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date: 26 May 2018

The Political Economy of Water Markets: 40 Years of Debates, Experiments and Lessons Learned

Abstract and Keywords

This chapter examines the political economy of water markets. It traces key debates about water markets, and examines how and why these debates have evolved since the 1970s. Experiments with water markets over the past 40 years have generated lessons about the politics, institutional design and performance of reforms to water rights and river basin governance institutions. Drawing on contrasting experiences with water markets in Australia, the US and China, the analysis demonstrates that strong government and community roles are necessary for water markets to respond effectively and equitably to water scarcity.

Keywords: river basin closure, water markets, water rights, Murray-Darling Basin, Colorado River, Columbia River

In 1973 the former US National Water Commission identified water markets as a key part of the “future of water policy.” Nearly forty five years later, many water-stressed regions are still waiting for the future to arrive. Even the most successful experiments with water markets have involved substantial political commitments and high transaction costs, requiring sustained investments in institutional reform and capacity at multiple scales. Notwithstanding the gap between the promise and progress with market-oriented water-rights reforms, water markets remain an appealing solution to water allocation challenges in water-stressed regions. Interest in water markets has arguably never been greater, triggered by severe droughts in California and Brazil (Moore 2015). This chapter examines the political economy of water markets. It reviews the origins, evolution, and performance of water markets and associated water rights reforms, culminating with lessons about the prospects and pathways for institutional reform.

River Basin Closure: Scarcity and the Need for Water Markets

Almost 4 billion people will live in river basins experiencing severe water stress by 2050, according to the baseline scenario of the most recent environmental outlook study by the Organisation for Economic Co-operation and Development ([OECD] 2012). In this context, the concept of river basin closure helps to frame the contested political economy of water allocation in iconic rivers as varied as the Colorado, Murray-Darling, (p. 377) Orange, and Yellow (Grafton et al. 2013). Molle, Wester, and Hirsch (2010) define river basin closure as conditions in which downstream needs are not met due chronic imbalances between supply and demands; basin closure is a function of societal choices about dilution, flushing, and environmental flows. Many closed rivers fail to reach the sea for all or part of the year. For example, construction of Hoover Dam in the 1930s and the subsequent growth in water use in the Lower Colorado River decreased the flows reaching the Colorado River Delta, which declined to a small fraction of its historic extent due to upstream storage and regulation (Figure 17.1). Long-run supply and demand in the Colorado River would eventually intersect in the mid-1990s; long-run demand eclipsed supply in 2002 due to overallocation and sustained drought.

Basin closure highlights hydrological and political connections between upstream water development and downstream impacts. Societal and economic impacts of basin closure include externalities of local interventions; in closed rivers, changes in water use patterns to meet new demands may come at the expense of existing uses or users, including environmental flows (Molle et al. 2007). In short, basin closure underscores the political and social drivers of water scarcity as demands and development strain finite and variable water supplies.

Scarcity and competition are cited as primary justifications for market-oriented approaches to allocate water to its highest (economically) valued uses in closed or closing river basins. However, as we will see, water is a complex economic good (p. 378) (Hanemann 2006). Water resources generate public and private goods, which are interdependent (Garrick 2015). As water consumption for farms, cities and energy production increase, consumption levels may exceed key limits and encroach on the water needed for freshwater ecosystems. Unsustainable water consumption practices can reduce renewable supplies as watershed conditions deteriorate or aquifers subside, building a strong link between the host of water uses and values that depend on functioning freshwater ecosystems. River basin closure thereby becomes a “commons” dilemma involving challenges of setting sustainable diversion levels and sharing water (allocating renewable supplies) among those with rights to access and use water. In this context, water markets have emerged as a prominent recommendation for responding to the water allocation challenges associated with river basin closure (Meinzen-Dick 2007).

The Political Economy of Water Markets40 Years of Debates, Experiments and Lessons LearnedClick to view larger

Figure 17.1 Flow Below Hoover Dam, 1906–2013

Source: US Bureau of Reclamation, Lower Colorado River Office (2015).

The Origin and Evolution of Water Markets: From Promise, to Pitfalls, to Pragmatism

Water markets can be defined as allocation institutions that facilitate voluntary, compensated reallocation of tradable water rights in which willing buyers and sellers respond to price signals that convey the scarcity value of water—that is, benefits forgone by retaining water in its current use (Colby 1990, Zetland 2011). Based on the experience in Australia, water markets have been defined “as a composite of a variety of water products (temporary or permanent), each situated within a given water system with various boundaries that allows water to be traded from one given place to another, under a range of conditions” (Grafton, Horne, and Wheeler 2016, 914).

The definitions of water markets have of course evolved with the changing thinking about their logic and limitations. Water markets have received attention since at least the 1970s, offering an appealing institutional response to water scarcity and associated governance and market failures (Anderson and Hill 1975). The promise of water markets lies in their potential to address competition and manage conflicts over water by using voluntary transactions between willing buyers and sellers. Equally important in the context of river basin closure is the potential for water markets to delay or even avoid costly new supply infrastructure by facilitating more efficient use of existing resources. More recently, the market logic has been extended to address unmet environmental needs in closed basins, by equipping public and private organizations with authority and capacity to enter the market on behalf of the environment, acquiring and managing water rights for environmental restoration (Garrick et al. 2009).

Water markets and cap-and-trade water allocation reforms are hardly novel or recent. As noted, it has been 40 years since the National Water Commission encouraged market-oriented reallocation to “increase the benefits gained from the use of water (p. 379) and . . . delay or make unnecessary the construction of new sources of supply” (Cody and Carter 2009, US National Water Commission 1973). Even in 1973, market-oriented reallocation hinged on effective governance and robust institutions. However, proposed water allocation reforms implied a single institutional transition, or “set-up” period, to complete market-enabling reforms by creating water-rights registries, adopting trading rules, reducing legal barriers, and establishing water supply projects to handle storage and distribution (Cody and Carter 2009).

Water markets are a form of cap-and-trade allocation policy, founded on economic ideas about allocating scarce natural resources or environmental goods and services (Tietenberg 2002). As such, the logic of water markets is premised on at least three institutional choices: a cap, an initial allocation of property rights, and trading rules. In principle, water markets emerge when these elements are developed, as follows. A cap on water diversions establishes cumulative limits, an explicit or implicit recognition of limits, ideally based on sustainability criteria and defined at nested hydrological scales. The allocation of water entitlements then creates an initial distribution of property rights based on political decision making informed by principles of efficiency and fairness. Finally, trading rules allow voluntary reallocation to enhance efficiency, subject to rules to limit negative social, economic, and environmental impacts of water trading. This description is very much an ideal, of course: in practice, it is rare to establish a cap proactively before formal and informal water claims proliferate and create structural imbalances of supply and demand. The de-watering of rivers and rapid depletion of groundwater often create a de facto limit and the conditions of river basin closure noted previously. Rules limiting negative impacts of trading may also struggle to respond to these effects due to the expectations and vested interests in place when markets are developed. Further, there is no presumption that the central government undertake these institutional reforms; local and community governance arrangements can address these key reforms.

Since the 1960s and 1970s, the debates about water markets have matured, shifting from the conception of free markets to an acceptance that markets are governed by a complex and nested set of water-rights institutions, conflict resolution mechanisms, and sustained policy reform and investments in administrative capacity. The following sections trace this evolution and its implications for contemporary and future of water markets.

Free-Market Environmentalism

The early arguments for voluntary water reallocation via market mechanisms in the 1970s were followed in the early 1990s by the concept of “free market environmentalism,” in which private, tradable, and exclusive property rights were the solution to resource scarcity and environmental pollution problems as part of a natural progression toward more economically efficient resource allocation institutions. (Anderson and Leal 2001) write: “Human ingenuity is switched on by market prices that signal (p. 380) increasing scarcity and provide rewards for those who mitigate resource constraints by reducing consumption, finding substitutes, and improving productivity.”(3) Critics of free-market environmentalism bemoaned early prescriptions as “over-simplistic, misleading and hyperbolic” due to the “failure of markets to allocate effectively environmental resources because of information costs, externalities, public goods and strategic behavior” (Blumm 1992, 372). The unfulfilled promise of some experiments with water markets and the challenges of using voluntary water transactions to resolve conflicts among hydropower, mining, and irrigation uses led Bauer (2004) to equate market reforms with a siren song that uses deceptive allure to trap its victims. Writing about the use of market-like water-rights acquisition for environmental restoration in the US Pacific Northwest, Neuman (2004) captures this disconnect between the promise and progress succinctly: “that was then, and this is now.” This perspective was shaped by Neuman’s experience as president of the board of the Oregon Water Trust, the first nonprofit entity to lease water rights from irrigators for instream flow restoration. The Trust had encountered stubborn resistance to a permanent acquisition in the Grande Ronde watershed of Northeast Oregon, which triggered protest and a six-year dispute involving administrative hearings and efforts by irrigators to repeal Oregon’s 1987 Instream Water Rights Act (Pilz 2006). Rather than a wholesale retreat, these initial obstacles re-shaped thinking about water markets and their institutional underpinnings.

Emerging Markets, Maturing Thinking

The scholarly community has developed an abiding interest in water markets, with major works assessing their emergence, maturation, and future (Easter et al. 1998, Grafton et al. 2011, Maestu 2013). A profound gap, however, has appeared between the initial logic of environmental markets and the reality on the ground. In the intervening years, on-the-ground experience has revealed that market-oriented water allocation reforms are more complex than initially envisioned (Neuman 2004). A more nuanced and mature conception of market environmentalism has developed in this period, comprising five interrelated elements: privatization, commercialization, environmental valuation, marketization, and liberalization of governance (Bakker 2014, also see Bakker, this volume). This builds on the concept of water marketization as the “process of creating the economic and policy infrastructure for treating water as a marketed commodity” (Conca 2006, 215).

A pragmatic middle ground has emerged between unqualified success and abject failure in which water markets and voluntary water transactions have an important role to play in enhancing the flexibility and adaptability of water allocation institutions. On the one hand, it is evident that water markets play an important role in water allocation in societies, economies, and environments as diverse as Australia, Canada, China, Chile, South Africa, and the western United States (Grafton et al. 2011). On the other, trading activity remains a fraction of the potential that had been anticipated in most of these regions as recently as the early 1990s.

(p. 381) The Australian experience in the Southern Murray is the exception; in some years 30 percent of water used in the Southern Murray or more has been traded (Grafton and Horne 2014). However, water trading in the Murray–Darling casts the lack of activity in the other semi-arid regions into sharp relief. A convergence of factors created a rare window for comprehensive and sustained reform. First, the Southern Murray is physically interconnected through a system of reservoirs, locks, canals, and salinity interception schemes. These physical connections allow the storage and movement of water. Second, a set of market-oriented water rights and basin governance reforms have developed over 20 to 30 years to establish a strong institutional framework for water markets, culminating recently with: a basin plan that establishes sustainable diversion limits (updating the previous interim cap), separation of land and water rights harmonized across state jurisdictions, transparent registries, rules for water trading, administrative capacity, and “environmental intelligence”—a term used by the Bureau of Meteorology to describe the water accounting tracking water availability, use, and trade. The necessary institutional reforms and “economic and policy infrastructure” were motivated in turn by intensified competition for water and broader economic reforms shaping public services and regulating the water industry in the early 1990s, enshrining economic competitiveness as a goal for a range of policy sectors. Notwithstanding these enabling conditions and driving forces, political disputes have been a defining feature of each stage of the reform process, requiring parallel investments both water rights reform and wider basin governance (as detailed further later).

By contrast, the physical, cultural and legal factors impeding markets in other parts of the world pose formidable and persistent barriers. For example, only 5 percent of total water used in California was traded in the water market in 2012, and it has declined to 3 percent of total water use in 2016 despite pressure from an unprecedented drought and competing demands (Hanak and Jezdimirovic 2016, Hanak and Stryjewski 2012). The barriers to water trading in California stem from multiple sources: legal uncertainties, (until recently) limited regulation and monitoring of groundwater, and regulatory barriers on trade to protect third parties from negative impacts, which in turn reflect political and cultural resistance to water trading (Hanak and Stryjewski 2012).

As market-based water trading emerges once again as a preferred response to shortages due to severe drought conditions (Culp et al. 2014), there is growing recognition that institutions and sound governance come before the market. A series of key institutional reforms must establish diversion limits, separate land and water rights, and regulate trade. These market-oriented institutional reforms are necessary but insufficient; narrow market-oriented reforms must be embedded in strong governance institutions. For example, the market-based reform of water rights in the Southern Murray has situated water markets within a wider set of governance initiatives, nested from the irrigation institutions and catchment management authority (local-region) to state governments, interstate cooperation, basin planning, and coordinated river operations at the basin scale (e.g. Murray-Darling Basin Initiative and Murray-Darling Basin Authority) (Garrick 2015). (p. 382)

Efforts to confine the reform process into a narrowly (apolitical) technical planning effort have triggered resistance and retrenchment, necessitating an ongoing engagement with states, irrigators, and environmental interests to secure legitimacy and accountability (Garrick and O’Donnell 2015). In this context, Challen (2000) has argued that water markets cannot be considered “self-maintaining” allocation options that operate smoothly after a single set-up period.

Integrated Water Markets: A Political Economic View?

The evolution in thinking is captured by the notion of “integrated water markets.” Integrated water markets combine water-rights reform and basin governance through a set of water policy, planning, and legal reforms at multiple scales. Grafton et al. (2011) define an “integrated water market” in terms of nineteen criteria across three dimensions: institutional foundations, efficiency, and environmental sustainability (see Table 17.1). The institutional foundations include not only the conventional prerequisites for markets—administrative capacity, legal clarity over property rights, recognition of the public trust, and so on—but also transboundary governance arrangements to scale up markets through “horizontal” and “vertical” coordination mechanisms. Horizontal coordination is concerned with interactions within each level of governance, such as the coordination of states sharing a river, or water users and user groups with a stake in a river or catchment (for example, irrigation, cities, environment) (Berkes 2002). Vertical coordination mechanisms structure interactions between different tiers of governance, such as those between state and federal governments and those between resource users and states (Young 2002). River basin governance and (p. 383) interstate agreements create an additional governance layer. Integrated water markets also require adaptive institutions, defined as the capacity to cope with crises, assimilate new information, and adjust water management as social values evolve (Grafton et al. 2011).

Table 17.1. Criteria for Integrated Water Markets: Institutional Foundations, Economic Efficiency, and Environmental Sustainability

Institutional Foundations

Economic Efficiency

Environmental Sustainability

  • Recognition of public interest

  • Administrative capacity

  • Horizontal and vertical linkages

  • Legal/administrative clarity

  • Priority of use

  • Initial allocation and reallocation

  • Dealing with market failures

  • Adaptive management of institutions

  • Size of market

  • Gains from trade

  • Storage

  • Nature of water rights

  • Breadth of market

  • Market price formation and availability

  • Adequate scientific data

  • Adequate provisions for environmental flows

  • Water quality considerations in water planning

  • Basin and catchment-level water planning.

Source: Grafton et al. (2011).

Toward a Political Economy Perspective on Water Markets

This section considers the political economy of water markets from the perspective of property rights, transaction costs, and path dependency. Understanding transaction costs, and the political, cultural and technological forces that drive them, is an important part of setting up more flexible and sustainable approaches to water allocation. Despite their importance, however, transaction costs are often neglected—or underestimated—because they are hard to quantify, and the boundaries around what counts as transaction costs are not always clear.

Property Rights to Water and the Problem of High Transaction Costs

Property rights refer to rules and norms governing interactions between people in relation to objects of value (Bromley 1989). The “problem” of water is that it is a “fugitive resource” that is difficult to bound and measure, and it supports multiple public and private values, some consumptive and others nonconsumptive (Libecap 2005). Blomquist (2011) counts at least sixteen ‘beneficial uses’ attached to water in the Western US. In semi-arid regions, beneficial uses range from farming and fire control to municipal, hydropower, and environmental purposes. How to resolve these trade-offs? Free-market environmentalism is based on the premise of private, exclusive, and secure property rights to align private resource use with the public interest (Anderson and Leal 2001)—a proposition complicated by issues of equity and sustainability (Raymond 2003, Schorr 2012). The neoclassical economic model requires “3D” property rights—defined, defensible, and divestible (Bougherara et al. 2008).

In theory, clear property rights are expected to develop when the benefits of defining property rights justify the costs of doing so. This occurs when two conditions exist: first, intensifying scarcity increases the benefits of defining private property rights, while second, technology (e.g., barbed wire for fencing or telemetry for water monitoring) lowers the costs of monitoring and enforcement (Anderson and Hill 1975). The reality of creating such property-rights regimes has proven complex and contentious due to the nature of the resource, its multiple uses and values, and the politics associated with defining and adjusting the property rights governing it (Ruml 2005).

(p. 384) Water’s common-pool resource characteristics and multiple uses have given rise to a system of mixed property rights and marked by high transaction costs (Cole 2002). Blomquist (2011) concludes that property rights to water must be multidimensional, like the water resources they govern, given the diverse values ascribed to water in these different uses; moreover, decisions about property rights are arrayed across multiple decision-making venues. In contrast to the private-property ideal promoted by free market environmentalists, the mixed property-rights systems governing water allocation have been conceptualized as polycentric governance arrangements (Meinzen-Dick 2007, Garrick 2015), in which different rights and responsibilities are arrayed across multiple levels of social organization. The result is what Schlager and Ostrom (1992) describe as a bundle of rights—access, withdrawal, decision-making, exclusion, and alienation—with different actors holding different “sticks” (or combinations of sticks) in the bundle.

Comparing the three prominent “panaceas” to the problem of water allocation—state, markets, and users—Meinzen-Dick (2007) describes polycentric arrangements as an “institutional tripod” in which these three models combine and are mutually reinforcing. Thus the tradable water rights established through market-oriented water allocation reforms often exist alongside both state ownership of water and self-governance by water users, such as irrigation districts, to regulate access and use and coordinate provision of necessary infrastructure.

In market-oriented cap-and-trade systems, property rights are nested: private tradable rights are conditioned by collective irrigation-district rights and state and federal ownership of water and water infrastructure. Changes to water rights at one level have potential knock-on effects at other levels. The unintended consequences and wider impacts of changing use patterns make it unlikely for water markets to attain the ideal of being a “self-maintaining [allocation] system” with a single set-up period followed by a period with “very little future need for government involvement” (Challen 2000, 2).

As consequence of the mixed system of property rights governing water, water markets have been constrained by high transaction costs (Colby 1990). Transaction costs have been defined narrowly as the “costs of exchange” (Demsetz 1968) and broadly include the costs of searching for willing buyers or sellers, bargaining over water prices and enforcing the eventual contracts. As natural resource allocation has become more complex, definitions of transaction costs have expanded, particularly to distinguish between transaction costs of implementing water transactions from the transition costs of undertaking and revising the necessary institutional reforms over time (Garrick et al. 2013).

In the context of ‘integrated water markets’ noted above, definitions of transaction costs have broadended to include the resources (e.g., financial, staffing, time) required to: undertake collective action in resource allocation; define, manage, transfer, and enforce property rights; and to operate and change the institutions governing property rights over time (Garrick 2015, McCann et al. 2005, Marshall 2013, Cole 2002). Despite calls for water-rights reforms to reduce transaction costs “as close to zero as possible” (p. 385) (Young 2014, 35), transaction costs are likely to remain substantial and positive because property rights to water are never complete (Barzel 1997). The striking reductions in transaction costs in the Australian water market and in a handful of geographies globally have depended on the sustained efforts and combination of market-oriented reforms to define tradable property rights across water’s multiple uses and values and the parallel efforts to strengthen coordination institutions. Legal scholar Daniel Cole (2002, 4) notes this tension, highlighting “the existence of a property system necessarily implies the existence of substantial transaction costs.” This highlights the need to reexamine the relationship between property rights and transaction costs in water allocation in the context of historical, political and technical forces impeding change.

Path Dependency and Water Allocation Reform

Path dependency is the simple notion that history matters because reversing or shifting course is costly; institutional choices and technologies support economic sectors that will resist changes that threaten their interests (North 1990). In the context of water, irrigation development has involved a set of vested interests organized around key historic choices about water-rights institutions and infrastructure. The intended and unintended consequences of past decisions can transform stability into rigidity that impedes adaptation. Transaction costs are one symptom of that rigidity. According to Libecap (2005, 76), path dependency “mold[s]‌ transaction costs, the extent of markets, and the nature of resource use, management, and investment.” Libecap also notes that these choices were once considered institutional innovations to address seemingly intractable challenges of irrigation development. Yesterday’s innovations have made it very costly to adapt to the pressures of today and tomorrow.

In a comparison of the Colorado, Murray–Darling, and Saskatchewan rivers, Heinmiller (2007) identified four sources of technological and institutional path dependency in cap-and-trade water reforms: vested interests, network effects (hydrological and institutional connections across scales), sunk costs, and property rights governed by both formal and informal contracts. Together, these factors raise “the difficulty and cost of reform . . . reinforcing the institutional status quo” (Heinmiller 2007, 135) because irrigators, states, and other vested interests will organize to resist change.

Cap-and-trade water allocation reforms, furthermore, involve multiple stages linked by path dependency, because decisions during initial stages impose deferred costs. Colby (2000) identifies five stages of cap-and-trade reforms:

  1. 1. resource abundance with informal rights and rules;

  2. 2. perceived scarcity and conflict;

  3. 3. a period of political disputes regarding capping, allocation and trading regulation;

  4. 4. the establishment of the cap, allocation of rights and trading rules; and

  5. 5. the expansion of trading activity.

(p. 386) Considered in terms of transaction costs and water-allocation reform, stage 3 can involve high transition costs due to the distributive politics and the race to legitimize informal claims during the grandfathering phase (Heinmiller 2007). Stage 4 is marked by high transaction costs during early trading to interpret and implement cap, allocation, and trading regulations. In some situations, the political and institutional hurdles of stage 4 are too high, particularly for complex economic goods with interdependent private and public values, such as water infrastructure and environmental flows. However, when initial impediments have been overcome, the expansion of trading activity is a sign that benefits of reallocation have increased, transaction costs have decreased, or, most likely, some combination thereof, making it possible to realize the perceived gains from trade. Thus, stage 5 is typically marked by relatively lower transaction costs. The need for periodic adaptation and institutional reform remains, however, as exemplified by the comprehensive basin planning efforts used to revise the cap on water diversions in more active water markets. For example, the Murray–Darling Basin has undertaken a statutory Basin Plan (2012) to define sustainable diversion limits, updating the interim cap adopted in the mid-1990s. In the western United States, the 2009 Secure Water Act has brought over twenty basin studies to assess and respond to climate change impacts on supply and demand, including several studies in basins with active water markets, such as the Deschutes River of central Oregon.

Trajectories of cap-and-trade reform processes are, moreover, not linear. Efforts to decrease transaction costs in early phases of reform (e.g., grandfathering) may prove shortsighted by shutting out key stakeholders from the process of developing the cap, the initial allocation, or trading processes. For example, environmental flows, the water rights of indigenous peoples, and the role of groundwater have often been neglected, creating unintended consequences and requiring new settlements, adjustment plans, and studies to account for the full range of water demands and supplies. Such efforts can prove self-defeating over the long term and dampen political will for market-based reallocation because “costless trading will produce inefficiencies when externalities are produced, or public goods are diminished” (Colby 2000, 652). Cap-and-trade water allocation reform must be considered in this historical and political economic context to achieve adaptive capacity over the long term.

Unlocking the Past: Cap-and-Trade Institutional Reforms

Following Tietenberg (2002), the cap, or aggregate limit, for resource use and pollution is based on some conception of sustainable use. The key institutional design variables are whether the cap is based on sustainable use or historic use (which may already be unsustainable) and whether the aggregate limit is fixed or can be reviewed periodically based on new information or sustainability values. The establishment of a cap often occurs after sustainable use levels have been exceeded. If a cap is based on historic uses, it can convert tacit and informal claims into more formal rights and expectations. Formal rights become costly to adjust if sustainability criteria later warrant a reduction (p. 387) in cumulative diversion levels (Heinmiller 2007; Colby 2000). The cap is therefore inextricably bound up with the initial formal allocation of rights, making the latter a critical institutional choice (Krutilla and Krause 2010).

There are four broad options for the initial allocation: random access (lotteries); first come, first served; administrative rules based on eligibility criteria; or auctions (Tietenberg 2002). Ostrom and Basurto (2010) demonstrate several additional permutations for irrigation water systems based on seven types of rules, including the boundary, position, and scope rules governing access and decision-making about irrigation infrastructure and access, making it necessary to consider a much larger number of possible configurations.

In terms of lock-in and path dependency, the initial assignment of property rights has considerable impact on trajectories of institutional change (Krutilla and Krause 2010). “Grandfathering” is a common basis for defining property rights because it recognizes historic investments and is therefore the method most likely to gain political approval (Tietenberg 2002). However, grandfathering formalizes these claims and establishes expectations of secure water rights that can become costlier to alter than other standards used for defining property rights. For example, the system of water rights in the western United States is known as prior appropriation, or first in time, first in right. Property rights were established by claims and historic water use practices by miners and irrigators in the nineteenth century. When formal administrative permitting systems took hold in the twentieth century, these prior claims were formalized through administrative permits or adjudications to clarify the extent and validity of the rights based on a history of “beneficial use” according to the principle of “use it or lose it.” Grandfathering reflects the deeply vested interests touched by water allocation decisions. This is particularly so when the sustainable water allocation reforms involve adjusting private rights or claims to water in the public interest, as has occurred in stressed rivers of Australia, Spain, and the United States after the recognition of the environment as a legitimate water user.

An appreciation of path dependency and the associated trade-offs led Challen (2000) to highlight the risks associated with allocation decisions that reassign water rights from state ownership to private control, as private property rights become more difficult and costly to adjust as preferences change. Writing in the Australian context, Challen noted that market-enabling reforms had strengthened efforts to treat water as a form of private property, which undermined the state’s historically strong control and ownership of rights, for example, under the 1885 Victorian Irrigation Act. The increasing perception of water as a form of private property right, despite the state’s continued formal authority and control, has strengthen the political claims of historic water users, leading for example to a buyback of water rights for the environment instead of a statutory plan with pro rata reductions in water availability for existing entitlement holders.

Finally, trading rules, or reallocation options, can be designed along the spectrum from principles of free competition to stringent protection for third parties such as the environment and the other irrigators and stakeholders in the community. Water-trading rules have erred toward the latter, particularly in the United States, by preventing harm (p. 388) and reinforcing irrigation district control by restricting water trade out of districts. Such rules may combine with infrastructure improvement schemes that reinforce lock-in. Together, these institutional choices about the cap, initial allocation, and trading rules create institutional arrangements ranging from more to less flexible, in the extreme case raising the prospect of a tragedy of the “anti-commons” in which formal specification of rights contributes to paralysis or even underuse (Heller 1998).

Lessons from the Leading Edge: Australia and the Western United States

Intensified competition for scarce and variable freshwater resources has made southeast Australia and western North America important international examples of market-oriented allocation reform. The Colorado and Columbia Rivers of western North America and the Murray–Darling Basin of southeast Australia face similar water allocation challenges: competition for scarce freshwater, uncertainties and risks related to climate variability and change, unmet environmental needs, and upstream–downstream trade-offs across subnational and, in the Columbia and Colorado, international borders. Over a century and a half of irrigation development, economic growth and diversification, and adaptation to climatic variability have made these regions laboratories for institutional reform—both successes and challenges—with cap-and-trade allocation reforms becoming a common response to competition for water.

Colorado Basin.

The Colorado River straddles seven states in the United States and two in Mexico (637,100 km2), as well as several Indian tribes, cities, and irrigation districts. It has supported extensive irrigation development (4.5 to 5.5 million acres of irrigated agriculture), hydropower production, and rapid urban growth for up to 40 million people in the major population centers of the western United States (US Bureau of Reclamation 2012). There is a chronic imbalance in lower basin deliveries from Lake Mead, which has been described by journalist John Fleck as a “structural deficit” with total outflows and losses of approximately 12.6 billion m3 and inflows of only approximately 11.1 billion m3. The annual imbalance is buffered by reservoir storage, but this cushion has been depleted during sustained drought.

Columbia Basin.

The Columbia Basin is one of the most developed rivers in western North America with more than 200 dams supporting millions of acres of irrigation; 16,000 megawatts of hydropower; a population of more than 7 million with increasing development in the rural, semi-arid interior; and a salmon fishery with high ecological, cultural, and economic significance. Like the Colorado, the Columbia straddles an international border, but between the United States and Canada. The basin drains almost 700,000 km2 across seven US states, one Canadian province, and several First Nations and tribal reservations. The Columbia River Basin is comparable in size with (p. 389) the Colorado in terms of drainage area but not in volume. It has an average volume at the Dalles Dam of 165 billion m3, an order of magnitude higher than the Colorado. However, like the Colorado, stream flow is characterized by spatial and seasonal variability due to a snowmelt dominated hydrograph. Tributaries still experience seasonal variability and exhibit scarcity conditions characteristic of semi-arid irrigation regions. Chronic seasonal water deficits in the tributaries occur in late summer (August, September), when peak agricultural use coincides with natural low flows after snowmelt.

Murray–Darling Basin.

The Murray–Darling Basin is more than 1 million km2 and 14 percent of Australia’s landmass, spanning four states and one territory. The Great Dividing Range forms the eastern boundary and feeds the Murray and Murrumbidgee Rivers. Prolonged droughts have combined with an almost fourfold increase in water use from the 1930s to the 1990s to place the basin under stress. During sustained droughts, there have been prolonged periods of reduced outflows, requiring dredging in 1981 and again starting in 2002 for several years during the Millennium Drought (1997−2009). In 2007, the Commonwealth Water Act set out an overarching objective to optimize social, ecological, and economic outcomes of water use in the basin by establishing sustainable diversion limits based on basin-wide environmental needs. In so doing, it established a federal authority—the Murray–Darling Basin Authority—to implement these provisions by invoking new constitutional authority.

A Common Challenge: Hard Limits and Vested Interests

The arrival of “hard limits” and basin closure occurred when development, demand, and drought converged to create chronic imbalances. Early evidence of the arrival of limits can be traced to the mid-twentieth century. The Colorado River experienced the 1950s’ drought; tree ring studies in the 1970s threw into question the long-term renewable water supplies and raised the specter of severe, sustained drought long before the unprecedented sequence of dry years since 1999 (Woodhouse et al. 2006). The Murray–Darling experienced several droughts since the Federation Drought of 1895–1902, punctuated by two sustained droughts coinciding with World Wars I and II and the Millennium Drought from 1997 to 2009 (Helman 2009). In parallel, major cities grew, and with them came new demands and the emergence of conservation and environmental values. Heightened competition for variable water supplies exposed the consequences of past decisions, particularly to address omissions of the previous interstate apportionment schemes (Kenney et al. 2009) in the case of the Colorado): the environment, indigenous claims, and, to some extent, the water needs of new urban populations.

By the mid-1900s “the boundaries drawn around responsibilities and authorities were increasingly inadequate for solving emerging problems” (Lach, Rayner & Ingram et al. 2005, 8). It is against this backdrop of new demands that drought and salinity problems triggered an era. of hard limits and an increasing need for trade-offs at the basin scale. The ensuing process of capping, allocating, and trading water rights has been intensely political and unresolved (Heinmiller 2007). The recognition of path dependency—that (p. 390) historic institutional decisions raise the costs of future change, opening some options while foreclosing others—heightens the political struggle to shape the outcomes at each stage. In the following sections we consider the early stages of cap-and-trade water allocation reforms in the context of path dependency and transaction costs.

Politics and Path Dependency of Capping, Allocation, and Trading in Three Rivers

Processes of capping water use are intensely political, precisely because of vested interests: water was fully allocated or overallocated in each of these basins before limits to sustainable water use had been recognized. Heinmiller (2007) traces the politics of cap-and-trade water policy across three distinct but interlinked phases: capping, allocating, and trading water. He argues that each component is shaped by different players and dynamics: “outcomes of the [capping] process can significantly shape . . . related allocation and trading processes” (Heinmiller 2007, 455). Thus the capping becomes a prime source of path dependency, impacting the options for allocation and trading rules, as illustrated by the diversion limits—both implicit and explicit—developed and adapted in the Colorado, Columbia, and Murray–Darling Basins.


Capping identifies cumulative diversion limits and in this instance builds on the prior history of interstate apportionment agreements (water allocation agreements among states) in all three river basins, where initial limits were reflected in the supply assumptions used to divide water among the states sharing the rivers. Distributive conflicts during the capping phase bring into conflict environmental versus irrigation interests on the one hand and upstream versus downstream interests on the other. This configuration of interests and alliances can produce strange bedfellows, as when downstream cities, states, and environmental interests working together as a bloc to oppose the development interests of upstream irrigation and cities. The downstream interests of Adelaide, the state government of South Australia, environmental groups, and irrigators have formed a loose alliance in advocating for greater volumes and reliability of water deliveries to South Australia. However, context and path dependency matter; vested interests differ depending on the “first mover” and the historic patterns of development and use. In the Colorado River, capping has not occurred at the basin scale; however, the era of limits, illustrated by the structural deficit between supply and demand noted previously, has occasionally pitted new users (cities and environment) against older, vested interests (irrigation); upper basin and lower basin states are therefore not the sole axis of conflict. The states within each subbasin have uneven vulnerability due to their allocation or its reliability, fueling tensions across sectors and between states within the Lower Basins (and not simply between those in the Lower Basin versus those in the Upper Basin). This is exemplified by the Arizona v. California Supreme Court case, involving two states from the Lower Basin in a protracted court dispute over the 1922 Colorado River Compact (Kenney 2009).

(p. 391) Crises and the emergence of new players can transform the politics of capping. For example, limits on water diversions in the tributaries of the Columbia followed the expected pattern of political struggle between fishing and farming until the new residential development and groundwater use in rural areas united environmental interests and senior surface-water rights holders. These traditional foes were unified by a common threat: the new pressures from “amenity migrants” moving from the cities to the urban–rural fringe. Zeimer and colleagues (Ziemer, Bates, Casey & Montague 2012) write about the transformation of previously antagonistic environmental and farming interests into staunch allies in the face of new groundwater development, leading to court action and efforts to change the Montana Department of Natural Resources and Conservation permitting policy for interpreting basin closure in relation to groundwater pumping. The potential for political realignment demonstrates that path dependency is not synonymous with stasis but rather a starting point shaped by the historic configurations of institutional arrangements and the vested interests formed around them.

The Murray–Darling experience, on the other hand, illustrates the steady accretion of political power by vested irrigation interests, despite the foresight of institutional architects to reserve state control over water resources in the 1901 Constitution (section 100). The basin-wide audit of water use was conducted in June 1995 in response to the 1994 Council of Australian water reforms and the salinity and scarcity crises that preceded them (including the 1000-km algal bloom in the Darling). These reforms led to an interim cap based on historical diversion levels under the 1993–1994 levels of development, adjusted from year to year subject to hydroclimatic conditions. Notably, only 61 percent of authorized water entitlements were actively being used at that time. What would happen to the dormant rights? The interim cap acknowledged the legitimacy of unused (sleeper) or underused (dozer) water rights, which set off a race by the holders of these dormant rights to actively trade them and put them into use, particularly after the cap. These grandfathering decisions made setting the cap politically feasible, but the agreement came with steep (deferred) costs (Young and McColl 2009). In particular, it led to an increase in water use after the cap was established and decreased reliability for all entitlement holders (principally irrigators) who held proportional shares of available water, rather than the fixed volumes provided by the prior appropriation system of the United States. In short, the cap created an incentive for unused rights to be activated, which meant the fixed volumes based on the 1993–1994 levels were now being shared and spread across more active users.


Allocation processes assign the initial distribution of rights, although historic use patterns and associated property claims have invariably predated the formal establishment of a cap and the subsequent allocation process. Reliability and security among water rights holders are a key source of distributive conflicts over allocation, both within and across state jurisdictions (Heinmiller 2007). The prior appropriation system in the United States and the entitlements with different levels of “security” (reliability) create rights—and users—with uneven access and availability. For example, those with lower security seek to strengthen their position at the expense of those with higher levels of security, while the latter defend their rights against encroachment. Examples of (p. 392) these dynamics are detailed next, showing how the perceptions of inequity among entitlement holders can feed resistance to reforms.

In the Colorado and Columbia Basins, the prior appropriation doctrine (first in time, first in right) led to a prioritization, or ranking, of individual appropriative rights and irrigation district bulk entitlements relative to one another, although the spatial positioning and location of the most secure rights could vary. A hierarchy of rights has been used to allocate water between and within states in three partially overlapping steps: laissez-faire appropriative claims within territories during the colonial period and early statehood (through the early twentieth century), followed by interstate apportionment (in Colorado only), and succeeded by an ongoing allocation process using administrative permit systems and/or general adjudications within states in the mid- and late twentieth century and into the twenty-first century.

After a laissez-faire period when appropriators established claims by posting a notice by a point of diversion in the mid-nineteenth century, an administrative system for permits developed in the mid-twentieth century to formalize the process, with general adjudications or negotiated settlements under way in many subbasins (e.g., Gila in the Colorado, Yakima in the Columbia). Adjudications and negotiated settlements have imposed exorbitant costs on efforts to determine the extent, validity, and priority of water rights. For example, the 1993 Rettkowski court case in Washington established a case-by-case determination of the validity and extent of historic rights pending the completion of a basin-wide adjudication (Rettkowski v. Department of Ecology; 122 Wn.2d 219, 858 P.2d 232). The Gila River Adjudication of the Colorado (started in 1974) and the Yakima River Adjudication of Washington (started in 1977) have entailed numerous hydrological studies, legal proceedings, and negotiations, without an apparent end in sight (Feller 2007). Federal water projects developed distinct systems for water permitting through contracts with the Bureau of Reclamation. Within irrigation organizations, allocation systems often relied on shares allocated on a proportional basis, although the decision- making and rules vary by type of irrigation organization. Potential for trading was much higher within than across irrigation district boundaries, for a variety of institutional and infrastructure reasons (Thompson 1993; Ruml 2005).

Australia’s water rights system is based on allocation authority vested in states by Section 100 of the 1901 Constitution, which allowed differences across the states and contributed to lock-in due to the difficulties of moving water outside of state and irrigation jurisdictions (Turral, Connell, and McKay 2009). States have adopted different strategies in establishing licenses, with Victoria opting to create higher-security rights (delivered with high reliability) and New South Wales opting for relatively lower-security rights (to support more expansive broad acre crops but with lower reliability). The creation of higher-security rights in Victoria has fostered permanent plantings in comparison to the annual plantings prevalent in New South Wales, where many entitlements have relatively lower reliability. The Victorian government has estimated that the higher-security entitlements have as much as double the economic value per unit of water in the early period since the entitlements were developed in the 1990s (OECD 2012).


The politics of trading revolve around the transaction as the unit of analysis. The main players are the buyers, sellers, and any third parties affected by the trade (p. 393) either directly (e.g., downstream rights holders) or indirectly (e.g., the irrigation industry) (Heinmiller 2007). The latter category is expansive and includes the wider irrigation communities and emerging stakeholders. In the Colorado Basin, the main buyers are the cities (e.g., Los Angeles), which purchase rights from agricultural sellers, particularly relatively lower-valued irrigation, by negotiating complex transactions to secure temporary or permanent water supplies. In the Columbia basin, environmental organizations and groundwater-dependent residential developers in the interior of the basin (e.g., Bend, Oregon; Yakima, Washington) seek water from agricultural users. In the Murray–Darling, high-value agriculture (e.g., horticulture) buys from lower-value agriculture (e.g., broad acre crops like cotton) during droughts. The spatial configuration of these buyers and sellers is a function of biophysical characteristics (e.g., soil quality) but also institutional, social, and economic. The third parties encompass the broader communities affected by the trading, such as the rural towns associated with the irrigation industry.

“Third-party impacts” is a term commonly used to capture the effects of trade on stakeholders other than the buyer and seller (Colby 1990). Historical choices about the regulation of third-party impacts therefore enshrine a set of values (such as the “no harm” principle) that can restrict the development of water markets. Third-party effects have been the source of contrasting regulatory approaches in the western United States and Australian contexts. In the former, a strict no-harm standard has been adopted. Pilz (2006) describes this in detail within Oregon where water transactions for environmental restoration have encountered resistance and irrigators have invoked regulatory safeguards protecting existing rights holders from negative impacts caused by water trading. Complying with these restrictions involves substantial transaction costs to compile information, verify historic water rights, negotiate price, resolve conflicts, and so on. In Australia, water trading rules have similarly protected against negative social and environmental impacts from trade; however, the interpretation and implementation of these rules are less restrictive because rights are much more standardized as fixed shares of the consumptive pool.

Third-party impacts of trade include a suite of technical, political, and economic issues, which affect the trajectories and transaction costs of trade, including

  • Area of origin concerns—that is, impacts of trade on communities due to the perceived loss of economic development potential in upstream regions which are net exporters of water (MacDonnell 2008).

  • Return flow issues—that is, impacts of trading on the reliability for upstream and downstream uses (Pilz 2006).

  • The fixed operations and maintenance costs facing irrigation districts, which are spread across fewer users and create system inefficiencies; for example, the “Swiss cheese effect” whereby tail-end deliveries get cut off because of insufficient hydraulic pressure to deliver water by gravity to the end of the canal.

In this context, Grafton et al. (2012) note the need for institutional reforms to improve water trading by addressing the size, duration, and distribution of third-party impacts. The ensuing enactment of market-enabling water policy reform has been underway (p. 394) since the mid-1980s in each region, albeit in different ways and at different paces. Despite these divergent paths of market-enabling reform and their consequences for transaction costs and adaptive efficiency, Grafton et al. (2012) note a set of common elements: decoupling water and land rights, regulatory oversight of third-party impacts, and changes to infrastructure to facilitate the measurement and movement of water through the system. The implication is that these broad technological and institutional reforms are enabling conditions for markets to play a role in water allocation. Garrick et al. (2009) operationalize these elements in the context of water markets in overallocated regions where environmental flows are being incorporated into policy design. These steps include

  1. 1. establishment of tradable rights to and cumulative limits on freshwater extraction and alteration;

  2. 2. recognition of the environment as a legitimate water user; and

  3. 3. authority to transfer existing water rights, including the potential for transfers of high-security rights to serve unmet environmental needs.

All three basins have achieved these enabling conditions in different forms, due to their distinct basin trajectories and the water-rights systems inherited and adapted from the past. A comprehensive solution is impossible at the initial design phase, requiring adaptive mechanisms to address unintended consequences and shifting social and environmental preferences. Piecemeal efforts to establish limits, recognize the environment, and promote water trading in the Colorado and Columbia Basins have been underway for at least three decades (Kenney et al. 2011).

In the context of past institutional evolution, water trading activity in the western United States and Australia has expanded, captured by a range of studies toward the end of the first decade of the 2000s (Brewer et al. 2008). More than $4 billion was spent on water leases and purchases from 1987 to 2008 in twelve of the western US states (Grafton et al., 2012). Trading in the Murray–Darling involves up to AU$2 billion (2008 dollars) in water entitlements and allocations traded annually and over 30 percent of surface water use traded in 2011–2012 (Grafton and Horne 2014). The Colorado has been the site of increasing activity within states, albeit through complex negotiated transactions between farms and cities (e.g., southern California and the Colorado-Big Thompson project where temporary and permanent transactions have moved water from farms to cities, particularly during dry years).

The Diversity of Water Markets: The Example of China and the Primacy of Politics

Australia and the western United States (along with Chile and Spain) are arguably at the leading edge of experiments with water markets as a solution for scarcity and competition, although there have been informal trading and parallel interest in the (p. 395) developing world for some time (Rosegrant and Binswanger 1994). The Australian and western US experiences have occurred in democratic, common law, and capitalist political economic systems. The development of water markets in China takes place in a fundamentally different context (Zhong et al. this volume). Juxtaposing China with Australia and the United States presents the chance for a “most different systems” comparison, yielding insight about the essential features of water markets that apply broadly as well as those attributes that are unique to a specific context. This comparison reveals the primacy of politics in the emergence, evolution, and performance of water markets across all three settings. The point on the primacy of politics is not only that politics matter alongside the economic rationale for markets. Instead, the political economy of water allocation is integral to effective institutional design. We consider what this has meant in practice in the Chinese context and how politics have influenced the performance and prospects of the markets over the long term in a region with uneven and inconsistent systems of water rights and plans. China is facing the challenge of meeting its mounting industrial and domestic water demands without harming the agricultural sector and while preserving or restoring natural ecosystems. As a consequence, the Chinese government considers market-based mechanisms such as water rights trading to be compelling options to induce changes in water use behavior and address water scarcity (Chen et al. 2014). In 2014, the Ministry of Water Resources announced an initiative to establish water use permit trading systems in seven provinces: Ningxia, Jiangxi, Hubei, Henan, Gansu, Guangdong, and Inner Mongolia (Chinese Ministry of Water Resources (MWR) 2014). The Chinese government has established water rights trading programs, and these schemes depend on legal and administrative reforms. The water rights trading system currently in place in China represents an administrative transfer of water use permit ownership. Given the diversity of water resource challenges in the country, there exist no one-size-fits-all design to water rights trading but rather several different models. In this light, water trading has taken the form of locally adaptive responses to different water challenges that conform to local development priorities, rather than a policy model scaled out to the country as a whole (Moore 2015).

Following Gao (2007), Moore (2015) cites three examples of water rights trading in the Chinese context—interjurisdictional transfers, intersectoral water-rights transfers, and short-term mechanisms. These three types are exemplified by the Donyang-Yiwu transfer, the Ningxia (Yellow River), and the Shiyang River Basin, respectively. The first transfer of regional water rights was in 2000 between Dongyang city and Yiwu city in Zhejiang province. It is widely regarded as a water supply contract carried out by engineering measures. Yiwu lacked adequate water supplies while Dingyang had surplus water resources, and thus a contract was signed to trade 50 million m3 of permanent rights at a price of 200 million RMB (Shen, 2014). The Yellow River Basin has also been the site of several water-rights transfer projects since 2003 with the common characteristic of investing in channel lining and transferring water diversion rights. Several provinces in the Yellow River Basin, including Inner Mongolia and Ningxia, have exceeded the water quota allocated when the Yellow River Water Allocation Plan was issued. The Yellow River Water Resources Allocation plan does not define rights to water in a way that enables local water resources bureaus to issue water abstraction (p. 396) permits that will be in accordance with the scheme set by the river basin plan. In other words, inconsistency and lack of integration between the Yellow River Water Resources Allocation Plan and water abstraction permits enables local water resources bureaus to issue abstraction permits that exceed the consumptive allowance. At the heart of central-local relations lies the enforcement gap between centrally determined policy targets and effective local policy implementation. In terms of water rights trading, these policies are often modified and filtered by institutional practices, leading to diverse implementation on the ground. As a result, the divergence between central and local preferences often creates space for local governments to pursue their own objectives, such as hesitancy to implement market-based water reforms in order to protect local industries. Local protectionism of water resources also undermines interjurisdictional water transfers when local officials prefer to retain water resources within their jurisdictions (Moore, 2015). This local pushback echoes the experiences in Australia and the western United States where communities and irrigation districts have sought to restrict trades that would negatively impact them, as illustrated by caps on the volumes of water traded out of irrigation districts in the Australian state of Victoria, which were in effect until 2014.

In addition to interjurisdictional and intersectoral trading, the water ticket and trading system for irrigation in Zhangye city, in the water-stressed Heihe basin, is another model of water rights trading based on short-term trading of water use rights. It was designed to reduce the overuse of irrigation water by establishing a water use rights system with tradable water quotas (Zhang et al., 2013, Zhang et al., 2009). However, its function is limited because it does not reduce the existing uncertainties over water rights to provide stable long-term expectations required by water property owners. Water rights reform in the Chinese context mirrors the experience in Australia and the western United States in important ways; a robust water rights and trading system depends on the consistency and integration of rights at nested levels linking local water allocation with interjurisdictional planning and politics. In a pilot entitlement trading program in the Jiao River Basin, for example, Speed (2009) distinguishes regional water rights, abstractor rights, and user-level rights. Regional water rights are roughly analogous to apportionment between states and among irrigation districts in the Australia and US context, dividing water among provinces, regions, and irrigation districts. Abstractor rights grant individuals, districts, or utilities with permission to abstract, while user-level water rights refer to the rights granted within districts. Coordination and alignment is needed across levels to manage social, environmental, and economic impacts, underpinning political disputes within and across levels. While water transfers are possible between regions, between abstractors, and between farmers, the initiatives have not been conducted under a systematic framework, and water rights are not clearly defined. This has led Speed (2009, 276) to conclude that necessary water rights reforms remain elusive:

Despite efforts since the introduction of the 2002 Water Law, water rights in most cases in China are not well established, either at the regional, abstractor, or farmer (p. 397) level. Rights have often not been granted at all, and where they have, the rules surrounding the rights are often ambiguous.

The experience in China suggests that several factors constrain the applicability of market-based water trading as a response to water scarcity. These include inconsistency and lack of integration between water resources allocation plans and abstraction permits, a lack of monitoring and enforcement of water use, and central-local tensions embedded in China’s water resources management (Moore 2015). Because of these constraints, water rights trading plays an important, but partial, role in addressing the country’s water resources challenges. In this respect, a key challenge is to integrate water rights trading with administrative regulation and supply-side approaches, including the South-North Water Transfer Project—a massive series of canals and reservoirs delivering up to 25 billion cubic meters of water from the Yangtze in the south to the drier north. Reconciling market-oriented water-rights reforms with wider administrative reforms and infrastructure development will present a multilevel governance challenge and require embracing the politics of water allocation in China’s unique political and economic context.

Lessons Learned

What can be said about the trajectories and political economy of market-oriented water allocation reforms in China and the three rivers of Australia and western North America? All have achieved incremental progress in the face of increasing pressures from growing demand, development, and drought. Strictly in terms of efficiency, the Murray–Darling has established the most advanced water market in the world. Over 30 percent of annual allocations is traded in the southern Murray–Darling, with an annual boost to regional GDP of hundreds of millions of dollars according to general equilibrium modeling (Australia National Water Commission 2011). The transaction costs of water trading have declined markedly, with approvals requiring less than a week in most instances and direct costs limited primarily to administrative fees. Trading activity is more limited in the Colorado and Columbia Rivers, constituting a much smaller fraction of total water use and far less than the trading potential identified by many observers. Reductions have occurred in places such as the Deschutes, Lemhi, and Big Thompson-Colorado, but they remain the exception. The Chinese cases have been limited primarily to pilot efforts with increasing central government interest despite lingering legal and administrative challenges.

The effectiveness of market-oriented allocation reforms in terms of sustainability, equity, and adaptability is decidedly more mixed. In terms of sustainability criteria, the Murray–Darling has gone the farthest—in volumetric and percentage terms—toward restoring ecosystem health. Moreover, it has adopted and adapted sophisticated diversion limits based on ecological and social criteria; yet even these gains are less than deemed necessary and have been critiqued on technical, ecological, and economic (p. 398) terms (Pittock et al. 2015). The Colorado, in contrast, has yet to acknowledge the arrival of hard limits; several experts in the Colorado River Research Group have now argued that the recognition and regulation of limits are a critical priority (Colorado River Research Group 2014). In the Columbia, limits on withdrawals have been adopted via multiple institutional mechanisms, including court decrees, administrative rules, and so on. Progress with enabling reforms has been patchy, and implementation is even more limited. On concerns of equity and legitimacy, and by extension the adaptability of water allocation institutions, all three basins have attempted to reform water allocation institutions to confront, paraphrasing Kenney (2009), the omissions of the past—environmental needs, cities, groundwater, and indigenous water claims. Addressing these issues has raised additional equity concerns for the historic users and interests that bear the concentrated costs associated with water allocation reforms: irrigators and some subnational jurisdictions (states) that have been either slow to develop their water supplies or with less secure water apportionments. The resulting efforts to establish regulatory safeguards and multijurisdictional plans and river basin institutions have met with limited success and are based on fragile compromises; even in the best instances they are saddled with high transaction costs (of coordination) and low compliance.

The outcomes of water allocation reform in China, Australia, and the United States therefore must be viewed against the counterfactuals (i.e., what were the alternatives?) to “restore a sense of the options that confronted people at the time to show the grit and friction that was evident in every one of these episodes” (Blackbourn 2006) 12). In the Colorado, predicted legal conflicts and water wars have failed to materialize (yet); instead, drought has fostered an era of unprecedented cooperation between states, with complex new instruments being devised to experiment and from which to learn. In the Columbia, after decades of court cases, legal reform, and rule-making, a steady trickle of water has been acquired for the environment, which in some cases has led toward more comprehensive subbasin planning and the scaling up of market-oriented reforms. Institutional reforms to scale up and coordinate basin-wide outcomes within a Columbia Basin Water Transactions Program are underway, to harness and spread pockets of innovation. In the Murray–Darling, it has been more than ten years since the “First Step” of The Living Murray in 2004 committed 500 gigaliters (GL) for the environment. Despite the concerns of retrenchment and retreat from this pathway to water reform, the basin has achieved a step shift in both the goals of the reform—to achieve sustainable diversion limits—and implementation progress, with more than 1500 GL in environmental holdings and a maturing water market with sophisticated rules to coordinate consumptive and environmental water allocation. The Chinese experiences, on the other hand, demonstrate the diversity of contexts in which water markets and associated reforms have been attempted. However, its occurrence in the context of an authoritarian regime prompted Speed (2009, 279) to note every effort to develop water markets must reflect local political, cultural and institutional context:

While the application of market forces has proved successful in other countries, it may not be the way forward for China, at least for the time being. Past examples of government-facilitated water transfers—water trading “with Chinese (p. 399) characteristics”— appear more in keeping with the country’s culture and political system, and have been successful in achieving their objectives.

Future Prospects: Embracing the Political Economy of Water Markets

Sustained drought has been prevalent in California and across the western United States since the early 2000s with only brief periods of average or above-average inflows. Scarcity and competition have spawned renewed interest in water markets with a particular focus on the Australian experience. By many measures, Southeastern Australia weathered its Millennium Drought (c. 1997–2009) with aplomb: water availability declined by two-thirds, but the gross value of irrigated agriculture dipped by only 20 percent (Kirby et al. 2014).

Typical headlines from Australia focus on the miracle of its water markets—the most advanced in the world. In the Southern Connected Murray—a plumbed system of reservoirs, locks, and canals—over 30 percent of water used in a given year has been traded, versus about 5 percent in California. However, the foregoing analysis demonstrates that a focus on the miracle of the markets risks missing the point: that development of the markets has been contingent upon sustained investment in governance capacity and intense political struggles at all phases.

Water markets in Australia, thus, are at least a 30-year “overnight” success. The initial separation of water rights from land titles began in earnest in the 1980s with an interim cap following in the 1990s and ongoing updates to diversion limits to achieve sustainable extraction. The water reform process in the Murray–Darling has been as deeply political as it is motivated by economic rationality. Australia’s experience shows that water markets have an important role to play. But they are a servant of sound governance, not the master. Above all, markets are certainly not free, nor are they self-sustaining. The experience of market-oriented water allocation reform demonstrates the need to embrace the political economy of water markets by empowering water users to manage risk, confronting the legitimate interests and path dependency of prior reforms, and charting reforms that are adapted to local geographic, political, and economic realities.

Empowering Users to Manage Risk

The real lesson from Australia is one of empowering water users to deal with risk. Farmers understand drought risk and water scarcity; they are intimately familiar with strategies to maximize returns to the land. The necessary policy reforms were possible precisely because irrigators were eventually convinced that markets would help them use this knowledge to manage their farms better.

(p. 400) In the western United States, the language and literacy of water risk are still primitive by comparison. Sustained drought has introduced new terms into the lexicon—water conservation agreements to boost reservoir levels in Lake Mead (the Colorado River’s largest lower-basin storage reservoir), water sharing from farms to cities during dry years, and so on. But most experiments with water markets are still missing the policy infrastructure and political will to scale these efforts up. It is here that Australia’s experience offers lessons.

Australians realized that building flexibility into water allocation policy would not be easy, and they committed to a long-term reform project. The ingredients include auditing water use, strengthening statutory water planning, cobbling together interstate accords, separating water rights from land titles, creating transparent registers of water rights, and incentivizing innovation. Trading rules were built on the premise that the benefits of flexibility outweigh the unintended—or underestimated—impacts on those who might be negatively affected by water trade.

Avoiding a Narrow Approach and Engaging Vested Interests

The main threat to ongoing reform in Australia’s Murray–Darling region—and to those regions considering adopting elements from the Australian experience—is that the political process that built the market becomes transformed into a purely technical one. The rollout of the Murray–Darling Basin Plan (2010–2012) initially suffered this fate before confronting the politics of “localism” and making concessions to compensate farmers, irrigation communities, and states bearing the costs of reform.

Politics matter in all aspects of the water market, but the impact is perhaps most obvious—and unavoidable—in setting and updating diversion limits. Diversion limits determine how much water may be consumed and how historic water entitlements are treated. The 2012 Murray–Darling Basin Plan updated diversion limits to achieve sustainability, requiring parallel efforts to “claw” water back for the environment.

The plan received almost 12,000 public comments over about four months in late 2011 and early 2012. The political pushback from all sides—irrigators, environmentalists, and states—led to many efforts to engage communities, some more successful than others. In one promising example, the Australian commonwealth government entered into a five-year, 50 GL partnership (about 40,500 acre feet) with a nonprofit organization in South Australia (the most downstream state) to deliver water for local environmental priorities.

It is important to keep parochial concerns from dominating reforms. But politics, coupled with transparency and public engagement, can provide the basis for moving the reform process down a better path. This also strengthens the water market to handle some—but not all—of the key choices about how water is used.

Overcoming political resistance to move water across subcatchments and state borders required sustained engagement amid larger questions of community development (p. 401) and rural livelihoods. To put it another way, politics remained an important part of the policy and institutional reforms governing water markets, a constant renegotiation of the boundary between private choices and the public interest. The same values that threatened to divide water users and states have formed the basis for an ever-fragile common ground.

It may be counterintuitive to let politics sneak into development of the market. But therein lies the paradox: the many economic virtues of water markets depend on sound governance and legitimate political discourse about how to distribute water between states, between consumptive users, and to the environment.

Charting a Local Path, Embedding the Market in Sound Governance

In the context of prolonged drought in the western United States and water scarcity in many parts of the world, the conventional wisdom suggests that drought is a window of opportunity for reform—a call to action, but not to panic. Any proposal for water reform that embraces politics will need to account for local hydrology and culture, which means confronting the legacies—and commitments—of prior water rights and embedding reforms within sound frameworks for water governance.

The lessons from Australia and the western United States hold less relevance in the developing world and emerging economies, where transparency, limited rule of law, and inadequate infrastructure for measuring, moving, and storing water can pose formidable barriers to market-oriented water allocation—and to sound water governance more generally. Nevertheless, the Chinese experience shows that politics are an unavoidable feature of water markets and associated institutional reforms, due to the inherently contentious nature of competition for scarce freshwater resources and the contrasting values, scales, and jurisdictions involved.

We close by emphasizing the danger of panacea thinking—the notion of cure-alls—that see water markets as a solution to water scarcity across all contexts and phases of water reform. Water markets have a strong potential role to play, but they are the servant of sound governance, not the master. The opposite is also true, and it is necessary to move away from naïve critiques of the “straw-man” version of free markets and knee-jerk rejection of market-oriented reforms strictly on ideological grounds (e.g. metering, tradable water entitlements). Neither success nor failure are automatic; the failures of water markets in one place do not prevent them working elsewhere, while successful experiences will not automatically transfer to different contexts (Garrido 2011).

Authors’ Note

Parts of this chapter are adapted, extended, and updated with permission from Garrick (2015).

(p. 402) The section titled “Future Prospects: Embracing the Political Economy of Water Markets” was adapted with permission from A Surprising Lesson from Australia’s Drought: Politics Matter


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