Stopping the Drain: Third-party Responses to California's Water Market

I. WATER MARKETING AND THIRD-PARTY IMPACTS In California, as elsewhere in the American West, the water needs of a growing population were met over much of the past century by investments in large reservoirs and conveyance systems, often with considerable public subsidies (Wahl, 1989). Environmental and financial cost considerations have reduced this option over the past few decades, pushing policymakers to explore a range of alternatives to meet the demands of continued rapid growth. Options include expansion of nontraditional sources of supply (underground storage, recycling, and desalination), conservation, and reallocation through water marketing. In an era when pricing has been advocated as a solution for a wide range of resource allocation issues, water transfers are seen as a means to accommodate the changing patterns of demand while compensating water rights holders--mainly agricultural users--for foregoing their own access on a temporary, long-term, or permanent basis. Not surprisingly, economists have been at the forefront in making the case for water markets and in promoting policies favoring their development (e.g., Hartman and Seastone, 1970; Phelps et al., 1978; Anderson, 1983; Vaux and Howitt, 1984). Nevertheless, a number of scholars have also highlighted the potential pitfalls of a market if it fails to shield "third parties" in the source regions from the negative impacts of trading (Colby, 1995; Howe et al., 1990; Howitt, 1994; National Research Council, 1992; Young, 1986). Although third-party impacts are often lumped together in popular discussions, there are distinct policy issues for different types of water transfers. For water made available through crop idling, which can cause a significant decrease in agricultural activity, the issue is strictly one of equity: some residents in the selling region may suffer economic losses even though the transaction enhances the overall efficiency of resource use. The policy challenge is similar to that arising with trade liberalization, which also enhances welfare in general, but which may necessitate finding effective, low-cost mechanisms to redistribute some of the gains from trade (Howe, 2000; Howitt, 2001). For certain other types of transfers, the third-party problem has both efficiency and equity dimensions. If the legal system governing transfers does not adequately protect the rights of other water users, transacting parties have an incentive to sell more than the optimal amount of water, with adverse physical impacts on other users. From a policy perspective, this is a classic technical externality problem: if the dimensions of the problem are sufficiently large, mechanisms are needed to encourage those who transfer water to internalize the full costs of their actions on the availability of the resource. This article examines the effect of third-party resistance on the development of California's water market. Following more than a decade of legal and administrative reforms to facilitate trading, California's market took off during a prolonged drought in the early 1990s. Predictably, market growth has fueled local resistance in the source regions. In part, objections have been raised to crop idling as a source of water for the market. What makes the California case of special interest, however, is the local reaction to the potential physical effects of the market on groundwater reserves. California's "no-injury" laws for water marketing, intended to prevent unmitigated physical effects of the market on third parties, are more comprehensive than in many other western states. (1) However, these laws technically apply only to surface water (Gould, 1988). Groundwater accounts for as much as 40 percent of statewide supply but falls largely outside of the purview of state regulatory authority (California Department of Water Resources, 1998; Foley-Gannon, 2000). As a consequence, the debate over protecting third parties in California is intimately linked to a wider debate over the appropriate mechanisms for sustainable management of a common pool resource such as groundwater (Ostrom, 1990; Provencher and Burt, 1993). …