Issues in Water Rights Markets

6.5.6.1 Types of Water Rights

In the Western United States, water rights have been established under the doctrine of (prior) appropriation, or first in time, first in right, which is codified in the laws of the states of that region. The first right to water from a given source is established by usage, and refers to the annual quantities taken out by that pioneering user. The use must be 'beneficial', in keeping with established criteria, and failure to exercise 'beneficial' use for a defined period of time can lead to loss of the water right. Subsequent rights, or 'junior rights', may also be established, but in the event of a drought the more senior rights have priority in receiving water.121 Informal water rights in developing countries also tend to be of this type.

The system of water rights which has been established for formal water markets in Mexico and Chile differs from the appropriation system. Called the proportional rights system, it confers rights to given shares of a river or other water source. Thus, in the event of unusually dry or wet years, all rights holders perceive reductions or increases in their water entitlements by the same proportion. (This provision for adjustments in quantities is stated formally in Chile and is left to the discretion of the National Water Commission in Mexico.) It has been contended that markets are easier to create for the system of proportional rights, because users have greater certainty of receiving water.122 However, markets function under appropriative rights also, and the price reflects the degree of seniority of the right (i.e. the degree of certainty of obtaining water). The principal advantage of the proportional rights is precisely that they share more equitably the burden of dry years.

Just as there is a role for communal land rights in an economy that recognizes land markets (Chapter 5), there also is a role for communal water rights:

It has been argued that establishment of trad-able property rights in water is somehow antithetical to traditional community values, and inimical to communal management of water.

121. An illuminating discussion of this doctrine and issues surrounding the transfer of water rights in the Western US is found in Allen V. Kneese and F. Lee Brown, The Southwest under Stress: National Reource Development Issues in a Regional Setting, Resources for the Future, Inc., The Johns Hopkins University Press, Baltimore, MD, USA, 1981, Chapter 4.

122. M. W Rosegrant, R. Gazmuri S. and S. N. Yadav, 1995, pp. 210-211.

.. . Tradable property rights can, however, be assigned to communal groups or water-user associations as well as to individuals. Assignment of traditional property rights to communal groups should in fact enhance the control of these groups over water resources, insuring better access to water than is often the case with existing water user groups. Assignment of tradable property rights in water to communal groups may be more cost effective than assigning rights to individuals in instances where internalizing bargaining within the group reduces the information, contractual and enforcement costs relative to pair-wise bargaining by individuals.123

Whatever the form that water rights take, water markets require a system for formally titling and registering those rights, as land titles are registered. Their duration must also be recorded. Thobani recommends that:

The best way to ensure support for the [water markets] law is to assign rights to users, without charge, based on their historic usage. Although this approach may provide a windfall gain to some farmers, it acknowledges that the land price already reflects access to water at low prices and that the government is unlikely to recover directly the capital costs of investment in infrastructure. Because this procedure also rewards users that are taking more than their fair share of water, there may be merit in trying to rectify some of the most egregious wrongs. If the government were to try to use this opportunity to correct all such mistakes or to confiscate all illegally obtained rights, however, chances are good that the legislation will fail and the injustices will continue. .. . New and unallocated water rights should be sold at auction in an open and transparent manner.124

This last recommendation provides another parallel to policies for the land resource. Chapter 5 recommends auctions of title or leasehold to newly opened agricultural areas on State lands.

6.5.6.2 Return Flows and Third-Party Rights

Water rights may be defined as total diversion rights, consumptive use rights or non-consumptive use rights. In the case of irrigation, there always are return flows to the water source (which in some cases is a joint aquifer-surface water system). Consumptive use is that portion of the water which is not returned. Non-consumptive rights are used mainly for the generation of hydroelectric power.

In the case of irrigation, where farmers are entitled to specified gross releases of water from the system, it is vital to define whether the transferable rights are gross or net of return flows. That is, whether they refer to full diversion rights or consumptive use only. For farmers in the same area, growing mainly the same crops with the same kind of on-farm irrigation technology, it may not matter whether they buy the gross or net rights, as long as all transactions are treated in the same way. However, if a municipality or other entity purchases farmers' rights to water and takes the water out of the irrigation system's area, then there may not be a return flow at all, or it may be sharply diminished. This could cause a reduction in availability of water for downstream users, and hence the concern over third-party effects of water transfers that was mentioned in the box on p. 239 on informal markets for water rights.

The portion of irrigation water which represents consumptive use is difficult to measure with precision, for it depends on the nature of a farm's soils (including their slope), the kinds of crops grown, the type of irrigation technology, and climatic factors. Therefore the need to distinguish

123. M. W. Rosegrant and H. P. Binswanger, 1994, p. 1620. The first part of this passage also is found in M. W Rosegrant, R. Gazmuri S. and S. N. Yadav, 1995, p. 217. A number of passages in the first publication are repeated in identical or virtually identical form in the second one, so hereafter reference will be made only to the first one in such cases.

between full diversion rights and consumptive use, in order to protect the access to water of third parties, would seem to place an insuperable barrier in the way of creating water rights markets. Nevertheless, pragmatic solutions have been implemented. One such solution consists of the retention of rights to return flows by the irrigation authority (usually the local irrigation district or the WUA). An explanation of this approach has been presented by Rosegrant and Binswanger:

In most western US states, water rights are based on consumptive use, with protection of third-party rights to return flows. .. . This system protects prior rights to return flows, but significantly increases the transactions costs of water trading, because of the difficulty in measuring consumptive use and return flows. In practice, farmers often must demonstrate fallowing of land to release consumptive water use for sale. In the Northern Colorado Water Conservancy District (NCWCD), however, rights are proportional to streamflow and rights to return flow are retained by the district. Return flows are made available to water users at no charge, but no rights are established to these flows. Changes in patterns of return flows due to trades are therefore not actionable. By defining away third-party rights to return flows, the NCWCD has greatly reduced transactions costs to trades, resulting in a very active water market. .. . Chile and Mexico have in effect followed the NCWCD model by defining rights which are proportional to stream or canal flow. Rights to return flow do not exist. In Chile, return flows to neighboring areas may be used by the recipients without the need to establish a right of use. Use of this water, however, is contingent upon the flow of the main waterways and usage rates of the rights holder. There is no obligation to supply return flows and such flows are thus not permanent. ... If initial water rights can be allocated equitably .. . proportional rights with no rights to return flow should facilitate efficient allocation without compromising equity.125

A second pragmatic solution is to restrict the scope for transfers of water out of agriculture in circumstances in which the effects on return flows could be substantial and could pose problems:

In Chile, there are two important river basins where additional protection to return flows has been employed: the Aconcagua River, in an area with a large proportion of high-valued crops; and the Elqui River, a small but significant river because it is located in a desert zone. . .. The Elqui River Water Users Association has dealt with this problem by limiting trades within upstream areas to farmer-to-farmer transactions (to retain all return flows within the basin), with agriculture-urban transactions authorized only in the downstream area.126

In other words, municipalities basically are limited to using water whose return flows otherwise would go to the sea, for the most part. Further protection of this nature is offered in Mexico and Chile by laws that require approval of the local WUA for each trade and prohibit both transfers that could damage irrigated agriculture and payments of compensation to third parties affected by transfers.127 Appeals may be made in Mexico to the National Water Commission and in Chile to the National Water Authority, and further appeals may be pursued in the court system. However, the vague wording of the protection clause leaves considerable discretion in the hands of the water authorities and raises the risk of politicization of the implementation of the clause.

This second solution, of permitting intersec-toral water trades only for waters in the lower reaches of the river, may be put into practice

125. M. W Rosegrant and H. P. Binswanger, 1994, p. 1619 [emphasis added].

126. M. W Rosegrant, R. Gazmuri S. and S. N. Yadav, 1995, p. 213.

alongside the first one. A third solution consists of developing and applying standardized or average rules of thumb for the arithmetic relation between total water diverted and return flows:

New Mexico uses simpler and less costly procedures than California. The State Engineer's Office determines transferable water quantities utilizing standard formulae together with historical and secondary data. Reliance on standard transferable quantities for specific regions, soils and climates reduces the transactions costs incurred by applicants for hydrologic and engineering experts, saves staff time of water agencies, and creates more certainty in the transfer process. . . . An even simpler procedure would be to create a uniform presumption regarding consumptive use and return flows, which eliminates the need to determine consumptive use on a case-by-case basis. In Wyoming, the statute which authorizes temporary water transfers creates a presumption that 50 percent of diverted water is allocated to return flows, with the remainder considered to be the tradable quantity. Although attempts to rebut the presumption could be made, these would likely be infrequent if the presumption is a reasonable approximation. If, as is likely, a uniform state-wide presumption is not feasible due to different agroclimatic conditions, regional presumptions could be established. .. . An approach worth assessing in practice in river basins where return flows are significant would be a combination of the Elqui and New Mexico methods. . . . the key is to keep the transactions costs low while limiting return flow presumptions to the maximum that are genuinely produced, so as to preserve incentives for conservation and increase the gains from efficient market transfers of water.128

To illustrate this point, suppose that, in a given area, return flows can be reduced to 30% of full diversions by implementing water conservation measures in irrigation, but that the presumption embodied in the regulations is the maximum observed return flow of 50%. Then, a buyer of water who obtains rights to 50 units of consumptive use actually obtains rights to 100 units of full diversion. However, with sound water conservation practices, those rights could be converted into 70 units of consumptive use, thus expanding the irrigation capabilities associated with those rights.

Thobani makes a similar recommendation to use average measures of return flow:

Because of technical difficulties in calculating the return flow component on a case-by-case basis, this approach may not be appropriate for developing countries. But it may be possible to calculate averages that specify the volume of water consumed by a certain crop or activity. In those cases in which return flows are an issue, this published volume would become the limit on the amount that owners could sell to buyers. . .. This procedure would work for both surface water and groundwater. Even though the system has shortcomings, it would be a vast improvement over prohibiting all transfers or having no controls, as is the case with informal water markets.129

These examples and recommendations make it clear that workable solutions to the problem of return flows exist, and also that the most appropriate package of solutions is likely to differ from case to case.

6.5.6.3 Intersectoral Transfers of Water

As the foregoing example of the management of the Elqui River shows, concerns have been raised that the creation of water markets could be injurious to farming by encouraging the sale of water rights for non-agricultural uses, which generally have a higher productivity per unit of water and thus can afford to offer a higher price for the

128. M. W. Rosegrant, R. Gazmuri S. and S. N. Yadav, 1995, pp. 213-214.

In Chile, the benefits of intersectoral water transfers have gone beyond financial compensation to farmers:

For example, the city of La Serena was able to purchase 28 percent of its water rights from neighboring farmers, allowing the government to postpone the construction of a proposed dam. Similarly, the city of Arica, in the arid north, has been able to meet the needs of urban residents by leasing groundwater from farmers. . . . Changes in the structure of water markets create new opportunities for conserving water. When Santiago's municipal water company, EMOS, was notified that it could no longer receive new water rights without charge, the company initially sought to purchase additional water rights. When potential sellers demanded too high a price, EMOS decided instead to rehabilitate its aging pipe structure to reduce water leakages (M. Thobani, 1997, pp. 168169).

water. Mexico and Chile have put in place institutional safeguards against this possibility, in the form of a requirement for prior approvals of sales at different levels, as explained above. The safeguards appear to be effective. 'Chilean irrigators are also generally content with the codification of their traditional water-use rights. And since water-use rights are a tangible asset, which do not currently face a property tax, irrigators benefit from ownership of property rights even when the market for these rights is inactive'.130

The presence of water markets has been shown to foster a shift in agriculture toward higher-value crops, and when that occurs the difference in water productivity between sectors may not be as large as supposed:

One of the most interesting results of this analysis is the relatively modest economic gains from intersectoral [water] trade in the Elqui

Valley. Although the value of water in municipal water supply is high, the value of water to profitable farmers is also high. ... If these farmers are profitable, then the economic gains [i.e. to society] of the reallocation are small, even though the financial gain to the seller is large.131

In light of the Chilean and other experiences, perhaps some of the doubts of the World Bank's Middle East and North Africa Regional Office (quoted above) about the appropriateness of water markets as mechanisms for intersectoral reallocations of water, can be assuaged. It would appear that water markets, appropriately designed and implemented, can indeed be useful channels for such reallocations, provided that appropriate institutional mechanisms for oversight of the trades exist. Usually, it is the watershed, not the sector, that normally constitutes the limiting framework within which water transactions can take place, unless the public sector has independently made the (expensive) decision to invest in infrastructure for interbasin transfers.

However, there has been a successful experience in Spain with the transfer of 4m3/s from the Ebro Delta Irrigation District to the industrial area of Tarragona, some 80 km away and located in a different watershed. Fees paid by industrial users of water are invested in improving the Ebro Delta irrigation network. In Peru, there are water transfers from the Amazon Basin to the arid coastal region, through tunnels in the Andes. Until now, these transfers have not been market driven, but it has been suggested that water fees collected in the coastal area could finance development projects in the poorer Andean region.

6.5.6.4 The Issue of Transaction Costs

A principal concern about markets for water rights is that the transactions would prove to be too cumbersome, i.e. that the transaction costs would be too high. Clearly, there is a tradeoff

131. Ibid.

between transaction costs and protection of third-party rights: the more elaborate the mechanisms of review and approval that are required for trades, in order to ensure that neither other individuals nor the environment suffers, then the higher the transaction costs. There is a general consensus that the procedures for water trades in California are weighted heavily in favor of protection of third-party rights and environmental concerns, and for that reason the water market there is not as active as in other western states of the United States.132 In Mexico and Chile, the procedures for transactions are less burdensome and, accordingly, the market in water rights is more active.

There are 'transaction costs' associated with the reallocation of water in any system (see the box opposite), and they include measures to avoid conflicts and to compensate injured parties in the event of negative third-party effects. Earlier in this chapter, examples are mentioned of farmers going as far as damaging irrigation infrastructure when they feel their water rights have not been respected by administrative allocations. It is not clear that transaction costs, defined in the broad sense, are necessarily higher in water rights markets than under systems of administrative allocation of water.

Hearne and Easter have provided perhaps the only empirical estimate to date of the transaction costs of water trading, for two valleys in Chile. When the those costs are expressed as a share of the transactions price, they are as follows:133

Buyers, Elqui Valley 0.21

Sellers, Elqui Valley 0.02

Buyers, Limari Valley 0.05

Sellers, Limari Valley 0.02

Transaction costs arise whatever the process by which water is allocated. Transaction costs include: the cost of identifying profitable opportunities for transferring water, the costs of negotiating or administratively deciding on the water transfer, the cost of monitoring possible third-party effects and other externalities; the infrastructure cost of actually conveying the water and monitoring the transfers; and the infrastructure and institutional cost of monitoring, mitigating, or eliminating possible third-party effects and externalities (M. W. Rosegrant and H. W. Binswanger, 1994, p. 1617).

In the Limari Valley, these authors comment that transactions are more frequent because of the degree of development of its irrigation infrastructure and the strong organization of its WUAs.134

These transaction costs are not generally high and, more importantly, it is evident they can be reduced by development of appropriate physical and institutional infrastructure. From a policy viewpoint, the issue of transaction costs can be restated. Because any significant reallocation of water implies transaction costs, the more basic question is whether the water policy framework should be designed to permit flexibility in the allocation of this basic resource. In light of the growing scarcity of water, the benefits to farmers of water rights markets as opposed to administrative increases in water prices, and the other considerations presented in this chapter, it seems clear that the answer to this question should be 'yes'. Whether or not water rights markets should be implemented depends on whether their basic

132. 'In California, the transferable portion of the appropriative water right is limited to consumptive use, with protection of third-party rights to return flows. This system protects prior rights to return flows, but. . . significantly increases the transaction costs of water trading. . . . California's system for determining the tradable fraction of appropriative water rights in terms of consumptive use imposes a strong burden of proof on the prospective water seller for determination of how much water is tradable' (from M. W Rosegrant, R. Gazmuri S. and S. N. Yadav, 1995, p. 211).

134. Ibid.

requirements can be satisfied, as discussed later in this section.

6.5.6.5 The Role of Water User Associations in Water Rights Markets

Strong, well-informed water user associations are one of the prerequisites for a successful water rights market. Their role in approving and overseeing trades, and even (in Chile) in owning the irrigation systems, has been noted above (see the discussion in Section 6.5.3). Hearne and Easter concluded their empirical study of water markets in Chile by emphasizing the importance of the role of the WUAs in facilitating reallocations of water via the market, especially in the LimarĂ­ Valley that has an active market in water rights and in the Elqui Valley where intersectoral trading occurs.135

WUAs play a key role in resolving conflicts among water users. The more that such conflicts can be resolved locally, through the mediation of these associations, then the lower are the overall costs of water management. Water user associations are also responsible for undertaking and financing the operation and maintenance of the systems. This responsibility includes collecting fees from their membership. Accordingly, the price of water rights established in markets is not its full opportunity cost but rather the opportunity cost net of O & M costs. If the buyer is not a member of the WUA, then he/she must cover the O & M costs in the new use of the water, as well as the transaction costs.

6.5.6.6 Water Rights Markets and Environmental Protection

Concern about the environmental effects of water rights markets is logical, given that market values largely ignore environmental externalities. Nevertheless, measures to safeguard the environment can be built into the water codes which authorize water rights markets. In Mexico, a water law established norms for protection of the environment by water users. The law's provisions include regulation that requires specification of minimal quality levels for water discharged to non-agricultural users and the National Water Commission has the right to impose controls on water use if there are severe water shortages, environmental damage or drawdown of aquifers.136

In principle, protection of the environment in regard to water use should be no more difficult under a transferable water rights system than under a system of administrative allocations, provided that an appropriate legal framework is in place:

. .. the presence of privately held water-user rights does not necessarily reduce the possibility of proper environmental management of rivers. Water quality regulations need to be established and enforced irrespective of the water allocation system.137

In Chile, the water code is weaker than the Mexican one in regard to environmental protection, although it does require the national water authority to review major projects of water infrastructure for environmental and third-party effects before authorizing them. In other respects, water-related environmental protection is the province of the environmental code.

Experience with the environmental effects of water markets in developing countries is too brief to allow a judgment as to how the various protection measures are functioning. Nevertheless, the case of California is illustrative. That state has placed relatively tight restrictions on trading water rights, as noted above, in order to protect the environment and third-party rights. Notwithstanding this policy orientation, many Californian environmental groups have seen water rights markets as a means of satisfying the increasing demand for water without having recourse to the construction

136. M. W Rosegrant and H. P. Binswanger, 1994, p. 1620.

of new water infrastructure, which they perceive as more injurious to the environment than water transfers.138

This experience in California tentatively suggests that not only can environmental protection be at least as strong under water rights markets as under administrative systems, but in fact it has the potential to be superior. Of course, in practice the result will depend not only on the legislative framework but also on the degree of commitment to environmental protection on the part of national and regional authorities and on the strength of the judiciary. These qualifications apply to any system of water allocation.

6.5.6.7 The Equity Issue for Water Rights Markets

Much as it is feared that land markets will lead to concentration of landholdings in the hands of a few, concerns have been expressed that markets in water rights will lead to semi-monopolistic concentrations of command over water. While concern merits analysis, it should be recognized from the outset that water markets are fundamentally different to land markets in that the former are characterized by much greater community (WUA) control over transactions. While this feature does not completely obviate the concern, it makes it much less likely that sales of water rights would result in large holdings by a few persons. In addition, it should be borne in mind that issuance of the initial water rights, if done in an equitable manner and free of charge, as recommended by the researchers cited in this chapter, endows poor families with a valuable asset. Even if they choose to sell the asset eventually, they will be better off than before the transferable rights were created.

Thobani has argued that water rights markets will help reduce poverty for several reasons:

Secure and tradable water rights reduce poverty in several ways. First, they allow scarce resources to be redeployed for more productive

Barbara van Koppen has observed that the presence of water rights markets can benefit poor rural families by increasing their access to irrigation supplies, which they sometimes are denied by the operation of prevailing local political power structures:

Poor farmers were well served. . . . in private irrigation (as buyers) if competitive private water markets developed, as seen in South Asia, on which poor farmers buy water. These competitive groundwater markets deliver good water services at low prices for millions of assetless smallholders. . . . Implications: Water markets, also those in conjunction with canal irrigation, can be more pro-poor if technology is available that is relatively small, but still provides excess water that the owners cannot use on their own land (B. Van Koppen, 'From Bucket to Basin: Managing River Basins to Alleviate Water Deprivation', International Water Management Institute, Colombo, Sri Lanka, 2000, pp. 10-11).

purposes, thus leading to increased output and employment. This occurred, for example, when farmers in Chile and Mexico sold their water rights to more productive farmers or cities. Second, tradable water rights encourage new investment in activities that require large quantities of water. An investment in a fruit farm is more likely to be attractive if the investor knows that water will not be transferred to a neighboring city in times of scarcity and that additional water can be purchased from farmers during water shortages. In Mexico, investors built a water-bottling plant after negotiating for the water rights from a farmer. Not only was the farmer better off, but the increased investment also generated additional employment.

Third, by empowering user groups to have a say on the issuance or transfer or water rights, secure and tradable rights help protect

138. M. W. Rosegrant, R. Gazmuri S. and S. N. Yadav, 1995, p. 215.

the poor. When water rights are granted without charge by public authorities, it is typically the rich and politically influential who have easier access to them, often at the expense of the poor. Fourth, secure and tradable water rights increase the value of the rights, which are often the most precious assets of poor farmers. In Mexico, many small farmers were able to take advantage of their ability to sell their water rights while still remaining on the land.

Additionally, by making it easier for cities to obtain water, such markets benefit the poor because they are the most likely urban residents to have been excluded from piped service. Chile provides almost universal coverage of piped water in urban areas. . .. Finally, because the transfer of water to higher-value uses occurs without confiscating water from less productive users (farmers) and without having to build new infrastructure, it is cheaper and fairer than alternatives, such as raising water charges substantially.139

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