Climate change will continue to amplify water scarcity and variability. Rising temperatures directly alter the hydrological cycle, intensifying drought and deluges. Climate models predict substantial declines in water resources for irrigation and more uncertainty over future river inflows (1).

These unprecedented environmental changes renew longstanding questions about the efficiency of water allocation. Water regulators typically allocate water through non-market mechanisms, such as quotas based on landholdings, political influence, or historical priority. Economists have amassed considerable evidence for water misallocation under these existing water rights regimes (2). However, such findings have rarely translated into policy, where market-based instruments remain highly controversial.

While water markets can improve efficiency under ideal conditions, the practical realities of a river system make it challenging to obtain evidence of the prospective gains from trade. As a long literature seeking to explain the rarity of water markets has emphasized, trading opportunities in an actual river network may be costly, uncertain, or manipulable. River flow constraints, noncompetitive conduct, and liquidity constraints can dampen or reverse prospective trading gains. Moreover, evidence from several nascent water markets has led some economists to conclude that “the reality of water markets falls short of their potential (3).”

In his paper, “Droughts, deluges, and (river) diversions: Valuing market-based water reallocation,” Professor Will Rafey contributes to this debate over water markets with an approach that accounts for evolving river flow constraints and other market imperfections. His paper relies on new data on water rights, trades, and agricultural production collected from the largest water market in human history, located in southeastern Australia. The empirical framework values the Australian water market in two steps. First, the paper estimates a model of irrigated agricultural production to recover the distribution of water values. Second, the paper compares welfare under observed pre- and post-trade water allocations.

The paper finds that water trading increased output by 4-6% from 2007-2015, which makes shutting down the market for water equivalent to experiencing the median water shortfall from 1°C of global warming. In addition, the gains from trade increased substantially during drought. This result implies that water markets can be important for adapting to climatic variation from long-run shocks like climate change and cyclical shocks such as droughts.

1. On climate change and the hydrological cycle, see Oki and Kanae (2006).
On droughts and deluges, see Prudhomme et al. (2014) and Sobel et al. (2016), respectively.
On irrigation, Elliott et al. (2014) document water scarcity and Schewe et al. (2014) analyze water variability.
2. Libecap (2011).
3. Regnacq et al. (2016), p. 1274.