An important part of a policy reform process is the development of a mechanism that adequately addresses negative impacts of the reform on various sectors (e.g., compensation), or that allows a fair share of the reform benefits (Williamson 1994). Current water entitlements systems are complicated by overlapping (and sometimes conflicting) statutory and customary rights, many of which are not subject to market transfer, or which may be transferable only under certain restrictive circumstances. A tradable water entitlements system is reliant on a non-attenuated property rights structure, with a clear definition of who is entitled to a certain percentage of water resources. It promotes the efficient allocation of water when some water rights are privately held (e.g., irrigation licences) and some are held in common (e.g., environmental water trust). The socially optimum allocation of water may require moving water from current commercial consumptive uses, in particular from irrigation, to increase environmental flows. Not surprisingly, farmers will seek compensation for what they perceive to be a loss of historical property rights. Tan (2002) argues that compensation may not legally binding on the state, but government buying of water property rights for environmental flows effectively compensates current right holders.
Water property rights reform creates an exchange situation that is constrained by transaction costs and formal rights distributed to resources. Since water resource is characterised by interdependent and jointly produced values, it is impossible to completely internalise externalities by property rights alone. Transfer of water entitlements cause third party effects, such as volumetric reliability (i.e., reduce the value of existing entitlements), delivery reliability (i.e., decrease system reliability) and water quality effects (i.e., harm ecosystems). In other words, markets may not maximize the collective outcome in terms of social equity, ecological sustainability and economic efficiency. The introduction of trade in water property rights without charging users the marginal cost of water conveyance and reticulation (including losses) may not necessarily lead to more efficient water use.
Existing water entitlements can be regarded as property rights of sorts in that state legislation backs an entitlement holder's right to the exclusive use of an allocation or diversion of water. However, the emphasis of the existing system is on regulatory and administrative control of entitlements rather than on a market-based system of tradable rights. This is called inflexibility, that is, once a dominant property right begins to emerge it becomes progressively 'locked in' (Arthur 1989). The current practice of issuing licenses for specified terms will continue and the conditions under which licenses can be changed should be carefully defined in legislation. Long-term licenses will be issued where it can be shown that there is little risk to the resource or other users. In other areas, where the risks are higher, licenses will be issued for shorter periods to allow periodic review. Early renewal of licenses will be possible if the license holder wants extra security before investing in new development or offering the license for sale.
The definition of property rights is a contested ground, resulting in a lively debate with little agreement on what a property right might be. In addition, informal institutions change more slowly than formal institutions. As a result, there is always tension between altered formal rules and persisting informal rules (North 1990). Policies shape property rights by intervening in specific parts of the bundle of rights held by the right holder. "Different degrees of policy intervention in private property rights, thus, may require different actions by government, and therefore different levels of political will and capacity depending on the constitutional framework" (Fuchs 2003, p. 91). Water use is comprised of both public interest and private/commercial interests, and government intervention should be confined in the area related to public interest, and not be involved in commercial activities.
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