Water, Water Everywhere, and Nary a Drop to Trade

What can we learn about property rights and markets from the negotiation over the Colorado Compact?

This winter, the seven Colorado River Basin states – Colorado, Wyoming, Utah, New Mexico, Arizona, Nevada, and California – renegotiated the century-old Colorado Compact, the agreement that stipulates water management for the Colorado River and its tributaries. If there's a thornier common-pool resource problem than electricity transmission and distribution, it's interstate water. The change in variability in weather patterns (and the fat-tails distribution) associated with climate change will compound the water allocation problems that the West has experienced for more than the past century, problems that the Compact was intended to ameliorate but never did. It didn't ameliorate them because it has entrenched a static, brittle, non-market set of regulatory institutions that prevent trading water to higher-valued uses and stifle the communication of the actual value of water through prices.

There's important economics in play here, as well as a hearty dose of political economy that the history of the Compact makes clear. In 1997, commemorating the 75th anniversary of the Compact, a Colorado River Compact Symposium drew together water scholars for a workshop. Joe Gelt of the University of Arizona's Water Resources Research Center summarized the history of Compact and its implications for current water use. His conclusions in 1997 resonate today, and the historical origins of the Compact illustrate how important it is to understand the underlying economics and politics when making water policy. If you are interested in understanding Western water, Gelt's essay is extremely valuable, and prescient.

In the 1920s concerns grew about water use from the Colorado River, particularly California's growing population and industrial activity. Throughout human history, the main challenge of river water has been the difficulty of defining and enforcing property rights in an ever-flowing and spatially changing resource. A river and its tributaries form a common-pool resource (CPR), a resource over which defining and enforcing property rights is costly or not feasible, so the resource is used in a shared way as a commons. But shared use means perverse incentives to accelerate use and to overuse the resource, reducing its future value or destroying it entirely. This situation is also known as a collective-action problem because each individual’s incentive to act is not aligned with the actions that would create the greatest aggregate benefit. The lack of alignment is a direct consequence of the costliness or inability to define and enforce property rights, and misallocation and inefficiency are the logical outcomes.

Ronald Coase (The Problem of Social Cost, 1960) analyzed situations like these through his lens of transaction costs: transaction costs prevent parties from negotiating over the use of scarce CPRs, from reallocating rights among the resource users (I discuss this work in Chapter 3 of the book I wrote for the Fraser Institute, The Essential Ronald Coase). With no transaction costs and if there's a clear definition of who has what rights to how much water, if Mary is extracting too much water from the river and it's harming Bill, and if they realize that this is an intertemporal problem and they need to solve this problem over and over every year, they can negotiate the reallocation of rights and the payment for that reallocation; this approach would make the system flexible and adaptable to changing drought conditions as they could reallocate rights when water availability changes. But, as Coase reminded us forcefully, transaction costs are never zero, so the way we define property rights and the institutional framework in which we make these decisions matters a great deal, particularly when the resource in question has hundreds of thousands of users across seven states.

Elinor Ostrom built on Coase's insights and created an even deeper and more profound understanding of how people in CPR situations devise governance institutions through a combination of custom (emergent institutions) and design (planned institutions) (Governing The Commons, 1990). Ostrom found successful commons governance through extensive field research, studying CPR governance practices in Cambodian rice farming villages, fishing villages around the world, and other situations in which people shared use of a resource that could be depleted or destroyed if not used sustainably. She and her colleagues found repeatedly that when the users of a CPR developed a governance framework, either by custom or by deliberate design (or a hybrid of the two), they could avoid the tragedy of the commons. Such governance frameworks rely on the recognition that property rights in the resource are ill-defined, and that defining them is either costly or not feasible, so CPR users instead have “use rights”, a right to use the CPR in a defined way, that can overcome collective-action problems.

The Colorado River Compact was in a way an attempt to create an Ostrom-style hybrid system of use rights for the watershed. The prevailing legal water rights framework in the American West is prior appropriation, "first in time, first in right", which developed out of customary practice as settled ranching and agriculture developed in this arid landscape. This customary practice has been codified into water law, and in 1922 the idea that Californians could create senior claims to Colorado River water that was being "underused" upstream caused concern in what the Compact would define as Upper Basin states – Colorado, Wyoming, Utah, and New Mexico. California, and Arizona to a lesser extent, did not produce much water but claimed a large share, a share that could increase without some agreement on use rights. As Gelt describes it:

Some form of concerted effort seemed called for. Delph Carpenter, a Colorado attorney, rose to the occasion and proposed that the Colorado River states negotiate a compact to determine individual state's rights to the river water. At the time interstate compacts to resolve water disputes was an untried, untested strategy.

Carpenter's reasons for advocating an interstate compact strikes a familiar note today. He was very wary some even say paranoid about federal involvement in state affairs and feared if the states did not get their houses in order the federal government would take charge, to the disadvantage of the states. Also, he wanted to head off litigation that would be time-and-resource consuming and believed an interstate compact would accomplish this end.

The compact's crowning accomplishment was the apportionment of Colorado River water, between Upper and Lower Basin states. The delegates initially intended to apportion river water directly to each state. A seemingly sensible approach, this strategy had the potential to prevent future conflicts among the states. The basis to determine each state's share was to be the amount of irrigable land within a state. Determining such acreage, however, proved to be a very contentious issue, one that threatened to undermine compact negotiations.

Further, as the discussions progressed it became clear to many of the delegates that the major disagreements on the table were between the upper and lower basins, not among the states within each basin. Also the data to determine appropriations to individual states simply was not available. A two-basin strategy was viewed as a means to resolve the difficulties, although it was not to the liking of all the delegates. Arizona's delegate W. S. Norviel complained, "It doesn't arrive at any conclusion, and ... it leaves the two divisions to work out their own salvation.

Despite the objections, the adopted strategy was to divide Colorado River water equally between Upper and Lower Basin states, with the demarcation line set at Lee's Ferry, located in northern Arizona's canyon country close to the Utah border. Wyoming, Colorado, Utah, and New Mexico were designated Upper Basin states and California, Arizona and Nevada Lower Basin states. Each basin was to receive 7.5 million acre-feet (maf) per year. Along with their allocations, the Lower Basin states could increase their apportionment by one maf. This represented a bonus to ensure lower basin acceptance of the compact.

After a long, costly legal battle between Arizona and California that went to the Supreme Court and undermined much of what the Compact was designed to accomplish, the Compact finally went into effect in 1963. But it rested on a fatal analytical flaw: the hydrologic data they used led them to benchmark an average annual water level enough above the actual average that they were perennially in overuse:

The delegates figured allocations on hydrologic data from the Reclamation Bureau that indicated annual Colorado River flow at Lees Ferry to be 16.4 maf. In truth, however, Colorado River flow is a good deal less than that. Data from three centuries indicate an average flow of about 13.5 maf. Also, flows are highly erratic, ranging from 4.4 maf to over 22 maf.

Water scarcity persisted, and in most years California has used more water than its allotment under the Compact. The Compact also did not account for tribal water rights, nor did it include any provisions for environmental quality; as Gelt noted, "That the Colorado River Compact did not include provisions to protect the environment is no more surprising than that Model T's did not have seat belts. Ideas mature, ripen and have seasons. 1922 was not the season for environmental protection." The management of water within states takes place through government administrative water management districts, and for the most part trades between water use types (i.e., between farm irrigation and municipal consumption) are outlawed.

Most importantly, there are no water markets, and therefore no process for price discovery, no way to discover the relative value of an acre-foot of water and how it changes over time and place and use. The political dynamic and disagreements among the Compact states stymied attempts in the 1990s to establish such markets, with encouragement from the federal government that was viewed with suspicion. As Matt Kahn noted recently, markets with price signals generated from actual underlying conditions and preferences would reveal which uses of water are higher-value and which are lower-value, and how those values change. Markets and prices enable us to adapt to those changes, and those changes will require us to adapt as climate change affects the variability of river water patterns.

The New York Times summarized the Compact renegotiation last week, which had been stalled by California farmers' objections to reductions in their allocations and other Lower Basin objections.

The agreement, announced Monday, calls for the federal government to pay about $1.2 billion to irrigation districts, cities and Native American tribes in the three states if they temporarily use less water. The states have also agreed to make additional cuts beyond the ones tied to the federal payments to generate the total reductions needed to prevent the collapse of the river.

It's a temporary deal, and one that required a federal government taxpayer-funded side payment to make it happen. I suspect the value of the side payments and the waste and inefficiency associated with not using price signals is high, and exacerbated by the existing regulations that prevent the establishment of markets and the exchange of water among uses.

How much better water use could we have if all the parties – municipalities, farmers, ranchers, tribes – could generate, observe, and act on more accurate and meaningful information about the relative value of water in its different uses?

In its analysis of the Compact renegotiation, the New York Times also produced a gorgeous and informative infographic on the typical annual uses of the Colorado River watershed water.

Note the large share used to grow livestock feed, 55%! One of those crops, alfalfa, is extremely water-intensive. Why are farmers growing a water-intensive crop in an arid region like Arizona? Matt Kahn provides some insight on that mind-boggling question.

Read up on Arizona’s production of alfalfa. This is a water intensive crop. Less of this stuff would be grown if farmers have alternative options for what they do with their water. If we allow markets to perform their core functions, then we can more cheaply adapt to climate change.

Similarly with cotton. And barley. And almonds. The non-market water allocation institutions embedded in the Colorado Compact and the administrative agencies that have grown around it waste water because they prevent farmers from doing other, more valuable things with the water they have rights to.

That's unsustainable, economically and environmentally.