Mechanisms for Addressing Third-Party Impacts Resulting from Voluntary Water Transfers

Agricultural and Resource Economics Review, Oct 2003 by Mastrangelo, Erin K

Master's Thesis Award of Merit

Voluntary transfers are now regarded as a central instrument in balancing and reallocating the changing demand and supply for water in the arid regions of the world. However, until it can be demonstrated that a water market institution is capable of protecting environmental and third-party values, voluntary water transfers will not realize their full potential as an integral part of a region's water management strategy in the 21st century.

This research uses laboratory experiments to test alternative water market institutions designed to incorporate the value of water in non-consumptive uses into the allocation process. The analysis focuses on third parties, specifically rural communities that depend upon irrigated agriculture but are not party to the market transaction; however, the results apply to most nonconsumptive uses, including environmental impacts and instream flow values.

The institutions tested include taxing mechanisms that raise revenue to compensate affected third parties and a market in which third parties actively participate. The results indicate there are some important trade-offs in selecting a policy option. Active third-party participation in the market is likely to result in free-riding which may erode some or all of the efficiency gains, and may introduce volatility into the market. Fixed limits on water exports are likely to result in a more stable market, but the constraints on transfers will result in lower levels of social welfare. Taxing transfers and compensating third parties offers a promising balance of efficiency, equity, and market stability.

Erin K. Mastrangelo

University of Massachusetts, Amherst

Advisor: James J. Murphy