets for a climate-changed future
This article was originally published in the Global Water Forum.
Water markets provide a mechanism for the efficient allocation of water resources based on market principles. In a water market, water rights can be bought and sold, allowing water to flow from areas of low value to areas of high value. Could this mechanism also play a significant role in addressing the challenges of transboundary water governance?
Enhancing efficiency
Newly released research published in the American Economic Review by Professor Will Rafey at the University of California Los Angeles provides valuable insights into the functioning and benefits of water markets (Rafey, 2023). Drawing on data from the largest water market in history, located in southeastern Australia, Rafey finds that water trading increased output by 4-6% from 2007 to 2015, equivalent to avoiding an 8-12% uniform decline in water resources. This indicates that water markets can significantly enhance the efficiency of water allocation and usage.
While there is a large body of research attempting to estimate the value of trading water rights, most studies have run into at least three challenges. First, there are practical realities that are tough to model with river systems, such as the costly and uncertain flow constraints. Second, there are also geographic and hydrological constraints, including changes in the ecosystem and climate that affect supply and behavior. Third, the set of feasible trades in the water network are subject to many constraints, such as the cost of moving water and the direction it flows.
Rafey takes a two-step approach that begins by estimating the production functions for water, which map irrigation volumes into agricultural output using producer-level longitudinal data on irrigation, physical output, and local rainfall. To address the traditional concern that some farms might be systematically more productive than others, thereby confounding the relationship between inputs and outputs due to unobserved differences, Rafey leverages the longitudinal nature of the data and the heterogeneity in how water sharing rules, also known as diversion formulas, evolve nonlinearly across space and time. Crucially, these diversion rules are not within the control of any individual farm, so they provide an external stimulus to study how output evolves. Then, Rafey links the water trading data with the production functions to estimate the realized value of trades, thereby sidestepping having to parameterize and specify the set of feasible trades and all the many constraints that go into water systems.
Policy implications
Rafey’s research is important for both methodological reasons and policy guidance. Methodologically, it shows how to estimate the value of trading in a setting where there is substantial stochasticity, absence of a complete market, and dynamic game-theoretic interactions without having to specify all these ingredients explicitly in the model. Instead, the two-step approach allows him to flexibly estimate the value of water trading.
In respect of policy, his results suggest:
There is growing institutional, including governmental, support for water markets. While market power and other frictions may exist, water markets have been proven to raise allocative efficiency. The estimated total gains from trade provide a lower bound on the value of maintaining the infrastructure required for water markets.
Australia’s experience with setting up and running water markets provides a template for other countries. They demonstrate that efficiency gains are possible using modern monitoring technology in an arid region. The extent of a river system’s underlying hydrological variability, which can be measured directly from historical river inflows and rainfall, is identified as an important source of water markets’ prospective value.
Especially in the presence of climatic change, water rights can play a substantial role in facilitating adaptation. Efficient annual trade should reallocate water from places of relative abundance to places of relative scarcity, lowering the costs of idiosyncratic variability across the river trading network. By increasing the productive efficiency of a basin’s aggregate water endowment, a water market makes drier years less costly, helping irrigators adapt to aggregate shocks. “Without water reallocation through the annual market, output would fall by the same amount as if farms faced a uniform reduction in water resources of 8–12 percent. By comparison, government climate models for this region predict surface water resources to decline by 11 percent in the median year under a 1°C increase in temperature by 2030,” said Rafey.
Although we have long known that water markets are important mechanisms for ensuring the efficient allocation of water resources, we have not known how much and how they depend on different conditions, such as varying diversion rules and a changing climate. This research provides the latest comprehensive evaluation on the importance of water markets and their value in the years ahead to help manage scarce resources in a stochastic world.
The role of water markets in transboundary governance?
Transboundary water governance is a complex social, political, and economic issue involving the management and allocation of water resources across political boundaries. It is a critical aspect of international relations, as water is a vital resource that is unevenly distributed across the globe. The governance of these resources is fraught with at least two major challenges.
First, water is a shared resource that does not respect political boundaries. Rivers, lakes, and aquifers often span across multiple countries, making it challenging to manage and allocate these resources equitably. Furthermore, the governance of transboundary water resources involves a multitude of stakeholders (eg, governments, local communities, non-governmental organizations, and private entities) each with different interests, priorities, and perceptions of how water resources should be managed, leading to conflicts and disagreements.
Second, the governance of transboundary water resources is further complicated by climate change, population growth, economic development, and more. These factors increase the demand for water and exacerbate the challenges of managing and allocating these resources.
The creation of water markets has the potential to help water managers meet these challenges by allocating supply and demand efficiently and quickly without central planning and in the face of a wide array of uncertainty, ranging from climatic change to macroeconomic shocks. Water managers and policymakers across the world should work together to build upon the successful lessons learned from Australia’s example in the Murray-Darling Basin.