An economic incentives model for California water markets

Funding Year: 2005

Research Areas: Freshwater

Regions: North America

Researchers are developing an economic model that allows qualitative insights as to the key drivers of participation in water markets, or, alternatively, long-term contractual exchange agreements. They are applying tools from finance, economics, and operations management to derive actionable conclusions from the model. The application of these tools is informed by the institutional and legal context specific to water rights in the state, as well as an understanding of the technological constraints.

Public intermediaries responsible for the management of uncertain water supply and demand face a number of decision problems. These include decisions with regard to water procurement and storage, capacity expansion, general operations, investment in demand side management programs, and pricing, among others.

To accommodate cyclical droughts, demand shocks for end products such as crops, as well as the states long-term water demand growth, a water market has incrementally developed in California since the mid 19805. The existing California water market, with a current annual volume of about two billion cubic meters of water (valued in the $100Ms), has arguably been successful in helping meet current demand (Hanak, 2002). However, despite predictions to the contrary by early economic models and surveys by the Department of Water Resources, the total activity in the market remains low, accounting for only approximately three percent of the states total water budget (Haddad, 2000). Given the importance of the water market as a tool for meeting Californias future water needs, there is a great need to improve our understanding of the incentives of current and potential market participants, in order to derive actionable recommendations for the future direction of development and role of the water market in the state.

Unlike most other water markets in the U.S., trades in the California market are predominantly for water (for short-term use) not water rights (for long-term use). Another innovative component of the California water market is the approach to environmental protection by including environmental players such as the Environmental Water Account (EWA), whose main purposes is the acquisition of water for environmental protection. Such innovations make the California water market an excellent test case for understanding the future potential of water markets to efficiently allocate water resources and, concurrently, meet environmental goals, including both environmental protection and restoration.

This EVP will investigate market participants incentives to form an understanding of the likely benefits and costs to the different stakeholders resulting from changes to the status quo. Researchers will develop an economic model that allows qualitative insights into the key drivers of participation in water markets, or, alternatively, long-term contractual exchange agreements. Researchers will apply tools from finance, economics, and operations management to derive actionable conclusions from this model.

The projects findings will further understanding of l) current and future California water transfers,2) the potential direction of the development of the California Water market and its role in meeting the states future water needs, and 3) mechanisms for facilitating transfers in the Water market. By developing an incentive model, we will provide insight into important questions regarding the direction of development of California water markets.

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Principal Investigators:

Thomas Weber

David Freyberg, Associate Professor of Civil and Environmental Engineering and Senior Fellow at the Woods Institute for the Environment

James Sweeney, Professor of Management Science & Engineering, Senior Fellow at the Stanford Institute for Economic Policy Research and, by courtesy, at the Hoover Institution

Barton Thompson, Robert E. Paradise Professor in Natural Resources Law and Senior Fellow at the Woods Institute for the Environment