76628
Formal and Informal Markets
for Water: Institutions,
Performance, and Constraints
K. William Easter • Mark W. Rosegrant • Ariel Dinar
Water markets—either formal or informal—can be an efficient methodfor reallocating
scarce water supplies. At the same time certain constraints can raise the transaction costs of
trading water. This paper reviews the conditions necessary to establish successful water
markets, identifies potential problems, and offers mitigating strategies. It also uses ex-
amples of several informal and formal water markets already in operation to illustrate
these problems and the solutions to them.
One response to growing demands for limited supplies of water is to reallocate avail-
able supplies through water marketing strategies. Although marketing is not a new
concept, what is new is the growing recognition that the policy of developing new
water supplies to meet future needs is no longer viable. Thus government officials
are more open than ever before to new ideas for improving water management. In
this context estimates of the economic benefits from trading water within and among
sectors illustrate the potential for relatively substantial gains from trade (Vaux and
Howitt 1984; Colby 1990; Chang and Griffin 1992; Weinberg, Kling, and Wilen
1993; Rosegrant and Binswanger 1994; Hearne and Easter 1997; Thobani 1997;
Diao and Roe 1998). As a result countries such as Mexico have taken the plunge and
adopted water use rights and water trading strategies as part of their new policy for
managing water resources. Others, such as Peru and Pakistan, are considering or
have considered implementing such programs (World Bank 1995, 1997).
This article proposes that countries facing water shortages under their current
water pricing systems consider water marketing as a way to reallocate water resources.
We illustrate the importance of understanding a country's institutional framework
before embarking on a comprehensive overhaul of water policies and review the
conditions required for effective water markets. Recent studies of formal and infor-
The World Bank Research Observer, vol. 14. no. I (February 1999), pp. 99-116
© 1999 The International Bank for Reconstruction and Development / THE WORLD BANK »9
mal markets highlight the gains from the efficient allocation of water as well as the
constraints that raise the transaction costs of trading water. As we point out, water
markets can provide the appropriate economic incentives to improve the efficiency
of water use and encourage the reallocation of water to higher-valued uses without
encountering the traditional opposition of existing water users.
The Institutional Setting
If a country has little experience with private markets for allocating scarce goods and
services, water is unlikely to be one of the first goods exposed to private market
forces. In contrast, in a country that is exploring new ways to use the private market
to improve the allocation of publicly managed resources, scarce water may be a good
candidate for market trading, depending on one's view of the requirements for mar-
ket exchanges.
There are two distinctly different opinions about the institutional setting required
for efficient market exchanges: The neoclassical view posits that a legal system is
required; a more pragmatic view emphasizes the importance of informal contract
enforcement. Greif (1997:239-40), for example, observes:
This neoclassical view that places the legal system at the center of contract
enforcement in market economies has recently been criticized on the basis
of evidence indicating that many contemporary exchange relations in the
West and elsewhere are informal. The associated contract enforceability is
not provided by the legal system but is based on reputation, general morality,
and personal trust within social networks. Empirical evidence indicates the
importance of two distinct systems of informal contract enforcement: the
individualistic system of informal contracts enforcement prevalent in the
West, under which the reputation and morality of the individuals are key,
and the collectivist system of contract enforcement prevalent in most other
societies, under which personal trust within the social network is critical.
Cooter (1997) comes to a similar conclusion in reviewing the problem of con-
tracting and establishing a rule of law that is consistent with a country's social norms.
At least in the case of markets for irrigation water, both the formal neoclassical
legal system and the informal system appear to be at work. The transfer of perma-
nent water rights seems to require the certainty that is provided by a legally based
approach in which water rights are recorded and can be defended in court. Water
transfers among districts are likely to change the amount of water that is returned to
streams and rivers, called the return flow, and a formal market may be required to
prevent losses of return flows to downstream users. If, however, the sales are tempo-
rary, that is, for one season or less, and do not affect return flows, informal markets
1OO The World Bank Research Observer, vol. 14, no. 1 (February 1999)
based on informal water rights can suffice. These informal sales will likely be among
farmers in the same water district and in many cases among farmers served by the
same canal. In addition, these sales are not likely to be anonymous, and enforcement
of the contracts will not be provided by the legal system but rather will be based on
reputation and personal trust. This suggests that to obtain more interdistrict or
interjurisdictional water trades, a country will have to develop legal water rights that
can be verified and defended in court at a reasonable cost.
Informal water markets work fairly well for groundwater as long as recharge to
streams is adequate and the market has a sufficient number of sellers (Palanisami and
Easter 1991; Shah 1993; Saleth 1998). The "tit for tat" game-theory enforcement
strategy appears to work; if farmers do not pay, their future supplies will be cut, and
if a seller does not deliver, the buyer can use another supplier. In one area of Gujarat,
India, farmers have pipelines from three or four different suppliers coming to their
fields (Shah 1993), and they can buy from the supplier who offers the best price and
service. Shah found that "while the main beneficiaries of private investments in pipe-
lines have been the buyers of water, early operators in the water business were moti-
vated mainly by the desire to establish monopoly positions and to overcome topo-
graphical constraints in supplying water to a large command" (pp. 61—62). In other
words, although sellers are motivated by profits to sell water, the buyers may be the
big beneficiaries.
If a country decides to establish a formal water market, the community of users
needs to support the concept as fair and beneficial. Thus the law must be written so
that the resulting allocation of rights is equitable. If the economic rents from water
trading are concentrated in the hands of a few individuals or the negative effects on
third-party users are large and unmitigated, the community is not likely to obey the
law. Cooter (1997:214) notes that "a modern economy needs effective laws to pro-
mote cooperation among people. Yet, states enact many laws that few people obey.
People tend to disobey, or obey out of fear, laws that are not consistent with social
norms and to obey laws that reflect social norms." In Pakistan, for example, farmers
tend to disobey the law against trading canal water. In contrast, the 1981 Chilean
water law that establishes private water use rights is widely obeyed because Chile not
only has a long record of private water development but also allocates water rights
based on past use (Hearne 1998b).
Conditions for Effective Water Markets
Thus effective formal markets are dependent on some basic institutional and organi-
zational arrangements to overcome a number of potential market constraints and to
prevent other associated problems from developing (see Garrido 1998a:tables 1 and
2). For example, tradable water rights or water use rights need to be separated from
K. William Easter, Mark W. Rosegrant, and Ariel Dinar 101
land rights. In many cases, institutional arrangements will also be needed to deal
with third-party effects that result from changes in return flows or declining eco-
nomic activity in the region in which water sales originate. Adequate management
and infrastructure will be needed for trades that are not in the immediate vicinity,
such as trades between users on different canals. Countries must consider establish-
ing mechanisms to prevent monopoly control over water and to avoid the
overexploitation of groundwater. In both cases, however, these problems can be dealt
with through the manner in which water rights are designed, quantified, allocated,
monitored, and enforced (box 1). How to do this effectively for groundwater is a
particularly vexing problem in many developing and industrial countries.
Box 1. Constraints on Effective Trades in Unregulated Water Markets
Potential problem1 Frequency Mitigating strategy
Third-party effects from a decline 1. Require review and approval of transactions
in output and employment in the by public agency.
water exporting area (1, 2, 3, 6, 2. Establish a fund to compensate third parties
7) damaged in trading, financed by levies on
Reduction or changes in return water transactions.
flows along with any changes in 3. Limit trades to a percentage of water rights
water quality (1, 3, 4, 6, 8, 9) in a given area or community.
Added incentive to overdraft open- 4. Revise water rights downward.
access groundwater stocks, 5. Grant water rights to those using return flows.
damage the aquifer, and increase 6. Limit trading outside the river basin or
pumping costs (3, 4, 10, 12, 13, sector to consumptive water use.
14) 7. Open litigation to nonholders of water rights.
Increased costs of irrigation system 8. Tax or ban trading from upstream to
for the remaining farmers (3, 10) downstream users.
Drop in land values (3, 11) 9. Set minimum instream flows to maintain
Market power for large-scale buyers aquatic ecosystems.
or sellers (1,3, 15, 16) 10. Require buyers to pay a fee for the costs
imposed on the irrigation system from
which water is transferred.
11. Require lending agency to clear permanent
water sales.
12. Adjudicate groundwater rights.
13. Tax groundwater sales based on their
scarcity value.
14. Limit trading in areas with rapidly declining
groundwater stocks.
15. Provide for regulation of monopolies or
expand supply options.
16. Aid small rights holders with legal fees and
registration.
a. Numbers in parentheses refer to appropriate mitigating strategies.
b. I, infrequent; F, frequent.
102 The World Bank Research Observer, vol. 14, no. 1 (February 1999)
In many cases, governments will also need to reserve or buy some of the water
rights to preserve instream uses that have strong "public good" characteristics, such
as recreation, fish production, and the preservation of aquatic environments.1 As
Howe (1998) points out, preservation has become a growing concern in the western
United States as the demand for recreation and environmental services has grown.
California has even reallocated water from irrigation to improve instream flows into
the San Joaquin-Sacramento delta that will help preserve aquatic environments in
the delta (Archibald and Renwick 1998; Howitt 1998).
Adequate information concerning water supplies and demands is a basic require-
ment for the efficient operation of markets. In Chile, for example, water user associa-
tions were essential in providing such information (Hearne 1998b). The central gov-
ernment generally has a comparative advantage in obtaining water supply data,
although the users are better able to determine their own demand. User associations
with access to such data can be important conduits for information. Asymmetric
information is much less of a problem for water markets with strong user associa-
tions, but farmers may withhold information about their willingness to buy or sell
water in order to obtain more favorable prices.
Informal water markets may be a good alternative, particularly if water allocation
at the local level is a problem and the transaction costs of establishing formal markets
are high (meaning the costs of enacting legislation, establishing institutional and
organizational arrangements for markets, implementing trade arrangements, and
monitoring and enforcing trades). Besides allowing water to be sold to the most
productive farmers, informal markets would give all farmers an incentive to use their
water more efficiently.
Gains From Water Markets and Organizational Constraints
The informal water markets that have evolved suggest that water users will buy and
sell water even if such transactions are illegal or discouraged by governments (Renfro
and Sparling 1986; Shah 1993). Problems arise when governments are asked to help
develop formal markets or allow informal markets to develop, particularly within
government-constructed irrigation projects. Because these are subsidized projects,
many government officials maintain that the users should not be able to sell the
water at a profit and that poor farmers will be disadvantaged because they will lose
access to the water unless they pay higher prices. (Both Meinzen-Dick 1998 and
Saleth 1998 dispute this claim, however.) Thus, even though water markets can
change the incentives for water users and improve allocation, organizational con-
straints may prevent their introduction (box 2).
One prerequisite for water marketing is some type of water or use right that can be
bought or sold separately from ownership of the land. Such rights may be difficult to
establish and are likely to be resisted by public water agencies that fear they will lose a
K. William Easter, Mark W. Rosegrant, and Ariel Dinar 103
Box 2 . Constraints That Raise Transaction Costs in Unregulated Markets
Potential problem' Frequency Mitigating strategy
Incomplete or poorly defined water w 1. Register and secure water rights.
rights that are not separate from land 2. Use proxies of water use (land area and use)
(1,2,8,10) to define water rights.
Inadequate infrastructure, including F 3. Invest in infrastructure.
conveyance and storage systems (3) 4. Provide management training for irrigation
Inadequate water management, lack of F agencies.
water user associations (WUAS), or 5. Provide water users incentives to organize WUAs.
both (4, 5) 6. Carry out education program explaining the
Imperfect or asymmetric information I benefits of water markets.
about trading (5, 9, 10) 7. Tax unused water rights
The granting of more water rights than I 8. Keep up-to-date single basinwide water
warranted by existing supplies (11, rights registries.
12, 13) 9. Use public agencies or WAUs as clearing-
Sleeper or inactive water rights that I houses for trades.
might be sold and activated by water 10. Aid small water rights holders with free legal
markets (7) protection and information.
Inappropriate initial allocation of water F 11. Encourage spot and option markets for
rights that causes conflicts among water.
water users (14) 12. Revise all water rights downward.
Reallocation by government agencies of F 13. Define two types of rights with one senior to
water among and within sectors the other.
without compensating original users 14. Base allocation of water rights on past use
(1,4,16) and conduct an auction for any surplus.
Opposition from farmers and environ- F 15. Use part of the water traded to enhance
mental groups (6, 10, 15; also stream flows.
strategies 3, 6, 7, 8, 9, 10, 15 from 16. Base water rights on shares of the water
box 1) supply rather than on absolute volumes.
a. Numbers in parentheses refer to appropriate initigating strategies.
b. I, infrequent; F, frequent; W, widespread.
great deal of power if they allocate water rights to users. Giving users water rights
means that system operators (the government officials) have the responsibility to de-
liver water more or less when die users want it. In contrast, a government agency that
retains the water rights can dictate die conditions under which farmers will receive
water, including (in some cases) die necessary side payments. Making die water rights
tradable creates an even greater dilemma for government agencies. To prevent loss of
control over tradable water rights, the National Water Commission in Mexico and
some of die water districts in die western United States limit trading among water
districts. In Mexico a water user must obtain special government approval to sell water
outside the district or jurisdiction, and any profits from die sale must accrue to the
district and not to die seller. This regulation discourages interdistrict trading, but it
also reduces the chance diat trades will have deleterious third-party effects.
1O4 The World Bank Research Observer, vol. 14, no. 1 (February 1999)
Even if the users set up and hire the management unit that allocates water, the
unit may have an incentive to use monopolistic power and discourage water trades
with other jurisdictions. If too much water is transferred out of the district, the
resulting shortage may reduce economic activity and make the irrigation system—or
parts of the system—difficult to operate effectively. Once most of the farmers along
a canal have sold their water, the few remaining farmers who own water rights on the
canal may be difficult and expensive to serve. Thus, although water markets may
change user incentives and encourage efficiency, the management of the system may
prevent trades or raise the transaction costs of interdistrict or interjurisdictional trades.
Cooter (1997) argues that an organization seeking to maximize the wealth of its
members will behave monopolistically toward outsiders but efficiently toward insid-
ers. By fixing prices, establishing jurisdictional territories, and withholding informa-
tion from the public, the organization will seek to create monopoly power for its
members in dealing with nonmembers. These motivations may affect water user
organizations and other water entities that can use their infrastructure as a monopo-
listic tool to block trades to outsiders. Water user organizations can either say that
their canals are used to capacity or charge such high transmission fees that the trades
become unprofitable.
The organizational problem appears to involve two important aspects: the resis-
tance to trading water between or among districts or jurisdictions, and the problem
of establishing water rights and giving the users more control. Other problems that
raise transaction costs include legal challenges by third parties claiming they might
be damaged by a transfer, the lack of sufficient infrastructure to transfer water among
potential buyers, and the lack of an effective means for verifying and enforcing water
rights. The question is whether taking action to reduce these transaction costs is in
the best interests of a country. If the answer is even a tentative "yes," then the second
question is how to lower these costs.
Potential Problems and Mitigating Strategies
Clearly, one should not go to the expense of establishing water markets if water is not
scarce or likely to become scarce in the foreseeable future. In Chile, for example,
where water markets have been encouraged, there is no trading in the southern re-
gion because water is not scarce in that area. Water markets will be active only in
regions where water is scarce.
Formal water markets are less likely to develop if they are constrained by the high
cost of institutional development and by the absence of the management and infra-
structure needed to implement trades. In areas where it is costly to establish, allocate,
and enforce water rights, markets will be slow to develop. This has been an impor-
tant factor in South Asia, where the presence of many small, fragmented farms makes
it difficult to establish individual water rights. In such cases, water rights may have to
K. William Easter, Mark W. Rosegrant, and Ariel Dinar 105
be allocated to water user associations, as they are in in Mexico, or to villages. If
water trading is really to expand, these countries may also need to take steps to
improve both their infrastructure and their system management. Yet most of these
latter improvements are needed even without the desire to establish markets.
In South Asia there has also been a general aversion to markets, especially for
allocating basic resources such as water and land, because of the belief that markets
will disadvantage low-income farmers. In practice, as Saleth (1998) and Meinzen-Dick
(1998) show, even "poor" farmers benefit from market exchanges. Clearly, if there
are too few sellers, buyers may be disadvantaged, but Saleth and Meinzen-Dick point
out that social conditions in India and Pakistan, for example, tend to mitigate against
such exploitation. Saleth finds little or no price discrimination in mature water mar-
kets or in situations where kinship and social relationships are strong.
One of the biggest problems in establishing water markets in irrigated areas con-
cerns issues.associated with changes in return flows and water-related economic ac-
tivities. These issues are important in California, as discussed in Archibald and Renwick
(1998) and Howitt (1998). When water is transferred into other sectors or out of a
river basin, governments need to have mechanisms in place that require the traders
to take these third-party effects into account. Archibald and Renwick note, however,
that these mechanisms must be carefully designed or they will foreclose many so-
cially beneficial water trading opportunities. Thus the government must ensure that
the appropriate institutional and organizational arrangements are in place. Clearly, a
strong legal system is an asset in establishing such arrangements. Other key assets are
a history of private irrigation development, strong water user associations, and ap-
propriate conveyance and storage systems. Hearne and Easter (1997) illustrate how
investments in storage capacity and a flexible infrastructure lower the transaction
costs of water trading in Chile.
In contrast, Hearne (1998a) shows how too much government involvement in
reallocation decisions can prevent water markets from developing. In Mexico the
National Water Commission has foreclosed any possibility of intersectoral market
exchanges in several regions. A better strategy may be for the commission to act as a
broker in facilitating water trades. That approach would mean a major change in the
commission's function and is not likely to occur without strong political pressure
from farmers and other interested parties.
Because the physical, institutional, organizational, and technical conditions that
affect the performance of potential water markets vary so much, it is difficult to
predict what will happen if water markets are introduced in a new area. The use of
experimental markets, as suggested in Dinar and others (1998), may be a low-cost
first step toward developing and evaluating alternative institutional arrangements.
Although not widely used for water resources, experimental markets can capture
some of the complexities involved in water markets.
106 The World Bank Research Observer, vol. 14, no. 1 (February 1999)
Experience with Water Markets
Formal water markets specify the volume and share of water to be sold, either for a
set period of time or permanently. Informal markets usually involve the sale of un-
measured flows of surface water from a canal for a set period of time or of water
pumped from a well for a set number of hours. Although the units sold in informal
markets may not be metered, both the buyer and the seller have good information
about the volume transferred. The key difference between the two markets is the way
in which the trade is enforced. If the users must self-enforce trades because no formal
water rights exist that can be enforced through the legal or administrative system, the
market is informal. Formal water markets are usually found in North and South
America, whereas informal markets are prevalent in the irrigated areas of South Asia.
Informal Markets
Groundwater markets are important for agricultural production and the distribu-
tion of water throughout the irrigated areas of South Asia. Saleth (1998) estimates
that 20 percent of the owners of the 14.2 million pumpsets in India are likely to be
involved in water trading. This means that water markets are providing water for
about 6 million hectares, or 15 percent of the total area irrigated by groundwater. In
Pakistan a survey reported that 21 percent of well owners sold water (NESPAK 1991).
In areas where dependable precipitation recharges the groundwater, the benefits
of buying and selling water from tubewells have increased farmers' income and pro-
duction. The economic gains from groundwater markets reflect improved efficiency
in pump management, in reducing conveyance losses, and in farm-level water use.
These markets also increase access to irrigation, especially for smaller-scale farmers
who do not own tubewells and cannot afford to invest in a well without a market for
their water.
Meinzen-Dick (1998), in one of the few studies estimating the economic returns
from access to water markets, found that water markets increased the availability and
reliability of water supplies. Both yields and income rose for those who purchased
water, particularly for those who also had access to canal water supplies. The highest
yields and income, however, were still found among farmers who owned their own
tubewells and had access to canal water.
PREVENTING OVERDRAFTS. Given that markets for the sale of groundwater draw
on an open-access resource (that is, one that is available for capture to anyone who
has access), it is not surprising that problems arise in areas with high demands and
limited supplies. Farmers have an incentive to ignore the scarcity and buffer stock
value of die groundwater and pump until their cost of pumping equals the market
K. William Easter, Mark W. Rosegrant, and Ariel Dinar IOT
price of water (Ramasamy 1996).2 Over time, the cost of pumping and the price of
water rise as the groundwater level declines. For example, the overdraft (that is, water
use in excess of recharge) in the Coimbatore District of India is almost 5,000 cubic
meters a year. Ramasamy estimates that if the overpumping continues, it will mean
a drop in total net returns to farmers of between $42 million and $69 million, a
result of the increased costs of power necessitated by increased pumping and addi-
tional investment to deepen wells. Here is a case where informal markets may exac-
erbate the problem, and formal markets may not work any better unless water rights
can be established and enforced in strict quantity terms. The problem is not the
water markets but the lack of exclusive property rights for groundwater. To establish
such rights, the number of wells and the amount of water to be pumped would have
to be agreed on and restricted. Such restrictions are probably unrealistic without
strong support in the irrigation community. If exclusive water rights can be estab-
lished, however, the water market should reflect the scarcity value of water and help
restrain overpumping.
Blomquist (1995) reports on one case where the demand for water is increasing
and the community of water users has been able to stop the overdraft. In the dry Los
Angeles metropolitan area in southern California, pumping is metered and taxed so
that users have an incentive to shift from local groundwater to more expensive but
more plentiful imported water. Surface and imported water are stored and used to
recharge the groundwater in the basin. One result has been a halt in saltwater intru-
sion from the ocean in the area's coastal groundwater basins. In some of these basins,
pumping rights have been defined, limited to the basin's average recharge, and made
transferable to other users through sales.
A more typical case, reported by Shah (1993), is in coastal Gujarat, India. Here,
the overdraft of coastal aquifers has caused a decline in groundwater supplies in some
areas and saltwater intrusion in others. Shah argues that any effective reduction in
this overdraft is unlikely without good local leadership and the involvement of water
user groups. He argues that "legal, quasi-legal, and organizational instruments of
public policy will not, on their own, succeed in securing the compliance of farmers
unless they are accompanied by measures aimed at affecting private returns to irriga-
tion . . . or unless the structure of property rights on the water resource itself is
drastically reformed (p. 147)." Similarly in Pakistan, Meinzen-Dick (1998:218) doubts
"whether government would have the institutional capacity to regulate sales among
hundreds of thousands of private tubewells, and if it had such capacity, it is unclear
what such direct intervention could achieve."
Yet in both India and Pakistan, any effect that water markets might have on the
overdrafting of groundwater is much less than the effect of subsidized electricity.
The zero or near-zero marginal cost of pumping means that farmers have an incen-
tive to use water to the point where the marginal value of production is close to zero.
This, of course, encourages farmers who can sell water to use their wells at close to
108 The World Bank Research Observer, vol. 14, no. 1 (February 1999)
full capacity. The low power rates not only create overdrafting problems but also
waste electricity in countries without adequate power.
As noted above, water markets can actually help solve the overdrafting problem
by increasing the incentives for efficient water use and making it possible to pur-
chase water from areas where water is abundant. The ability to find another source
of water, but at a higher marginal cost, can help promote community action for
self-regulation and demand management. Shah (1993) cites a case in coastal Gujarat
where self-regulation became possible when additional new supplies were piped
into the area.
Overdrafting tends to be concentrated in coastal areas of India and Pakistan and
in the hard rock areas of southern India. In many of the northern areas, pumping
actually improves growing conditions by lowering the water table below the root
zone (Shah 1993; Meinzen-Dick 1998). In cases where water tables are high or re-
charge rates are rapid, water markets are not likely to cause negative externalities
except possibly temporarily if neighboring wells are too close or deep tubewells inter-
fere with shallow wells. Where these externalities are small, personal trust and repu-
tation may be enough to foster competitive informal water markets. This is particu-
larly true where farmers own a number of separate plots that cannot be served by the
same well. In such cases, most water sellers are also buyers because most farmers who
own a well are able to irrigate only their large plots and must purchase water to
irrigate other plots (Shah 1993; Meinzen-Dick 1998; Saleth 1998). In addition,
their wells are likely to be underutilized unless they can sell water. Yet because of the
costs of conveying water and the need for cooperation from neighboring farmers
when water is to be conveyed any distance, high transaction costs can restrict trades
in areas with only a few wells and prevent water markets from being competitive.
COUNTERING MONOPOLY PRICING. This raises the other concern about water mar-
kets, the potential for monopoly pricing and discrimination. Groundwater markets
are somewhat confined by the physical limits of the location and supply of ground-
water. Still, pipelines can extend markets, and the investment costs of new wells
should put a limit on monopoly power. An abusive monopolist who raises prices too
high will find others investing in wells and undercutting the price. Shah (1993)
notes a lack of balance between the numbers of buyers and sellers in areas with high-
capacity wells, where one seller may serve as many as 70 or 80 buyers. He fails to say
how many sellers the average individual buyer can access. Monopoly pricing may be
avoided if the buyers can purchase water from three or four sellers—so long as the
sellers do not collude.
The evidence on monopoly pricing is mixed. In a 1991—92 survey in Pakistan,
Meinzen-Dick (1998) found that sellers were pricing water at little more than the
cost of pumping. The two most common ways of charging for groundwater are a flat
charge per hour of pumping (ranging from $0.57 to $3.27 an hour, depending on
K. William Easter, Mark W. Rosegrant, and Ariel Dinar 109
the pump type, capacity, and location) and arrangements whereby the buyer sup-
plies the diesel and motor oil for the pump and pays an additional fee of $0.16 to
$0.24 an hour to the well owner to cover the wear and tear on the engine.3 Sellers
with diesel pumps were just recovering their own costs under either type of contract.
In contrast, Saleth (1998) suggests that in some areas of India, monopoly rents
may be extractive. He cites as evidence the variation in water charges compared with
pumping costs in different areas. For example, water charges are 1.3 to 2 times higher
than operating costs in the Indo-Gangetic region but 2.5 to 3.5 times higher in the
water-scarce hard rock regions of southern India. The difference in rates, however,
might be explained in part by the difference in water scarcity and in the value of
water in those two regions. t
The degree of monopoly power may also be related to the terms of the transaction
or contract for water. Not surprisingly, some of the contracts for water are quite
similar to contracts for land. Water contracts include crop sharing, crop and input
sharing, and labor arrangements. If the payment is cash-based, buyers have more
freedom to take their business to another well owner anytime during the season.
When the transaction is a contract in kind, especially one based on crop sharing or
on crop and input sharing, the buyer is tied to the seller for at least one season, if not
longer. Similarly, if buyers contract to pay for the water with their labor, they may
find it difficult to change suppliers until they have fulfilled the contract. Yet in the
villages, informal markets do not appear to face extreme cases of monopoly rents. In
fact, monopoly power that restrains trading in areas with serious problems of declin-
ing groundwater levels may help reduce overextraction. In contrast, when suppliers
are taking advantage of their monopoly position and there are adequate groundwater
supplies, the best strategy is to encourage (legalize) trading and increase competition
through community and private well development (Palanisami and Easter 1991).
Thus informal water markets can improve water use and incomes in irrigated
areas where water rights are not well defined or recorded. They also may be a good
option if formal water markets are likely to produce third-party challenges and result
in excessively high transaction costs. Finally, informal markets would work well in
traditional irrigation systems where the farmers manage the irrigation system and
would be able to maintain a relatively modest level of transaction costs.
Formal Markets
In situations where informal markets can work well, it may not be necessary to incur
the extra expense of establishing formal water markets. Formal markets will be re-
quired, however, to provide the certainty necessary for permanent water transfers or
transactions between different sectors and jurisdictions. Because the need for perma-
nent trades and interjurisdictional water exchanges is likely to become more impor-
tant as nonagricultural demands for water grow, formal water markets are likely to
I1O The World Bank Research Observer, vol. 14, no. 1 (February 1999)
become more common. The growing demand in water-scarce regions has been one
of the driving forces behind the new interest in water markets. Several studies have
illustrated the benefits that are possible from interjurisdictional trading in perma-
nent water rights for short-term use.
In Texas 99 percent of the water traded has been transferred out of the agricultural
sector in the Rio Grande Valley to nonagricultural users (Griffin 1998). Of the mu-
nicipal water rights in the valley that existed in 1990, 45 percent had been purchased
since 1970. Although water markets are not active in other areas in Texas, Griffin notes
that the surface water law has evolved to the stage where trading will be more wide-
spread in the future. In contrast, the groundwater law is just beginning to evolve.
ECONOMIC GAINS. In a study of the Guadalquivir Basin of southern Spain, Garrido
(1998b) finds that the economic gains of trading within an individual water district
or community may be relatively modest. In contrast, if permitted, trades among
communities subject to different supply constraints and drought conditions could
produce substantial gains. Garrido estimates the total welfare gain at no more than
10 percent over the current water allocation for four communities where trades were
only intracommunity. Intercommunity trading, however, could produce estimated
economic gains in one of the older irrigation communities of almost 50 percent.
Garrido also shows that both types of trades are very sensitive to the level of transac-
tion costs. If those costs exceed 8 to 12 percent of the market price, trading and the
gains from trading would be too small to justify the expense of establishing formal
markets. Yet Garrido may underestimate the potential gains because he considers
only the crops traditionally grown in the region (cotton, wheat, corn, oilseed, and
sugar beets) and excludes any transfers to nonirrigation uses. Evidence from Chile
found significant changes in cropping as a result of water trading (Hearne and Easter
1997).
In contrast, Horbulyk and Lo (1998) found that most potential gains from intro-
ducing water markets in Canada's Alberta Province were likely to come from trades
within a subbasin. They considered four subbasins and compared die current water
allocation situation with the allocation under four separate markets (one in each
subbasin), as well as with a market encompassing the total basin. The four separate
market scenarios created 90 percent of the welfare gains that were obtained when unre-
stricted trading was allowed among the four subbasins. The urban sectors purchased
most of the water, except on the South Saskatchewan River, where the agricultural
sector purchased additional water when market trading was allowed among the subbasins.
TRADING PATTERNS AND TRANSACTION COSTS. In their analysis of selected water
markets in Chile, Hearne and Easter (1997) found trading both within and between
sectors. In the case of permanent transactions either within or between sectors, well-
established water use rights that were recorded and recognized by the government
K. William Easter, Mark W. Rosegrant, and Ariel Dinar 111
were critical in fostering trade. Several trades between farmers and the city of La
Serena were not consummated because of uncertainty regarding ownership of the
water rights. La Serena is a growing vacation destination located on the coast in a dry
region some 400 kilometers north of Santiago. Rapid growth in demand has strained
the city's water supply, particularly during the summer tourist season. The opening
of water markets allowed the city to purchase water and delay development of new
water sources. Starting in 1992, the city's water company purchased enough water to
increase its water supply by 28 percent. Additional purchases were made by up-
stream households for domestic uses and by farmers.
Elsewhere in Chile, significant trading occurs in the Limari Valley for agricultural
purposes (the urban sector has adequate water). A survey of 37 farmers selling water
and 19 farmers buying it reported transfers of rights to 9.2 million cubic meters. The
gains from trade (measured as the difference between the value of water to the seller
before the sale and the value to the buyer after the sale) were, on average, $2.47 a
cubic meter ($3,045 an acre-foot), with a transaction cost of $0,069 a cubic meter
($86 an acre-foot).4 This sample was neither random nor complete, but the numbers
surveyed were large enough to show that the water market was very active and had
created significant gains from trade. The largest gains accrued to three grape produc-
ers who purchased 5.8 million cubic meters of water (63 percent of the total amount
traded in the sample). In these active water markets, transaction costs were low and
did not seem to constrain trading. In other areas, such as the upper section of the
Maipo River that supplies the southwestern Santiago area and irrigates 100,000'hect-
ares, the transaction costs are high, and trading is quite limited. The Maipo River is
divided into three sections for management and water trading. As a result, water
rights are uncertain, and the lack of adjustable control structures raises transaction
costs and therefore limits trading (Hearne 1998b).
Similarly, Archibald and Renwick (1998) found that high transaction costs in
California limited a large number of potentially profitable trades. Two types of trans-
action costs were identified: administrative-induced costs, which are explicit and
included in the price of water sold through the California Water Bank, and policy-
induced transaction costs, which stem from existing legal requirements designed to
avoid injuring owners of water rights, damaging fish and wildlife, and creating nega-
tive third-party effects in exporting areas. Administrative-induced transaction costs,
including the costs of locating buyers and sellers and negotiating quantities, timing,
and other terms of transfer, were $0,041 a cubic meter ($50 an acre-foot) in 1991
and $0,014 a cubic meter ($17-50 an acre-foot) in 1992 and 1994. Policy-induced
transaction costs in the West range from $0.152 a cubic meter ($ 187 an acre-foot) in
Colorado to $0,044 a cubic meter ($54 an acre-foot) in New Mexico, all states with
less stringent state and federal transfer requirements than California. Policy-induced
transaction costs in this range would be as much as or more than the potential gains
from trading in the California Water Bank (Archibald and Renwick 1998).
1 1a The World Bank Research Observer, vol. 14, no. I (February 1999)
Because of high transaction costs in Colorado, Howe (1998) recommends shift-
ing the administrative responsibility for water transfers from the water courts to the
State Engineer's Office. He also recommends reserving or acquiring water for "pub-
lic good" uses such as recreation, as well as making other changes to allow water to be
marketed as freely in Colorado as it is in the neighboring states.
Colby (1998) suggests that the claims of Native Americans have the effect of im-
posing high transaction costs on water trading in many western rivers. She argues
that even though markets do not work well with high transaction costs, when those
costs are compared with the costs of litigated solutions, water markets look like a
much better alternative.
Howitt (1998) reports that spot and options markets performed well during
California's droughts in the 1990s. Even though these markets are a fairly recent
phenomenon, he thinks they are a promising option for stabilizing available water
supplies in California and other similar areas. Permanent shifts in demand, however,
require a much more active formal market for water rights.
Conclusions
Contrary to the claims of many critics, water markets have worked and are likely to
be a better mechanism for reallocating water than the alternative methods. There are
both formal and informal water markets at work today. In addition, there are spot
market sales, sales of permanent water rights, and leasing arrangements that are simi-
lar to those used for land, including crop sharing and cash rents (Saleth 1998).
Where water is scarce and large amounts of the available water supplies were com-
mitted to particular uses a long time ago, the economic benefits from water markets
are likely to be large. In contrast, if the allocation was made fairly recently, based on
the most highly valued uses of water, and new opportunities are not available, then
the gains will be much more modest, as is shown in the Spanish example developed
by Garrido (1998b).
For markets to be effective, transaction costs must be kept low. To keep these
costs low, the appropriate institutional and organizational arrangements need to be
in place, as well as flexible infrastructure and management. As pointed out earlier,
the critical first step is to establish tradable water rights or water use rights separate
from land, as well as the mechanisms to deal with third-party effects.
If it is difficult to establish legally enforceable, permanent water rights, a "thick"
spot market may provide almost the same security as ownership of permanent water
rights. In other words, the ability to buy the water needed at a reasonable price may
provide enough security so that firms are willing to invest in enterprises that are
dependent on this purchased water. A contingent water market can provide addi-
tional security so that firms can be assured of a given volume of water at a set price.
K. William Easter, Mark W. Roscgrant, and Ariel Dinar 113
With only a spot market and no contingent markets, firms may be subject to wide
fluctuations in prices.
For those users needing certain supplies, spot water markets are probably cheaper
alternatives than having to buy enough senior water rights so that one is guaranteed
adequate supplies even in the worst drought. (Owners of senior water rights have the
right to whatever water is available, before the more junior water rights owners.) In
Pakistan, for example, the markets for groundwater have greatly improved the secu-
rity of water supply, particularly in government irrigation projects. This security has
allowed increased investment and increased production. It will be important to see if
spot and contingent markets have similar effects on the productivity of water.
Finally, the evidence indicates that appropriately designed water markets, sup-
ported by sound institutions, are an effective mechanism for reallocating scarce wa-
ter among sectors. Carefully designed water markets make it possible to meet the
growing urban and industrial water demands without derailing growth in crop pro-
duction. Market transfers among sectors may make it possible to significantly scale
back investments in new water supply projects. Government inaction, ineffective
institutions for water management, and high transaction costs, however, are likely to
prevent water markets from reaching their full potential for reallocating scarce water
resources.
Notes
K. William Easter is a professor of applied economics at the University of Minnesota, St. Paul; Mark
W. Rosegrant is a research fellow at the International Food Policy Research Institute, Washington,
D.C.; and Ariel Dinar is a principal economist in the Rural Development Department of the World
Bank.
1. "Public goods" are goods that consumers cannot be excluded from using and that are not
consumed during use but continue to provide the same benefits to other consumers (World Bank
1993).
2. Scarcity value is the opportunity cost of water. It is the present value of the sacrifices imposed
on the future by using the resource today. Buffer stock value is the value of groundwater in stabiliz-
ing water supplies when the supply of surface water is uncertain (Tsur 1990).
3. The 1995 exchange rate of 24.5:1 was used to convert Pakistani rupees to U.S. dollars.
4. An acre-foot equals 1,233 cubic meters.
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