Multilateral water governance: Prospects for transboundary water banking?

October 21st, 2012

Christos Makridis, Stanford University and North American Center for Transborder Study, United States

Climate change has broad and heterogeneous international consequences. In particular, simultaneous increases in demand for water and declines in water quality are forecasted. Because water exhibits many public good features, the emergence of multilateral policy instruments that optimize both environmental and economic outcomes is necessary.

While the industrial organization and environmental economics literatures are robust, applications in water policy and transboundary governance are scarce. From Milgrom (2011)1 in auction theory to Nordhaus (2007)2 in climate policy, the principles of efficient, mutually beneficial, and socially optimal policies can also be applied in the area of multilateral water governance through transboundary water markets, specifically water banks. To investigate their feasibility and potential costs/benefits, this article considers the conditions and market design elements of a water bank along the Colorado River between the United States and Mexico as an innovative market mechanism for promoting sound water governance.

Water Markets: The Intersection of Economic and Environmental Sustainability

Coase (1960)3 established that bargaining strategies are effective instruments for addressing externalities, except when transaction costs are sufficiently high and/or property rights are not well-defined; these latter criteriaincluding the presence of heterogeneous agents, seasonal and stochastic shocks to water supplies, and non-linearities in demandfrequently characterize water-based transactions.4 For example, during times of drought, adversely affected agencies can lease/buy water from agencies with excess reserves. Absent price signals and a well-defined market, efficient transfers are highly unlikely. Zilberman (2007)5 uses the California experience to demonstrate that, absent markets, there are large disparities in agency water productivity and environmental distress (i.e. droughts) is especially damaging.

To address this, consider a water bank whereby the International Boundary and Water Commission (IBWC) auctions a finite number of water rights, in the form of tradable permits, and defines water quality standards for participating water agencies. Agencies would purchase and/or trade permits over water quantities stored in a centralized bank on the basis of their marginal costs of water production. Initial allowances could be tested through a small scale water bank of 750,000 acre-feet (AF) over non-contentious land; based on its success, the trading scheme could expand by phasing additional water agencies in the same vein as the successful sulfur dioxide (SO2) trading scheme.6 The IBWC would settle disputes, enforce contracts, and address informational asymmetries to ensure efficiency and equity.

A transboundary water bank requires special attention to not only the terms of trade, but also the perception of the terms of trade, among participating agents. Even if forecasts suggest a policy is mutually beneficial, a country may still perceive ill-intent because intentions are frequently mis-communicated and nations have different sovereign objectives, as well as initial conditions that define trade prospects. For instance, although the United States and Mexico signed the 1944 Water Treaty, which partitions water resources between both countries, the legal framework does not address a variety of binational disputes, like recent water seepage along the Rio Grande. Among other reasons, since both nations believe that they have a right to the seepage, cooperation over water resources has come to a near impasse. Creating and encouraging water markets offers a solution to ongoing environmental, economic, and political impasses.

The most challenging component of a water bank with tradable permits is getting the price right. Costs due to spatial heterogeneity (i.e. the cost of production, given physical constraints) are exacerbated by climatic changes with uncertainty in the probability, location, and magnitude of damages. In particular, climatic change will (and is) fundamentally affect(ing) the entire landscape of “marginal damages”; generally accepted water practices are now becoming costly in the face of environmental distress. What was once a luxury is now becoming a necessity: efficient markets that align incentives and properly price marginal costs and benefits. Despite the challenging essence of pricing risk and marginal damagesall in a complex water resource environment with multiple layers of partiesthe application of core principles in market design, such as dynamic pricing and incentive compatibility, provides reason for optimism.

Climate change will cause increased salinity content7 and droughts8 along the Colorado River, among other waterways, with devastating consequences for agricultural and health outcomes. Figure 1 illustrates the expected salinity exceedance levels, in milligrams per liter (mg/l), for three water basins in the Colorado River: Hoover, Parker, and Imperial.

In economic terms, salinity content alone could imply $800 million in direct costs between 2014 and 2030. Using a discount rate of 3%, Figure 2 illustrates the expected costs for each of the water basins.

Equally as important, indirect costs include irreversible environmental degradation and increased poverty, since the most adversely affected communities are agriculture-dependent.

If necessary conditions, articulated by Makridis (2012)9 and Chand et al. (2003)10, for a transboundary water bank are satisfied, it can help create the needed structural reforms to address these economic and environmental concerns. Specifically, Makridis (2012)9 quantifies that net benefits from 2012 to 2030 of a U.S.-Mexico water bank could approximate $38 billion.

Policy Suggestions

There are few instances of truly transboundary water governance schemes, due primarily to the challenges of optimizing long and short-term interests for participants, balancing environmental and economic objectives, and establishing sufficient private incentives that also optimize social welfare.10 Yet, for these policies to become the norm, rather than the exception, water banks should have:

Flexibility: unlike subsidies, water banking can provide flexibility by using permits as a mechanism for defining, maintaining, and pricing property rights over water resources. With incentives to innovate and produce, this flexibility helps minimize the costly effects of stochastic supply shocks.

Price signals: policy uncertainty and non-committal foreign policy create volatility for many countries’ water governance. Pricing and creating a market for water transplants the locus of decision-making from bureaucratic agencies to companies and individual farmers to trade on their own terms.

Decentralization: water trading schemes establish the “rules of the game” and contractual incentives for environmentally and economically sustainable water management, specifically local trading based on marginal production costs. This decentralization is necessary to ensure efficient compliance, according to Nobel Laureate Elinor Ostrom and Agrawal (2001)11, especially since agents will not “go out of their way” for regulatory authorities. Managing international externalities in common pool resources requires the design and implementation of instruments that optimize economic and environmental rents for each agent.

In a similar vein as other research, like Chand et al. (2003)10, tradable water permits are suitable quantity instruments for encouraging multilateral governance. While transboundary water management strategies are politically difficult to implement, requiring the application of market design principles to water systems and recalibrations of existing legal agreements to accommodate needed structural reforms, water banking can help solve today’s international water challenges.

The author of this article was awarded second prize in the 2012 Global Water Forum Emerging Scholars Award. The other finalists’ entries and details regarding the Award can be found here.

References:

1. Milgrom, P. (2011), Critical issues in the practice of market design. Economic Inquiry, 49(2), 311-320.

2. Nordhaus, W. (2007), The “Stern Review” on the Economics of Climate Change. National Bureau of

Economic Research. Available online at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=948654.

3. Coase, R. (1960), The problem of social cost. Journal of Law and Economics, 3(1), 1-44.?[5] Colorado River Basin (CRB) Salinity Control Forum. (2011). Water quality standards for salinity Colorado River System. Available online at: http://www.crb.ca.gov/Salinity/2011/2011%20REVIEW-June%20Draft.pdf.

4. Hanemann, W.M. (2006), The economic conception of water. In: Water Crisis: myth or reality? (Eds.) Rogers, P., Llamas, M., and Martinez-Cortina, L. Taylor & Francis plc.

5. Zilberman, D. (2007), Water marketing in California and the West. International Journal of Public Administration, 26(3), 291-315.

6. Environmental Protection Agency [EPA]. (2009), Acid Rain Program SO2 Allowances Fact Sheet.

Available online at: http://www.epa.gov/airmarkt/trading/factsheet.html.

7. Vineis, P., Chan, Q., and Khan, A. (2011), Climate change impacts on water salinity and health. Journal of Epidemiology and Global Health, 1(1), 5-10.

8. Backus, G., Lowry, T., Warren, D., Ehlen, M., Klise, G., Loose, V., Malczynski, L., Reinert, R., Stamber, K., Tidwell, V., Vargas, V., and Zagonel, A. (2010), Assessing the Near-Term Risk of Climate Uncertainty: Interdependencies among the U.S. States. Albuquerque, NM, and Livermore, CA. Sandia National Laboratories. Available online at: https://cfwebprod.sandia.gov/cfdocs/CCIM/docs/Climate_Risk_Assessment.pdf.

9. Makridis, C. (2012), Do Water Markets Work? Transboundary Cooperation Along the Colorado River. Under Review in International Journal of Public Administration. Available online at: https://people.stanford.edu/cmakridi/.

10. Chand, S., Grafton, Q., and Petersen, E. (2003), Multilateral governance of fisheries: management and cooperation in the Western and Central Pacific tuna fisheries. Marine Resource Economics, 18(4), 329-344.

11. Agrawal, A., and Ostrom, E. (2001), Collective action, property rights, and decentralization in resource

use in India and Nepal. Politics and Society, 29(4), 485-514.

Christos Makridis is a Ph.D. student in the Management Science and Engineering program at Stanford University and a Non-Resident Fellow on State and Local Sustainable Security at the North American Center for Transborder Studies (NACTS). Christos has published in the Undergraduate Economic Review, Michigan Journal of Business, Science Engineering and Ethics, among others. This article is based upon Makridis (2012)9, which was completed through the fellowship of the North American Center for Transborder Studies. Christos can be contacted at cmakridi@stanford.edu.

The views expressed in this article belong to the individual authors and do not represent the views of the Global Water Forum, the UNESCO Chair in Water Economics and Transboundary Water Governance, UNESCO, the Australian National University, or any of the institutions to which the authors are associated. Please see the Global Water Forum terms and conditions here.