Tapping Water Markets in California

Drought may force the unthinkable: resorting to property rights and markets.


Pray for Rain

Reed Watson sees a silver lining in California's drought crisis. "Only such an environmental crisis changes the law," says Watson, executive director of the Property Environment Research Center (PERC) in Bozeman, Montana. "Only when a situation gets so severe do people begin to define property rights and turn to markets to solve environmental problems."

Make no mistake: The drought in California is severe. The current shortfall in precipitation has now lasted four years. The snowpack in the Sierra Nevada Mountains that supplies most of California's surface water is just 5 percent of the April 1 average. As an emergency response to the drought, Democratic Gov. Jerry Brown has ordered the State Water Control Board to "impose restrictions to achieve a 25 percent reduction in potable urban water usage through February 28, 2016."

Achieving such steep reductions will be a huge challenge. As it happens, the board reported in April that statewide water use fell by less than 3 percent in February, as compared to the 2013 baseline. To bring the total down more, Brown has empowered the board to "bring enforcement actions against illegal diverters and those engaging in wasteful and unreasonable use of water." Water wasters in some cities could be fined up to $500 for breaking the rules.

"Too little, too late," says Watson. "A predictable byproduct of 20 years of water mismanagement." 

What about transferring water from agricultural uses to thirsty urban areas? After all, 80 percent of water in California not allocated to environmental uses goes to irrigate farms. Some rice farmers in northern California are reportedly considering selling their irrigation water to Los Angeles for $700 per acre-foot. An acre-foot—enough water to cover one acre to a depth of one foot—amounts to just under 326,000 gallons. At $700 per acre-foot, LA would be paying about two-tenths of a cent per gallon for that water.

A drought does not necessarily entail a water shortage. Droughts are caused by nature. Shortages exist when demand exceeds supply and markets are prevented from allocating a resource to its highest value use, usually because the price of the resource is held artificially low. So trades like the proposed water sales from farmers to Los Angeles can help alleviate shortages in drinking, hygienic, pool, and lawn sprinkling water.

Unfortunately, California has failed to develop institutions to handle water scarcity other than political allocation. Consequently, such trades are very hard to pull off. So what to do?

In an interview, Watson provided a preview of an upcoming PERC report titled Tapping Water Markets in California. The report's goal is to offer incremental, politically possible reforms that can be done this legislative session. (In a column last September, I discussed a more radical and longer-term water market reform based on Australia's system of water rights. Although Watson thinks it's a good idea, he believes that it would require a political miracle to get California to adopt so sweeping a scheme.)

Watson is agnostic about transferring water from farms to cities, although he does note, "I personally prefer to look on a landscape of rice paddies rather than the next marginal housing development in Los Angeles." He thinks that farmers have already made significant efforts at conservation and that there are not a lot of additional savings to be found in the agricultural sector. To my suggestion that Americans should get their vegetables from New Jersey, where Gaia regularly provides adequate rainfall, Watson observed that the growing seasons are longer in the Golden State.

Right now lots of water in California is stuck in low-value uses because the bureaucratic transactions costs to arranging water transfers are so high. PERC's plan includes a proposal to let people bank water in underground aquifers. In the current system, holders of water rights must specify to the State Water Control Board when they are going use their water, where they are going to use it, who is going to use it, and for what purpose it is going to be used. If water rights holders fail to put their supplies to a beneficial use, they run the risk of losing their rights to it. Storing water underground for later use—say, during a drought—is not considered a beneficial use by the State Water Control Board. This should be changed. "During wet years, water entrepreneurs could pump and save water and then market it later in dry times," said Watson.

Another PERC proposal is to streamline the very onerous environmental review process that strongly discourages water transfers. Watson notes that a lot of water transfers are repeat transactions, yet each one must be evaluated anew every year, even though the new transaction is the same as the already-approved old transaction.

A third change involves how water transfers are adjudicated. California has special judges who resolve disputes brought under the California Environmental Quality Act. Since would-be plaintiffs know that the judges are experienced in handling this type of litigation, this system tends to discourage frivolous and time-consuming suits. Plaintiff lawyers who want to dispute or disrupt water transfers now have the power to forum-shop, seeking friendly or inexperienced judges to hear their cases. PERC proposes to establish a similar set of water court judges to discourage such shenanigans and to speed up water trading.

PERC's longer-term vision would involve wiping the slate clean of water subsidies and encouraging every interested party to participate in water markets. Watson believes that environmentalists will eventually come to understand that they can compete in water markets too, and that they would be better able to achieve their conservation goals that way than through the political process. Some examples already exist in the state, such as the Scott River Trust in northern California, which leases water from farmers to enhance salmon spawning habitat. 

"If people can't trade water, then they just keep doing the same things that they've been doing," said Watson. "The ultimate goal is to flip the switch on entrepreneurship. If unleashed, entrepreneurs will discover and develop all sorts of new technologies to use and conserve water." Perhaps the current crisis will become sufficiently severe that it forces California policy makers to contemplate the unthinkable: secure property rights and free markets.

Disclosure: I have had a long, friendly and intellectually productive relationship with PERC. I had the honor of being a Julian Simon Fellow at PERC in 2010.