C4.02. Water Markets

Amidst of the global reforms towards a freer market-oriented economy, water markets have been advocated as a demand-instrument to cope with water scarcity. However, before diving into its technical details on how it functions and contributes to solve this issue, it is important to understand where it positions itself in the repertoire of water management policies and its differentiated potential in developed and developing countries. This Tool introduces the basics of water trading, discusses how to implement it as a mechanism to reallocate water in cases of scarcity, and provides an overview of the key lessons for water management practitioners and decision makers.

What are Water Markets?

An alternative to reallocate water rights among users is through a market pricing mechanisms (SIWI, 2016), better known as “Water Trading”, defined as “the voluntary buying and selling of water in some quantifiable form; either in the present or future” (Wheeler et al., 2017, 22). Water trading can exist for groundwater and surface water markets. It can take place through informal arrangements between users (e.g., neighbouring farmers) or formal arrangements (water markets governed by standardised rules and processes through governments or communities). Additionally, it is possible to classify water trading into three types (Wheeler and Garrick, 2020):

• Water allocation trade: Short-term or temporary transfers of water that is already allocated and available for immediate use.
• Water leasing: Medium-term leasing of water allocations in a manner that enables a water user to plan secure access to water for a period of time specified in a contract.
• Water entitlement trading: Permanent transfers of water entitlements (property rights), specifying either a proportion or fixed quantity of the available water at a given source.

Justification and Benefits of Water Markets

There are several justifications to use water markets:

• An efficient means of transferring water from lower to higher value uses, or from purposes with a lower to a higher social priority. This is particularly important in serious droughts (e.g., Australia in the 2000s).
• A cheaper way for communities and/or farmers to obtain their water than the alternatives, which may include creating a new source of supply (e.g., a multipurpose dam).
• A cost-effective alternative for public authorities and private users to insure against drought (e.g., water future contracts)
• An option for environmental champions to buy out existing users and preserve the water for habitat or other natural amenities.
• From the perspective of public authorities, it is a way of overcoming the resistance of entrenched property rights holders when dealing with water reallocation, solving corruption issues when allocating water rights, and as a potential source of public revenue (where water rights are held by those authorities).

Experience has shown that water markets have been growing in use. For example, the owners of water rights sell their rights to use water to others, on a seasonal or permanent basis (such markets exist in parts of Australia, Chile and some Western States of the USA). Although farmers are the main players in these markets, some large trades are done by cities to secure water for household use. Water markets are also one strategy used to avoid monopolies in water access or distribution. Public authorities might purchase water for “banking” as a precaution against severe drought, or to release into rivers to preserve minimum environmental flows (e.g., in California and the Murray-Darling Basin of Australia). This may also be done by an NGO or other civil society body, acting as an environmental champion. Other situations include public auctions of water on a daily or weekly basis (e.g., in Spain) and groundwater markets (e.g., in South Asia), where farmers with ground water rights sell surplus water to others.

Designing Water Markets

However, as experts points out, setting a water market is the most complex economic policy option when dealing with water reallocation and the risk of scarcity. It needs strong institutional arrangements (Tools A; Tools B) to make them operate effectively, which most developing countries do not possess (Wheeler et al, 2017). Some of the most relevant preconditions when thinking of adopting a water trading scheme are:

• A clear legal framework permitting holders of water rights to transfer their rights, either temporarily or permanently, to other parties (Tools A2).
• Regulation of the impact of these trades on third parties (e.g. downstream users) and provision for compensation (Tools B1).
• Recognition of the potential environmental impact of trades and the need to invoke relevant safeguards (Tool C1.06).
• The physical means of transferring water between potential users.
• Regulation to avoid monopoly build up is essential.

Apart from the discussion on stringent preconditions (see next subsection), there are conflicting views about using water markets for reallocation of water resources (Garfton et al., 2016), such as:

• It is a means to privatisation of water, as private actors might acquire resources previously held in common and without compensation.
• It is a form of commoditising water in opposition to the idea that water access has been widely accepted as a human right, therefore, it should be considered a public good.
• In a similar vein, water markets might not consider community, environmental or social values, closely related to the discussion about attaching a monetary value to water (UN, 2021).
• There might be a risk that water markets have a negative impact on the environment as they might foster water-intense uses, leading to depletion or higher pollution levels.

However, as Grafton et al. (2016) contend, “economic, social and environmental goals are compatible with water markets, but this demands appropriate property rights, hydrological information, market rules and design”. More important, its design requires a multi-stakeholder approach (private sector, government civil society) to guarantee all views are incorporated and concerns are properly addressed (Tools B3.05).

Methodologies for Developing Water Markets

Based on the experience in implementing water trading schemes, Wheeler at al. (2017) developed a systematic methodology to identify key enablers for water markets adoption.

These authors also developed a conceptual Water Market Readiness Assessment (WMRA) framework relevant to developing countries with low institutional capacity interested in adopting a water trading scheme, which is guided by three methodological steps:

• Step 1 - Background Context: It is a scoping exercise that establishes the context of a proposed market (planning considerations and resource knowledge that allows for a definitive cap or an initial allocation/extraction level). In terms of institutional capacity, it recommends careful consideration of: broad reviews of the status and maturity of water rights; governance and institutional capacity; the current level of infrastructure development and operational rules and; the availability and quality of water data.
• Step 2 - Market evaluation, development and implementation: It considers capacity and assesses the current institutional arrangements that support or impede trading.
• Step 3: Monitoring and continuous review/assessment: It outlines a continual review and assessment of water trading in the pursuit of further gains as experience emerges.

Water Market Experiences & Lessons Learned

There are three emblematic cases of the adoption of water markets in the world:

• Australia: The Murray-Darling Basin experience with water markets is the most publicised case in world, based on the idea of trading water allocations (rights to use water given by an authority). Even though it has served to take most of the relevant lessons in the design an implementation of this market-based instruments, it should be taken with cautious. This region has prior experience during and after the World War II with water trading (Wheeler and Garrick, 2020) and it started creating the institutional arrangements to set up a formal water market in the 80s-decade, that is, it has more than 40 years of conscious work and political commitment to create a sophisticated model of water trading (Grafton el al., 2016; Hanemann and Young, 2020). Nowadays, the discussion has shifted its focus from using markets to solve water reallocation for economic purposes to solve issues related to ensuring environmental flows to protect nature (TNC, 2016).
• Western US: The discussion about the use of water markets in US western states (California, Nevada, Colorado, Arizona, Idaho, Montana, Wyoming, and Texas) has a long legal tradition that can be traced to the nineteenth century, with the adoption of the idea of riparian and appropriative rights to water (private rights to water attached to the ownership of land or mining permits) (Tool A2.01). In this sense, water trading is not a new issue and builds up on historic, economic, and cultural features, and depends on the path of development each state has taken in recent years (Hanemann and Young, 2020). Even though, it does not show the level of centralisation in the design of water trading of Australia, it has been used to solve water urban shortages, agriculture efficiency amid droughts, and environmental protection conflicts. In some cases, sophistication of financial instruments used in water trading, such as water futures contracts, has served as a learning ground for water practitioners around the world (Reuters, 2021).
• Chile: This country is an interesting study case as it created the legal framework for establishing a formal water market in the early 80s marked by a strong sense of treating water as an economic good (Bauer, 2005). The Chilean model has allowed water trading between agriculture and urban areas in the northern region and agricultural water transfers in the central and southern regions (Hearne and Donoso, 2014). Even though it seems attractive to learn from a developing country experience, Chile faced an extraordinary transformation of its economy towards a free-market economic model in the 70s, an enabler which paved the way to adopt a water trading mechanism (Bauer, 2005; 2008).

Besides, active piloting of water markets has taken place in China (Moore, 2014), and South Africa (Matchaya et al, 2019). In general, some lessons from implementation of water markets are:

• There is a need for a mechanism to allocate initial rights (whether for water or pollution discharges), which should be fair, equitable, and effective.
• Trading schemes can be intensive in terms of information and enforcement, hence costly to administer; the high transaction costs of certain markets may outweigh their benefits.
• Markets do not substitute for regulation and monitoring, but they can make such systems more flexible and make pollution control less costly to society.
• Markets can help identify the highest value use and assist in conflict resolution.
• Water auctions may be useful to adjudicate water allocation under competitive conditions but must be regulated to prevent monopoly build-up.
• Markets work best where there are a large number of traders and transactions, so that the risk of build-up of monopolistic market power is minimised.