Cato Policy Analysis No. 104 April 26, 1988

Policy Analysis

Going With the Flow:
Expanding the Water Markets

by Terry L. Anderson and Donald R. Leal

Terry L. Anderson and Donald R. Leal are associates of the Political Economy Research Center in Bozeman, Mont. This paper is excerpted from their forthcoming book, Free Market Environmentalism. Anderson is also the author of Water Crisis: Ending the Policy Drought (Cato Institute, 1983).

Executive Summary

Beginning with the Carter "hit list" and continuing with the fiscal conservatism of the Reagan administration, westerners have been obliged to realize that the days of concrete and steel solutions to water problems are gone. In stressing the West's need to adjust to the new realities of water, Gov. Richard D. Lamm of Colorado described the change that has taken place as follows:

When I was elected governor in 1974, the West had a well-established water system. . . . Bureau [of Reclamation] officials and local irrigation districts selected reservoir sites and determined water availability. With members of the western congressional delegation, they obtained project authorization and funding. Governors supported proposals, appearing before congressional committees to request new projects, and we participated in dam-completion ceremonies.

In 1986, the picture is quite different. The boom in western resources development has fizzled, though tourism remains an economic mainstay. . . . Congress, including members of the western delegation, has to worry about how to cut spending, not which [water] projects to fund. . . . Farmers are trying to stay in business and are recognizing that their water is often worth more than their crops. Policymakers recognize that the natural environment must be protected because it is a major economic asset in the region.[1]

The current political, social, and economic climate is ushering in a whole new era in western water. In the face of efforts to curtail runaway government spending and protect the environment, water institutions must foster the conservation and efficient allocation of existing supplies. They must also take water's growing recreational and environmental value into account. The crucial question is, can the current water institutions meet today's requirements?

In most cases, the answer is no. The current regulation of water allocation is not equipped to promote efficiency and conservation because it evolved during an era when massive federal outlays to fund huge water projects made tradeoffs unnecessary. The objective was to deliver enough water to make the desert "bloom like a rose." Centralized water management, under which supplies are often allocated at highly subsidized prices on the basis of political clout, is a legacy of that era. Water may run uphill to money, but it gushes uphill to politics.

Despite the resulting inefficiency and waste, traditional resource economists continue to identify taxes, regulations, subsidies, and governmental allocation as solutions to today's water problems. More than anything else, that mindset reflects a deep suspicion of the market that precludes its being recognized as a viable alternative.

In the natural resource field generally, the problem of externalities is widespread, and various organizational arrangements and regulatory measures have been adopted or proposed to cope with it. Laws have been written and established by courts to protect the third parties in water transfers. Special districts have been formed to internalize some of the externalities. The general tendency in institutional development has been to modify market procedures or completely replace them.[2]

A few economists, however, take exception to the idea that centralized planning is the solution to the problems of natural resource allocation in general and water allocation in particular. Anthony Fisher, for instance, has noted,

We have already abandoned the assumption of a complete set of competitive markets. . . . But if we now similarly abandon the notion of a perfect planner, it is not clear, in my judgment, that the government will do any better. Apart from the question of the planner's motivation to behave in the way assumed in our models, to allocate resources efficiently, there is the question of his ability to do so.[3]

Such challenges are based in part on the new resource economics (NRE) paradigm, which provides a clearer understanding of the problems of water allocation.[4] It incorporates elements of the property rights, public choice, and Austrian schools of economics. The property rights approach is to focus on the importance of institutions and incentives. Public choice theorists question whether collective action can increase either efficiency or equity. Austrian economics emphasizes the production of information through the market and the importance of entrepreneurial activities to the market process. The focus of the NRE is on individual decision makers, be they buyers and sellers in the private sector or bureaucrats and politicians in the public sector.

There is a clear distinction between traditional resource economics and the NRE. The traditional approach is to rely on the knowledge of a few experts to direct societal activities. In describing conflicting visions of the role of centralized control in the economy, Thomas Sowell noted,

Given that explicitly articulated knowledge is special and concentrated, in the unconstrained vision, the best conduct of social activities depends upon the special knowledge of the few being used to guide the actions of the many. . . . Along with this idea has often gone a vision of intellectuals as disinterested advisors.[5]

The NRE does not deny the importance of such expertise, but it stresses that society-enhancing activities are more dependent on knowledge of individual tastes, experiences, and circumstances. Such information does not exist in cohesive, integrated form but is distributed among the members of society. "With knowledge conceived of as both fragmented and widely dispersed, systematic coordination among the many supersedes the special wisdom of the few."[6]

Thus, those who take the NRE approach continually ask how responsibility and authority could be conferred on individuals so as to coordinate their disparate knowledge. In the case of water allocation, there has been an implicit reliance on (some would say a blind faith in) the ability of the few decision makers within a centralized structure to act objectively, omnisciently, and responsibly in pursuit of the public interest. The NRE economists ask whether decentralized markets with well-defined property rights could do better.

Consider how the NRE approach could be applied to water. If property rights in water use were fully defined and transferable, each owner would incur the full costs and benefits of his actions. An owner who ignored the need to allocate water to higher-valued uses would see his personal wealth decrease. Thus, knowledge and incentives would be linked. That is not the case when property rights in water are "owned" by the government. Irrigators may derive benefits from water supplied by public works projects, but they are not at liberty to transfer the water to nonagricultural uses--even when such reallocations would be of higher value. The actions of the "owner"--the agency official who authorizes water use--are not directed by the value of competing uses, as would be the case in a market setting, because he would not gain monetarily from such transfers and in fact could lose discretionary power. Disallowing voluntary trades and restricting water use to irrigation are ways of ensuring that agency control will be maintained.

There are other important differences between market and centralized allocation. Water markets would send supply and demand signals that would enable managers to conserve water and coordinate its use--precisely the type of information that is conspicuously absent under centralized allocation. Water markets would also allow decentralized knowledge to be brought to bear on water management decisions. As Rodney T. Smith explained, "A farmer can apply his first-hand knowledge of his land, local hydrology, irrigation technology, and relative profitability of alternative crops to decide how much water to apply and which crops to grow on his land."[7] Because they lack such information, public officials are typically forced to use comprehensive plans that are not appropriate under the circumstances.

Water markets cannot exist, however, in the absence of a legal structure that supports private ownership rights. Practitioners of the riparian doctrine, which originated in England and is still being applied in the eastern United States, cannot utilize water markets because property rights in water use are equal for everyone who owns land that adjoins a watercourse and cannot be transferred to others. The riparian doctrine has relatively innocuous effects when water is abundant and tradeoffs are unnecessary, but because it does not permit market reallocation, inefficiency can result when water is scarce.

Because the arid western United States faced scarcity from the beginning, a very different doctrine, the prior appropriation doctrine, evolved there. To support agricultural and mining operations, it was necessary to transport water considerable distances from its source. That could not be accomplished by restricting water use to riparian landowners on an equal basis, so the early California gold miners, in the absence of a formal government, devised their own system for allocating water use. They determined how much water each claimant was entitled to divert by applying the prior appropriation doctrine--"first in time, first in right." Usage rights were well defined and transferable and were enforced by the miners association. A market for trading such rights evolved, and for a time the arid West had in place a legal structure that fostered market allocation of water among competing uses.

That success was short-lived, however; a series of court and administrative decisions led to the centralized restrictions and controls that currently hamper efficiency.[8] It is becoming evident throughout the United States that if the legal impediments to water markets were removed, substantial benefits would result.

The enormous potential of water markets has become particularly evident in central California's San Joaquin Valley, which has 4.5 million acres of irrigated land, and in southern California's burgeoning Metropolitan Water District. Like farmers in other parts of the nation, San Joaquin Valley farmers are suffering because product prices are low. In addition, the quality of the soil in the valley is steadily deteriorating as a result of years of salt buildup and high concentrations of trace elements, such as selenium, in the drainage water. Several years ago high levels of selenium in the irrigation water draining into Kesterson Wildlife Reservoir caused largemouth and striped bass, catfish, and carp to disappear and caused newly hatched waterbirds to develop crippling deformities. The reservoir had been transformed from a fish and wildlife sanctuary into an environmental disaster.[9] Selenium pollution now poses a serious threat to the San Francisco Bay, a critical wildlife and marine life ecocenter.

Solving such problems will require significant investments in water conservation and cleanup; the estimated costs range from $10 an acre-foot for scheduling irrigation and recycling tailwater to $175 an acre-foot for using dripsprinkler systems. None of those investments, however, make economic sense to the region's farmers, who currently pay $5 an acre-foot for irrigation.[10] So where will the money for cleanup come from?

The solution to central California's pollution problems may be a proposed transfer of water from the San Joaquin Valley to southern California. The logic of that choice becomes apparent when one considers southern California's situation. It is a densely developed and highly populated area that is extremely dry and heavily dependent on imported water. The prospects for meeting southern California's growing demands for water were diminished when a readjudication of the Colorado River reduced its share by nearly 500,000 acre-feet a year. Studies of the Metropolitan Water District have forecast significant supply shortages during the 1990s unless new sources can be acquired.[11]

The proposed water transfer would thus benefit both regions. Southern California currently pays $200 an acre-foot for water for urban use and expects to pay as much as $500 an acre-foot for water diverted from rivers into proposed reservoirs. But southern California could continue to pay $200 an acre-foot if it purchased water from San Joaquin farmers--water that they had saved by practicing conservation techniques. The sale of water to southern California at $200 an acre-foot would mean that the valley's farmers could make a profit even if they invested $175 an acre-foot in drip-sprinkler systems. And they could improve the environment, too, by taking damaged land out of production and eliminating the toxic runoff from agricultural chemicals.[12]

Under current federal policy, however, such transactions are discouraged. The Bureau of Reclamation acts as if it owned the water, and San Joaquin farmers are not empowered to sell their water without its consent. In essence, the bureau has become the water OPEC of the West. It has funded massive projects that supply 35 percent of the West's delivered water and holds contracts that govern the use of the water, most of which is sold to irrigators at heavily subsidized prices. Irrigators in the San Joaquin Valley, for example, pay only about 15 percent of the cost of their delivered water. Conservationists argue that such subsidies have led to a large overinvestment in water storage and delivery, wasteful water management practices, and the overcultivation of farmland.

It is becoming increasingly clear that the bureau's subsidies and ability to veto transfers are standing in the way of efficient water allocation. A 1986 report to the Western Governors' Association concluded that a fundamental change is needed:

Essentially the Bureau must make a transition from an agency whose workload has been constructing large water projects to an agency that assists the West to make better use of the waters the Bureau already provides. It can facilitate this transition by providing support for voluntary transfers of Bureau-provided water.[13]

Change is coming slowly because the bureau has traditionally depended on expensive structural solutions to sustain its substantial budget and its discretionary power. Supporting water transfers would reduce the need for the pork barrel and thus threaten the bureau's potency in western water management.

In all likelihood, major changes will be spearheaded by state legislatures. The same report recommended that western states take

significant steps towards the encouragement of water use efficiency . . . in terms of meeting in-state demands for water at the least cost, with due regard for community and environmental values in water . . . [and] consider implementing a comprehensive program, going beyond water pricing reform, to encourage conservation and salvage of water through markets.[14]

There are already signs that the states are moving in that direction. The legislatures of New Mexico, Colorado, Utah, and California have made it legal for one person or agency to temporarily transfer surface-water rights to another and reclaim those rights in the future, thus providing additional opportunities for short-term transactions. California's legislature has also taken a step toward encouraging voluntary water conservation by "vesting the senior right to saved water in the user who saves the water. The law enables him to dispose of that water as he wishes, subject to basic transfer legislation."[15]

There are also many indications that water-market solutions are being taken seriously in the policy studies arena. At a 1987 symposium on water policy, for example, one of the country's water experts stated that "regulatory and pricing measures can be contrasted with what promises to be a more effective approach, namely facilitating voluntary market transfers of water"[16] and another that "the nation is approaching limits of what can be achieved by increasing supply. . . . This means introducing market devices into the equation."[17] Market allocation of surface-water use throughout the nation is clearly an idea whose time has come.

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