John F. Raffensperger

Water Markets in a Stochastic World

To this point, the smart market models have been deterministic, using one estimate of future inflows into the catchment. This chapter explores sources of uncertainty and discusses which of those the market should directly address and which it should not, why the deterministic approach may not calculate the best allocation, and ways to address uncertain inflows explicitly within the market-clearing mechanism using stochastic optimization. We will see that a stochastic optimization will probably be too hard to solve, and could complicate bidding and market clearing. We discuss some alternatives to the stochastic market model.

Water Allocation: The Joint Problem of Interaction and Transaction Cost

This chapter reveals the problem of water allocation as a joint problem of hydrological interaction and externalities. The chapter describes the reason to use markets to allocate water. The chapter explains why most current methods of water allocation have a high transaction cost, and summarizes the problems that need to be solved to improve water allocation.

Examples: Hypothetical and Real

This chapter gives examples, based on hypothetical hydrology data and real hydrology data. The first section describes how marginal cost pricing can help better allocate water. The second section contrasts assignment of water allocation with assignment of environmental impact quota. The third section covers different ways to scale allocations during a drought. The final two sections describe cases for groundwater and one reservoir, and surface water and one reservoir.

The Smart Market Optimization Model

This chapter focuses on the optimization model that is at the heart of the smart market for water, expanding on the model introduced in Sect. 6.6. We first contrast net pool markets with gross pool markets, and the implications of those market designs. The following sections provide market model formulations for specific hydrological cases: a basic reservoir, surface water systems without storage, surface water systems with reservoirs, groundwater systems without surface water intakes, and conjunctive use with groundwater and surface water. We show how the hydrology affects the model, and discuss the market issues specific to each hydrological situation.

Smart Markets for Water Quality, Sediment, and Impervious Cover

This chapter discusses smart markets for water quality, sediment, and impervious cover. The market designs for these resources are similar to the design for a water quantity market. Implementers must work through prerequisites, including setting initial allocations, which may need to be subject to scaling of some kind for revenue neutrality. But the designs differ in important ways from the water market design. Briefly, users cannot precisely know and control their run-off or groundwater recharge quality; they can control only their use of the land. Thus, implementers must design the bid structure to allow users to buy and sell the right to change their land use, not to buy and sell the water resource impact.

Participants in and Components of the Smart Market Institution

This chapter describes the roles of market participants, starting with the market manager. The chapter assumes that the prerequisites, or extra-market considerations, for market implementation are already in place. It discusses the participants’ bids and the bidding process, the market manager’s transaction and allocation database, and the market-clearing model. A section describes the steps in routine operations, and gives additional rules for operations. Later sections describe how hydrological recharge affects the market design, and give an example from Australia of salinity discharge. The final sections discuss the problems that would arise if the private sector were to operate the market, various market structures, and likely questions that implementers would face.

Converting Users’ Rights to Tradable Allocations

This chapter describes the process of converting users’ rights to tradable allocations. The first section discusses the nature of the water rights in the smart market, why initial rights are important, and whether this conversion is privatization. The second section discusses the need for the new license system to be able to manage new entrants. The third and fourth sections discuss the degree of security for the new rights, and make a case against long-term and perpetual licenses within smart markets. The final two sections discuss trading of long-term licenses, and converting disparate existing water quantity rights to smart market allocations.

Prerequisites for Implementation

This chapter describes six prerequisites for a water market. The first five of these prerequisites should be met even if the policymaker does not have the goal of an active market; they are simply good management. First, stakeholders should share trust. Second, the regulator must have a hydrological model that describes the water flows with a level of accuracy acceptable to the community. Third, the regulator must specify the required environmental flows. Fourth, users must meter their water use. Fifth, the regulator must record and manage water rights and use. Sixth, the regulator must grant relevant parties full legal ability to trade, with as few impediments as reasonably possible.

Critical Perspectives on Water Markets

This chapter describes a wide range of comments and objections about water markets generally, and our smart market design specifically. The first section describes our experience in collecting these comments. The remaining sections then group the comments, along with our responses to those comments. The comments included objections to water markets, such as “Pricing and trading water are ethically bad,” and doubts about the feasibility of a smart market systems, such as “The problem cannot be fixed” and “It is more complicated than you think.”

Water Markets: Theory and Practice

The purpose of this chapter is to review some economic fundamentals to market approaches, to point to the extensive literature on markets by water policy analysts, and to examine applications of water markets worldwide.