March-April 2011

The State of Knowledge

External impacts of water transfers

Tweet

In 2002, Imperial Irrigation District in southern California transferred 300,000 acre-feet of Colorado River water from crops to urban areas. To achieve the water transfer, farmers had to fallow land, which meant fewer jobs in the fields. The resulting unemployment by sector was very high, and as a result farm workers moved away or began to learn new skills to find jobs in other sectors—indeed the unemployment rate in Imperial County was the highest in any county in California (Weiser 2002).

A decade earlier, in 1991, the State Drought Water Bank (SDWB) was initiated in California, to purchase water from willing sellers and provide it to meet critical needs. In Butte basin, in northern California, local water districts were paid to relinquish deliveries out of Oroville Reservoir and substitute groundwater instead. The relinquished water was then transferred to water users away from the watershed. Groundwater pumping steadily increased until 1994, the fourth year of the Drought Water Bank, when groundwater pumping in the Butte basin alone reached over 100,000 acre-feet.

The magnitude and location of pumping reduced groundwater levels to the point that, by July 1994, nearby domestic and agricultural wells were adversely affected. During the summer of 1994, water levels in wells not participating in the SDWB declined such that several domestic wells failed to produce water. Some wells reportedly sustained pump damage, while others had to be deepened (Thomas 2001). Opposition in the local communities grew and eventually gathered enough momentum that it prompted a temporary cessation of pumping and limited it to a lower level.

These are only two examples of the less sanguine side of water markets. Reallocation of water through water marketing has become a mainstay of every discussion on water conservation. Demand for water is growing and supply is not likely to increase by much. Gone is the era of building big reservoirs to capture “new” water and make it available for new farms or homes. The resulting shortages have often sparked conflicts amongst competing users where each side claims to have a higher value of water.

In a world where charging a price for water to reflect its true value is almost impossible, water markets are seen as a promising way to reallocate water to higher-valued uses and give users, both sellers and buyers, strong price-based incentives to conserve water. Experts agree that water markets hold tremendous promise to solve California’s water problems, especially in the face of real political difficulties for altering historic water rights. But despite the promise and potential of water markets to conserve water as the two examples above demonstrate, communities in the area of origin have experienced a range of negative impacts of water sales out of their area. These impacts will have to be addressed if the maximum benefit of water markets is to be tapped.

Another reason this research is important is that, often, there are long-range consequences of some the environmental changes. This is especially so when groundwater is concerned—groundwater, as opposed to surface water, is a “long memory” resource, which means that sometimes it takes years for the effect to become apparent, and equally long, if not longer, to reverse the negative changes brought about by the environmental changes. It is important to stress, however, that the problems that occurred in 1994 likely resulted from the combination of drought history, SDWB pumping, and agricultural pumping practices. Groundwater level monitoring data did not conclusively point to SDWB pumping as a unique source of the problems, and thus pumping was resumed in some wells (Thomas 2001).

It is therefore important that we understand what these impacts are, to ensure that there is no damaging irreversible environmental change. The public is becoming increasingly familiar with water scarcity concerns—even urban populations are feeling the pinch of water shortages due to recent forced conservation measures in the urban areas of California—it is important to educate and inform the public about the true environmental cost of water transfers.

In this article, I present the state of knowledge on these third-party or external impacts of water markets by synthesizing a broad array of studies from myriad sources, peer-reviewed journal articles, newspaper articles, as well as agency reports. I will present data on water transfers in the West, followed by a brief economic view of how to understand and categorize these impacts. I present the view that the existing property rights to surface water and groundwater are often at the heart of these problems. This article is, for the large part, inspired by the California case, although broad references are made to the western US in general.

What do data on water markets tell us?
In a pioneering study, Brewer et al. (2007) report comprehensive data on prices and the extent, nature, and timing of water transfers across 12 western states from 1987–2005. They clarify that the term “water markets” refer to three different types of voluntary transactions: sales of water rights, one-year leases, and multi-year leases. Brewer et al. (2005) were primarily interested in three types of water trades: agriculture-to-agriculture, agriculture-to urban, and urban-to-urban.

They present several important features regarding water markets. Their first finding is that prices are higher for agriculture-to-urban trades relative to within- agriculture trades. The data reveal that the average price for 1 acre-foot of water leased from agriculture to urban uses was $114, much higher compared to the average lease price of $29 per acre-foot of water leased within agricultural sector.

They also find that agriculture is the origin of the majority of transactions. This is a very important, although not entirely surprising, finding. Water is leaving agriculture, partly reflecting the difference in values between agriculture and non-agricultural uses. Hanak (2003) elaborates the California case and reports that in California water demands have been direct or indirect results of environmental regulations. Direct state and federal purchases to support environmental programs have accounted for at least one-third of purchases of water.

Brewer et al. (2005) also measure the volume of water transferred. They find that the annual flow of water traded and the amount of water committed for transfer in a given year through long-term contracts (long-term leases and sales) reveal very different patterns regarding the movement of water. As measured by the amount of water contractually committed in a given year, the volume of water traded in the West is increasing over time, whereas, if measured by the annual flow of water traded, the amount is not rising. Annual flow of water refers to amount of water transferred in the initial year of the transaction, whereas totally committed water includes all transfers that originated in a given year. (I am grateful to Steffen Mehl, for bringing this point to my attention.)

Other findings were that the number of market transactions is increasing over time, primarily due to agriculture-to-urban trades, sales, and that multi-year leases are growing while one-year leases are not. Whether measured as annual flow or committed water, Arizona, California, and Texas are among the top four states in the quantity of water traded. And finally, agriculture-to-urban trades involve the majority of the water moved in most states when using the committed measure, whereas agriculture-to-agriculture trades involve the majority of water in most states when using the annual flow measure.

While studying the detail and impact of water transfers over the past 20 years, it would be useful to keep in mind that the concept of water transfers is not new to the West. For good or ill, 100-plus years of water use has altered the hydrology of virtually all Western watersheds. California has spent the past century building the most elaborate water-delivery system on the planet, replete with giant pumps and thousands of miles of pipes and canals (Hundley Jr. 2001). With 70% of water supplies in the north and 80% of demand in the mid to southern California, the state has built monumental waterworks to move water from the wettest to the driest regions. Indeed, this “replumbing of California” has brought water to the people, allowing the agricultural development and rapid growth of urban centers in the south (Bourne 2010).

But there is a broad consensus among policy makers of all leanings, that the era of solving the water shortage by building another reservoir or transferring water from one watershed to another is over. Today, if an urban area needs more water, it will come at the expense of agriculture or the environment, or other urban users.

This is the era of reallocation-of water. As water is moved around to other uses, it is becoming increasingly apparent that it must be done carefully—without injuring other water users. If change is to occur without squeezing the agricultural sector (or anyone else), then moving water from one use and place to another will, and must, be a slow, careful process. Using more economics terminology, it is extremely important to pay attention to what the cost of water transfer is and who is paying it. The concept of externality helps us organize our thoughts regarding these impacts.

What is an externality?
Externalities, or external impacts, occur because economic agents have effects on third parties that are not reflected in market transactions. These effects are called externalities because they are external to the transaction decision. In the second example noted above, agricultural unemployment was the direct result of Imperial Irrigation District’s decision to lease its water rights and fallow land. The District reduced its purchase of labor and non-labor inputs, thereby affecting how these third parties could—although they were not involved in the decision— lease water.

The dampening of the agricultural economy is one of the most common externalities of water transfers; with the most infamous precedent being that of the Owen valley, which experienced a complete collapse of the agricultural economy and considerable environmental damage when water was purchased by Los Angeles beginning in the 1920s. To illustrate the difference, consider a five-year lease of 1,000 acre-feet per year, beginning in 1990. The annual flow would record 1,000 acre-feet in 1990 only. The committed variable instead would discount the 1,000 acre-feet transacted annually across the five years of the contract at 5% and sum the total. In so doing, 4,329 acre-feet would be recorded for 1990, rather than 1,000 acre-feet (Brewer et al. 2005).

Sometimes, economists distinguish between pecuniary and non-pecuniary externalities. In a “pecuniary externality,” an agent affects other agents by changing market prices. I go to an auction and bid for the objects that are being sold. For the other bidders, my presence will lead (in expectation) to higher prices and, therefore, harms them. This is an example of a pecuniary externality.

The most well-known pecuniary externality in a water market is the incidence of economic losses through crop idling in the area of origin. Government tax revenues may shrink if farmers fallow land or non-profit entities (including municipalities) purchase water rights or secure long-term water leases. Further, rural political influence may be lost when large water transfers are made, populations migrate away, and there is no clear mechanism for compensation. Political opposition to water transfers over these issues can arise even when the actual costs are likely to be fairly small.

If an agent affects other agents by any other effect, economists speak of a “non-pecuniary externality.” I pollute the environment by driving my car. My action harms other people directly, for example, because other people may get ill as a consequence of environmental pollution. Since my action affects other people directly, this is an example of a non-pecuniary externality. The key issue is that non-pecuniary externalities often affect assets that are not bought or sold on the market—therefore, there is no “price signal” that could allow all affected parties to adjust to the changes.

If farmers sell surface water and increase their groundwater withdrawal as a substitute, it may increase pumping costs, cause subsidence, and lower water quality (by salt water intrusion, for example) for other extractors (Glennon 2002). Conversely, a farmer who invests in ditch-lining and similar conservation actions may reduce groundwater recharge to the detriment of other groundwater users (Brewer et al. 2009). But unlike the case of agriculture labor, there is no market for groundwater, so price signals would be fail to appear, and it would be harder to take a corrective action.

Another non-pecuniary externality arises from lost return flows when water is shipped out of the watershed. This effect occurs not only with reduced groundwater recharge, but also when upstream sales diminish downstream surface water. When a party diverts water from a stream, some water will be consumed, but much of it (perhaps 50% or more) will percolate back to the stream for use by others. When the diverted water is sold, however, this return flow may be blocked.

Chang and Griffin (1992) point out that water markets have formed where such effects are small, either due to a limited number of potential third-parties or to a unique geography that makes return flow easy to quantify, track, and measure. Johnson, Gisser, and Werner (1981) argue that restricting transfers to consumptive use will limit these downstream effects.

How should public policy respond to pecuniary versus non-pecuniary externalities? Should there be compensation programs to affected parties?

From a welfare perspective, economists are more concerned with non-pecuniary externalities. The reason is that, if the action affects the market price, as in pecuniary externalities, then there are always winners and losers and the externalities may cancel each other. Not surprisingly, therefore, the AFL-CIO’s San Diego-Imperial Counties Labor Council concluded that the water transfer made in 2001–02 were good for the valley’s workers. They knew that nearly all the jobs available were seasonal fieldwork and losing some would be painful, but money raised by the water transfers—$50 million a year, eventually—could diversify the economy and produce more skilled, permanent jobs. The council had commissioned a study that concludes the water transfers may be “the best economic opportunity the valley had ever seen” (Weiser 2002).

What about non-pecuniary externalities? Are they larger in magnitude and merit a stronger public policy concern?

These non-pecuniary externalities are often very complex, and the full range and magnitude of these externalities is only beginning to be understood. There have been claims that these effects are not that large compared to the overall gains of water markets. But as academics and policy makers try to understand these impacts, local governments have already responded by enacting ordinances to restrict groundwater trades—a move that has successfully retarded water trades in some cases, according to Hanak (2003).

 

Photo: stockPhoto/Solidago Irrigation canal, bordering on Imperial Valley

 

How is water different?
Why do these externalities arise? It turns out that the answer lies in the unique nature of water and the nature of property rights to water. A distinctive physical feature of water is its mobility. Water tends to move around. It flows, it seeps, it evaporates. When water is applied to plants in the field a substantial portion either seeps into the ground or runs off the ground as tailwater. The consequence is that there can be several sequential uses of the same molecule of water since water is rarely consumed fully by a given user and what is left is physically available, in principle, for use by others.

The mobility of water and the opportunity for sequential use and reuse make water relatively distinctive as a commodity—especially compared to land, for which such multiple, sequential uses are impossible (except in nomadic societies). These properties of water have important economic, legal, and social implications. Keeping track of water flows is costly and sometimes difficult. Consequently, it is often hard or impractical to enforce exclusive rights to return flows. In this respect, water is very different as an asset than land, which is relatively easy to divide and fence. The common solution is to resort to some form of collective right of access; in effect, this internalizes the externality associated with the mobility of return flow Hanemann (2006).

The appropriative right, which was developed in the arid West permits the diversion of water, regardless of whether the diverter owns the riparian land, in a fixed quantity, subject to the principle of first in time is first in right. The theory is that, if the streamflow is inadequate to meet all the diversion requirements, those with a more recent (junior) date of initial diversion cede to those with an older (more senior) date. This system fails miserably when there are multiple simultaneous users of water and can claim a right to water due to historic water usage. As a basin develops and most of its water supplies are allocated to consumptive or non-consumptive uses, externalities would arise with every water transfer.

Moreover, in California, there is not a functioning system to record the actual diversions of water, nor to check these against the quantity associated with the water right. Consequently, much of the surface water use by agricultural occurs outside the formal structure of California appropriative water rights law. This can become an impediment to long-run water transfers as the inadequate documentation casts a shadow of doubt on a seller’s specific property right (Hanemann 2006). Water rights to groundwater are another crucial missing link in the chain—I talk about that in the next subsection.

An important feature of the externalities of water transfers which makes their measurement particularly difficult is that there is often a considerable time lag between the transfer decisions and the appearance of the externality. Environmental changes, especially those that are transmitted through groundwater levels or quality, may take years to appear, whereas short-term trade decision may be completed within a year. This mismatch makes it difficult to adjust the transfer decision or compensate parties. Market prices may be less effective when there is a long time lag between the time that a predictable shortage of an essential commodity, such as food, is reflected in a price rise and the time it takes either to increase supply or adapt to the shortage when it occurs (California State Water Resources Control Board 2002). The time lags may be even more significant for the transmission and appearance of non-pecuniary externalities. Thus, at times, market forces can fail to achieve the highest social welfare.

The Missing Link: Property Rights of Groundwater
California has “no injury” laws to protect third parties from damages due to water trades, but these laws largely apply to surface water transfers and groundwater largely falls outside the domain of these water laws. In fact, groundwater in California has largely been unregulated, even though it accounts for as much as 40% of state’s supply of water resources. The absence of complete property rights to water is a missing link in the chain of welfare maximizing water transfers.

In most areas of California, overlying landowners may extract percolating groundwater and put it to beneficial use without approval from the State Board or a court. California does not have a permit process for regulation of groundwater use.

In several basins, however, groundwater use is subject to regulation in accordance with court decrees adjudicating the groundwater rights within the basins (California State Water Resources Control Board). This is a legacy from the old days when groundwater and surface water were considered separate. Surface water was divided up based on prior appropriation and groundwater had a de facto allocation based on right of capture. It now well known that surface water and groundwater are connected, and that the use of one affects the availability of the other. This state of affairs has led some analysts to refer to it as “California’s looming groundwater catastrophe” (Gleick 2009).

Groundwater is typically a common-pool resource i.e., while one entity’s use of groundwater may preclude another’s, it is very difficult to effectively exclude non-right holder from using it. This applies to consumptive as well as non-consumptive uses.

Moreover, if withdrawals exceed recharge, which is the case in many groundwater basins in California, important institutional arrangements need to be made to protect long-term benefits of the resource. For this reason, groundwater therefore often requires complex management requirements—missing in California. The principal consequence of the law of capture of groundwater allocation policy relied on by many states is that potential future uses of groundwater are not taken into account.       

Water transfers that allow for groundwater substitution or groundwater banking, without adequate monitoring of the these impacts, can create several non-pecuniary externalities such as declining groundwater levels caused by changes in traditional pumping patterns resulting in increased groundwater pumping costs and, in extreme cases, the need to drill deeper pumping wells. Also, water quality impacts caused by migration of poor quality water, either laterally or vertically, can require changes in crop selection, groundwater treatment, drilling deeper pumping wells, or alternative sources of supply. Moreover, impacts to wildlife as a result of reduced groundwater or surface water flow to a wetland area. From a technical point of view, it can be difficult to establish that a project will have no significant third-party impacts given the uncertainty of future hydrologic conditions, regulatory requirements, and project operations.

What has been done to address these external impacts?
When groundwater and surface water supplies are hydrologically connected, courts typically have followed the “underground stream” doctrine to interrelate surface water and groundwater rights of use. This means that the wells will be treated as surface water diversions and governed by surface water flow.

For example, Colorado has an elaborate system for integrating surface appropriations and appropriations of subflow and tributary groundwater. Generally, junior groundwater appropriators are expected, through plans of augmentations to compensate the stream for their expected stream depletions effects of well pumping (National Research Council 1997, p.112).

As each water transfer is being developed, the following three factors, set forth in various sections of the Water Code, must be evaluated regardless of the approval process for the water transfer:

1. prevention of injury to other legal users of water;
2. avoidance of unreasonable effects on fish and wildlife; and
3. if water is moved by the SWP or other state, regional, or local public agency, actions needed to avoid the unreasonable effects on the overall economy in the county from which the water is transferred.

Including these actions as part of the water transfer from its initial design, as well as a brief assessment of how the proposed transfer would serve public interests, will assist greatly in making the water transfer succeed (California State Water Resources Control Board 2002).

In California, the Department of Water resources has recognized that the economic and social effects of land idling, in response to water sales to the Drought Bank, are exacerbated when an unusual amount of land is already being idled. Therefore, it has instituted that in order to mitigate the pecuniary effects, the Drought Water Bank would not purchase water via crop idling if more than 20% of recent harvested rice acreage in the county would be idled. Also, the Drought Water Bank would also acquire less water by crop idling when the level of land idling is already larger than historically normal. Therefore, idling less land in a local area when the amount of land idling is already more than historically normal would lessen economic effects (US Department of the Interior Bureau of Reclamation 2009).

A lack of understanding of the hydrologic, geologic, and engineering factors of utilizing aquifers for water supply can create significant barriers to implementing welfare maximizing water transfers. This is the case of groundwater substitution water transfers, as well as in groundwater banking projects. In both cases, a baseline level of technical and economic information is needed as a crucial starting point. States should be encouraged to develop clear and enforceable rights to groundwater where rights are either lacking or absent. A system of clear and enforceable extractive rights to groundwater is prerequisite to economically efficient use of that water. Without such rights users will not have the incentive to value groundwater correctly either now or in the future (National Research Council, p. 125).

Some experts have called for a more widespread use of water transfers that involve groundwater in order to discern the “real world” prices for water, which can be useful to value groundwater. According to this view, water marketing and banking could be important to assign economic values to water which in turn could provide useful information to value groundwater (National Research Council 1997, p.113).

Review processes for transfers that states have established to reduce the externalities of water trades may therefore impede trades. The analysis by Howe, Boggs, and Butler (1990) shows a wide range of transaction costs in nine case studies of water transfers. They find that costs tend to be smaller if: (1) larger amounts are involved; (2) there is less opposition to the transfer; and (3) the water right has a higher priority.

Concluding Thoughts and Recommendations
This article has presented some of the most recent evidence on the nature and extent of water transfer activity, categorized and described the nature of externalities arising from the transfers using economic theory, and outlined why it is necessary to develop programs that these impacts are better understood and addressed. California was the main focus of the discussion presented above.

Although the parties engaged in the transfer remain responsible for the mitigation of externalities, the optimal approach would be to design programs that help in minimize these impacts or eliminate them. The discussion of options for dealing with pecuniary and non-pecuniary externalities needs to take place during the development of a water transfer program. This participation up front will allow local government to help facilitate water transfers that will address local concerns (California State Water Resources Control Board 2002). This would ensure that the benefits from the water transfers are more widely distributed. Calls for groundwater monitoring and measurement have to be heeded which would imply that the law of capture of groundwater has to be limited to renewable supplies.

Water transfers have been effective tools to achieve a balance between supply and demand and to increase total efficiency. But it is important to note that use of water involves an unusually complex mix of price responsive and non-price responsive social values, and, therefore, the externalities may or may not be captured in price changes. In these circumstances, focused regulation and government intervention are necessary to protect social interests that are not price responsive. A lack of understanding of the hydrologic, geologic, and engineering factors of utilizing aquifers for water supply can create significant barriers to implementing welfare maximizing water transfers (National Research Council p. 125). This is the case of groundwater substitution water transfers, as well as in groundwater banking projects. States should be encouraged to develop clear and enforceable rights to groundwater where rights are either lacking or absent. A system of clear and enforceable extractive rights to groundwater is prerequisite to economically efficient use of that water. Without such rights, users will not have the incentive to value groundwater correctly either now, or in the future.                
 

Author's Bio: Anita Chaudhry is Assistant Professor for the Department of Economics at California State University, Chico.