Issues in the Design of Water Markets

Melbourne Institute Working Paper No. 18/05

Date: December 2005


John Freebairn


Developing the institutional details for markets which will improve the allocation of scarce water as proposed in recent government initiatives is still a work in progress, and the designers face many challenges. Differences in the relevant market time interval, the important effects of geography on costs, and differences in the forms and extent of market failures suggests a system of three property rights rather than a single property right system. Specifically, it is proposed that there be a market for water at source, for water delivery, and a water use licence to capture differences in external costs. For water at source, a dual system of water entitlements with different levels of supply security is proposed. The public good nature of most benefits provided by environmental flows requires direct government intervention informed by ecological assessments and nonmarket valuation of these services. Water treatment and delivery infrastructure costs should reflect at least operating costs and scarcity rents when capacity constraints are reached. The importance of natural monopoly calls for regulatory oversight over infrastructure fees. A system of water use licences based on one of regulations, taxes or tradeable permits is proposed to internalize the different regional and water use external costs of water use.

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