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Designing Groundwater Markets in Practice

Lessons from three California groundwater basins

This policy brief is part of a volume entitled “The Future of Water Markets: Obstacles and Opportunities,” published by PERC, which addresses timely water policy issues and offers ideas to enhance the future of water markets.

In many areas of the western United States, groundwater reserves have been and are increasingly overdrawn. When surface water supplies from rivers, reservoirs, or lakes are low, farmers often extract and use more groundwater from underground aquifers. Issues resulting from groundwater overdraft—such as increased energy costs to pump, domestic drinking water wells going dry, land subsidence, and saltwater intrusion—are leading regulators to consider pumping restrictions to stabilize water tables. Allowing trade of limited pumpable water can cut the costs of achieving sustainable management dramatically. By trading allocations, pumpers with lower-value water uses can benefit from curtailing or ceasing pumping and selling their allocations to higher-value uses. Farmers and municipalities can compensate their neighbors for making conserved water available, thereby allowing scarce water to flow to its highest-valued uses.

Managing groundwater optimally, however, isn’t quite so simple because groundwater is spatially interconnected—in other words, groundwater extracted in one location can affect groundwater resources elsewhere in the same basin. Surface water and groundwater are also hydrologically connected, meaning that pumping near a stream could affect streamflows at the surface. Thus, groundwater extraction in one location can have unintended and uncompensated adverse impacts on the environment that may be different from impacts incurred in another location from the same amount of extraction. Pumping that has no apparent impact at one site, for example, could dewater a wetland if pumped from elsewhere in a basin. Regulators in groundwater basins are challenged to formulate and design market institutions that maintain flexibility with limited information about the potential effects of a new spatial distribution of pumping.

Given these realities, three prerequisites for an effective groundwater trading program include:

  1. Developing a water budget to inform accounting
  2. Establishing an initial allocation of groundwater pumping rights to groundwater users within a management area
  3. Addressing the differential impacts that groundwater pumping can have within a single basin

A water budget that accounts for groundwater and surface water interactions is foundational to the development of a market and any rules to mitigate unintended environmental consequences. Such a budget should also be coupled with an understanding of the water demands of various users, including for environmental purposes. The water budget determines the cap on the aggregate amount of water that can be extracted, constraining extraction to match the sustainability goals of the basin. The initial allocation of groundwater rights determines the baseline distribution of pumping, which can change if and when trades occur. 

To address the fact that pumping has varying impacts depending on where it occurs in a basin, economists have proposed trading programs that assign trading ratios that adjust the volume of groundwater trades by multipliers to account for spatial consequences. These types of policies are intended to maximize overall well-being, balancing the gains from trade with the mitigation of location-specific, third-party impacts of pumping. 

This policy suggestion, however, abstracts away from the real-world costs of collecting information about each source’s unique impacts, which could prove substantial. Instead, others have proposed simpler market rules, such as designating smaller trading zones within a basin or setting geographic trading restrictions. While these more streamlined market rules may be easier to implement, they add additional barriers to trade that can constrain market activity. 

In this policy brief, we discuss the relevance of these issues to California groundwater management and provide lessons for groundwater managers in other states. Addressing the spatial impacts of groundwater trading is a particularly timely concern in California, where groundwater markets are emerging under the Sustainable Groundwater Management Act. We provide background on this legislation and draw upon three case studies at various stages of development and implementation to assess how unintended third-party consequences are currently being recognized and addressed. We conclude by highlighting important trade-offs in the design of these mechanisms.

  • Groundwater is spatially interconnected, which means that pumping in one location can have direct, unintended impacts on third parties that are different from the impacts of pumping in other locations.
  • As a result, the development of groundwater markets requires careful accounting and design to balance gains from trade with the costs of uncompensated third-party effects.
  • In California, several groundwater markets have emerged that attempt to address these challenges, providing lessons for the development of other groundwater markets.
  • Solutions such as designating distinct trading zones or setting geographic trading restrictions can leverage existing information about the resource to reduce third-party effects, but they may also create barriers to trade that constrain market activity.

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