Market Design for Surface Water , by Ferguson and Milgrom

 The potential market for surface water is a market in which any transfer of rights involves externalities affecting the water consumption of others.

Market Design for Surface Water  by Billy A. Ferguson & Paul Milgrom, NBER WORKING PAPER 32010, DOI 10.3386/w32010, December 2023

Abstract: Many proposed surface water transfers undergo a series of regulatory reviews designed to mitigate hydrological and economic externalities. While these reviews help limit externalities, they impose substantial transaction costs that also limit trade. To promote a well-functioning market for surface water in California, we describe how a new kind of water right and related regulatory practices can balance the trade-off between externalities and transaction costs, and how a Water Incentive Auction can incentivize a sufficient number of current rights holders to swap their old rights for the new ones. The Water Incentive Auction adapts lessons learned from the US government’s successful Broadcast Incentive Auction.

From the introduction:

"Why is there so little water trading in California despite the heterogeneous uses and huge price differences? The consensus among many economists studying water is that much of the problem lies in an archaic system of property rights, which was perhaps simple and clear enough to function well when California was first settled, but which is dysfunctional today. We will argue below that trading in traditional water rights creates externalities, so efficiency-enhancing changes in water allocations cannot be achieved by exhausting profitable bilateral trades. Rather, it requires a coordinated, multilateral effort. The next section on the Institutional Background provides a description of water rights and the externalities that can result from trade or from certain other decisions about uses. What is most novel in this paper comes after that: we analyze a mechanism that enacts a change in water rights that could lead to much more efficient trade.

Our analysis draws on lessons learned from the US Broadcast Incentive Auction in 2016-17, in which some rights to use radio spectrum for television broadcast were combined, converted, and subdivided into more flexible rights that were better suited for wireless broadband communications. This was accomplished using an auction procedure designed to provide an “incentive” for broadcasters to participate. As in that auction, participation in an analogous Water Rights Incentive Auction could be entirely voluntary, with current water users incentivized to participate because they could trade their existing rights for new, more flexible rights and possibly additional payments as determined by an auction. Just as the Broadcast Incentive Auction achieved its goals described in the National Broadband Plan even though many broadcasters chose not to sell their rights, a Water Incentive Auction could provide the substantial benefits of more flexible water rights even if many water users decline to participate. We describe some details of a possible Water Incentive Auctions in a later section of this paper."