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."

Incentive auctions for water rights

 Here's a press release from Auctionomics, the consulting firm run by Paul Milgrom and his business partner Silvia Console Battilana. They propose to repurpose water rights in a way that may resemble the recent incentive auctions for repurposing radio spectrum.

From Lawsuits to Solutions: Auctionomics Is Harnessing Efficient Market Design and Deep Tech for a Litigation-Free Solution to the Water Crisis by Auctionomics 

"Earlier this year, Paul co-hosted a conference at Stanford University attended by a group of economists, lawyers, and water experts. The group developed a proposal for a novel policy to fix the Colorado River crisis: the U.S. should redefine and buy back existing water rights, just as it did for misallocated rights to radio airwaves.

Auctionomics led the development of the FCC's Broadband Incentive Auction, converting TV licenses to new valuable uses. The current issues with water rights are similar to those of the radio spectrum, where existing rights holders with solid legal standing were hesitant to change the status quo, despite the clear misallocation of resources.

However, Auctionomics successfully addressed the problem with its innovative auction design, facilitating next-generation telecommunications and raising $19.8 billion while safeguarding existing broadcasters.

The Colorado River proposal aims to address deficiencies in the current water rights allocation system. The existing system hinders mutually beneficial trades between users and prohibits water banking - a means to enable farmers or cities manage current water use more efficiently, leaving more in reservoirs for future dry periods.

While there are historical reasons for these limitations - the uses of river water are diverse, interconnected, and poorly measured. Modifying them can result in severe consequences in a system that guarantees inefficiency and overconsumption. However, the same model employed to redistribute broadband spectrum can incentivize water rights holders to use their water more efficiently.

Auctionomics aims to adapt this model to the Colorado River with practical steps involving a hydrological survey, voluntary redefinition of water rights, and purchasing enough new rights from willing sellers to meet the necessary reductions in total consumption."

Blue water, green water and climate change

 Much of the discussion of redesigning the markets for water focus on "blue water," i.e. surface water in rivers and lakes, and runoff from rain, and resulting accumulation in reservoirs, snowpacks, and ground water.

Here's a paper in Nature pointing out that, particularly as climates change, we also have to think of "green water," namely water from evaporation and rain, and how to manage that.

Rockström, Johan, Mariana Mazzucato, Lauren Seaby Andersen, Simon Felix Fahrländer, and Dieter Gerten. "Why we need a new economics of water as a common good." Nature (2023).

"Water managers have always had to deal with natural variability, building larger reservoirs and tapping aquifers to fight scarcity, for example. But current challenges and trends in the rest of this century demand a completely different approach: a radical shake-up in how water is governed, managed and valued, from local to global scales, including a re-evaluation of human water needs (see Supplementary information, Box S1).

"Today, the sector concentrates on flows of ‘blue’ fresh water — liquid that runs off the land and is stored in rivers, lakes, reservoirs and underground aquifers. Utilities capture and extract this water locally for drinking and sanitation, agricultural irrigation and industry.

...

"Managing fresh water on a global scale means going beyond our current fixation on capturing blue water, which constitutes 35% of all fresh water on land, to also encompass green water, which makes up the remaining 65% (see Supplementary information, Fig. S1). Flows of moisture and vapour from land and vegetation are essential for regulating the water cycle and securing future rainfall, as well enabling carbon sequestration in soils and forests.

"Globally, up to half of terrestrial precipitation originates from green water evaporated over land, with the rest from evaporation over the ocean3. Thus, landscape changes can alter water supplies in regions downwind, as well as changing local climates and streamflows. For example, deforestation in the Congo Basin lowers rainfall in neighbouring countries, and even across the Atlantic in the Amazon. Heavy irrigation of crops in India can boost the streamflow of the Yangtze River in China, through moisture transported downwind4.

"By analogy with watersheds on land, researchers refer to ‘precipitationsheds’ and ‘evaporationsheds’ in the atmosphere. Simply put, a precipitationshed is where rain comes from and an evaporationshed is where evaporation goes to. (Here, evaporation refers to total evaporation from the ocean and green water flows from land, including from soil and water bodies, as well as transpiration from vegetation.)"

Paul Milgrom on auctions for water rights

 ZME Science (in Romania) interviews Paul Milgrom about water shortages (in California):

Could auctions help California make better use of its water? This leading economist believes so.  by Mihai Andrei  

"“People get confused when they think about auctions, they think about bidding for a piece of art or something like that,” Milgrom told ZME Science in an interview. “What economists mean when we talk about auction is a process of decentralized resource allocation using prices. It means that we’ve got people who have knowledge about what they need and how valuable things are to them, and we take account of that information to allocate resources specifically, we make bids, and those things are converted to determine prices.”

“If you’re not using an auction you either mean you’re not using prices to guide the resource allocation or you’re not using individual bids. If you don’t use that information, you’re gonna have waste.”

"Waste also means opportunity, and the opportunity Milgrom sees would be transferring water use from those who value it less to those who value it more (and are willing to pay more for it).

...

“In California, less than 5% of water is reallocated, even in the most severe drought,” Milgrom says

“The prices adjust [water gets more expensive], but the reallocation doesn’t adjust even when there is insufficient water. The prices are responsive, but the value of trade isn’t very responsive. So why doesn’t the market work, and what can we do to fix it?”

“It’s not what you expect in a market. What you would expect in a well-functioning market is that the water allocation would increase more to adapt to sending more water into higher value uses and less water into less-value uses. So we’d expect more trading to go on. The fact that it didn’t suggests there’s a problem with the market.”

...

"Designing a large-scale market for water isn’t without precedent. In Australia, a much larger proportion of water is being traded (about 50%); with a roughly similar standard of living, and similar environmental challenges, people in Sydney use about half that amount. But while Australia can serve as an inspiration for California, the same system can’t be replicated exactly.

“We can’t apply the Australian model to California because there are different property rights regimes, the rights are defined differently. They also don’t take into account return flows, which California water law does.”

...

"“I’m cautiously optimistic,” Milgrom says, drawing from his experience with auctioning broadcast spectrum space. “Part of what’s making me optimistic that this is the right time is the progress in measurements and hydrological models.”