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March 15, 1991

Droughts and Water Markets
California and other parts of the West are facing
extreme drought conditions. After four consecutive drought years, water storage is at the lowest
level in recorded history, and despite recent
rains, the prospects for normal water supplies
remain bleak.
In response to the impending shortages, state
agencies and regional water districts have begun
making plans to intensify water conservation and
to restrict use. Agricultural customers of the State
Water Project were told they will be cut off completely this year, while the federal system is
considering 75 percent reductions in deliveries.
The governor, state Water Resources Control
Board (SWRCB), and the individual water
districts all are 'vvorking on plans to limit
In addition to these responses by water
providers, the drought has raised interest in
water markets. A growing number of economists
and business publications have begun exploring
the feasibility and desirability of allowing markets to handle most water allocations. In this
Letter, the case for water markets is examined.
Particularly in drought years, water markets
could reduce the burden of cutting back on
water use for residents of the state.
The current setting
The California water system is complex, in both
physical and regulatory terms. Water is transferred from the northern part of the state to the
central valley farmers and coastal urban areas
through a sophisticated network of dams and
canals. Water generally is allocated according
to historical rights, with the rights often attached
to specific tracts of land. Water rights, however,
are not like rights to most commodities. According to state water law, the state owns the water:
water rights simply give people the right to use
the water, not sell it.

If water districts have surplus water, they can
sell it to other water districts, but only by incurring high transactions costs imposed by current
water policies. The local water district must first

ensure that the holders of junior rights to the water
do not wish to exercise them. Then the SWRCB
must be convinced that the transfer does not
cause adverse environmental or third-party
effects (such as reducing runoff that would
otherwise be used by someone else). Other
agencies, including the state Department of Fish
and Game, the
Bureau of Reclamation, and
the Environmental Protection Agency, also may
place preconditions on the transfer or require
satisfaction as to the potential effects. In general,
therefore, these transactions costs make many
transfers too costly to undertake.


These limits on trading result in prices that do
not signal the value of the water. Prices charged
by the federally managed Central Valley Project
(CVP) are as low as $8 per acre foot to some
farmers in the San Joaquin valley. These prices
are based onthe amortized cost of constructing
the dams in the system. Interest on the construction costs is not charged, however, which means
that these prices do not even cover the cost of
construction, let alone the market value of the
water. In this and other cases, prices do not
reflect the opportunity cost of the water.
Limits on resale of water result in large
inefficiencies. Urban consumers pay upwards
of $200 per acre foot, and growing needs have
forced urban water districts to consider building
desalinization plants that will cost over $2,000
per acre foot-more than 200 times the price
paid by some CVP customers. Instead of selling
water to consumers who are willing to pay
higher prices, existing water policy encourages
farmers to use their full allotments at the low,
subsidized price.
Because of this policy, we find that 40 percent
of the state's water is used to grow rice, alfalfa,
cotton, and pasture, even though these crops
altogether account for only about 0.2 percent
of total state income.
Regulatory response to drought
During periods of drought, policymakers are
forced to set water allocations to accommodate

lower supplies. These allocations inevitably raise
questions about fair distributions of water supplies. Agricultural users are heavily restricted,
and urban users face potential fines for excessive use.
Policymakers attempt to determine restricted
allocations in ways that minimize the burden
on water users. Water to urban users is typically
based on family size, historical use, or other
characteristics that are argued to result in fair
burden-sharing. Agricultural users are cut back
more than urban users, while water used for
long-term crops, such as tree crops or grapes, is
restricted less heavily than those for field crops.
Such allocations, while designed to be as fair as
possible, could be improved by allowing trading.
Trading between customers makes it is possible
for individuals to change the initial allocation
when such changes are mutua! Iy beneficial.

Markets can help
Economic theory suggests that markets provide
a mechanism to achieve these mutually advantageous trades at minimum cost. A water market
would allow consumers to adjust their initial
allocations to compensate for special needs or
capabilities to reduce consumption. Prices offer
a direct measure of the value of water to all potential consumers. In response to rising prices,
consumers who can reduce their consumption
do so-and are compensated by payments from
those who want more than their initial allocation.
Once water users face the true cost of waterthat is, the price others would be willing to pay
for it-they have financial incentives to put water
to its most valuable use. Water priced in deregulated markets gives direct signals to the farmer
about crops to plant and irrigation equipment to
purchase. Moreover, farmers growing low-valued,
water-intensive crops may find it worthwhile to
hold land fallow during drought years and reduce
their water consumption.
For households, water markets would allow
users to weigh the costs and benefits of water
use, adjusting their consumption to match their
specific situations. For example, a 300 gallon per
day limit on all households ignores the fact that
some people, such as apartment dwellers or condominium owners, may use far less, while others,
with expensive landscaping, may wish, at some
price, to protect some of those investments. As

prices rise, households without large watering
needs are encouraged to cut back their consumption to reduce their water bills.

Allowing individuals to trade initial allocations
in markets could improve the fairness of the initial allocation. For example, even with reduced
deliveries, farmers in some areas may find it
more profitable to sell their water allotment to
urban users or to other farmers than to use it on
their own land. Moreover, different farms have
different abilities to reduce consumption, given
the crops they grow and the equipment they
have in place.
Similarly, trading could improve fairness in
urban use. If urban users could voluntarily sell
their water, or buy that of their neighbors, they
could make informed decisions about water use,
including landscaping and water conservation
investments. Factors that lead to differential use
by different households and that are not easily
observed by those setting the initial allocation
could be accounted for by such trading.
In all, allowing trading to occur unambiguously
improves fairness because parties that choose
to trade do so voluntarily. At worst, no trading
would .occur if no mutually advantageous
exchanges can be reached.

Moving in the direction of water markets is not
a trivial exercise. Many issues would have to be
resolved including the establishment of rights,
compensation to potential losers, and developing
institutions to facilitate the transfers. While these
issues are complicated, they can be surmounted.
Fairness is the major stumbling block to creating
a deregulated water market. Because water currently is underpriced, assignment of water rights
that can be sold confers potential windfall gains
to the rights holders. Moreover, those who currently purchase water at below market prices
would face higher prices, which in the case of
agriculture, could result in decreased land
In theory, improved efficiency in ailocation
would yield gains to society that could be used
to compensate those who lost. The government
could impose windfall profits taxes on the new
rights holders, lost value in real estate could be

compensated, and other schemes could be devised to protect those facing potential harm.
Consider one approach where water rights are
granted to the agencies that constructed the
dams, and, at the extreme, existing users lose
their water rights. Because the value of the water
rights iscapitalized in the value of the land, removal of those rights would decrease the value
of that land. This loss can be measured, however,
and the water district granted the ownership right
of the water can be required to use revenues
from water sales to compensate the landowner
for any loss. Unlike most cases, where the harm
to one group from a transfer of rights cannot be
measured, water markets offer direct ways to
measure and compensate for the harm.
Nevertheless, devising compensation schemes
will inevitably be imperfect and may cause transitional problems. Some former rights holders will
be forced to make significant changes in farming
practices, and some areas may fall out of agricultural production. Designing policies to tax
windfall gains and redistribute those revenues
inherently requires controversial judgements.
For the purpose of addressing the drought, this
problem may be less critical. The current pol icy
has defined property rights explicitly through the
granting of quotas. Whether or not that initial
allocation is the best possible allocation, trading
can be allowed to improve well-being from that
starting point.
And a market may not be difficult to establish.
For example, a water district could issue
vouchers to consumers for their entitlement
of water and charge them the normal fee for
that quantity of water. Those vouchers could be
traded by individuals through financial institutions, with the price of the voucher determining
the cost of water. Consumers would have to have
a voucher for each unit of water they consumed,
so as consumption rose, the price of a voucher
would rise, and consumption would be discouraged. Under this scheme, those who use
less water would be net sellers of vouchers,
while those above quota would be net buyers.
Schemes such as this have been used in other
situations successfully, such as in the use of marketable discharge permits, in which potential

polluters buy the right to discharge pollutants
from other participants. As long as consumers
can monitor their use and have price information
provided by a market, they can choose the strategy that minimizes the burden of reduced water
Oil and natural gas industries also provide some
insights into the potential operational feasibility
of a water market. Those industries now are
largely deregulated, and are capable of delivering products from the field to refineries or natural
gas processing plants through a complex web of
pipelines, through the distribution network of the
local utilities or oil suppliers, to final consumers.
Electric utilities routinely sell surplus bulk power
from one region to another, in the process using
transmission lines owned by other utilities. Thus,
the complexity of other, similarly structured
industries has been managed easily in a market
system. Moreover, such markets flourish even
when portions of the system operate as regulated
monopolies, such as pipeline and electric utility
distribution companies.
In the short term, limitations on the system's
interconnection could be important. But in a
deregulated market, interconnecting infrastructure-canals or pipelines-would be expected
to be developed by the private sector where
such investments are warranted.

Addressing water allocation problems becomes
increasingly important during droughts when
water supplies are limited. Most allocation
schemes could benefit from the introduction
of markets to allow trading among individuals.
By doing so, the flexibility and creativity that
individual water users would employ to adjust
consumption can be fully realized.
Over the longer term, deregulated water markets
could offer an automatic mechanism to solve the
allocation problem in the least- cost way. As supplies shrink, prices would rise. And those who
can most easily reduce their consumption will
do so. While implementation will require careful
planning, other industries have provided examples that could prove useful in that design.

Ronald H. Schmidt
Senior Economist

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Judith Goff) or to the author.... Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco 94120. Phone (415) 974-2246.

Research Department

Federal Reserve
Bank of
San Francisco
P.O. Box 7702
San Francisco, CA 94120