I have distilled my three top questions for new or additional water markets in California. I would oppose any proposition for new market activity until I had answers I liked to these three questions.
- What social goal is the water market trying to achieve? That goal cannot be “have a real good market”. Water markets are tools, among other tools like regulation or planning, that can be used to achieve something. What is that thing for this specific proposed market?
- What is the built-in mechanism that ensures that the market is redistributing a fixed amount of water with economic efficiency, rather than efficiently drawing an open-ended amount of water out of the environment, the ground, and rural communities?
- What is the built-in mechanism for the Kaldor-Hicks compensation? The Kaldor-Hicks criteria says (roughly) that the water reallocation would create so much more value that the winners could compensate the losers (beyond or outside the sale itself). But that never actually happens, so I would want to see a mechanism for that built right into the market.
As an example, I will apply these three questions to a couple different potential water markets.
Example 1: A newly formed Groundwater Sustainability Agency has determined the sustainable yield for the year and wants to allocate that yield among the users in the area the GSA covers. It proposes to do so by water market. I have three questions for them!
Q1. What social goal is the proposed water market trying to achieve?
A1. Our goal is to allocate this year’s sustainable groundwater yield amongst the users in our boundaries. We want to do this the way that gets the most economic value out of that water.
Q2. What are the mechanisms that ensure that the market is only allocating a fixed amount of water?
A2. We used geology and hydrology to tell us how much water could be withdrawn from the groundwater basin this year. After the market allocates that amount of water, we will check well meters, pump electricity bills, and patrol irrigated lands to ensure that only that amount of water is used and there is no additional theft of groundwater.
Q3. What is the mechanism for the Kaldor-Hicks compensation?
A3. All water sales will include fees for paying back the state for repairs of infrastructure damaged by subsidence, for compensating the people who were not able to buy water this year, and for helping injured third parties.
Those are great answers. I am not opposed to this water market, although I would like to see if other tools could generate greater benefits for the state. Now let’s try another example.
Example 2: People really think that California should have a more faster better water market because water markets would fix everything.
Q1. What social goal is this water market trying to achieve?
A1. I suspect it is a combination of getting additional water for urban use and new urban development, prying water lose from senior rights holders without challenging the water rights system, and retiring some ag land because we “shouldn’t” be growing field crops. But no one says those things. I don’t know what the goal is, because the goals people list are usually vague-ass bullshit about sending price signals or improving efficiency. Or hell, being cool, like Australia.
Q2. What are the mechanisms that ensure that the market is only allocating a fixed amount of water?
A2. Right now, proposals for a statewide market are usually paired with calls for “better data” on realtime use. But that measuring and monitoring barely exists now, not even for direct use, much less water sales. It takes a long time to verify that sellers are only selling water they’d have consumed, that they aren’t just backfilling the sale with groundwater or riparian water. There is no effective statewide mechanism for this.
Q3. What is the mechanism for the Kaldor-Hicks compensation?
A3. HAHAHAHHHHAHAHHAAHAhahahahaHAHAhah ha hah ha hah ha. *Sigh* You’re killing me. Rural communities try to get at this by passing Area of Origin laws saying water can’t be sold away, and we try to ensure that third parties aren’t hurt before permitting the sale. But those are the types of things that market advocates want to “streamline” away.
These answers do not give me confidence, so I am opposed to setting loose (more of) an unguided water market in California.
If you are in the path of a proposed water market, you should ask those three questions until you get answers you like in small words. The answers aren’t economic concepts, they are social concepts, so you should understand every inch of the answers. Oppose using market mechanisms until you are satisfied on these points.
On the public record 
Note that we already have water markets in many venues. The CVP and SWP are water markets; you pay your water utility in another version of a water market. The proposals in water markets that are discussed most are for expanded interregional trading. Those kinds of markets have various issues because moving water long distances is cumbersome and expensive with lots of losses along the way. I’ve dismissed the various commentators who advocate for water markets to solve our problem because they don’t know the situation at all. (Chris Thornberg is a good example of someone venturing too far out his realm of expertise.) But that doesn’t mean that water markets aren’t a better solution than what we have now to allocate water across regions.
So I’ll answer your 3 questions for this particular interregional water market, which are generally good ones:
1) The social goal is to move water to a use that generates the highest economic value for society, thus making the whole economy better off. This is the fundamental basis of relying on a market system for resource allocation rather than using central planning or feudalism. Decentralizing decision making to make resource allocations allows economic actors who are best positioned to address their own interests. This is more effective because someone else doesn’t have to guess at their needs and wants. If equity is an issue, that is best addressed outside of the market system, through grants, etc. In most cases, urban water uses produce higher value per gallon of use than agricultural uses for now. That’s changing somewhat (see my blog) but is generally the case still. (The other issues you listed are just impediments and transaction costs, NOT the social objectives of the markets.)
2) The restrictive mechanism will depend on the setting. Within the SWP and CVP, the water contract amounts are clearly specified, so there’s already limits in place. There is a system in place for other water rights for rights holders to challenge each other if they think too much is being diverted. If there are lots of trades, that may trigger an adjudication process. In fact, that may be the best option for triggering such a process.
3) I’ve written about the failure across many government fronts, most particularly in environmental policy, to address compensation in the benefit-cost test. Too often environmental policies have been rammed down various parties throats without the general public paying for the costs that they’ve imposed. On the other hand, there are numerous cases of water agencies compensating for third party impacts. In California, we’ve had at least 3: 1991 and 92 Water Banks, GCID-MWD, PVID-MWD, and IID-SDCWA. For larger trades, this is now standard practice. Only the “know-nothings” are advocating for streamlining these away. That’s a strawman argument. “Unguided” water markets are not going to happen–they’ve mostly had restrictions, and certainly since the early 1990s.
This is a great post, with useful and important questions. I’d answer them in a different order, as I do in my book*
(2) Set aside as much water as “agreed” to serve social ends. This is the water for public/collective goods (the environment, mostly). See chapters 6 & 10 of my book)
(1) Allow markets for remaining water. These markets would be limited by the need to account for buyers and sellers. There’s no need to compensate anyone b/c trades are voluntary. See chapters 1 and 5
(3) There’s no need for K-H compensation if (1) delivers on the public side and (2) does not “steal” from others. I am not a fan of “third party impacts” as a justification for damages (we don’t care about them when a factory closes), BUT I don’t mind social programs for helping poor people afford water, penalties to polluters who destroy public/private water quality, or even a distribution of public goods/extraction taxes from those who use water to citizens. See chapters 4 and 7
* Advertisement: free download here: http://livingwithwaterscarcity.com/
David, generally agree with your points, except one. We are now considering the problem of how factory closings impact communities. This is becoming more important as we become more aware of how our collective governmental decision making, that is intended to benefit the larger society, can lead to targeted negative effects such as factory closings. Perhaps the best know analogy is the closure of a coal mine due to air quality and GHG regulations. We need to consider whether the change in government policy creates a different market outcome. If so, those who had invested contingent on continuation of that government policy should get some form of compensation outside of a market transaction in which they were not a participant. If we don’t give this type of assurance, in the future we will see risk-averse underinvestment in polices society finds desirable, but those targeted may view as risky.
I have to be honest, I still think “efficiency” and “highest and best use” are circular definitions of the social goals of a market as defined by OTPR’s question 1. “Making the whole economy better off” is a social good only to the degree that water is properly measured and understood as an economic development resource- when we know that it is much more than that. It’s a provision of environmental goods, a social binder, a source of subsistence that isn’t denominated in dollars, and much more. Or at least I think so, and so do most water users.
Brian, what are the metrics that you propose for environmental goods and as a social binder? They are easily addressed as constraints on transfers, such as minimum % for environmental flows. I’m not sure how one even defines “social binder” much less measure it. I’ll note that subsistence use in California is truly trivial and can be addressed directly through programs such as well drilling for underserved communities. Unless you can clearly define all of these factors, it sounds like the only objective is to throw up obstacles to transfers by using the “go find me a rock, no, not that rock…” ruse.
My top two are:
Protects about 5 million acres of irrigated agriculture for growing food for direct human consumption.
Minimizes human misery from the changes from climate change until the end of the century.
I agree with Devine, that economists tend to select economic goals that don’t capture much of what humans enjoy or want to have in their lives.
Directing the acreage to be farmed in specific crops is a largely unworkable central planning disaster. Just ask the Soviets. This is where economics excels in allocating resources across the decentralized preferences of millions of people, not just the preference of a single blogger.
As for minimizing human misery, I don’t see how restricting water transfers actually enhances that. There are many other more effective means of accomplishing that task, and it only distracts from working on effective water policy for California to pull that in. (That could be more relevant in areas where subsistence agriculture is actually important.)
… a single blogger who has captured the zeitgeist.
Believing that is the scary part…
BTW, I rant at my friends about what I would do as king, but I don’t make the mistake of writing it down somewhere…
Measurability is circular too! I have heard this so many times- economic theory is the proper discipline to manage water because it’s the only way we can measure it… okay, how do we measure it?… through the convenient tools of economics, of course! How do I fix my TV? With this hammer! Wait, why? Well, we know how it works. And all these other tools seem really complicated.
BTW, I’m not opposed to markets in water at all, if properly implemented. I just think market failure (or market absence) isn’t the proper way to define our water management problems or the proper starting point for a fix. I hope that markets that meet physical and institutional realities will be a part of that fix. I hope that comes across in my longer, non-OTPR-comment writing.
To have a coherent discussion about achieving social goals, the first critical step is to have a complete definition of what we’re concerned about. That’s where metrics come into play. Leaving it to “I’ll know it when I see it” creates a completely subjective environment in which there really is not ability to come to a common understanding. I see “social binder” defined as a cultural element. Introducing without a clear delineation of how it actually works appears to be just a means of vetoing water transfers by local NIMBY groups. This definition need not be in economic terms, but it does need to be in a way that we can discuss how a change affects the issue in question. Too often that is not the case and people who oppose any change take umbrage when one tries to push their lack of definition.
And I’m curious where you propose to start the fix given that we function in a market-based economy (and I strongly believe that the decentralized decision making created in a market economy is critical to maintaining a robust economy–just ask the Soviets.) Fixed uniform standards will be a failure as will be fixed allocations. Markets provide the flexibility required to adapt to individual situations; bureaucratic oversight is pragmatically impossible. I agree that market transactions need to be regulated, but at the core is a market transaction.