Addressing the ‘liquidity’ crisis

Fresh water is a natural resource, self-replenishing via the water cycle but with limited sustainable supply at any one time. Similar to wood in a forest, clean air, fish stock and other common goods, water resources can easily be over-exploited, and society as a whole needs to coordinate to make usage sustainable. Sustainability covers the need to safeguard the supply required for human well-being and for a functioning ecosystem (including the water needs for wildlife and vegetation) – but it can also be defined more broadly to include other requirements such as household supply at affordable prices and recreational use of open waters.

To avoid the tragedy of the commons – depletion through over-exploitation – societies around the world have come up with various forms of ownership and usage rights to regulate who can use how much water from the available sources. These rights range from exclusive ownership of groundwater wells located on private land, over rights to divert the flow of a river, to the permission to dispose waste water into a waterway.

iStock_000012574231Lar_optThe challenge of limiting water usage to levels that are sustainable has found widespread recognition over the last decade. The European Water Framework Directive1 outlined the key issues and set a number of objectives, which are currently implemented in the EU Member States. Where current water usage levels are found to be unsustainable because of the volume of abstraction licences issued in the past, because of climate change or because of increasing population in certain regions, initiatives such as the UK Environmental Agency’s Restoring Sustainable Abstraction programme may be required. Most recently in March 2012, the European Environment Agency published the first of five reports, which together are meant to set out a ‘blueprint to safeguard Europe’s water resources’ by the end of 2012 and support the implementation of the Water Framework Directive by 2015.2

Of course water is not only used for the subsistence of mankind, but also plays an important role in economic activities ranging from agriculture to industry. There are a multitude of competing uses for the potentially ever-decreasing amount of water that is available once the basic needs of society and nature have been satisfied. In the interest of overall welfare this ‘surplus’ water should be put to the best possible use. Thus, methods for allocating the available water efficiently will become increasingly important. The need for such an efficient allocation of this scarce and valuable resource has been widely recognised and discussed, in the UK for example in the Cave Review3 and the Government’s recent Water White Paper.4

There are many ways in which water can be allocated to different uses, for example via public administration, user managed allocation or water trading. The attraction of a well functioning trading scheme is that it reveals information about relative values of different uses of water, which can be used to inform water usage and investment decisions. The value of different uses of water can be compared and weighed against outside options such as the cost of water saving technologies. For example, a farmer’s decision to grow a more profitable, but also more water intensive crop would be based on comparing the cost of the additional water needed with the higher profits that might be achieved, and the farmer would switch to the more water-intensive crop only if higher profits justify the extra cost. Similarly, an industrial firm may decide to invest in a more water-efficient plant if the costs are lower than the gains it could make from selling the water that it no longer needs. Provided that the price of water can be established through competitive trading, individual usage decisions will be economically efficient and maximise overall welfare.

Trading water may involve physically transferring bulk water between parties, for example via a channel or pipeline. This requires an investment in infrastructure, which – given the relative low value per volume of the traded good – severely limits the opportunity for such trades. But if the two parties use water from the same ‘water ecosystem’, they have a much easier and cheaper option: rather than trading water, they can trade codified rights. For example if both parties have access to different points of the same river or aquifer, or access connected water sources within the same catchment area, the buyer may obtain the right to abstract a specific amount of water from this source in return for the seller foregoing its right to extract an equivalent (which is not necessarily the same) amount.

Trading of water rights

Whilst trading of water rights is a cost-efficient way of signalling opportunity costs of water use as it does not require infrastructure for physically transferring water, an efficient trading scheme for water rights has its own requirements and its own costs.

Obviously, water rights need to be defined as transferable licences, rather than being attached to land ownership as they traditionally were and often still are in many countries. This might sound easy, but faces a number of practical complications. Owing to the ecological complexity of the water system, transferring water abstraction rights from one location to another might require a change in the allowable volume of the licence and its covenants. For example, abstraction of water close to the source of a river has a much stronger environmental impact than abstraction further downstream, and is still very different from abstraction from an aquifer. This can make trades complex transactions where one licence may need to be revoked and a potentially rather different licence may need to be issued.

Indeed, such water rights trading is already possible in England and Wales under the existing regulatory regimes. Water rights trading allows users to sell unused rights for others to buy, but abstraction licences are defined to give the licence holder the right to take a specified amount of water from a particular source of supply (e.g. river or groundwater) for a specified purpose (e.g. irrigating crops) and for a specific period of time. This means that a buyer who needs water for a different purpose cannot simply ‘buy’ an existing licence, as the rights may need to be altered in such a way that is not detrimental to the environment. Unsurprisingly, the existing system is perceived by users as complex, time consuming and lacking in transparency.5 Water trading in the USA and Australia often involves a similar process.6

While often unavoidable for ecological reasons, the heterogeneity of water rights, , raises uncertainty and transaction costs for potential traders. In order to reduce the negative effect on licence trading, licences should be standardised to the greatest extent possible, and differences should be made clear to prospective buyers within the sale process. Trading rules ought to be clear and transparent, identifying the types of trade that will and will not be allowed, or where the conditions of the licence will be required to change as part of the trade. By removing uncertainty and complexity from the system we are likely to see more trades taking place. For example, the success of a trading scheme in Colorado, USA stems from clearly and uniformly defined annual allocation of water ‘shares’. Each share relates to a portion of the total amount of water available; this takes account of changes in the weather and water levels in any one year.7 Shares are homogenous, removing any uncertainty surrounding the results of the trade, allowing users with shares to easily rent or sell water on a seasonal basis, or sell shares permanently to any location or town in the project area.

Another strong driver of transaction costs is the lack of information about demand, supply and current market value of licences. If demand and supply are not clearly visible the costs of finding an interested counterparty increase. This is a general problem in ‘thin’ markets, and in order to support effective trade, there has to be a visible market in which information about prices and licence changes realised in recent trades is easily available, and trade volumes and locations of licences being traded are known to participants, as this indicates the market value of water usage to potential buyers and sellers.

One solution would be to develop a central trading platform, similar to the stockbroker platforms run by independent service providers for the trading of shares. A single trading ‘location’ that is easily accessible for interested parties will improve the visibility of the market and increase its ‘liquidity’ by bringing more trading parties together in one place.

The need for larger liquid markets has been acknowledged, for example, in an Australian water trading scheme operating in the Murray-Darling Basin which covers four different states. Until recently each state had developed a market for the temporary trading of water allocations. However, in a bid to increase the flexibility of trading, these regimes are being integrated to allow for a single trading market with the Australian Competition and Consumer Commission developing the trading rules.8

In order to address concerns about speculation and hoarding, additional policies may be required to increase the opportunity cost of holding on to unused licences. For example, a tax may be applied on unused water rights as is currently done in Chile.9 If set at an appropriate level, and alongside other measures such as revocation of licences remaining unused, this approach will discourage rights holders from hoarding.

The presence of a visible market for rights with clear and transparent trading rules to lower perceived transaction costs should encourage rights holders to engage in trade and thus realise the benefits associated with finding the most efficient allocation of water rights.

Going further

While ensuring the optimal use of available water, trading of rights within a catchment or groundwater area will simply re-distribute but not change the total level of abstraction within that area.

In those areas that are already hydrologically linked or can be connected with infrastructure the trading of physical bulk water provides a further alternative to the purchase of water rights, but there are relatively few such links in place in England and Wales at present.

The presence of an effective trading regime in neighbouring catchment areas and regions could reveal differences in the value of water in each area, which will allow for an assessment of whether the physical transfer of water and the associated capital expenditure is a cost efficient option. What matters in this context if of course not short-term fluctuations, but long-term trends, given that infrastructure investment would be costly and long-lived. However, if the demand and supply of water become increasingly polarised across regions in the future, trades between those areas may become an important complement to water rights trading within the regions. A region with surplus water could sell water to a region with water scarcity if the price it can achieve covers infrastructure and transport costs, and is lower than the investment that would be required to develop new resources, efficiency measures and treatment facilities in the region with scarcity.

The combination of intra-regional trade of water rights and inter-regional trade of physical water would facilitate the realisation of the full potential benefits from ‘water trading’. The trade within regions would provide a market price for water in each region, which could provide scarcity information to inform intra-regional trade. Water users will be able to consider the relative costs of efficiency measures, capital investment, buying water rights within a region or buying and transferring water from another region and make informed and efficient decisions regarding their water usage.

Conclusion

Wider reform of the abstraction regime and policies to encourage reduction in demand will play a large role in addressing the increasing shortage of water in particular regions (e.g. the densely populated and relatively dry South-East of the United Kingdom). The role of water trading is complementary to that of abstraction reforms, as reductions in the level of water available for abstraction mean that methods used for allocating water efficiently will become increasingly important in order to ensure that not a drop is wasted.

In the absence of a transparent water trading scheme capable of revealing a ‘true’ value for water and promoting efficient use, abstraction and investment decisions will remain distorted. Lacking information about the economic value of water at different locations, and scarcity across different areas, stakeholders and water abstractors will find it increasingly difficult to compare private, social and environmental benefits of alternative options for managing water supply. A better understanding of the value of water, and differences in value across locations, potential uses and over time would support better decisions about where and how to develop the water supply system.

 

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Footnotes

  1. Water Framework Directive, 2000, “Directive 2000/60/EC of the European Parliament and of the Council establishing a framework for the Community action in the field of water policy”. []
  2. European Environment Agency, 2012, EEA Report No 1/2012, “Towards efficient use of water resources in Europe”. []
  3. Professor Martin Cave, 2009, “Independent Review of Competition and Innovation in Water Markets: Final Report”. []
  4. HM Government, 2011, Water White Paper, ‘Water for Life’, Cm 8230. []
  5. Synovate UK for Ofwat and the Environmental Agency, 2008, “Exploring views on the potential for more active water rights trading”. []
  6. Food and Agriculture Organisation of the United Nations, 2006, FAO Legislative Study, Vol. 92, “Modern Water Rights – Theory and Practice”, Chapter 9.1, page 73ff. []
  7. Ofwat, 2010, “Valuing Water – How upstream markets could deliver for consumers and the environment”. []
  8. Ofwat, 2010, “Valuing Water – How upstream markets could deliver for consumers and the environment”. []
  9. Reuters Factbox, “Water trading schemes around the world”. []

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