Designing water institutions : market failures and institutional response

To foster economic efficiency, says the author, rights to water resources must be both secure and flexible. Designing institutions to deal with the physical peculiarities of water in a way that establishes sensible incentives and efficient resource use is complicated. Basically, establishing security in water rights requires protecting water users against intrusion by others. This is challenging, since water users are naturally interdependent. Security does not mean that one must be guaranteed an exact amount of water all the time. Rather, it means knowing the probability of water availability and being certain about allocation procedures under changing circumstances. Economic efficiency in water allocation in response to short-term supply changes (such as droughts) requires that economically sensitive sectors take precedence over less sensitive or more adaptive sectors. This can be accomplished through markets or administratively (by government agenciesor private water user groups). In a market scheme, rights must be differentiated according to the probability of receiving water in times of shortage. Those with high-value uses can then either acquire high-probability rights permanently or negotiate an option to be exercised only in drought years. There is less agreement among experts about how to design institutions to provide flexible water allocation in response to long-run changes in demand. Certainly no one interested in economic efficiency would suggest either a complete ban on transfers or completely unrestrained transfers. The difficulty is to ensure that water transactions allow economic development do not impose externalities on other water users. Market mechanisms for water transfer can entail substantial transaction costs, which threaten to delay or stymie transfers altogether. Moreover, third-party and community effects continue to concern those involved in water transfers. Local citizens and officials raise issues about the distribution of economic activity rather than its aggregate level (economic efficiency). Perhaps these issues are negligible when the amount of water transferred is small in proportion to total supply. But when the transfer threatens a community's economic base, these concerns deserve more consideration. Successful water institutions require a delicate interplay between administrative and market control. Institutions establish the basis for markets and can assure competitive conditions. Water agencies will always be involved in allocation, given the economies of scale in centralized water management. The challenge for water professionals is to structure institutions so that they foster sound economic development.