Group Title: Working paper - International Agricultural Trade and Policy Center. University of Florida ; WPTC 06-01
Title: Getting the farmers' feet wet (dry?) in the water market : why isn't the invisible hand working?
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Title: Getting the farmers' feet wet (dry?) in the water market : why isn't the invisible hand working?
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UNIVERSITY OF
FLORIDA
Institute of Food and Agricultural Sciences


Getting the Farmers' Feet Wet (Dry?) in the Water Market:
Why isn't the Invisible Hand Working?
By
Ram Ranjan
WPTC 06-01 July 2006










INTERNATIONAL AGRICULTURAL TRADE AND POLICY CENTER


THE INTERNATIONAL AGRICULTURAL TRADE AND POLICY CENTER
(IATPC)

The International Agricultural Trade and Policy Center (IATPC) was established in 1990
in the Institute of Food and Agriculture Sciences (IFAS) at the University of Florida
(UF). The mission of the Center is to conduct a multi-disciplinary research, education and
outreach program with a major focus on issues that influence competitiveness of specialty
crop agriculture in support of consumers, industry, resource owners and policy makers.
The Center facilitates collaborative research, education and outreach programs across
colleges of the university, with other universities and with state, national and
international organizations. The Center's objectives are to:

* Serve as the University-wide focal point for research on international trade, domestic and foreign
legal and policy issues influencing specialty crop agriculture.
* Support initiatives that enable a better understanding of state, U.S. and international policy issues
impacting the competitiveness of specialty crops locally, nationally, and internationally.
* Serve as a nation-wide resource for research on public policy issues concerning specialty crops.
* Disseminate research results to, and interact with, policymakers; research, business, industry, and
resource groups; and state, federal, and international agencies to facilitate the policy debate on
specialty crop issues.










Getting the Farmers' Feet Wet (Dry?) in the Water Market:
Why isn't the Invisible Hand Working?1




A Survey











Ram Ranjan
Postdoctoral Associate
International Agricultural Trade and Policy Center
Department of Food and Resource Economics, University of Florida
G097, McCarty Hall B, P.O. Box 32611-0240, Gainesville, FL
Email: rranian@iifas.ufl.edu, Ph: (352) 392 1881-326; Fax: (352) 392 9898












July 2006



**Preliminary and Incomplete**






1 Most of this work was done at the USDA-ERS where the author was a visiting scholar. Views expressed
in the paper are of the author's alone and do not reflect those of the USDA-ERS.









Introduction

Water reallocation through markets has been proposed as an efficient way of

handling the increasing water scarcity facing urban and environmental uses in the United

States. The case for water market development has been based on the fact that the value

of water in agriculture, which accounts for most freshwater consumption nationally, is

significantly lower than the value of water for urban uses, hydroelectricity generation and

other non-consumptive uses that benefit the environment. Limited markets have evolved

in areas of the U.S. to facilitate the transfer of water from agriculture to higher value

needs. However, the success of such efforts has been low both in terms of number of

participants and the volume of total transfers.

A number of reasons have been cited for the low inclination of agricultural water-

rights holders to water trading. Economists have analyzed the institutional setting and the

political economics underlying water market development. An important factor involves

the risk perception of farmers and their wariness of water trading due to potential

droughts. Water trade may have adverse impacts on water sellers. The farmer has been

thoroughly scrutinized, from his wallet to his head. Yet, significant additional research

will be required in order to fully understand all the nuances involved in development of

operational water markets.

The traditional theory on market evolution projects a stylized evolutionary

process involving various stages of market development from a nascent state to a well

functioning market. However, such a characterization ignores critical feedback

feedbacks between the market and infrastructural and institutional conditions

accompanying it. A brief review of water market development patterns in the US


Preliminary Analysis, Not for Citation or Quotation









highlights this frictional pattern of co-evolution. Whereas some States have advanced

into well developed water markets characterized by formal spot and options markets with

supporting institutional structures, other States lag far behind. There is a need to

investigate the underlying interactions between the institutions and the markets that

influence the extent of water market development.

While the literature on water markets has addressed various aspects of this

problem-borrowing from a vast array of concepts in economics, psychology, finance and

political economy- there exists a need to glean from the current and past work in the

theory of water market co-evolution in order to develop a comprehensive analysis of the

process.

In this paper we seek to explore the market development process through a brief

survey of the existing literature, highlighting selected studies that examine key elements

of the evolutionary nature of water markets. We begin by examining the evolutionary

stages of water markets with feedback linkages on various institutional settings. In doing

so, we focus on factors such as transaction costs, transactions risks, role of property

rights, third party impacts, behavioral responses, and the political economy and their

ability to shape the water market development. Special attention is devoted to the role of

selected market instruments such as permanent rights transfer, spot markets, and

particularly contingent markets. The approach in much of the existing literature has been

to borrow from finance theory on options to evaluate the feasibility and impacts of

contingent water markets. However, contingent water markets differ from general

options markets in a number of ways due to the unique characteristics of water. We

borrow from the literature from the behavioral economics to delve in the behavioral


Preliminary Analysis, Not for Citation or Quotation









aspects of farmers in explaining their risk averse nature. This may help explain the

success of advance markets such as spot and options markets. Finally, using a simple

model, we suggest that ignoring such considerations, when calculating option value for

leased water may give misleading results.

Feedback Co-evolution and Stages of Water Market Development

There exists a pattern in the evolution of new markets. This evolution has been

observed, most notably, in the case of certain agricultural commodities and markets for

pollution permits. Specifically, seven stages have been identified in the evolution of new

markets that span creation of demand for capital, uniform standards, development of legal

infrastructure, informal spot and forward markets, development of securities and

commodities exchange, organized future and options market and deconstruction (Sandor

et al. 2000). The seven stages approach, while a useful construct, gives the impression

that there exists a somewhat linear tendency of market evolution from its nascent stages

to the final stages towards maturity. However, the actual evolutionary process may

involve a complex system of feedbacks involving the various stages and the existing

political, physical, legal and institutional infrastructure that drive changes in both market

structure and supporting infrastructure. In cases where serious bottlenecks exist in

market infrastructure, and normal feedback effects fail to overcome them, the evolution

of the market may be stymied. This failure may be reflected in terms of rising gaps

between potential and actual consumer surplus attained through market transactions,

wasteful uses of scarce resources in some sectors despite high opportunity costs in others,

growing discontentment with the existing structure of property rights and increasing

number of related lawsuits, prevalence of political economy over economic-efficiency


Preliminary Analysis, Not for Citation or Quotation









based motives in federal rules and regulations, high transaction costs associated with

commodity exchanges, etc. When such conditions exist and are hard to overcome, the

evolution of markets may either be significantly restricted. The degree of market

restrictions may vary from region to region based upon the mix of structural bottlenecks.

Water markets in the US have failed to evolve into advanced stages of market

development despite the rising urban and other non-agricultural high values needs. The

need to transfer water at least cost, while recognizing property right claims is a major

challenge to water managers and policy analysts. In the following sections we propose a

construct for the various stages of the market development as applied to water, and the

infrastructural and exogenous forces that interact with market development and in turn

are modified through the process. This mutual interaction forces the evolution of both

markets and supporting infrastructure through the various stages of development. For

purposes of discussion, we classify the infrastructural network into three distinct

categories: physical, legal and financial, each depicting an evolution from nascent (or

informal) stages into highly developed stages. Evolution of the physical infrastructure

involves a shift from the traditional methods of storing water to the ability to access water

from far off regions through canals and finally to be able to allocate current storage and

transfers based upon future availability. Legal infrastructure in its primitive stages may

offer ill-defined property rights that evolve through government enforcement to

incorporating third party impacts and finally to private enforcement. Financial

infrastructure evolves from primitive forms of water market transfer contracts and no or

little scope for hedging of risks through financial instruments to advanced stages in which

a host of financing agencies such as banks and markets such as spot and options market


Preliminary Analysis, Not for Citation or Quotation









co-exist. The stages of water markets have been classified accordingly. These involve

informal between -agriculture exchanges to out of agriculture exchanges which are

facilitated by water banks and spots and options markets. These are represented in figure

1 below.

INSERT FIGURE 1 HERE

In addition, there are several external forces that influence both market and

infrastructure development. These include changes in water and agricultural demand,

changes in public preferences towards the environment, changes in the political economy,

external financial innovation, changes in the technology, etc.

It is clear that advanced stages of development in a water market would require

similar advancements in the accompanying infrastructure. Yet, the forces at play

between these are subtle and need to be clearly identified. Besides the exogenous forces,

we have identified a number of key endogenous forces that act upon the system

including, transaction costs, third-party impact relating to litigation costs, federal

regulations redefining property rights and monitoring and enforcement of infrastructure

to note a few. This feedback related evolution is depicted in figure 2 below. The flow of

feedback is depicted through arrows that go in either directions, connecting institutions

and market. Well defined property rights lead to evolution of the market and an evolving

market throws new challenges to the legal infrastructure in the form of legal nuances that

need to be taken care of to reduce market friction. This causes further refinement of the

property rights. For instance, redefinition of property rights to allow small scale

transactions may facilitate marginal purchases of water thus allowing buyers to wait until

their needs become known instead thus avoiding costly and irreversible over-investment


Preliminary Analysis, Not for Citation or Quotation









in water rights (Howe and Goemans 2003). Property rights may also be affected by

exogenous forces such as the political economy. Well defined property rights may

further facilitate the evolution of physical infrastructure as investment in infrastructure

such as canals (which yields low returns and thus needs a longer break-even time) would

get a boost from assured water transactions in future. Physical infrastructure in turn

makes possible and insures water transfer from far-off areas thus extending the market.

Similar co-evolution can be observed in the case of financial infrastructure and the

markets with better modes of finances and insuring coming up in the more developed

stages of the market.

In order to get a better insight over this co-evolutionary process with respect to

the water markets we look at the forces that facilitate these linkages namely the property

rights, transaction costs and risks, third party impacts, etc. Markets are characterized by

participants and institutions. At the center of this evolutionary process are the market

participants, the buyers and the sellers of water. Whereas, the feedback linkages are a

major determinant to market evolution, we also need to explore the forces that facilitate

market participation. Due to special characteristics of the market such as seasonal

supply, limited transferability and storability, risk plays a prominent role in facilitating

market participation. When the market is in primitive stages and the transactions are low,

an informal mode of exchange prevails. However, with the sophistication of the market

there is a manifold increase in transactions accompanied by an increased level of risk. As

the market evolves, the nature of participants itself may change from individual farmers

to large organizations representing the interests of several farmers. However, the nature

of evolving participants is subject to the co-evolution of institutional and exogenous


Preliminary Analysis, Not for Citation or Quotation









factors also. For instance, adequately developed physical and informational

infrastructure may facilitate a development of a competitive market, thus making possible

the participation of large number of uniformly sized water rights holders. Whereas, high

transaction costs, risk aversion, property rights uncertainty may limit market participation

to a few. Evolving participants would vary in their response to risks. For instance large

participants are more likely to be risk taking as compared to smaller ones. Organizations

would vary in their risk aversion depending upon the objectives of the mangers which in

turn would be guided by the voting rights of the members. Further, repeated transactions

may affect risk aversion, a topic which is getting a lot of scrutiny in behavioral

economics.

Therefore, the co-evolution of markets and institutions becomes highly dependent

upon forces impacting linkages and participation. This issue needs special attention due

to the current emphasis on promoting the advanced stages of markets such as the options

and the spot markets. We explore the influence of such forces on the success of these

advanced stages in the final section.

Ideal Conditions for Water Markets

One fundamental prerequisite for functional markets is the presence of a sound

institutional setting. Optimal institutional arrangements have, so far, evaded most of the

States in which water trade has occurred. Young (1986) describes four basic ingredients

of an institution that would make water markets viable- security, flexibility, certainty, and

consideration of third party impacts. Until now, the water markets served by the

Colorado-Big Thomson (C-BT) project have been the most successful in terms of

facilitating transfers between buyers and sellers of water. Some 2,698 water-use rights


Preliminary Analysis, Not for Citation or Quotation









exchanged hands in the period between 1970 and 1993. Michelsen (2000) has identified

a number of ideal conditions that exist to facilitate transfers. First, is the availability of

well-defined and clearly understood property rights. Second, supply uncertainty in the

dry years has been a minimum, allowing for improved decision making. Annual delivery

for the period of 1957 to 1993 averaged 65 percent of the maximum acre-feet available to

the right owners. Certainty of high supply is extremely essential for trade, as it is the

'wet' water that would be used and not the 'paper' water. Third, water rights are easily

transferable from one party to another. Since C-BT water is imported from outside the

watershed regions, the issue of ensuring return-flow of water does not exist and transfers

between two parties does not infringe upon the rights of a third party. Fourth, transaction

losses are minimized through an efficient network of reservoirs and ditches. Fifth,

administrative procedures associated with water transfer are fast and clear-cut. A water

rights transfer application requires a flat $75 fee irrespective of the number of units

transferred. Maximum time required to process a C-BT transfer is four to six weeks, in

contrast to an average 20 months for other water rights transfers in Colorado. Sixth, any

water that has been unutilized through conservation activities can be transferred to

another use by the farmer.

Feedback Linkages

Property Rights and Water Markets

A number of theories exist in the property rights literature that identify its

evolution either as an endogenous or an exogenous process. Brooks et al. (2003) have

provided a brief review of the existing points of views driving property rights evolution.

Demsetz (1967) argues that property rights evolve endogenously to internalize the gains


Preliminary Analysis, Not for Citation or Quotation









from technological change or prices. Eggertsson (1990) adds on the role of political and

social environment inn shaping the evolution of property rights. Posner (1998), in his

common law efficiency argument, argues against the ability of the legal system in

bringing redistributional changes in the society which forces them to redefine property

rights in a way so as to maximize social wealth. Brazel (1999) argues that the property

rights evolve in order to legalize the contracts desirable to both the parties. Whereas

Sened (1997) ascribes to the influential political entrepreneurs the role of bringing about

changes in property rights to suit their own needs.

According to many observers, the most significant institutional element required

for facilitating water transfer is the presence of well-defined property rights. While some

(citing the Coase theorem) have downplayed the role property rights could play in

determining an efficient allocation of water amongst users, Richards and Singh (2001)

contend that the issue of property rights cannot be ignored. Some of the basic conditions

that need to hold in order for the Coase theorem to be satisfied do not hold in the case of

water. These include wealth effects and transaction costs. The wealth effect requires that

the amount of compensation required by an individual in order to switch from one

commodity to another should not vary with level of income. Richards and Singh argue

that some of the non-economic factors that determine the sale of water may be counted as

wealth effects. Non-economic factors that may raise the seller's reservation price include

'access value', 'regional economics impacts', and 'community cohesion' (Young 1986).

Further, the fact that water is perceived as an asset may cause a significant diversion

between willingness to pay and willingness to accept compensation for water. When

agents are risk averse, disutility from loss may be much higher than gain in utility from


Preliminary Analysis, Not for Citation or Quotation









an equivalent gain. There are also significant transaction costs involved with water

transfer. Richards and Singh cite uncertainty over enforcement of contracts and lack of

credible commitments as two major transactions costs involved in exchange of water.

There is some literature on the evolution of property rights in water markets over

time. Howitt (1995) looks at the evolution of property rights as an endogenous process

determined by the evolution of water demand, uncertainty of future water supply and the

institutional costs of redefining water rights. The water rights, according to Howitt

(1995) are malleable, with economic pressure being the primary force acting on

established rights. Thus, riparian rights gave way to the appropriative rights as use of

water for exploitation of exhaustible resources required different sets of conditions than

riparian rights which basically allocated water rights based upon land adjoining the river

course. Later, the water rights were further modified to incorporate the 'beneficial use'

of water as urban water demand rose. Therefore, it is apparent that while well defined

water rights are crucial to the development of water markets, water rights themselves are

shaped in part by the economic pressures and the existing market structure of the times.

Water rights are also subject to third-party impacts and environmental uses, reasserting

the public good aspect of water. For instance, even well-defined water rights could be

challenged if water is needed for preservation of endangered species which may be given

a higher priority in the 'public trust'. The definition of public trust/use itself is subject to

change with the societal evolution. In the 19th century water diverted from main streams

fro agricultural purposes was considered as 'public use' as there were no other beneficial

uses of water. Now, it is the environment which is considered to have a higher beneficial

sue for water.


Preliminary Analysis, Not for Citation or Quotation









While the need for establishing clear-cut water rights has been widely

acknowledged in the literature, one study (Gaffney 1997) takes a critical view of the

property rights argument to water marketing. Gaffney challenges the notion of providing

firm water rights to current users of water. He argues that one reason why sellers are "de-

motivated" from selling their water is that the benefits from speculative use during dry

years are often high compared to a one-time sale of such rights. This disincentive is

further strengthened by rising land values and the fact that water permits are costless and

'free of property taxes'. He proposes water taxation, either via a property taxation or

severance taxation and water royalties, as a means of overcoming the 'de-motivation'

obstacles. Such taxation could be either property taxation or severance taxation or water

royalties.

The establishment of clear-cut property rights to water users has not been easy to

implement. A key institutional bottleneck involves the non-separability of water rights

from land. Crouter (1987) applies the theory of hedonic prices to determine whether

water prices are separable from land prices. Crouter identifies several reasons why water

and land attributes could be intertwined. First, legal and institutional restrictions on

water rights transfer might prevent it from being sold separately from land. Such

appurtenancy restrictions are imposed in order to protect the water rights of downstream

users of water who depend upon the return flows. Transaction costs related to

overcoming legalities and subsequent negotiations may represent a further hindrance to

separate water markets. Further, legal restrictions that prevent arbitrage possibilities may

hinder the development of a competitive water market. Due to such inseparabilities, land

and water qualify as Rosen commodities whose attributes cannot be sold separately.


Preliminary Analysis, Not for Citation or Quotation









Crouter demonstrates that in a market where competitive bidding is allowed, the hedonic

price of attributes is equal to that which the buyers are willing. Therefore, in equilibrium,

the joint price of land and water would be endogenously determined by the bids of the

buyers. Now, if there exists a separate market for water, the hedonic price function

would be separable in land and water. In order to test this hypothesis of separability the

model is applied to Weld County of Colorado for land parcel transfers for the first six

months of 1970. Results indicate non-separability of land and water attributes.

Transaction Costs/Risks, Third Party Impacts and Water Markets

For exchange of goods between two parties to be Pareto optimum, the transaction costs

must be zero as specified by the Coase theorem. In real life transactions costs are never

zero thus making the initial endowment of property rights a significant determinant to the

efficiency of trade outcome. Lund (1993) distinguishes between transaction costs and

transaction risks. He shows that the risk associated with the actual delivery of water

matters, and can be a significant factor in determining the success of water markets.

Such risks of failure generally arise from court challenges posed by third parties who

might be affected by such transfers. In such settings, transaction costs can be divided

into pre-contract and post-contract costs. Since there is a significant time lag between the

contractual agreement for transfer of water rights and the actual delivery of water, such

risks may force the buyers to consider alternative water supply. Using a numerical

example, Lund demonstrates that when the risk of a successful transfer is 50% and the

post-contract transfer costs are 10% of the difference between the transfer volume and an

alternative supply, the buyer would be willing to pay only 55% of the pre-contract costs

under the case with certainty. The willingness to pay for water transfers may fall further


Preliminary Analysis, Not for Citation or Quotation









if the buyer is risk averse. The above analysis may have significant implications for the

study of options market, as so far such transaction costs and risks have not received any

additional consideration in the few studies that exist in this area.

Transactions costs, on the positive side, play a key role in the evolution of

institutions as is widely supported by the theory of institutional economics (Williamson

1985). High costs of searching for water rights holders may lead to the formations of

large organizations such as the California's IID and WDM. Similarly high risks of

failure to ensure future water delivery may bring in changes in the property rights through

continual litigations. Arguably high transaction costs in the water market have hindered

market participation, but they have also worked in their own way to prune the system and

aid in market evolution. Colby (1990) justifies the presence of transactions costs in water

transfers as policy induced transfer costs (PITC) that help bridge the gap between private

and social costs of water for the non-agricultural users2. This is so, because, water right

holders often do not adequately reflect the indirect impacts imposed on third parties and

environmental interests. She argues that the stronger the third-party and environmental

interests associated with water transfers, the greater the number of protests filed with

such transfers, thus reducing or otherwise delaying the chances of a successful

transaction. Litigations and delays may reduce both the benefits and the number of

transactions to a level where private costs approximately equal the social costs. This

works much like a Pigouvian tax, except that costs of legal guidance and delays might be

thought of as dead weight losses to society. However, Colby argues that such costs help

enforce the property rights of third parties and that transaction costs that arise from

government regulations are therefore justified. She notes that over the period of 1975-


Preliminary Analysis, Not for Citation or Quotation









1984, such transaction costs were about 6% of the water rights prices in Colorado, Utah

and Mexico, and it is possible that in the presence of significant third-party effects the

water markets have been under-regulated. Howe, Boggs and Butler (1990) examine the

importance of third-party opposition to transaction costs for water transfers. In a model

of water transfers in Colorado, they regress per acre-foot transaction costs (ATC) on size

of transfers (AF) and whether or not the transaction faced any opposition (OPP):

ATC=799-1481n AF + 660 OPP, R2=.61

They find that while size of transfers leads to economies of scale, third-party

claims often significantly influence the transaction costs. Howitt (1994), in a study of the

effectiveness of the 1991 California Drought Water Bank evaluates both direct and third

party impacts. He finds that while the exporting regions suffered net economic losses, the

importing regions derived net benefits, thus leading to positive net benefits to the society

from establishment of such a bank. However, the study also brings out an important

problem associated with water market creation; the third party impacts. Trade in water

assumes that the fundamental property right of water belongs to the farmer. However,

the interests of third parties that derive significant pecuniary and technological benefits

from agriculture must also be taken into account as most of the facilities such as canals

that facilitate irrigation were financed through public expenditure. These third-party

impacts are mostly non-point in nature. The study finds that the third party impacts could

be reduced by lowering the intensity of water sales in a given region and spreading them

as widely as possible.

Behavioral Factors affecting Market Participation



2 See Sandra and Renwick (1998) for more on PITCs.

Preliminary Analysis, Not for Citation or Quotation 17









The fear of adverse consequences from trade may form the most significant

hindrance to market participation. Adverse impacts on the farmers from federally

induced markets may have political fallouts. In absence of conclusive evidence over such

impacts, a cautious federal policy may slow down the evolution of new markets. Risk

aversion of participants itself is another significant factor. Participants may be more

wary of small losses than the prospect of small gains from market participation. The

traditional theory of risk aversion through expected utility maximization has been found

to be lacking in explaining such behavioral anomalies. We borrow from the insights

offered by behavioral economics to capture a more realistic risk aversion behavior. This

theory is then applied to explore the success of the advanced markets such as the spot and

options markets. Finally, the nature of participants also may play a significant role in

determining the success and outcomes of markets. This aspect is briefly dwelt upon.

Adverse Impacts of Water Markets and the Political Economy

Perhaps the most significant bottleneck involves the political nature of water

rights which are mostly owned by agricultural farmers who have significant clout over

the water transfer decision processes. Gaffney (1997) emphasizes the political economy

aspect of water rights as the main obstacle to the proper functioning of the water market.

Water used in agriculture is heavily subsidized by the federal government. For example,

the water drawn from Santa Ana River in Southern California is available to the farmers

for $30 per acre-foot, whereas the social cost of the same water has been estimated at

about $3000 per acre-foot. Gaffney (1997) argues that giving permanent property rights

to the farmers transfers the value of this subsidy to the farmers. Gaffney proposes

allowing water transfers, but requiring the gainers from such transfer to pay for the


Preliminary Analysis, Not for Citation or Quotation









subsidies inherent in such rights. Further, the social cost of water must not be measured

as the cost of acquiring the water, but the cost of providing a substitute for that water.

An additional challenge to implementing water markets is the fear that agriculture

would be severely impacted in the wake of continued droughts. However, most studies

have found little impact on the agricultural sector from water transfers. Howe et al.

(1990) examine the impact from water transfers on the area of origin for a seven-county

reach of the Arkansas River in southeastern Colorado. Their analysis involves an input-

output based approach that incorporates both backward and forward linkages of the

agriculture sector. They find that total losses to the agriculture sector from irrigation

reductions are insignificant and easily accounted for by the gains to urban areas from

increased water transfers. They argue that such losses could be further reduced where

revenues generated from water transfers are properly internalized within the agriculture

sector.

On the other hand, Moore and Dinar (1995) come up with opposite conclusions.

They design various models of input use involving two inputs- surface water and land- to

test whether such factors might be treated as fixed by the farmers. Empirical models are

estimated using data from western San Joaquin Valley of California. The model results

indicate that farmers treat surface water as fixed input rather than a variable one, with

significant implications for federal water policy, the Central Valley Project Improvement

(CVP) Act. The CVP act was proposed to charge water price to agricultural water users

in a three tiered approach, with rising prices for the last 20% of allotted water use. The

purpose of this act was to facilitate transfer of water to urban users and induce farmers to

conserve water. Moore and Dinar, however, claim that treatment of water as a fixed


Preliminary Analysis, Not for Citation or Quotation









input by the farmers would make such conservation goals ineffective as the price of water

does not figure in their decision of how much water to use. Further, the Reclamation

price charged by the government may not adequately reflect the actual shadow price of

water to farmers and therefore the difference between the Reclamation price and the

urban willingness to pay should not be interpreted as the benefit from water transfer. The

benefits would be much lower if shadow prices are taken into account. The authors

suggest that such a policy would also create significant costs to government if

compensation were provided to the farmers for lost output. Their results indicate that a

12 percent reduction in water supply would lead to a reduction of regional cotton acreage

(which is mainly exported) by 0.8 percent of total cotton acreage nationally.

Market-based approaches often fail to provide for public goods and water markets

are not an exception. An important issue with water rights is how non-consumptive

benefits should be accounted for in water transactions. Booker and Young (1994), in a

significant departure from traditional approaches that focus at efficiency gains from

market transfers resulting to consumptive users only, include non-consumptive uses of

water such as salinity reduction and hydropower generation from instream water flows.

Their study focuses on the Colorado River basin that supplies water to the agricultural

users within Colorado, urban users in Southern California and international treaty

obligations. They conclude that while market transfers might minimize costs to the

consumptive users, they fail to account for non-consumptive benefits and may prove to

be inefficient in the presence of substantial non-consumptive benefits and absent

institutions through which interests of non-consumptive benefits could be reflected.


Preliminary Analysis, Not for Citation or Quotation









Their estimates suggest that markets could only achieve as much as 50% percent of

efficiency gains that are theoretically possible through water transfers.

Risk Aversion, Speculation and Water Markets

While institutional bottlenecks can be serious impediments to creation of water

markets, institutional reforms do not necessarily guarantee that water markets would

function correctly. Further challenges lie in ensuring a competitive environment that

minimizes strategic behavior on part of the participants. Young (1986) hypothesizes that

one reason water markets are not being successful is that the seller's willingness to pay

may not be considerably large relative to the buyer's reservation price in order for water

exchanges to take place. Mitchelson et al. (2000) explore the role of expectations of

future water-right prices in determining current prices. They observe that in the case of

Colorado-Big Thomson Project the water right prices were well above returns in

irrigation for the period 1986-1993. The authors suggest that owners of water-rights may

treat water as a speculative asset. They find that water-rights prices were correlated with

the prices of speculative natural resources such as farmland, crude oil and silver. Some

of the key variables affecting expectations of future water-rights prices in their study are

historical water prices and level of regional economic activity. Goodman and Howe

(1997) conduct an econometric analysis to determine the fluctuations in the share prices

of ditch companies in Colorado that are owned by the water-rights owners. The price of

the shares (for 1983-1990) were positively correlated with seniority of water rights and

average diversions of water per unit of share by the farmer, and negatively correlated

with transportation losses. Importantly, price of crops was not significant in determining

the price fluctuations. Further, prices paid for shares varied widely by cities acquiring


Preliminary Analysis, Not for Citation or Quotation









water. Goodman and Howe (1997) attribute such differences to varying degrees of risk

aversion, expectations of future growth and urban expansion around the agricultural

lands.

Behavioral Economics too may have some insights to offer regarding the

reluctance of sellers to part with water rights. In one study, List (2003) conducts

experiments involving 500 participants in a market to study the willingness of

participants to sell their entitlements based upon their record of past transactions. He

concludes that the willingness to sell increases with the level of experience with past

transactions.

Accurately assessing the demand side too is not free of problems, contributing to

restrictions in water transfers in some cases. Hersh and Wernstedt (2001) look at the

difficulties faced by water utilities in Portland in utilizing their water rights. Despite the

fact that one of these utilities possessed three times as many senior water rights than their

current use, it was unsure of its ability to utilize all of that water in dry seasons due to

infrastructural bottlenecks, such as need for large intake structures and pipelines, which

would require extensive negotiations with the federal and state governments to construct.

The feared reaction from environmental groups posed an additional element of

uncertainty.

Role of Risks: A Fresh Look from Behavioral Economics

Risk averse farmers would hold back water from the water market if the sale of

water poses future threats to property rights. Risk could also be associated with the price

of agricultural commodities, and depending upon the relative revenues earned by water in

agricultural production or the water market, the allocation of water would be decided.


Preliminary Analysis, Not for Citation or Quotation






















Figure A


Utility












-20 10 20 Money


The conventional approach, so far, has been to model risk aversion with a concave utility

function. However, a growing body of literature has pointed to some of the weaknesses

of this kind of approach. Consider figure A. If the farmer is unwilling to accept a

gamble that would give him 10 and -10 with equal probability, then there is no way one

could make him accept a gamble that gives him -20 with probability half and an infinite

amount of money with probability half. Similarly, people have been found to act in ways

that violate the expected utility hypothesis. For instance, individual generally place more

weight on payoffs that are certain as compared to uncertain payoffs (depicting risk

aversion). However, when two uncertain payoffs, both with low probabilities, are


Preliminary Analysis, Not for Citation or Quotation









available, a risk-taking behavior has been observed. This phenomenon was first

documented by Maurice Allais and is popularly referred to as the Allais paradox (Starmer

2000). One of the most popular alternatives to the conventional risk aversion theory,

termed the 'prospect theory', has been presented by Kahneman and Tverskey (1979) in

introducing the concept of 'reference dependence'. Individuals do not consider their final

utility while making a gamble, but consider the losses and gains from some reference

point (such as their current wealth). This choice is characterized by 'diminishing

sensitivity' and 'loss aversion'. Diminishing sensitivity implies that the losses that are far

away from the reference point would have lower psychological impact relative to losses

closer to the reference point (Starmer, 2000). Loss aversion implies that losses are given

higher weightage than gains, i.e., u'(x) < u'(-x) (Starmer, 2000). The effect of both

diminishing sensitivity and loss aversion may lead to an S-shaped value function. The

Rank Dependent Expected Utility theory, proposed by Quiggin (1982), claims that agents

tend to put higher subjective weightage on events that lead to lower values (pessimism)

and lower weights to events that lead to higher outcomes. Such kind of weighting of the

probability distribution may lead to non-linear probabilities and may consequently alter

the risk aversion of the agents. For instance, people with high risk aversion and

pessimistic attitude would be 'universally risk averse' (Starmer 2000). On the other hand,

people with high risk aversion but who tend to put high weights on higher valued

outcomes and low weights on low-valued outcomes may still turn out to be risk takers3




3 While the reference dependent preferences theory has merit and is rightly being applied to explain
economic behavior, one could easily get swept away by the deluge of theories in psychology to explain risk
aversion. Recent advances in psychology have tried to explain risk taking behavior through mood swings
which could be brought in by factors such as weather conditions (Kliger and Levy, 2003). Apply this to
water markets and you get risk taking behavior under sunshine (read droughts)!

Preliminary Analysis, Not for Citation or Quotation 24









So what implications can be drawn for water markets from this new emerging

theory of risk aversion that accommodates psychological and behavioral aspects? First,

the prospect theory suggests that if farmers consider the potential loss of water rights to

be real, then risk of water rights loss represents a further disincentive for them to enter

the water market. Similarly, the rank theory would imply that farmers with high

subjective probabilities regarding the loss of water rights would shy away from water

market participation even if they are not risk averse by nature.

The literature on behavioral economics has largely relied upon the use of

'Machina' triangles (Machina 1982) to depict the indifference curves between various

prospects given their probabilities. The figure below gives an example.



N Figure B







*D


M 0

In the above triangle, M, N, and O represent three prospects. The probabilities of their

occurrence are depicted on the sides of the triangle. For instance, event M occurs with

certainty at point M with falling probability as one moves along the side towards O.

Similarly, the probability of M falls along the side towards N. Point D puts positive

probabilities on the occurrence of all the three events. The straight lines connecting the

sides represent the indifference curves between the three prospects. These indifference


Preliminary Analysis, Not for Citation or Quotation









curves increase from south to north and east to west. Risk averse behavior would imply

that prospects M (at the origin M) and D both of which yield the same value do not lie on

the same indifference curve. Prospect M (at the origin M) lies on a higher indifference

curve than D. This is because M is received with certainty whereas D is in probabilistic

terms. This risk aversion has been captured by the 'fanning out' of the indifference

curves as they move from east to west and south to north, thus implying that a certain

prospect could be forgone for an uncertain one only if the probability of the uncertain

event rises by more than what is required to give the same expected value as the certain

prospect. Let's consider the application of the above approach to the case of water

markets. A major decision for the farmer's involves participating in spot and options

market into order to hedge against the risks or simply to make speculative profits. We

use the Machina triangle analysis to depict the preferences over the two markets. Figure

C below depicts the case when spot markets yield the highest profits followed by options

markets and finally the agricultural markets yielding the least profits. ON and OM

represents the indifference curve between option, spot market and agricultural profits.

Risk aversion implies that a prospect R which yields the same expected profits as a sure

return in the option market denoted by the origin O lies below the indifference curve that

ranks a sure profit from the option market with probabilistic outcomes in all the three

markets. Therefore, when profits in the option market are sure and higher than the

agricultural markets, spot market participation would be deterred. This may not be the

case when uncertainties in the option market increase as shown by point S, which lies

below the indifference curve OM. In such a case the farmer is willing to take more risks

as is evident from the figure, with point S lying above the indifference curve OM. The


Preliminary Analysis, Not for Citation or Quotation









tradeoffs between the spot and options market are not that straightforward in real life.

Options markets are more prone to transaction costs imposed by litigation which may not

be found in the spot markets due to the short nature of their transactions. This case is

shown in figure D. Note that the east axis of the triangle holds the options market profits

implying that the profits from agricultural markets are now higher than the spot market

profits. Note that in this case point S' that yields lower probabilities of agricultural

returns and higher probabilities of a lower option market return make the farmer a risk

taker inducing option and spot market participation.



Spot Spot







Option *R

Ag Ag
Figure C Figure D






On the other hand when the chances of agricultural profits are high, both spot and option

market participation is discouraged as show by point R' which lies below the curve that

would make the farmer indifferent between a sure return in the agricultural market and an

uncertain return from all the markets.

Organization and Water Market Failure


Preliminary Analysis, Not for Citation or Quotation









The nature of market participants is another factor affecting water development

potential. Rosen and Sexton (1993) provide an interesting explanation for the infrequent

trade in water between the rural and urban areas. They argue that most of the water rights

are owned by large organizations in the West which suggests an element of co-operative

decision making between water sellers and buyers. For example, in southern California,

the Imperial Irrigation District (IID) provided about 2.6 million acre-foot of irrigation

water to about 6,900 farm accounts annually in the 1980s. On the other hand, the

predominant buyer of water from IID was the Metropolitan Water District (MWD), a

water wholesaler to about 27 municipal and county water districts. Vaux and Howitt

(1984) claimed that water trade between IID and urban users could reach up to 1,090,000

acre-foot. resulting in a gain in capitalized value of $3 billion. However, the actual

trading between IID and WMD reached only to a level of 10, 0000 acre-foot. in 1989

after a protracted period of negotiation spanning almost a decade. In their study, Rosen

and Sexton attribute this low level of transactions in the face of potentially large gains, to

inefficiencies brought on by the intra-organizational conflict within the IID. They argue

that in such a cooperative entity, majority voting may not lead to an optimal equilibrium

due to the cycling effect. Cycling is caused when it is impossible to arrive at an

organizational preference that is transitive in nature, i.e., even though individual

preferences may be transitive, group preferences may not. Further, even if no cycling is

observed, the group choice may not maximize group welfare if voting rights are not

properly defined. In the case of IID, voting rights were defined on per-person per-vote

basis. Four types of policies were available to the group. The first, limited entry, was to

not participate altogether. The second, expanding the resource, would lead to utilization


Preliminary Analysis, Not for Citation or Quotation









of trading revenues for conservation and expansion of water supply. The third,

negotiating certificates, would allow distribution of revenues based upon the level of

individuals' water rights. Finally, the fourth, maintaining the resources, focused upon

maintaining water deliveries at their pre-trade levels. The actual transaction between IID

and WMD required that a substantial portion of the revenues from trade be devoted to

irrigation system improvements which were ineffective. The parties within the IID that

would have benefited most from this trade were the absentee landlords owning large

tracts of land. Whereas, the parties that would have lost most were the high-value crop

growers that mostly rented their land and large land owners with crops that yielded low

values. The main point of this paper is that due to the one-person, one-vote nature of

restriction in the cooperative, maximum benefits could not be realized. Further, a clash

of interests among the water right owners within the cooperative resulted in inordinate

delays in operationalizing the water market.

Spot and Options Markets: The Advanced Stages of Water Markets

While trade in agricultural water proved so complex, ironically, some agricultural

commodities have been successfully traded in the options market since the 19th century.

After a governmental ban on agricultural commodity options in 1936, trading in

agricultural commodities options was reintroduced in 1984 by the Commodity Futures

Trading Commissions (CFTC). The Chicago Board of Trade (CBT) today trades

commodities options such as corn, soybean products, wheat, rice, etc. Future markets

also exist at New York's Cotton Exchange and Chicago Mercantile Exchange. The main

purpose of future options has been to allow the farmer to hedge against the risk of volatile

future prices. Similarly, options markets exist in the natural resources arena. Brennan


Preliminary Analysis, Not for Citation or Quotation









and Schwartz (1985) apply the option pricing theory to study investment in copper mines.

The option to invest is related to the value of mines, which is related to the price of

copper in spot markets. Paddock, Siegel and Smith (1988) have looked at the oil sector

to study the option value of oil exploration and extraction, related to the future prices of

oil. Watters (1995) points out the supply-side similarities between oil and water markets;

while oil supply is a function of geological uncertainties, water supply risks are

hydrological.

Psychological factors may play an important role in determining the amount of

options traded the water markets. For example, when prices are rising, sellers may have

expectations of still higher prices and may hold back sale of their water. Lutgen (1999)

demonstrates that when other financial instruments such as insurance and bonds are

available, the farmer may buy insurance to guard against falling prices while wait until

the premiums on the put options start to fall, before selling.

Limitations of water market development may vary with the type of market

transaction. There are three basic types of water market: the permanent water rights

transfer, spot water market, and the contingent (or options) water market. Temporary

transfers have been advocated due to reduced impacts on both the farmers and the

environment. Some impacts of long term water transfers include loss of soil fertility due

to prolonged periods of no-cultivation, invasion of fallow lands by alien species that

might be costly to eradicate, increased waste water treatment costs, and reduced

agricultural productive capacity (Howe 1997).

Most studies have treated water rights as assets that are traded through long-term

contracts. However, some studies have emphasized the role of spot markets in


Preliminary Analysis, Not for Citation or Quotation









facilitating water transactions as they allow more flexibility and generally do not cause

severe third-party impacts. Saleth et al. (1991) assess how spot markets would be

restricted to few participants in presence of third party impacts caused by the flow pattern

of water. For example, if a water transaction between two parties infringes upon the

original water rights of downstream users, the scope of water transactions may be limited.

In presence of such thin spot markets, transactions may be characterized by bargaining,

the outcome of which would be affected by such factors as the size of the bargaining

units, the nature of water rights (equal sharing versus priority sharing), the nature of the

bargaining mechanism, and the availability of information on the participants payoffs.

One common form of bargaining involves a process in which the product of the

payoffs of the bargaining parties is maximized. Formally stated, if z, is the payoff of

agent i from a successful bargain and c, is his payoff in presence of a failed bargain, then

a bilateral bargaining equilibrium (bbe) would be to maximize the Nash product

(z, c, )(z c ) between two participants i andj. In case of multiple agents, a multiple

n(n 1)
bargaining equilibrium (mbe) would be an outcome of simultaneous ( 1) bbes
2

between all the n parties participating in the bargaining game. Saleth et al. use a

modified version of the above bargaining rule designed by Zeuthen (1930) and Harsanyi

(1967-68) that incorporates the possibility that a bilateral deal struck between two players

may foreclose the possibility of trade for other participants, a defining characteristic of

the water market. In the modified approach 'risk limit' of players is used to resolve this

issue. Risk limit, or the level of a player's vulnerability to a successful bargain is defined

as:


Preliminary Analysis, Not for Citation or Quotation










(1) r, -=


That is, player i's risk limit is a function of the difference in i's payoff and the

amount offered by bargainer j. The higher this number, the higher the risk limits of

player i. Saleth et al. (1991) apply this approach to a case of Crane Creek watershed in

the Kankee County of Illinois. Their results indicate that the vulnerability of a market to

bargaining-related distortions is inversely proportional its size. Distortions are measured

in terms of payoffs relative to a competitive case outcome. Distortions are also found to

be greater under an Equal sharing scheme as allocation of an equal amount of water

results in more bargaining power for all agents. Similarly, the case of perfect information

about each others' payoffs is less efficient as compared to imperfect information. In the

case when information over other party's payoffs is not available, concavity of yield

function results in lower expected payoffs thus restricting the bargaining strength of

parties. Recently Murphy et al. (2000) have looked at the performance of spot markets

through Experimental Economics. In such experiments computers are used to jointly

maximize the total surplus of buyers and sellers, wherein bids are submitted by buyers

and sellers in the spirit of auctions. The authors argue that such experiments help better

understand the real world problems and allow us to prepare in advance for them. The

experiments face similar problems faced in a real spot market, namely low efficiency in

case of thin markets and high volatility caused by participants' reluctance to wait until the

last moments of the game before releasing information regarding their valuation for

water.

Of the three main types of water markets, the permanent, the spot market and the

contingent market, the last one has been advocated to be of particular interest in various

Preliminary Analysis, Not for Citation or Quotation 32









regards. Howitt (1998) makes the case for options markets by arguing that spot markets

and the permanent-rights markets constitute two polar cases wherein risk is shifted from

one party to the other. In case of spot markets, most of the risk is borne by the buyer due

to the thin market characteristics of such transactions. In the case of permanent rights

market, the seller of the rights needs to evaluate the value of his rights given current and

expected future demands. The risk of selling the rights at a lower price than what may

occur at sometime in the future is always there, especially if the seller is risk averse.

These risks and uncertainties introduce significant transaction costs. He argues that

options markets can help lower the risks arising from both supply and price uncertainties

to both parties. The analysis of options has been largely restricted to the finance,

literature and relatively little is available in terms of derivation of option value of water.

Michelson and Young (1993) examine the role of water-supply options contracts

in facilitating water markets. Under this kind of contract, owners of the water (farmers)

do not give up rights to water and typically lose access to water only in the dry periods.

A number of conditions must be satisfied in order for the option markets to work. Chief

amongst them are reliability of water supplies (to ensure sufficient water during dry years

and plenty during normal years), well defined property rights, ability of the seller of the

water rights to temporarily suspend his operations, availability and knowledge of risks of

drought, and attractiveness of option contract costs as compared to alternative costs of

attaining water in dry years. The authors further cite features of the water market that

distinguish it from other kind of options contracts. These include the temporary nature of

the contract (transferring use Vs ownership rights), potential exercise of the option

multiple times over the contract period, and exercise of option being supply- dependent


Preliminary Analysis, Not for Citation or Quotation









rather than price dependent. They define the option value of water as the difference in

the cost of the options contract and the next best alternative source of water. Applying

their model to water supplies for Fort Collins, Colorado, obtained from the irrigated

farmland in Cache la Poudre River Basin, they derive the maximum option value of water

to be about $295 per acre-foot, which is well above the range of farmers' forgone benefits

in 'dry' periods that fall in the range of $39-$135 per acre-foot. In their results, farm

offer price- defined as the cost of exercising the option- has a negative impact on the

value of options; on the other hand, the option value rises with both water-right prices

and the discount rate. It may be possible that farmers incorporate both the price of water

rights and benefits from future contracts in deciding the amount and price of future

contracts. For example, if the expected benefits from future contracts fall below the

water right prices, they would be more inclined to sell their rights rather enter into an

option contract. This kind of analysis would involve a simultaneous solution of demand

and supply curves for buyers and the sellers and could be examined in a possible

extension to the above work.

Using a continuous-time stochastic dynamic approach, Howitt illustrates some of

the features of the option value of water. Assuming that the value of water rises over

time, its growth rate could be defined as:


(2) = dt + cdz
s

where, p is the deterministic drift parameter and o is the standard deviation. dz is a

Weiner process that is equivalent to a continuous time random walk. Now, the value of

water at time T is what the buyer would be willing to accept or the seller willing to pay at

that time. Therefore, if the price for use of water at time T is E, then the option would be


Preliminary Analysis, Not for Citation or Quotation









of value S(T)-E, if S(T) is higher than E; on the other hand, it would be valueless if the

above difference is negative. Howitt then defines the worth of an option at any time t

before its maturation period as:

(3) p(t) = f(S, E, T, t)

Using Ito's Lemma, the rate of change of this price of option is then derived as:

dp df d 2f
(4) = rp rS- -.5r2S2d2f
dt dS dS2

In the above equation, r is market rate of interest. Thus, the change in the value

of an option over time is a function of the ongoing market rate of return, the value of

water at that time and its variance. From the above equation one could infer that the rate

of change in the option price for water would be lower at a higher value of water

assuming concavity in the option price and value of water relationship. Also, a higher

variance in the value of water would raise the rate of change in the price of options.

Howitt also provides the solution to the option price from the past literature (which is too

cumbersome to put here, see equation 6, pg. 129). However, from that equation it can be

inferred that the option price of water varies positively with the time of maturity of water

and the market rate of return. A higher time of maturity raises the price of the option

because it helps spread the risk over a longer time horizon. Howitt sees this as a

particularly significant contribution relative to spot markets and permanent water rights,

as it allows spreading of such risks without requiring permanent transfer of water rights.

Houffaker et al. (1993) study the potential use of contingent water markets to

augment stream flows in the Snake River that would help the downstream migration of

salmon stocks listed as 'endangered' under the ESA. The authors note that most of the

cost of buying water through contingent markets could be borne by electric powerplants


Preliminary Analysis, Not for Citation or Quotation









that use inriver flows for generating electricity. They point out that given the beneficial

impacts and the federal priority for protection of endangered species, legal obstacles that

have hindered contingent markets from developing could be readily overcome.

While Howitt (1998) assumes that the value of water rights are influenced by

stochastic supply and demand conditions, numerous factors determine the supply and

price of options. The seller's perception of the risk from loss of water in a dry year is

regarded as a major determinant of the supply response for water rights. As one study

(Moore and Dinar, 1995) points out, water might be regarded as a fixed input rather than

a variable input, thus substantially increasing the opportunity costs of water to the farmer.

The drift term p and the variance term o may only capture the change in value of water

brought by rising urban demand and land values. However, these reflect the demand side

impact. The supply-side impacts can only be determined by incorporating the farmer's

optimization function given his perception of future risks from supply shocks. Further,

some (Gaffney 1997) have even argued that water is over applied in agriculture and thus

any future reduction in supply could easily be absorbed at no loss of profits or substituted

through groundwater extraction. If such is the case, some farmers might be inclined to

use water for speculative gains in the spot markets instead of hedging in contingent

markets. Similarly, size of the water market would have implications for the profits

farmers could earn from selling contingent claims. Currently, not much work has been

done to model such supply side issues related to water rights in order to fully integrate it

into a contingent market framework.

A related study that looks at contingent water markets is by Villinski (1999).

Villinski notes some of the drawbacks of the current contingent water market approach.


Preliminary Analysis, Not for Citation or Quotation









One major drawback of adopting the contingent market approach from finance involves

the manner in which evolution of uncertain prices has been handled. The assumption of a

Brownian motion implies that prices follow a continuous-time, random walk with mean

zero and variance of one that is rising linearly over time. Villinski points out that water

prices might show seasonality, and perhaps a mean-reverting approach would be more

fitting. While she follows a similar framework as Howitt, the methodology used is quite

different. Drawing on data from Watters (1999) and applying it to the case of California,

she solves for the European call option value of water, which could be exercised two

times in a three year period. While the calculated option value is quite low ($1.45), it

approximates the real option value that the buyers of water in California were willing to

pay in case of an options market in 1994-95. The California department of water

resources, in an attempt to reduce the scarcity of water to the urban areas, invited bids

from both buyers and sellers for sale of options for water for 1995 (Jercich 1997). Some

310, 000 acre-foot of water were demanded by the buyers in response. However, only

230, 000 acre-foot of option water supplies was offered by the sellers. The negotiated

option value of water turned out to be $3.50 per acre-foot with an exercise price of

$36.50 per acre-foot. However, due to high precipitation in 1995, these options were

never exercised.

Another example of contingent water trade (Howitt 1998) involves the Palo Verde

irrigation District (PVID) and the MWD of California. In this program irrigators were

promised $620 per acre that was fallowed. This led to a total conservation of 114 million

m3 of water, which could be called by the MWD at any time up through year 2000.


Preliminary Analysis, Not for Citation or Quotation









Options market may also have unintended effects of mitigating third party effects.

Because of the time lag between the sale of an option and the exercise of the option, the

seller has sufficient time to inform the third parties of potential impact. Similarly, the

indirect impacts of forgone agricultural output can be mitigated substantially through

advanced planning and supplementary income generated through options sale.

A Simple Model

In most modeling applications to water markets, the exercise price of water-or the

price paid for use of water in the future- is treated as a constant when assessing the option

value of water. In reality however, the exercise price and the option value are likely to be

both endogenous and related. As a consequence, the option value cannot be accurately

solved for when ignoring such supply-side factors as farmers' level of risk perception and

size of market. Consideration of these factors is explained below with the help of a

simplified model.

Let wo0, be the water available to the farmer in a wet year when full water

entitlement is used, and wotbe the water available to him in a dry year when he sells s

units of water through the options market. It is assumed here that the farmer is able to

substitute groundwater for reduced surface supplies, in a dry year, so that he has tot units

of water whether or not drought occurs. Only reduction in supply he faces is through his

water sales; water transfers cannot be made up by increased groundwater use. Let

z(wto,)be the profits from water use in the wet year and zr(w t,)the profits in a dry

year. Also let hbe the option price for water this year and k the exercise price of water

next year. Now, if he decides to enter the market his profits are computed as4


4 This is a one-year option with one-time option value.

Preliminary Analysis, Not for Citation or Quotation 38









(5) hs + (1- q)r(w.to) + (q)(Qr(w,, ) + ks)
1+r

where, q is the probability of a dry year next year, and r is the market rate of interest.

The optimal amount of water he sells would be determined by the maximization of the

above objective function with respect to water sales. If he stays out of the market, his net

present value of profits next year is5:


(6)
1+r

Assuming transactions costs and risks are zero, the farmer would enter the market if:

() h* + (1 q)-r(w, ) + q( r(w,,, ) + ks*) (wtot)
(7) hs >
1+r 1+r

where s* is the optimal amount of water sold. Rewritten, this can be expressed as:


(8) h> (
1+r s 1+r

The option value has to be larger than the expected value of the difference between 1) the

per unit opportunity cost of sold-water to the farmer and 2) the exercise price of water.

The above equation defines a relation between the option value and exercise price

(exogenously specified, thus far) and farm level parameters such as productivity, market

discount rate and risk perception. Note that if the opportunity costs of forgone water are

higher than its exercise price, the total option value required to induce the farmer to

participate (on the left hand side in equation (8) ) becomes larger, the larger is the

probability of a dry year. On the other hand if the exercise price is well above the

opportunity cost of water, the inducement threshold would fall as the probability of a dry


5 This is the simplest case. If the seller does not enter the market, he might still have the option to indulge
in spot market sales with the possibility of higher gains.

Preliminary Analysis, Not for Citation or Quotation 39









year rises. Risk perception of the farmer, therefore, turns out to be an important

parameter in the above case. Also, note that if the profits from water usage are concave

and the farmer is fully using his water entitlement, the opportunity cost of water sold at

the margin may be lower, thus lowering the threshold for market participation. Finally, if

the farmer is risk averse, his expected utility (the right hand side) would be much lower

than if he received the same income with certainty. In that case, for a given option value,

the exercise price would have to rise to induce him to participate.

The above equation also yields a negative relationship between option value and

exercise price, keeping everything else constant. In reality, the farmer may be able to fix

both while negotiating with the buyers. Therefore, significant opportunities exist for the

farmer to incorporate both the option value and exercise prices as endogenous parameters

into the sellers profit maximization function in order to maximize his own gains.

However, in cases where the market size is large, such opportunities may be limited.

Consider a simultaneous settlement of exercise price and option value by both buyers and

sellers.

From the above, the relationship between option value and exercise price for the seller

can be characterized as:

(9) h = h(q, r, 7r, k)

The buyer of water has a similar negative relationship between option value and exercise

price (see Howitt 1998):

(10) h = h(v, r, k) where v is the value of water to the buyer6





6 Buyer's option value, among other things is affected by the next best alternative source of water to him.

Preliminary Analysis, Not for Citation or Quotation 40









Howitt derives the option value of water under the assumption that water price evolves

stochastically over time in a geometric Brownian motion fashion, and therefore is not

directly applicable to our model. We instead, borrow an exposition of option value from

Cox et al and apply it to the case of water. Following Cox et al., we can write the option

value of water as:


(11) h = ( --d)h ( + ( -)hd
r u-d u-d

where, r-1 is the risk-free rate of return, u-1 is the value of water in a dry year, and d-1 is

the value of water in a wet year. Further,

(12) h, =uP- k & h =dP k

where P is the current price of water. This formula however reflects the no-arbitrage

condition which requires that the option value of water could be replicated by a portfolio

consisting of water stocks and a risk-less bond. In reality however water is not traded in

the stock market. Therefore, we simplify the above formula by assuming that the option

value of water is simply its expected return in the future given by:

(13) h q(uP k) + (1- q)(dP k)
1+r

or,

(14) h =h(q,P,k,r,u,d)

Notice that the option value falls with exercise price as suggested in the literature.

Plugging the value of h into the farmer's participation constraint given by equation (8),

we derive the threshold level of current price of water beyond which the farmer would

find it attractive to enter the market as:


Preliminary Analysis, Not for Citation or Quotation










(15) P > or to-s
s{q(u-d)+d -k(- q)}

Figure 1 represents the relationship between option and exercise price of water, and

possible cases that would lead to an exchange and those that won't.

[NSERT FIGURE 1 HERE]

The solid line is the (h, k) relationship for the buyer, the dashed lines are for the seller7.

In case A, the seller values the option price highly relative to exercise price, whereas in

case B the exercise price is more valuable. The relative importance of the two would be

determined by the farmers own discount rate, which is a function of the market rate and

individual risk perception. Both these cases would potentially lead to a successful

transaction. On the other hand, case C represents a market failure as the buyer's

willingness to pay is below what the sellers are willing to accept, not uncharacteristic of

conditions in current day water markets. This may also occur when the farmer

compares the benefits from participating in the spot markets and the options market as

well. Formally, if uP is the price in the spot market for a unit of water, his participation

constraint would be given by8:

zuPq (1- q);r(wo ) > q(r(w,,, + ks) + (1- q);r(w,, )
(16) q r(wto(l ) + + > + hs
1+r 1+r 1+r

In the above equation, z is the amount of water sold in the spot market. The optimal

amount of z would be determined by the optimization of use of water in agriculture and

expected profits from the spot-market sales. Similarly, the amount of water sold in

options market would be determined by the maximization of the right hand side term in



SNote that the buyer's (h, k) relationship could be non-linear, but is assumed linear here for simplicity.
8 We make a simplifying assumption here. There is no spot market in a wet year as the buyers can access
alternative sources of water much cheaper than those from agriculture.

Preliminary Analysis, Not for Citation or Quotation 42









equation (16). If equation (16) holds, then the farmer would rather sell his water in the

spot market instead of the options market. The profit curves from the two cases are

depicted in figure below.

[INSERT FIGURE II HERE]

AB represents the falling marginal productivity of water in agriculture. L'L is the option

value of water and N'N is the spot price of water. AL is the use of water in agriculture in

the case of option sales. In the case when the farmer intends to sell water in the spot

market, AM is the use of water in agriculture when spot market happens and AMB is the

use in a wet year. The profits in case of option market participation are ANZ and in the

case of spot market activity are AUW with probability q and AMB with probability (1-q).

The condition that would determine whether spot market participation is more beneficial

would be given by:

zuPq q(r(tw0or- + ks)
(17) qcr(wto- ) + + > + hs
1+r 1+r

Not that the first term on the left hand side is the expected profits in agriculture from spot

market participation, whereas the first term on the right hand side is the expected profits

in agriculture from sale of water in the options market. Since water drawn from out of

agriculture would have the same impact on loss of productivity whether in a spot market

or the options market, we could discard the two terms to get:

) zuPq qks
(18) +> + hs
1+r 1+r

The above condition requires that expected profits from spot market sales must be larger

than the sum of the option value and the expected exercise price. In the above equations

we have assumed that the farmer chooses between spot and options markets on an 'either/


Preliminary Analysis, Not for Citation or Quotation









or' basis. However, if the above condition holds, that choice would still be optimal even

in a case where profits are maximized by allocating some water to the options market and

some to the spot market. This is so because we have assumed that there is no demand-

side constraint and that the farmer is able to supply as much as he chooses. Given that, if

it is optimal for him to sell one unit of water in the spot market, it will be optimal for him

to sell the next unit as well since his marginal revenues do not fall. Note that while the

gains from both the spot market and the exercise price in an option value market are

assessed in terms of expectations, the option value is certain. Therefore, a higher option

value-despite high expectations of profits in a spot market- may deter the farmer from

participating in the spot market. However, from above we know that the options value is

given by:

(19) h q(uP k)+(1- q)(dP k)
1+r

Plugging the above back into (18), we can solve for the critical threshold for current price

of water beyond which the spot market becomes an attractive option over the option

market. This is given by:

(20) sdP (1- q)ks
(20) P >
q(zu s(u d)

The above is a simplified model. Decision rules would be far more complicated

within a multi-period setting with multiple exercise options or when more realistic

scenarios such as transaction costs and risks are incorporated. First consider the impact

of significant transactions costs on the above results. Transaction costs would lower the

effective price received by the farmer from his sale of water options. This would,

therefore, require a higher threshold level of current price of water (given by equation


Preliminary Analysis, Not for Citation or Quotation









(15)) in order for him to participate. Similarly, the threshold level of price derived in the

case where he has a choice between participating in spot market or water options market

would be affected by the relative transactions costs of the two markets. Typically, the

transaction costs of water are much higher in an options market as it may involve an

actual transfer of water rights (over the specified period). In such a case, the spot markets

would become more attractive and the threshold level of current water price (given by

(20) above) would fall.

There are a number of other significant characteristics of water markets that have

not been addressed by this simple model. First of all, the model assumes the existence of

a competitive market. However, in reality, the size of the market would vary across

location based on level of urban needs; presence of alternative supplies of water;

existence of regulatory, legal and financial infrastructure necessary for successful water

markets; and other factors. A small market would have a higher element of strategic

behavior as compared to a market with a large number of participants. Strategic behavior

would make the option value endogenous as sellers could affect it by holding back water.

Second, decision rules would be much more complicated in a multi-period setting

with multiple exercise options. While, the one period model considered only the risk of

water shortage from drought, there are other types of risks too may become more

significant in a multi-period setting. Transaction risk from third-party claimants to water

may increase with contractual arrangement tied to future water supply contingencies, and

uncertainty regarding future water supply demand conditions. Another source of risk

involves the fear of loss of water rights for farmers who trade their water in the markets.

This reflects a concern that future adjudications of water rights might consider previous


Preliminary Analysis, Not for Citation or Quotation









use pattern of water (agricultural consumption versus market sale) by farmers and that

market sale may not be regarded as a beneficial use. Finally, there are various demand-

side risks. Prices of commodities might fluctuate with weather and global supply

conditions. Such risks would affect the way the farmer views his profit potential from

agricultural output in a water-constrained year. Some input supply and output processing

industries that depend upon a reliable production of agricultural commodities, might shift

to water-surplus regions if water markets affect agricultural productivity, with

implications for agricultural sector returns. There is also a risk of irreversible changes to

the productivity of farmland from sale of multiple year options. In case of a severe

sustained period of drought, farmers' land could get invaded by invasive weed species

which might be difficult to eradicate. Other effects of multi-year fallowing may include

loss of employment; farming skills; equipment depreciation; loss of tax base, etc.

resulting in reduced support for water transfers.

The modeling of long term risks of droughts may require a different approach.

While year to year water supply is forecast based on the current status of hydrological

conditions, long-term forecasts require a historical assessment of such events. In the

finance literature, the value of an option is composed of two parts; time vale and intrinsic

value. Time value is determined by the time left to expiration of the contract. The

farther is the time to expiration, the higher the time value, as uncertainty is higher. In the

case of a multi-period water option, time value would need to be determined by the

historic probabilities.

Conclusion


Preliminary Analysis, Not for Citation or Quotation









Water constitutes one of the most fundamental needs for the humans, animals and

the environment. However, there is not enough water to meet the needs of all. To

compound the problem, current allocation of water does not meet the efficiency criterion

of water going to the neediest. It is with this need that efforts are being undertaken to

implement water markets in USA and rest of the world. Yet there are significant

challenges to implementing water markets. Surface water has certain unique feature

that separates it from other commodities. The supply of surface water is seasonal and

uncertain, largely dependant upon the hydrological conditions. Further, there are

significant limitations to the extent it could be transferred and stored. Other challenges

include uncertainty of water supply, institutional bottlenecks, behavioral responses, etc.

Such challenges manifest themselves at various levels of water market development.

Whenever the institutional infrastructure fails to co-evolve with the water markets or is

completely lacking, the development of water markets is stagnated. Evolution of markets

also leads to the evolution of market participants which in turn requires further evolution

of institutions to match with their specific needs. The survey of the literature suggests

that while transactions costs, ill defined property rights and third party impacts constitute

significant institutional deterrents to market development, response to risks and future

expectations of government policies make for major participatory risks to its

development. The advanced stages of water market, namely spot and the options market

need the backing of very sound institutional settings to function effectively. Further, the

choice between the two itself is dependent upon several factors which affect the impact of

water trade upon the buyers and the sellers. Even when the institutional development is

sound and forthcoming, inexperience of water right holders in market transactions


Preliminary Analysis, Not for Citation or Quotation









coupled with suspicion over market induced federal policies that may take away their

water rights could be a significant inhibiting factor for water trade. Further research will

need to focus upon these behavioral responses in order to come up with meaningful

policy implications for water market management.


Preliminary Analysis, Not for Citation or Quotation









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Preliminary Analysis, Not for Citation or Quotation









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Preliminary Analysis, Not for Citation or Quotation









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Preliminary Analysis, Not for Citation or Quotation











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Preliminary Analysis, Not for Citation or Quotation










Figure 1: Market and Institutional Evolution


Physical Infrastructure


Stored Water Controlled
Delivery


Measurement
Capability


Inter-State
Transfer Facility


Legal Infrastructure


Take All You
Want


Property Rights Development of State Controlled
Well Defined Units Enforcement


Incorporation of Private
Third Party Impacts Enforcement


Financial Infrastructure


Informal--
Between-Farmer Contracts
Between Commodity Contracts
Government Subsidy and
Indemnity Payments


Formal--
Banks, Insurance, Hedging,
Forward Markets


Stages of Market


Informal Ditch
Exchange


Project
Exchange


Out-of-Project
Exchange


Non-
Competitive

Water Banks


Competitive/Non-
Competitive

Spot and
Options Market


Preliminary Analysis, Not for Citation or Quotation


Enhanced
Hydrological
Predictability


None











Figure 2: Evolution of Water Market through Feedbacks


Exogenous


Transaction Costs


Water


Enforcement
And
Monitoring,
Reduction in


Risk Sharing


Definition of Property
Rights


Preliminary Analysis, Not for Citation or Quotation










Figure 3: Determination of Option Value and Exercise Price


Case B


Case C


Exercise Price


Preliminary Analysis, Not for Citation or Quotation


Option Vc










Figure 4: Profits from water Sales in Option and Spot Markets


water use in agriculture


Preliminary Analysis, Not for Citation or Quotation


productivity ofwater





A





M'




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