**Measuring the Transaction Costs of Historical Shifts to Informal Drought Management Institutions in Italy**

#### **Adam Loch 1, Silvia Santato 2,3, C. Dionisio Pérez-Blanco 4,\* and Jaroslav Mysiak 2,3**


Received: 6 May 2020; Accepted: 26 June 2020; Published: 29 June 2020

**Abstract:** Coase shows how costly resources are (re)allocated via costly institutions, and that transaction costs must therefore be positive. However, Coase did not elaborate on transitions between institutions which incur positive transaction costs that are characterized by numerous institutional complementarities; that is, feedback loops that inform the need for, and pathways toward, institutional change. Economic investigations of complementary modes of (re)allocation are rarely undertaken, let alone studies of transitions between modes. However, modes of (re)allocation that achieve similar results at less cost are generally viewed as having production-raising value. This paper measures the costs of transitioning drought management institutions in Italy toward informal, participatory, and consensus-based approaches during several recent drought events. The chosen model is Drought Steering Committees, which offer a substitute for current formal (less flexible) planning approaches, and where lower transaction costs that are associated with the transition are inferred. Our results highlight the relevance of empirical assessments of 'costly' transitions based on a historical study of transaction costs, as well as supporting previous works that highlight the value of contextual analysis in economic studies, in order to identify the benefits of institutional investment.

**Keywords:** Po River Basin; institutional economics; climate change adaptation; cost of adaptation

#### **1. Introduction**

Water, an essential resource, is becoming increasingly scarce and costly worldwide [1]. As water scarcity increases, existing institutions that are reliant on inflexible water governance arrangements will constrain corrective action leading to a crisis of governance [2,3]. Identifying or transitioning toward good governance practices and institutions delivering effective, fair and sustainable management of water resources is thus increasingly urgent especially in institutions capable of (re)allocating costly water resources during extreme scarcity events, such as drought.

Generally, institutions can be defined as 'the rules of the game' within which political, social and economic realities operate [4]. Two overarching institutional categories coexist in water resources management: (1) formal institutions, which are established and communicated through channels that are widely accepted as official, such as laws and regulations enforced by authorities and (2) informal institutions, where the social rules, customs, traditions, or codes of conduct are part of the culture and ideology [5]. In both cases, these institution types distribute power to differentially constrain and enable actors and facilitate or limit the response(s) of individuals and communities to climate hazards, such as drought [6]. Further, these institutional approaches may complement and/or substitute for one another depending on governance requirements and choices.

Coase [7] introduced institutional choice to economic investigation, extending a notion proposed by Robbins [8] that transitions between institutions occur within costly frameworks characterized by institutional complementarities. However, although Coase explained that costless bargaining (i.e., zero transaction cost institutions) were unrealistic, the concept of positive transaction costs with respect to institutional substitution was not considered [9]. Ostrom [10], among others, outline ways by which institutional change may be analyzed and selected. However, with respect to transaction cost specifically, while earlier works [11,12] affirm multiple options for dealing with transactions, they do not elaborate upon the role that economic investigation should take in clarifying the function of different modes of resource (re)allocation or organisation. Williamson [13] offers useful insights into governance modes and their selection with respect to economizing objectives (e.g., first order issues to get the institutional environment right, while third order economizing is better aimed at adapting to continuous uncertainty, such as drought). However, Coase typically framed an answer to the comparative institutional analysis problem as one of identifying alternative modes of organisation that achieve similar results at lower costs, which would enable the value of production to increase [11]. An appreciation of these issues by Pagano and Vatiero [9] led them to two hypotheses that we are keen to explore in this paper. The first is that institutional change (i.e., from formal to informal organisation) involves transition and transaction costs, both of which can be empirically measured in order to identify improved (i.e., low(er) costly) governance arrangements (H1). The second is that costly institutions imply complex complementarities (e.g., feedback loops akin to those discussed by Ostrom [10]), which may limit (promote) substitution. Thus, a historical analysis of the complementary institutional factors framing governance choices will be needed to understand equilibria outcomes (H2). To test these hypotheses using an applied case study we focus deeply on a set of historical transaction costs and institutional outcomes, which are a key premise of institutional economics.

#### *1.1. The study of Transaction Costs*

Transaction costs are defined as the costs of resources used to define, establish, maintain, administer, and change institutions and organizations, as well as those that are needed to define the problems that these institutions and organizations are intended to solve [14]. In the larger context of institutional evolution, they are all of the costs involved in human interaction over time. The arguments for measuring transaction costs represent an increasingly relevant feature in investigations of environmental or common property policy design and analysis, along with their budgets and benefits [15,16].

From an economic perspective, appropriate formal and informal institutional choices include options that minimise/lower all transaction and abatement costs [14]. In the context of complex multiscale problems, such as water management, the measurement of transaction costs usually focuses on markets and other formal institutions [17,18], with little research being conducted on the transaction costs of informal institutions [19]. The latter are frequently used for water resource management in several areas worldwide, particularly to mitigate the adverse effects of droughts, e.g., through informal water markets [20], quota-based water reallocation [21], or risk sharing [22]. Reasons for reliance on informal institutions include trust, networking, shared norms, and reciprocal arrangements, which may help to lower total transaction costs [23].

Measuring transaction costs is challenging, leading Quiggin [24] to describe them as generally being treated by economists as "something of a black box, the contents of which are inaccessible". Most water management institutions do not empirically quantify institutional transaction costs such that they can be easily distinguished from other cost categories. Researchers also report a number of difficulties that are related to the measurement of transaction costs, often suggesting that data are partial and indirect and/or derived from limited cost typologies or proxies to represent transaction costs [25]. Further, there is no broad agreement on a standard terminology about the definition of transaction costs [26]. For this reason, it seems unclear how to identify the peculiarities of a transaction, and which expenses/investment should be regarded as transaction costs. All of the above is even more challenging where informal institutions may amplify accounting data gaps. Consequently, economic

investigations of complementary institutional modes of (re)allocation are rarely undertaken while using empirical transaction cost measures, let alone historical studies of transitions between modes.

However, a relatively common feature of transaction cost measurement is the distinction between ex-ante and ex-post costs; that is, those occurring before and after the transaction. The sum of ex-ante and ex-post transaction costs yields total transaction costs. Total transaction costs can be further divided into: (1) administering, monitoring, contracting, and enforcing current policy arrangements (termed *static transaction costs*) and (2) periodically designing, enabling, implementing new, and/or transitioning existing management arrangements to new systems (termed *institutional transition costs*). In addition to these costs, the total transaction costs may be increased when subsequent adaptation requirements are triggered by policy shocks or surprises (termed *institutional lock-in* costs) [14]. Table 1 references the typical transaction costs categories and examples, sub-divided between ex-ante and ex-post transaction costs, which we will focus on later in the analysis section.


**Table 1.** Categorisation examples of transaction costs, adapted from Garrick [27] and Marshall [14].

#### *1.2. The Contribution of this Study*

The goal of this paper is to evaluate whether, via a case study of informal drought management arrangements in northern Italy, less costly—and ideally improved—governance arrangements have been achieved (H1). This evaluation will entail a historical examination of the evolution of water governance institutions for Italy, in general, and Po River Basin (PRB) drought management systems in particular (H2). We will then measure and track transaction costs with respect to transitioning drought management institutions toward informal, participatory, and consensus-based approaches during several recent drought events, with a view to identifying any evidence of low(er) transaction costs coupled to similar—or improved—drought management outcomes. Ultimately, this approach will enable an assessment of the hypothetical propositions and their value for further study to develop the assessment process. The paper is structured as follows: in Section 2, we assess the historical context of the case study area, the PRB in northern Italy; in Section 3, we present methods and data; in Section 4, we conduct an empirical transaction cost analysis of the institutional transition in the PRB; Section 5 discusses the results; and, Section 6 concludes.

#### **2. Historical Institutional Analysis**

The PRB is located in northern Italy and extends, with five per cent of its total area (~74,000 km2), to portions of French and Swiss territory (Figure 1b). In terms of average annual water discharge, the PRB is one of the largest in Europe with an outflow at the mouth of the Po River in Pontelagoscuro

of 1470 m3/s. Po River flow rates depend on the water captured and stored in artificial reservoirs in the mountains, principally in five lakes (Maggiore, Como, Iseo, Idro, and Garda) located at the foot of the Alps. Demand for water is high: the PRB supplies water for hydropower generation in upstream lakes and reservoirs, and potable water to some 3700 municipalities within seven administrative regions with a thriving industry that accounts for 40% of national GDP.

**Figure 1.** (**a**) the seven river basin districts in Italy; (**b**) the area of the PRB; and, (**c**) the boundaries of the territory managed by the Po River Basin Authority(red outline).

The system also supplies irrigation water to Italy's largest contiguous agricultural region, which comprises 21.5% of total Italian agricultural land, contributes 30% of national agricultural value-added production [31], and represents around 80% of total water extractions [32]. Water is also needed in the lower reaches of the river to mitigate salinity intrusion during low flow or drought periods—as the area is located below sea-level—and to support fisheries and aquaculture demand.

Average precipitation ranges from a maximum of 2000 mm in the Alpine regions of the PRB to less than 700 mm on the eastern plains, with an annual average of 1100 mm. Under future climate change temperatures will increase, while summer precipitation will likely decrease [33]. Po River discharge is expected to decline during the summer months—when the demand is typically at its peak—and shift to higher levels of discharge in the winter (Figures 2 and 3).

**Figure 2.** Anomalies in (**a**,**b**) seasonal precipitation in % and (**c**,**d**) two meter mean temperature in ◦C for the PRB, 2041–2070, versus a 1981–2010 benchmark period. Left side (**a**,**c**) refers to raw CMCC-CM/COSMO-CLM outputs, while the right side (**b**,**d**) indicates the bias-corrected climate projections [33].

**Figure 3.** Climate change signal for the period 2071–2100 versus 1981–2010 for mean precipitation, maximum, and minimum temperature [34].

Thus, the frequency and intensity of extreme events, such as droughts, are expected to increase making current levels of water extraction in the basin unsustainable [35]. Evidence of these changes is already noticeable at the regional and local levels, with recorded rainfall reductions and increased temperature variations of around one degree centigrade [36,37]. Droughts also appear to be affecting the region more frequently, with a State of Emergency (SoE) being declared in 2003, 2006, 2007, and 2017. Since 2000, these SoE events have lasted 25 months in total, with an average duration of 6.25 months per declaration. A coordinated climate change adaptation strategy that identifies the main impacts of climate change for a number of socio-economic sectors in Italy was adopted in 2015, followed by a National Adaptation Plan for Climate Change (PNACC) [38]. The PNACC encourages institutions to identify effective ways to mainstream adaptation into existing plans and regulations at different levels of territorial government [21,39]. River Basin Authorities are responsible for identifying and coordinating drought adaptation actions and measures.

#### *2.1. Water Abstraction Licenses Regime in Italy: An Obstacle to Climate Change Adaptation*

The current system of creating and managing water abstraction licenses (WAL) in Italy creates a significant obstacle to the effective implementation of these two adaptation strategies. Originally, Italian legislation viewed water as a plentiful resource, and this attitude has remained essentially unchanged since the 1930s. As a result, the volume of authorised WAL in the PRB now exceeds average water availability; for example, current hydroelectric and agricultural licenses amount to 1840 m3/s, against an average river flow of 1470 m3/s [21].

Although many licenses are dormant, over-allocation complicates the management of water deficits during drought periods. WAL quotas are also difficult to implement in Italy [40,41] due to the fragmented nature of WAL, and the challenging interplay of Italian water institutions [42] where regional governments have been granted the power to regulate WAL matters. For these reasons, the PNACC proposed a revision of the WAL regime system [38,39]. Recent legal definitions and laws now recognise the limits to national water use, and articulate collective uses of water resources in Italy with respect to protection of environmental water resource uses (Law 183/1989), integrated water resource management (Law 36/1994), and the protection of water quality (Environmental Code 152/2000). The government sought to reorganise water services in the early 2000s, in what was then regarded as a first step towards the introduction of market and pricing reallocation mechanisms. In June 2011, a law favouring privatisation of water supply and sanitation, largely viewed as opening the possibility of water trading, was repealed by referendum. The prevailing view following the referendum was that access to water should be treated as a fundamental right, not subject to free market reallocation. Thus, the referendum outcome limited the use of formal market instruments such as water pricing, trading, or buyback for drought management [43], requiring alternative institutional arrangements. Ultimately, the capacity of river basin managers to coordinate parties and address climate change impacts and future population and economic growth, and/or to prioritise different water uses during drought has been compromised, and regional governments granted the power to regulate WAL matters. Governance of water resources in Italy thus remains complex, emergency-driven, and focused on short-term problem-solving. This is particularly evident during drought events in 2003, 2006, 2007, 2015, 2016, and 2017, where reactive strategies probably increased the negative impacts of water scarcity.

#### *2.2. Formal Drought Management Institutions*

In the absence of market-based reallocation mechanisms drought management in Italy has traditionally focused on formal command and control approaches, where the state intervenes in the management of basin water resources as a last resort instrument (Law 225/1992) to enact water restrictions with sanctions for non-compliance [44]. By contrast, recent evidence of climate change and increased drought events from 2003 onwards have served to focus EU Member States' attention on alternative political and technical responses that involve participatory (e.g., informal) approaches [45] over prescriptive (e.g., formal) sanctions. A key document was the communication addressing the problem of water scarcity and droughts in the European Union [46], which presented an initial set of non-mandatory policy options at the European, national, and regional levels to address and mitigate the challenge posed by water scarcity and drought.

During the process of transitioning the European Water Framework Directive (EU-WFD) into national legislation, the PRB experienced a severe drought event in 2003 that presented a significant threat to urban, industrial, and agricultural water supplies. The Italian government formally declared a SoE, which enabled them to: (i) centrally manage drought emergency interventions in the PRB for a period not exceeding 180 days (but which could have been extended by another 180 days by the central government); and, (ii) allocate funding for initial drought management interventions, with the option for further interventions where recognised as necessary by the delegated commissioners in charge of managing the emergency. This formal institutional arrangement was managed by the National Civil Protection Department (NCPD), anchored to the Presidency of the Council of Ministers which supervised all activities.

#### *2.3. Informal Arrangements for Drought Management—The Case Study*

In the 2003 drought event, the NCPD and Po River Basin Authority (PRBA) jointly sought to avoid last resort interventions by the central Italian government. Both were concerned about the impact of the drought on energy supply, and the need to act more rapidly (and collectively) to address issues in line with EU best drought management practices. Consequently, a Drought Steering Committee (DSC) was initiated, presided over by the PRBA, with the purpose of coordinating communication and voluntary responses to drought across a large number of organisational members. The DSC constituted an informal institution, because it was not legally recognised, and stakeholders participated on a voluntary basis. Further, there was no capacity for sanctions in the case of non-compliance with decisions made at the meetings and, in cases of conflict, the DSC could not be sued and/or prosecuted due to its informal status. Therefore, any decisions had to be made via agreement or consensus due to a lack of explicit legislative (formal) mandate in support of those activities. Ultimately, trust among the membership, networking and shared objectives were expected to reduce total institutional transaction costs of drought management, as outlined below.

The mission of the DSC, sanctioned under a Memorandum of Interest (MoI), was to manage severe water deficits in a unified manner and to delay or prevent critical water shortages. Two main objectives were included in the MoI: (i) maintenance of minimum water withdrawal opportunities for downstream irrigators and Po River Delta water users (e.g., aquaculture); and, (ii) maintenance of hydroelectric outflows to guarantee maximum possible electricity production, as requested by the national transmission grid operator. Under these common objectives, the DSC initiated a network of information gathering aimed at measuring lake storage data, monitoring of PRB water flows in real time, and a summary of WAL water uses. These measures served to better assess and understand the negative impacts of the drought, contributed to an overall stabilization of water flows and availability, and brought progressive increases in supply to WAL-holders during the drought. This initial success meant that, since 2003, the DSC has been convened again when necessary to deal with PRB drought events and to limit (potentially costlier) state intervention. Drought management planning through the DSC is now enshrined in the Po River Basin Plan [47], along with requirements for water-stress mapping, temporary restriction measures for intensive (e.g., back-to-back rotation) cropping, and early-warning systems that are based on basin modelling.

The success of the DSC has also become a reference point for the management of water crises in Italy more generally, given its capacity to aggregate and coordinate various stakeholders' interests when considering regional differences. Therefore, the DSC is now recognized by the Italian government as an effective instrument for the fair and sustainable management of water withdrawals. In 2016, legislation provided for the mandatory activation of a DSC in each of the seven Italian basin districts, along with responsibility for coordinating different local water authorities. These DSCs are aimed at harmonizing adaptation efforts under the larger Permanent Observatory (PO) institutional structure in

Italy, which monitors climate dynamics and variability, climate hotspots, and natural environmental hazards from extreme weather events.

The success of the original PRB-DSC suggests that it may provide a useful model for jurisdictions beyond Italy, particularly in the EU. Incentives for a jurisdiction to participate in their own version of the DSC are two-fold. First, the DSC represents an opportunity to coordinate with other water users before any drought declaration is made, after which centralized (distant and/or coercive) decision-making arrangements may dominate to reduce negotiation/adaptation opportunities. Second, the DSC is an opportunity to foster greater mutual understanding and trust among relevant organisations, increased information exchange, and collaboration between water users that may otherwise be hampered by administrative and political fragmentation. The informal nature of the DSC may also lead to relatively inexpensive institutional arrangements that are more readily enacted (institutional transition costs) and administered (static transaction costs) by other watersheds with limited or poor water right structures.

From this assessment, we conclude that our understanding of the equilibria transition from formal to informal drought management institutions in the PRB is enhanced by considering complementarities and how they have hindered certain institutional choices, while fostering the selection of others. This lends support to H2 and the value to economic investigations from a consideration of the historical context. However, whether the transition has broadly resulted in low(er) costly modes of organisation (H1)—and therefore productivity increasing outcomes—is the subject of our subsequent analysis.

#### **3. Materials and Methods**

#### *3.1. Stakeholders, Interviews, Document Analyses, and Assessment of Governance Arrangements*

Our measurement of transaction/transition costs was based upon extensive stakeholder consultations. The stakeholders are all of the interested parties who affected, were affected by, or otherwise influenced drought governance decisions. We defined the domain of stakeholders involved in the DSC and different focus levels, which range from identifying relevant institutions and key persons to finding the interactions and associated transaction costs. Our methodology comprised: (i) analysis of water allocation governance frameworks in place; and, (ii) analysis of informal DSC institutions and how these are embedded within the national and regional PRB governance. Initial meetings were held with senior members of the DSC to identify whom to interview. Face-to-face and telephone interviews were scheduled and conducted involving a total of 12 experts, with each interview lasting around two hours. The interviews enabled us to explore technical and organizational details that are necessary to identify sources of transaction cost data.

#### *3.2. Transaction Costs Data Collection, Categorisation and Analysis*

McCann et al. [30] established a framework and typology for transaction costs measurement based on previous work from Thompson [48], which we follow in this study. The data collection approach is similar to that detailed in Loch and Gregg [49]. The main function of the DSC is to coordinate stakeholder participation and consensus in the wake of significant drought event periods. Routine technical meetings during non-drought periods—which, together with hydrologic basin modelling, constitute the bulk relevant transaction costs—are also commonly arranged by regional authorities with the support of Environmental Protection Agencies (EPAs). DSC meetings were used to track stakeholder involvement, with the salary cost rates (per hour) at each expert-level providing a proxy base value for transaction costs estimates. These data were obtained while also considering: physical or virtual participation by experts in meetings; estimates of travel distances and/or costs from the organization to which they belong to the venue of the meeting; and, the duration of the meeting. Information for the study was collected through interviews and meetings minutes. For some meetings the minutes were not available, requiring additional interview data collection to fill information gaps. Our approach was informed by previous studies that interviewed government staff [50] and representatives of stakeholder groups [51] to identify the time spent on various relevant activities within

the organisations. Further, in 28 out of 235 cases, the mean salary cost values (~€70,000 per annum) had to be assigned when information was not publicly available or provided in the interviews. DSC meetings and related transaction costs were then classified based on their key focus: meetings to agree memoranda of understanding involved ex-ante enactment costs; meetings to develop/test new hydrologic models for the basin involved ex-ante design and implementation costs; meetings to extend the modelling framework and, thus, enhance institutional capacity to monitor water use and compliance and limit illegal abstractions that are involved ex-post monitoring and detection costs; while meetings to incorporate the DSC institution within the PO arrangements for Italy as a whole provided some measure of lock-in (i.e., substitution-hindering complementarity) transaction costs.

The DSC was assisted by the PRBA through organisation of meetings, data collection and analysis, and technical advice. Initially (2003–2008), this role was accomplished with the support of an external service provider that was subsequently transferred to the PRBA (2008–2016). Financial data from the PRBA provided transaction costs related to the collection of information in support of decision-making by the DSC, including hydrologic modelling and analysis. As an example, two external staff from the Regional Environmental Agency of the Emilia-Romagna Region (ARPA-ER) worked part-time on the development and maintenance of the hydrological model to support DSC activities. It should be noted that the total transaction costs involved in the DSC process were absorbed by different organisations at different points of the original program life-cycle (2003–2016).

Table 2 summarizes for the case of the DSC the classes, sub-classes, typology, and categorisation of transaction costs, plus the data sources used for data collection.


**Table 2.** Categorisation of transaction costs, adapted from [30], Garrick [27], and [14], including categorisations identified for the Drought Steering Committee (DSC) case study, and related data sources.

As an example, in order to calculate the research and information costs corresponding to the physical participation of an expert from Torino in a DSC meeting, the travel time between Torino and Parma (headquarters of the PRBA) was obtained, and multiplied by a standard cost per km to generate the transportation costs by car, or alternatively the cost of the train ticket was used, depending on the type of transportation used. This amount was added to the salary cost rate (per hour) times the duration of the travel plus the duration of the meeting to obtain the corresponding transaction cost(s). Following this travel cost calculation, we could estimate that a representative of the Regional Environmental Agency of the Piedmont Region (ARPA-Piedmont), taking part in an in person meeting in 2017, spent EUR 120 in the train trip (economy ticket, high speed train). Next, the salary cost was obtained from institutional salary tables (60,000 EUR/year), its' hourly equivalent calculated (assuming a standard 36 h/week working time and 52 weeks per year yields EUR 32.1), and multiplied by the duration of the meeting (1.3 h) plus the duration of the round trip (5.2 h), which gives as a result EUR 208.3. The total cost for this participant is therefore estimated at EUR 328.36 (208.3 + 120).

Another example is provided for hydrological model implementation, the most significant transaction cost in the 2006–2011 period. This transaction cost is obtained as the sum of the cost of the contract with an external provider during the 2006–2011 period, obtained from accounting records (EUR 700,000), plus the cost of the personnel employed by ARPA-ER from 2008 to support the consulting firm and maintain and update the model once the consultancy was over, which is obtained as in the example above multiplying the hourly cost of the personnel dedicated to model support and maintenance times their dedication to the task.

After data for each cost item were carefully collected and calculated, they were transformed into real values using 2017 as the base year (e.g., meeting costs during the 2003 drought were converted into euro of 2017 using data from the World Bank [52]).

All final transaction costs were then categorised into institutional transition (ex-ante) and static transaction (ex-post) costs, as per Table 2. Following the method adopted by Loch and Gregg [49], analyses were performed to identify: trends in each category over time, summed total transaction costs for the DSC, and comparisons between drought and non-drought periods. The following sections detail the results of the institutional mapping exercise, which assists in our assessment of whether the institutional transition achieved similar/improved outcomes, and subsequent transaction cost analysis to measure and assess the costs of that process.

#### **4. Results**

#### *4.1. Stakeholder Map and Assessment of Drought Governance Arrangements*

Current drought management systems in the seven Italian river basin districts involve three main actors with differentiated roles and responsibilities for River Basin Management Plans (RBMPs): national government and ministries in coordination role; river-basin district authorities in operational role; and, regional governments and administration in both coordination and operational roles (Figure 4). They are all part of PO, and they have to implement the RBMP through a Protection Plan (PTA) by addressing the qualitative and quantitative water resource management objectives.

Based on the objectives of the PTA, the Optimal Territorial Areas (ATO, for the domestic use of water) and the Land Reclamation Boards (LRB, for the management of irrigation water) are in charge of preparing the Area Plan (AP, in Italian: *Piani d'Ambito*) and Water Conservation Plans (WCP), respectively. During this process, drought is monitored through the relevant sub-basin's Drought Management Plan (DMP), a subsidiary instrument to the RBMPs that assesses the basin status on a continuous basis using four stages (normal, pre-alert, alert, and emergency), and identifies appropriate measures for delaying and/or mitigating drought impacts (e.g., information campaigns) [40]. Therefore, a variety of legislative requirements must be adhered to with respect to drought events. Critical Italian government institutions (from 2016 onwards) include the NDCP, the Ministry of Agriculture, the Ministry of Infrastructure, and the Ministry of Environment; all of which are accompanied by the National Association of Land Reclamation Boards (ANBI), the Italian research organization dedicated to the agri-food supply chains (CREA), the National Institute of Statistics (ISTAT), Institute for Environmental Protection and Research (ISPRA), the Foundation representing companies operating in the public services of water, environment and energy (UTILITALIA), the Association

for the reorganization of the Integrated Water Service (ANEA), and the National electricity company association (ASSOLETTRICA). The PO are now operating in each of the seven Italian RBDs: Padano (i.e., PRB), Alpi Orientali, Appennino Settentrionale, Appennino Centrale, Appennino Meridionale, Sardegna, and Sicilia. The PRB regions are the Autonomous Region of Valle d'Aosta; Piedmont; Liguria; Lombardy; Emilia-Romagna, Veneto; Autonomous Province of Trento; and, Toscany.

**Figure 4.** Framework of drought management planning and arrangements in Italy.

When a drought emergencyis declaredin the PRB, the DSCis triggered.Naturally, this process requires coordination at a decentralized level. The PRBA is responsible for coordinating all DSC stakeholders (local and national), and their responses to the emergency drought status (Figure 5). The PRBA collects, updates, and disseminates information on the availability and use of water resources across the relevant river basin organisations. These include: the Italian Ministries of Agriculture, Environment, Infrastructure, and Productive Activities; representatives from each of the five Lake Regulators; the Dam Management Agencies; the operator of the national transmission grid (GRTN); the inter-regional agency for the Po river (AIPO); the national Association of Land Reclamation Boards (ANBI); the agencies responsible for energy supply (SPE); representatives from regional drought committees responsible for managing these emergencies at the local level; and, a representative from the autonomous province of Trento. The PRBA is responsible for notifying these stakeholders that a DSC has been convened, and inviting them to participate in the process and provide the latest technical synthesis reporting to describe current water resources through indicators, bulletins, reports, etc. This technical information is supported by hydrologic modelling data and technical information provided by ARPA-ER, and used to reach decisions on water reallocation via agreement or consensus.

From the interview process, it became clear that, when first implemented, the DSC was not trusted to deliver interventions on its own and needed the administrative support from one or more relevant authorities (i.e., the PRBA and other key institutional stakeholders). However, this is changing under new PO regulatory structures aimed at strengthening informal cooperation and dialogue between water governance organisations within each district to promote sustainable use of water resources in line with the EU-WFD. Nevertheless, these arrangements did not increase formal institutions. The PO is a voluntary and subsidiary structure supporting integrated water governance to manage the collection, update, and dissemination of data on the availability and use of water resources in the districts. Thus, the PO provides guidelines rather than prescriptive arrangements for the regulation of withdrawals, resource use, and possible compensation to users. During droughts, the PO interacts with the DSC to ensure common objectives that include an adequate flow of information that is necessary for the assessment of critical water scarcity levels, the evolution of that scarcity and current water withdrawals, and for implementing appropriate emergency actions to proactively manage the drought event. Therefore, public and private organizations at all levels of water governance can participate in the decision-making to achieve these common strategic objectives during a drought.

**Figure 5.** Participatory map of the Permanent Observatory (PO) of the PRB and stakeholders, 2016–ongoing.

Thus, the arrangements identified for the PRB above offer a good example of informal water governance institutions for managing drought events, where we recall that: (i) the DSC is not legally recognized and stakeholders participate on a voluntary basis; (ii) there is no capacity for sanctions in the case of non-compliance with decisions made at the meetings; and, (iii) in cases of conflict, the DSC cannot be sued and/or prosecuted because of its informal status. Yet, the arrangements detailed above also have an increased potential to meet EU-WFD objectives over existing institutional approaches due to their integrated water resource management methods, coupled with processes aimed at avoiding political or legal interference (last-resort measures) during drought emergency response implementation. The DSC demonstrates capacity for coordinating actions on a voluntary basis and encompassing a wide range of stakeholder trust (democratic legitimacy), while achieving robust water governance institutions. Thus, the transition to informal institutional arrangements in support of successful adaptation to drought events appears to have achieved improved drought management outcomes, but at what cost?

#### *4.2. Transaction Costs Measurement and Analysis*

We must be able to observe some reduction in the average static transaction costs and that any periodic institutional transition costs associated with drought events must be short-lived (i.e., evidence of improved total outcomes) in order to test whether a transition to informal institutions with improved outcomes has been achieved at low(ered) costs over time. Our measurements of total DSC transaction costs for establishing, coordinating, and managing the DSC are summarised in Figure 6, while the share of ex ante and ex post transaction costs is shown in Figure 7—where a change in (ex-post) transaction costs for new institutions cannot take place without (ex-ante) transition costs in support of those changes. A more detailed breakdown of the individual ex ante and ex post transaction cost categories is available in Appendix A. The base-line for our cost-reduction analysis is the 2003 drought event, when the DSC officially came into existence.

The initial transaction costs were relatively significant in that year, consisting mainly of enactment and research/information gathering investments. Growth in total transaction costs was then experienced in response to three-consecutive drought events (2005–2007). This corresponded to investments in further information gathering, administrative costs for the DSC, and hydrological modelling to monitor water use across the relevant PRB sub-regions. Interview analysis revealed that a significant fraction of these costs that are involved identifying and agreeing upon common objectives for the DSC, consistent with informal network requirements and building trust between the stakeholders.

**Figure 6.** Total transaction costs for the DSC (years with droughts are in grey).

**Figure 7.** Ex-ante and Ex-post transaction for the DSC. Droughts in 2003, 2006, 2007, 2015, 2016, 2017.

Post-2007, no drought emergency events occur in the PRB. Investments in the hydrological modelling continued at high levels for a few years (2008–2011) until the contract with the external provider that supported the development of the model finished. After 2011, the DSC total transaction costs generally fell due to reduced hydrological modelling implementation costs and because extraordinary meetings were not needed; thus administration costs for routine management comprised the majority of required investment. However, in the period between 2015 to 2017 the PRB experienced a series of consecutive drought emergency events. This period also reflected a shift toward interaction with the PO arrangements, requiring some increased transaction costs. In response, the total transaction costs rose over that period due to increased administration and the enforcement of DSC requirements but critically this increase is approximately one-third of the peak transaction costs of previous periods. Some of that lowering of transaction costs was due to an increased use of technology to support/conduct DSC meetings, as well as a lower degree of drought severity in the later events, relative to the period before 2010. Many of the meetings were now held at the PRBA while using media (Skype) lowering the requirement for travel and salary costs to attend meetings in person for many of the organisations, as well as the response and coordination times for managing drought emergencies.

With specific regard to individual transaction costs categories (Appendix A, Figure A1), the average static transaction costs decreased over the period considered, while short-lived institutional transition costs increases were observed during drought events (Figure 6). In total, the trend is downward, which suggests a lowering or minimisation of total costs across the life of the informal DSC governance arrangements.

According to Garrick [27], such trends indicate robust institutional outcomes—i.e., institutions that are capable of taking corrective action through "relatively less transaction cost-intensive autonomous and planned adaptation". For our purposes, the measurement of transaction costs enables a confirmation of positive transition costs to establish new institutions—as we should expect, and in support of H1—but also that this new mode of organisation provides scope for productivity and efficiency gains for Italian water users.

#### **5. Discussion**

The results from our analysis of the collected data offers a novel contribution to the transaction cost literature by: (i) applying ex-ante and ex-post transaction cost measurement to informal water governance institutions, (ii) providing evidence in support of the usefulness of measuring transaction costs for evaluating institutional transition or substitution objectives, (iii) highlighting the relevance and value of historical context for economic investigations; and, (iv) showing how informal institutions may underpin water governance/management arrangements to lower total transaction costs related to drought management in an EU context. Beyond our support for the two main hypotheses, the results from the informal management of drought events at river basin scale determined the following key points.

#### *5.1. Drought Management Arrangements*

Drought requires a flexible management approach that is able to monitor the evolution of the event, to then respond within and across multiple governance levels (e.g., across multiple economizing orders in Williamsons' framework [13]). In comparison to formal arrangements that are available in Italy, the informal DSC approaches outlined above may be more flexible and adaptive with respect to drought management and adaptation (third-order economizing), which is also consistent with new EU water governance objectives. Shifting the management focus to a local level increases the appreciation of drought impacts, and provides for more appropriate responses in shorter timeframes than that of monocentric models, although such shifts may also lead to local capture of, and rent-seeking in, the policy process.

Positive effects of the DSC also arise from improved information transmission among stakeholders, and a tangible capacity to lower drought impacts and increase adaptive capacity. Further, monitoring the availability of water resources (inflows, reservoirs, outflows) and their adjustment in real time has allowed for the DSC to more quickly recognise and react to drought events via the use of short to medium term forecasting tools, drought indicators, and event evolution scenarios. These scenarios have also contributed to the construction of regional technical tools in support of managing water balances at the basin scale. Finally, the recent institutionalisation of DSCs and relevant stakeholder involvement across all (ordinary) periods of water management through the PO, rather than limiting their existence to drought periods, is an improvement upon the typically reactive (emergency) commencement of Italian management measures.

Without a measurement of the marginal centralised transaction costs in contrast to counterfactual institutional arrangements, we cannot draw any formal conclusions regarding the value for money or total transaction cost differentials. However, the PRB DSC arrangements have now been extended across each of the seven River Basin Districts (RBDs) in Italy, formally established in May 2017. According to interviewed stakeholders, the DSC arrangements were attractive to the Italian government because they did not require any additional funding to implement (i.e., lower transition costs), while avoiding some negative impacts of drought events (i.e., improved management outcomes). Thus, it seems logical to conclude that the political value of these transaction costs and their institutional outcomes has been recognised. By favouring an informal institution, like the DSC, the Italian government could potentially observe an increase in the effectiveness of water governance arrangements, although it will require further evidence over time to support this conclusively. This will be the focus of a future research project involving hydro-economic modelling of costs and benefits.

#### *5.2. Transaction Costs and Policy Performance Analysis*

Our findings are relevant for policy makers and other stakeholders beyond the PRB. Here, the measurement and analysis of transaction costs undertaken paves the way toward performance assessment of similar initiatives based on informal voluntary partnerships for water management in Italy and Europe. These include incipient river contracts, forums for dialogue and knowledge sharing between public/private stakeholders, and local communities in compliance with the EU's subsidiarity principle, which are gaining momentum in Italy and elsewhere in Europe [53]. A constraint to any application of the findings reported here may arise from the non-conjunctive catchment characteristics of the PRB; that is, they do not share water resources with other basins. This is often not the case for the other river basin contexts in Italy or elsewhere in Europe, for whom the issues may be more challenging as a consequence, and involve higher transaction costs.

Moreover, comparisons of the cost-effectiveness of alternative policy options to enhance flow rates during droughts must account for the total costs of the options relative to a baseline or status-quo scenario. These include the transaction costs of the reform measures, along with any abatement costs incurred by economic agents during the implementation of local adaptation strategies. Recent research focusing on the analysis of abatement costs in the PRB shows that the proportional rule used to reallocate water under the DSC approach—which relinquishes a fixed percentage of the initial allocation from users, irrespective of the economic losses involved—underperforms other formal drought management arrangements, such as water charges [54]. This gap will be further amplified via forward and backward linkages among economic sectors within the PRB, and with other Italian regions outside the basin. Thus, a complete policy performance assessment calls for empirical analyses that combine transaction and abatement costs estimates [55]. This too will be incorporated into future research work in the area.

#### *5.3. Transaction Costs and Uncertainty Analysis*

Finally, water resource management is performed in a context of Knightian or deep uncertainty, where it is often not feasible to identify all of the possible outcomes and/or assign a probability to each identified possible outcome [56]. Under deep uncertainty, rather than optimal institutional settings, we should aim for robustness through the avoidance of path dependent institutional trajectories to enable future adaptation in the face of unpredictable future events that are explainable only after they happen. This requires adaptive institutional frameworks [27].

As indicated above, our transaction cost measurement framework can provide initial information on the robustness/adaptive ability of PRB institutional arrangements. However, conclusions regarding the robustness of these arrangements in response to future uncertainty would need to consider additional measures of adaptive efficiency according to Garrick [27]. For completeness, these measures would also have to include the lock-in cost impacts of institutional options to allow for a cost-effectiveness evaluation [14]. Similar to the work undertaken by Loch and Gregg [49], this would entail identifying and measuring three performance indicators over space and time: (1) how well the drought management objective(s) have been met; (2) the average transaction costs per unit of those met objective(s); and, (3) total program budgets. For adaptively efficient and robust institutions, these three performance indicators should be increasing, decreasing and sufficient respectively. Measures of these indicators are beyond the scope of this pilot study, but remain an objective for a wider research program focused on identifying instruments best-suited to achieving water policy and management targets. The wider research focus of this work will examine maximised benefits per unit of transaction cost (alternative measure of cost effectiveness), as well as maximising the net public/private gains from transaction cost expenditure (social welfare). This broader assessment framework should enable a more comprehensive assessment of total policy or program benefit-cost outcomes.

Finally, future climate change and economic dynamics may change the outcomes that are reported in this study. Further research will be necessary to determine under what conditions this may happen, and any requirement to adjust or change policy accordingly [57].

#### **6. Conclusions**

Transaction costs matter for effective organisation and institutional management of scarce and costly resources, such as water. During times of drought, formal institutions may provide costly and inflexible management arrangements that may increase the total transaction cost requirements. This paper explores the transaction costs that are associated with a historical transition toward informal drought management arrangements in the PRB of northern Italy. We test two hypotheses related to the value of transaction cost analysis in support of institutional transition/substitution choices, and the value of historical context to economic investigations. By measuring and tracking transaction costs with respect to drought periods in the basin we explore the total costs associated with a new institutional approach, and note that the DSC arrangements have been mandatorily adopted by the six other River Basin Districts in Italy—somewhat ironically, as this has formalised what was originally an informal process. It remains to be seen whether the formalisation of drought management arrangements based on the PRB DSC will ultimately increase total transaction costs, or further reduce the total transaction costs of drought management in Italy by following a participatory, consensus-based approach elsewhere. However, it is impossible to draw more robust conclusions without a more detailed study of centralised costs. That said, in contrast to standard approaches where a complete set of empirics might be provided, some may find our approach here less satisfying. However, we would argue that value is provided by the thought and measurement processes that have gone into the study, rather than arriving at any 'number'. The process of empirically identifying, measuring, and assessing transaction costs is in its infancy; but remains a critical means by which adaptive effectiveness and efficiency for future institutional choices will potentially be explored, as we have done in this case. While our empirics may not be complete they do provide a valid contribution where—as we have pointed out—it is our intention to explore additional means by which we can get at a final set of 'numbers' in support of the full costs and benefits. Like all good research, it is a process, and one that we are interested to continue following. Overall, though, our study highlights the usefulness of transaction cost case studies, and the need for extensions to this approach that incorporate not only transaction and abatement cost minimisation evaluations, but also assessments of per unit private/public welfare benefits that accrue from policy and programs, such that more comprehensive evaluations and uncertainty analyses may be achieved in the future. We believe this to be a rich area of future research that may require the incorporation of climate, hydrological, and economic modelling assessments to be successful.

**Author Contributions:** Conceptualization, S.S., A.L., and C.D.P.-B.; methodology, A.L., S.S.; validation, S.S.; formal analysis, S.S., A.L., C.D.P.-B.; investigation, S.S.; resources, S.S., J.M.; data curation, S.S.; writing—original draft preparation, A.L., S.S., C.D.P.-B.; writing—review and editing, A.L., C.D.P.-B., S.S.; visualization, J.M.; supervision, A.L., C.D.P.-B., J.M.; project administration, J.M.; funding acquisition, J.M., A.L., C.D.P.-B. All authors have read and agreed to the published version of the manuscript.

**Funding:** Adam Loch's involvement in this research was funded under an Australian Research Council DECRA grant (DE150100328) and the 2015-16 UNESCO Grants Program. Carlos Dionisio Pérez-Blanco's involvement in this research was supported by the Program for the Attraction of Scientific Talent's SWAN (Sustainable Watersheds: Emerging Economic Instruments for Water and Food Security) Project, and by the Ministerio para la Transición Ecológica y el Reto Demográfico, through Fundación Biodiversidad (ATACC Project—Adaptación Transformativa al Cambio Climático en el Regadío).

**Acknowledgments:** The authors are thankful to Graham Marshall and David Adamson for useful comments and advice on earlier drafts of the paper, and to the experts from the Po River Basin Authority and the Environment Agency of Emilia-Romagna for their valuable support in this research. The authors thank Mattia Amadio for drawing Figure 1c.

**Conflicts of Interest:** The authors declare no conflict of interest.

#### **Appendix A**

**Figure A1.** Measures of DSC individual ex ante/ex post transaction cost categories over time.

#### **References**


© 2020 by the authors. Licensee MDPI, Basel, Switzerland. This article is an open access article distributed under the terms and conditions of the Creative Commons Attribution (CC BY) license (http://creativecommons.org/licenses/by/4.0/).

## *Review* **Water Markets in the Western United States: Trends and Opportunities**

**Kurt Schwabe 1,2,\*,**†**, Mehdi Nemati 1,\*,**†**, Clay Landry <sup>3</sup> and Grant Zimmerman <sup>3</sup>**


Received: 13 December 2019; Accepted: 7 January 2020; Published: 14 January 2020

**Abstract:** Efforts to address water scarcity have traditionally relied on changing the spatial and temporal availability of water through water importation, storage, and conveyance. More recently, water managers have invested heavily in improving water use efficiency and conservation. Yet as new supply options become harder to find and/or appropriate, and demand hardens, society must consider other options to, if not reduce scarcity, minimize the impacts of such scarcity. This paper explores the role water markets are playing in addressing water scarcity in the American southwest: a water-limited arid and semi-arid region characterized by significant population growth rates relative to the rest of the US. Focusing on three representative southwestern states—Arizona, California, and Texas—we begin by highlighting how trends in water supply allocations from different water sources (e.g., surface water, groundwater, and wastewater) and water demand by different water users (e.g., agricultural, municipal, and environmental) have changed over time within each state. We then present recent data that shows how water trading has changed over time—in terms of value and volume—both at state level and sector level aggregates. We end with a discussion regarding some institutional adjustments that are necessary for water markets to achieve their potential in helping society address water scarcity.

**Keywords:** drought; water markets; Western US

#### **1. Introduction**

One of the most pressing challenges confronting the US in the 21st century is water scarcity. Population growth, which will increase the demand for water throughout the US, has risen by nearly 7%, or approximately 22 million people, since 2010 (Figure 1). Of course, there have been increases in water use efficiency that have somewhat counteracted the impact of population growth on demand. For example, in California, per capita daily use dropped from 244 to 178 gallons from 1995 to 2010 [1]. Yet increased evapotranspiration from a warmer climate suggests a less available supply reaching our municipalities, agricultural lands, and water bodies, likely increasing the level of conflict among water sectors. Furthermore, while most climate change models suggest that the amount of precipitation may not change significantly over the next 50 to 100 years, precipitation events will become much more variable, intense, and infrequent, with more precipitation falling as rain than snow [2–5]. Combined, these characteristics suggest that conflicts over water scarcity will increase as the temporal distribution and form of supply deviates from what our infrastructure was designed to handle.

The objective of this review paper is to shed light on how water scarcity is changing in the Southwestern US, and the role water markets have and might play in addressing this scarcity. In particular, we focus on how the demand and supply of water are trending in representative states in the southwest—Arizona, California, and Texas—and the increasing role of water markets in helping states to address such scarcity. Two of these states—Texas and California—have accounted for nearly 1/3rd of the population growth in the US (Figure 1). Relative to US averages, the southwestern states of Arizona, California, and Texas confront higher population growth (2.45% vs. 1.15% between 1920 and 2018), higher temperature (61.1 ◦F vs. 52.5 ◦F), and less precipitation (20.68 in vs. 30.48 in). Such differences increase water demand and decrease the supply of runoff from precipitation events resulting in rising water scarcity.

Since markets depend on differences in the marginal values across users to create incentives to trade, we differentiate between different types of water use (e.g., agricultural, environmental, municipal/city) to better understand which sectors will likely be driving the market, where scarcity might arise within a state, and the role of water markets in potentially assuaging such scarcity. After briefly describing some general climate and population statistics within each state that likely influence water scarcity, we introduce water supply and demand conditions by state, with a brief background of water use trends.

Following each state-level discussion, we provide data on water market trends and transactions within each state and discuss how those trends may relate to water scarcity characteristics within each state. Note that the effectiveness of water markets and growth in water demand, supply, and use is largely influenced by each state's water rights laws and regulations. Given space limitations, we have opted to focus strictly on presenting the most recent data on water demand, supply, and markets but direct the reader to other sources for an in-depth understanding as to how water rights and regulations within each state influence the trends we identify. For example, for California, see Hanak, et al. [6]; for Arizona, see Colby and Isaaks [7]; for Texas, see Kaiser [8].

Data are presented on the overall market size measured in total volume and value during 2009–2018 as well as the distribution of market activity across western states. We also review active sectors buying and selling water and discuss commonly traded types of water entitlements and transaction structures. In this paper, we use water markets data from WaterlitixTM, the largest and most comprehensive database of water rights price and sales information in the United States. WaterlitixTM is a proprietary database developed and maintained by WestWater Research. The data are the results of two decades of continuous, primary research of water right trading and leasing. Transaction information is compiled from state and local regulatory filings, public and private transaction documents such as leases and purchase and sale agreements, and through direct interviews with parties involved in transactions. The database is structured to include both water asset/water right details and transaction specific information. Water asset information includes details on the water asset type involved in the transaction such as authorized diversion volume, quantity of water approved for transfer (which may differ from the authorized diversion volume), other information on the water rights or assets such as priority date, authorized use, source and locational characteristics including water basin, administrative districts or water management boundaries such as a water district or ditch company. The database also includes specific transaction details such as buyer and seller information, previous and new use of the water, transaction structure such as single year lease, multi-year lease, permanent purchase or other complex exchanges where financial consideration is paid. Other transaction information includes financial consideration paid, financial and transaction terms, total payment, and unit price payment that has been normalized across all transactions to allow for comparisons of equivalent transactions and water asset types. All of the transactions within WaterlitixTM are geo-referenced within a geospatial searchable data platform. Prior water market studies include comprehensive transactions from 1987 to 2009 in the Western US [7,9–12]. Our analysis provides an update to these prior studies. We end with a discussion of how the role of water markets may be improved in the future to help states, and the US as a whole, better cope with future rising water scarcity.

**Figure 1.** Changes in population over time, average annual temperature, and total precipitation in the US and southwestern states (Arizona, California, and Texas) (1950–2018). Source: Authors calculations, US Census Bureau for the population estimates, and National Oceanic and Atmospheric Administration (NOAA) National Centers for Environmental Information for temperature and precipitation [13]. Notes: Population growth indicates annual population changes in the US and average annual population changes in the three states included in this review. Temperature and total annual precipitation indicate the average annual statistics for the US and the three states.

#### **2. State-Level Water Summaries: Trends and Trades**

In this first section, we provide a brief discussion of general water scarcity conditions in each state, and both state and sector water demand, supply, and market trends.

#### *2.1. Arizona*

Arizona encompasses a variety of landscapes, ranging from desert to mountain, within an arid to semi-arid climate. Average annual precipitation varies from around 40 inches in mountain areas in the east-central part of the state, down to approximately 3 inches in the southwest region, which is comprised of a hot desert landscape (with temperatures in the summertime between 105 and 115 ◦F) [14]. Responses to these challenges, though, have led to Arizona having one of the most progressive water management systems' in the southwest. Much of Arizona's water comes from the Colorado River, which meets approximately 32% of the state's surface water withdrawals. With the looming pressure surrounding an over-allocated Colorado River, Arizona must tackle issues of diverting water supplies into rural communities while managing its limited supply. Rural communities, in particular, are more significant in the context of Arizona's water supply issues due to inadequate groundwater and few surface water rights, high population growth rates, in combination with water supplies that often are vulnerable to drought, and limited hydrogeological information from these areas [15–18].

#### 2.1.1. Water Supply and Demand

In 2017, the four primary sources of water in Arizona included groundwater (1.44 million acre-feet, MAF), Colorado River water (1.22 MAF), other in-state surface water supplies (0.84 MAF), and wastewater (0.23 MAF). Using the most recent available data in 2017, groundwater was the leading supplier to the agricultural sector (0.85 MAF) and the industrial sector (0.17 MAF), while the Colorado River was the main supplier to the municipal sector (0.55 MAF). Effluent supplies are allocated to municipal (0.11 MAF), industrial (0.09 MAF), and agricultural (0.03 MAF) sectors. As shown in

Figure 2a, Arizona has increasingly been relying on water supplies from the Colorado River and local effluent since 1985, while local surface water supplies are declining.

Over 50% of Arizona's total supply of around 3.75 MAF is allocated to agriculture [19]. In addition to agricultural demand, there is a significant—second only to agriculture—demand by the municipal sector to keep pace with Arizona's growing population. Native American and industrial water demand round out the other two significant categories of demand, the latter of which is largely influenced by the US demand for copper, of which Arizona supplies 65%. Note that Native American water supply and demand in this article refers to Indian reserved water rights. Arizona has many Indian reservations, both on the Colorado River and in central Arizona, close to Phoenix and Tucson [20]. The mining industry, on average, uses about 96,200 acre-feet annually to run its operations and generate power for its plants.

**Figure 2.** (**a**) Water supply by source, (**b**) water demand by sector, (**c**) total volume traded, and (**d**) total value traded in Arizona. Source: Authors calculations, Arizona Department of Water Resources (DWR), and WestWater Research. Drought data are from the US drought monitor [21]. All prices are in real 2009\$ using the Consumer Price Index (CPI)—All Urban Consumers Average from the Bureau of Labor Statistics (BLS).

As mentioned above, demand for water in Arizona primarily comes from the agricultural and municipal sectors, followed by Native Americans and industry. As shown in Figure 2b, we see that while Arizona's population has grown by nearly 100% since 1985, overall water use has increased by only around 10%. Over this period, demand for water by the agricultural sector has been on a slight decline, while the municipal sector, which saw significant increases in water use due to population growth and development in the late 1980s through the early 2000s, has tapered off.

#### 2.1.2. Water Trading

Arizona has an active water trading market. From 2009 to 2018, nearly 151,000 acre-feet (AF) of water was traded annually (Figure 2c), which comprises approximately 4% of its overall consumptive water use annually. There has been a near seven-fold increase in total volume traded since 2009, with a clear trend upwards since 2012. During the extreme or exceptional drought years of 2010 to 2015, traded volume was relatively low compared to 2018, which was also considered an exceptional drought year. In terms of types of trades, 92% of the water trades were in the form of leases, while only a small volume (~8%) was in the form of permanent sales. Noteworthy, in 2018, approximately 20% of the total water supplied was associated with some water trade.

Figure 2d juxtaposes the trade value (in 2009\$) over the past ten years across Arizona with the percentage of Arizona under extreme or exceptional drought [21]. In 2018, the over 375,000 acre-feet of water traded through leases and sales had a total market value of \$138 M (million) (in 2009\$). Market activity has been increasing significantly since 2013, an attribute that may also be related to a healthier US economy, which experienced a significant downturn in 2008, beginning with the housing crises. While it seems apparent that the market is responding to the drought of 2018, both in terms of value and activity, this contrasts with the drought from 2011 to 2014 in which trading activity in the form of a lease or purchase prices did not seem to respond.

Columns 2–4 in Table 1 show the acre-foot price of water leased or sold during the last ten years as well as percentage area within the state under extreme or exceptional drought. As indicated, the price associated with permanently traded water was around \$2046/AF, on average, whereas the price associated with a temporary sale registered at approximately \$130/AF, on average; consequently, the lease price was about 6% of the sales price. Looking at the change in the three-year moving average over 2009–2018 indicates that the price per acre-foot traded through leases increased slightly by 1.40%.


**Table 1.** Leases and sales price United States Dollar/acre-feet (US\$/AF) by year (2009–2018) and state.

Notes: All prices are in real dollars in 2009 using the CPI—All Urban Consumers Average from the BLS [22]. <sup>1</sup> Average annual percentage area under extreme (D3) or exceptional drought (D4) [23].

#### *2.2. California*

Two characteristics that define California are climate variability within the state and the geographic mismatch between the sources of supply and the bulk of demand. That is, average annual precipitation varies from less than 5 inches in the arid to the semi-arid southern part of the state to more than 100 inches in the more mountainous northern parts [24]. This characteristic also leads to the challenge that over 1/3rd of its water supply comes from northern California, while the bulk of demand, from agriculture to the large urban centers in and around Los Angeles, is from the central and southern parts of the state. As such, water conveyance, storage, and transfer are very much ingrained into California's development path, factors that are critical to changing the spatial and temporal availability of water in California, and the ability of water trading to complement its water portfolio.

#### 2.2.1. Water Supply and Demand

Based on data from 2001 to 2015, the three primary sources that comprise the nearly 61 MAF of water supply in California include surface water (60%), groundwater (22%), and wastewater (18%). Comparing 2015 to 2001, on average, surface water supplies decreased by 1%, groundwater supply increased by 2%, and treated wastewater supplies increased by 1% (Figure 3a). These estimates are largely influenced by the severe and extreme drought California experienced starting around 2013 that resulted in reduced surface flows and aquifer overdraft.

On the demand side, approximately 89% of California's water goes to environmental and agricultural usage and the rest to the urban sector. Environmental water use refers to water in rivers to protect "Wild and Scenic", instream flows to maintain habitat, water to manage wetlands, and water to maintain urban and agricultural water quality (i.e., Delta outflow) [25]. Figure 3b illustrates the trends in water demand by sector as well as population growth in California since the 2000s. Comparisons among sectors indicate that the average annual growth of water demand from 2000 to 2015 in the urban sector was slightly negative (−1%), as was the growth in the agricultural sector (−0.33%). On average, water allocated to the environment was down by approximately 2%. Interestingly, even though the California population grew significantly between 2001 and 2015, overall urban water use declined, primarily due to efficiency and conservation measures enacted by Californians, including during the drought in 2014 to 2016. Similarly, improvements in irrigation efficiency facilitated the downward trend in water use by the agricultural sector.

#### 2.2.2. Water Trading

California's water markets are comprised of transferring rights either in the short-term (less than one year) or long-term (greater than one year). The majority of California's water rights are held by the farm sector, which has the majority of water sales primarily in California's San Joaquin Valley. More recently, lease activity has increased, dominating the market share in terms of traded volume and value. In terms of the average annual volume (Figure 3c), from 2009 to 2018, nearly 1.1 MAF of water was traded in the form of leases and slightly over 29,000 AF in the form of permanent sales. Given California's overall annual water allocation is around 61 MAF, water trades account for around 2% of the supply, having decreased slightly over the past decade.

Figure 3d illustrates how the total value of water trades have changed over the past ten years. As shown, during the height of the most recent drought, the value of sales soared up to nearly \$800 million in 2015, dropping precipitously to nearly \$300 million in 2018 after the drought subsided. In the past two years, the number of permanent sales decreased significantly, with nearly 79% of the trade value tied up in leases. In terms of water prices, columns 5–7 in Table 1 indicate that the price of an acre-foot of leased water reached its apex in 2015 during the worst period of the drought, which is also when the price of permanent water also reached its highest level (over double its ten-year average). In terms of prices, leases, on average, sold for around \$277/AF, while permanent sales sold for around \$4268/AF. As expected, prices tend to increase during periods of significant drought.

**Figure 3.** *Cont.*

**Figure 3.** (**a**) Water supply by source, (**b**) water demand by sector, (**c**) total volume traded, and (**d**) total value traded in California. Source: Authors' calculations, California Water Plan updates [26], and WestWater Research. Drought data are from the US drought monitor [27]. All prices are in real 2009\$ using the CPI—All Urban Consumers Average from the BLS.

#### *2.3. Texas*

Water laws and policies in Texas are continuously changing in order to accommodate the growing population and demands while adjusting to changing climate and drought. The state's primary abundance of resources, such as cattle, agriculture, and oil are dependent on the water supply in a state with significant climate variability. Precipitation varies from around 9 inches, on average, in the west and southern part of Texas to approximately 60 inches in the east and northern parts. The temperature varies between 16 ◦F and 50 ◦F (with an average of 32 ◦F across the state) in January to between 88 ◦F and 100 ◦F in July (with an average of 94 ◦F). While average statewide precipitation of around 27 inches may seem significant, the overall demand for water based on predicted population growth is projected to increase by up to 22% by 2060. This population growth, when coupled with climate change and other factors contributing to drought, including increased evaporation and ground absorption, presents significant challenges to Texas in its efforts to confront water scarcity. Challenges include an estimate water shortage of 8.9 MAF annually in 2070, caused by current supply allocation problems [28].

#### 2.3.1. Water Supply and Demand

The water supply resources in Texas emanate primarily from two sources: groundwater and surface water [29]. As illustrated in Figure 4a, groundwater, which comprises approximately 54% of the state's overall supplies, has been decreasing over the past two decades, dropping from around 10 MAF to around 7.5 MAF. Surface water, which comprises nearly 43% of the state's overall supply, has experienced some variability over the past two decades but has generally remained slightly below 6 MAF. Recycling has contributed a minor amount to Texas's overall water supply portfolio. The overall decline in available water supplies in Texas nearly mirrors the decline in aquifer storage.

Similar to other states, the major diverter of water in Texas is agriculture, which uses approximately 60% of the state's overall supply, followed by the municipal sector, which uses approximately 1/3rd of the overall water. While municipal water demand has slightly increased since the 2000s, agricultural water use has declined somewhat significantly, from slightly less than 10 MAF in 2000 to slightly less than 8 MAF in 2017 for an approximate 20% reduction. Industrial use, approximately 1 MAF per year, has trended slightly downward as well. According to a water usage summary report for 2017 conducted by the Texas Water Development Board (TWDB) [29], municipal water is primarily sourced from surface waters, approximately 64%, while groundwater supplies municipalities with approximately 32% of its needs, with the remaining 4% coming from effluent (Figure 4b).

#### 2.3.2. Water Trading

In Texas, groundwater trading is much more prominent compared to Arizona and California. For example, approximately 69% of the total value traded in Texas between 2010 and 2014 came from Edwards Aquifer, an active market for sales and leases of groundwater entitlements [30]. From 2009 to 2016, the volume of water traded in Texas increased annually up to nearly 240,000 AF, which is about 2.4 times the amount that was traded in 2009. For 2017 and 2018, there was a slight drop to approximately 200,000 AF annually. Given that there is approximately 13 MAF used annually in Texas, trading accounts for less than 2% of this usage. As Figure 4c shows, there was a spike in permanent sales during the height of the drought in 2011, but otherwise traded volumes mostly occurred through leases.

**Figure 4.** (**a**) Water supply by source, (**b**) water demand by sector, (**c**) total volume traded, and (**d**) total value traded in Texas. Source: Authors' calculations, Texas Department of Water Resources, and WestWater Research. Drought data are from the US drought monitor [31]. All prices are in real 2009\$ using the CPI—All Urban Consumers Average from the BLS.

In terms of value, we see quite a different story. The years 2009 to 2011 saw the highest value in water trading over the past ten years, with 2011 reaching nearly \$120 million in sales (primarily due to permanent water sales). The trading value decreased quite significantly from 2012 to 2018, with permanent sales decreasing significantly (Figure 4d). Interestingly, in considering columns 8–10 in Table 1, we see that while the price per unit of permanent water transfers and leases was highest in 2012 and 2013, the volume traded was low, as was the overall value, especially relative to 2011 which experienced significantly lower prices but higher volumes.

#### **3. Discussion**

In this section, we first provide a comparison between the three states in terms of water demand and supply by sector and source. We then provide a discussion of notable water market characteristics—both similarities and differences—across the three states. We conclude with a brief discussion on the importance of developing more transparent and efficient markets to facilitate the usefulness of this tool in helping states confront rising water scarcity.

As illustrated in Table 2, across all three states, the agricultural sector requires the highest volume of water, with it consuming 58% of the water in Texas, 51% in California, and 46% in Arizona. Note that while we use the term "consuming," a more accurate term would be "diverting" since a fraction of the water not transpired or evaporated often returns to the system [32]. However, while agriculture consumes the most water, its overall use has gone down over the past two to three decades, most notably in Arizona (~22%) and Texas (~12%). Improvements in irrigation efficiency are responsible for much of this decline. On the municipal side, demand is trending slightly up in Texas, is somewhat stable in Arizona, and trending slightly downward in California over the past two decades, with water efficiency measures again playing a significant role in counteracting significant population growth in all three states. As the agricultural and municipal sectors adopt more efficient water use behavior and technologies, demand hardening (i.e., as farmers/households become more efficient, it becomes more difficult to further reduce demand during a shortage or drought) will ensue thereby increasing the potential benefits of water markets as a tool to address increased future water scarcity.

**Table 2.** Comparison of demand share for each sector and supply share from each source in percentage terms across the three states.


<sup>1</sup> Using the most recent available data in 2017. Arizona also includes demand by Native Americans (11.44%). <sup>2</sup> Sum of surface water share (22.51%) and water from the Colorado River (32.71%). <sup>3</sup> Using the most recent data in 2015. Demand-side in California also includes demand for the environment (38.53%).

In terms of source supply, surface water is the primary provider in Arizona (55%) and California (48%), but in Texas, groundwater is the primary source (54%). Unlike the role the Colorado River played for Arizona during the 1980s and 1990s, surface water sources are unlikely to provide any new volumes to these states moving forward, and groundwater supplies are in decline in all three states. Furthermore, with the enactment of new groundwater sustainability legislation in California in 2014, groundwater pumping is likely to decrease even more than it currently is. As such, water markets again can play an increasingly important role in responding to an increased level of water scarcity due to declining or less reliable water supplies in each state. Of course, effluent in the form of treated municipal wastewater may help assuage such scarcity in local markets, as is taking place in California, yet such efforts require significant infrastructure investments, along with other costs due to technological constraints [33,34], to play a more significant role.

Since 2009, our data suggest that water markets in all three states are functioning to help address water scarcity, although there is likely plenty of opportunities for improvements and growth. While California has by far the highest amount of water trading—both in terms of volume and value—Arizona's market transactions comprise approximately 4% of the overall water used in the state, double the approximate 2% that defines both California and Texas (Figure 5a,b). However, even at 2%, approximately \$3.9 billion of water was exchanged in California over the past decade. Most of the activity and value is derived through temporary leases rather than permanent sales, on average. Exceptions to this include significant increases in the price of permanent water sales in California

during its most recent drought, although trading activity did not change significantly, and permanent sales and the value of those sales in Texas during the drought in 2010 and 2011. Overall trading activity, though, has been on the rise in Arizona, somewhat stable in Texas, and quite variable in California over the past decade, highlighting the importance of the heterogeneous market, environmental, and institutional conditions across states, conditions that determine market performance.

(**b**)

**Figure 5.** Average annual trading activity by state and trade type (2009–2018). (a) Average annual trading activity (\$ Milions, 2009-2018); (b) Average annual trading activity (Thousand AF, 2009–2019); Source: Authors' calculations and WestWater Research. Notes: \* All others include other western states, including Idaho, Montana, Nevada, New Mexico, Oregon, Utah, Washington, and Wyoming.

In terms of who is selling and/or leasing the water, Figure 6 provides a comparison of the sources of supply and demand for water trades and transfers in California (Figure 6a,b), Texas (Figure 6c,d), and the Western US (Figure 6e,f) across the major sectors. In California, agricultural water rights holders provided most of the water to the market over the past ten years (Figure 6a). Approximately 76% of the total volume transacted over this timeframe originated from the agricultural sector, followed by the municipal sector (19%). Agriculture's market share as a supplier has increased over the last ten years by around 2%, although it should be recalled that overall traded volumes have gone down slightly.

**Figure 6.** Summary of water trade activity by sector in California, Texas, and Western US (2009–2018). (**a**) Volume sold by sector (1000 AF) in California; (**b**) volume purchased by sector (1000 AF) in California; (**c**) volume sold by sector (1000 AF) in Texas; (**d**) volume purchased by sector (1000 AF) in Texas; (**e**) Volume sold by sector (1000 AF) in the Western US; (**f**) volume purchased by sector (1000 AF) in the Western US. Source: Authors' calculations and WestWater Research. Note: The western states include Arizona, California, Colorado, Idaho, Montana, Nevada, New Mexico, Oregon, Texas, Utah, Washington, and Wyoming. Note that we did not have state-level data on Arizona.

In terms of major buyers in California, the municipal sector purchased/leased the most water, on average, over the past ten years, followed by agriculture and then the environment (Figure 6b). While the municipal sector had a somewhat stable level of purchases from 2009 to 2016 (on average they comprise approximately 55% of the total market share), there was a slight decrease in 2017 and 2018 potentially due to (i) lower incentives to trade due to drought subsiding in 2017, and (ii) increased acreage of higher revenue perennial (e.g., tree and orchard) plantings whose significant capital investments increase the opportunity cost of fallowing land. While the agricultural sector has comprised approximately 25% of the market purchases over the past ten years, there was a noticeable and significant increase in the year 2018, as the drought eased and groundwater regulations were tightened under the recently passed Sustainable Groundwater Management Act of 2014. The environment, meanwhile, also plays a significant role in California water markets, comprising approximately 18% of total transactions by volume traded.

In Texas, similar to California, agricultural water rights holders provided most of the water to the market over the past ten years (Figure 6c). Approximately 89% of the total volume transacted over this timeframe originated from the agricultural sector, followed by the industrial sector (8%). In terms of major buyers, the municipal sector purchased/leased the most water, on average, over the past ten years (84%), followed by agriculture (13%) (Figure 6d).

The Western States in this figure include Arizona, California, Colorado, Idaho, Montana, Nevada, New Mexico, Oregon, Texas, Utah, Washington, and Wyoming. Not surprisingly, water is sourced primarily from the agriculture sector. Over the past ten years, approximately 73% of the total volume transacted in the Western US originated from the agricultural sector (Figure 6e). The municipal sector is the second-largest supplier, comprising approximately 23% of the overall sourced supply in the Western US. The industrial sector is responsible for approximately 4% of the sourced water. Note that while in Texas the agricultural sector is responsible for typically around 90–95% of the overall water sales/leases in the state, in absolute terms it is relatively minor compared to California, where the municipal sector is responsible for around the same volume of water sales/leases compared with the agricultural sector in Texas.

On the demand side, participation remains relatively stable, with municipalities continuing to be the largest buyer with 46% of total market share over the past ten years (Figure 6f), although it plays a much more significant role in percentage terms in California and Texas (Figure 6b,d). Environmental buyers, usually comprised of private entities, conservation groups, but also state and federal agencies in efforts to maintain or meet obligations associated with environmental quality, instream-flows, and wildlife habitat [35,36], also play a significant role in western water markets—mostly arising in California—comprising approximately 26% of total transactions by volume traded, followed by agricultural (16%) and industrial (12%) sectors. As noted in Szeptycki, Forgie, Hook, Lorick, and Womble [35], there is significant variation in how water transfers for the environment are regulated across western states, and these differences can significantly limit the type and scope of transfer. While all three states we considered have opportunities to reduce obstacles that are hindering environmental transfers, particularly the administrative burden buyers and sellers confront exercising such transactions, California and Texas are noted to confront fewer of the legal challenges than Arizona in terms of the scope, certainty, and permissibility of environmental water transfers.

In considering the year-to-year variation, we see that there were some significant volumes purchased by the agricultural sector in Texas during the drought years between 2011 and 2014, but on average, over 90% of the volume bought was by the municipal sector. While purchases of permanent water or leases by industrial users do happen, the percentage of the overall volume is quite small. Finally, and what perhaps California's experience in 2018 forebodes for the rest of the West, water supply firming for agriculture associated with the increase in permanent cropping, especially in California, has prompted agriculture to participate in the demand side in higher proportions. As shown in Figure 6b, California's agriculture demand-side market participation has increased by 6% and 15% by value and volume traded, respectively, over the last ten years.

#### **4. Concluding Remarks**

Water markets at their core, as with any market, are intended to help reduce the impacts of scarcity by facilitating the transfer of water to its highest-valued uses. What this review has shown in evaluating three western states, is that water scarcity is likely to increase significantly moving forward, primarily due to population growth and the added water demand associated with such growth. Of course, improvements in water use efficiency, both in the agricultural and municipal sectors, have helped society respond to date (indeed, overall water use in California has decreased in the agricultural and municipal sectors). However, demand will harden, and thus such efficiency gains will be harder to come by, resulting in water demand rising with population growth. Scarcity will also heighten due to lower and/or more variable supplies coupled with increased regulation surrounding groundwater pumping and use. These conditions, increasing demand coupled with stagnating or declining and more variable supplies, which seem to characterize each of the three states we examined, suggest an increasingly important role for water markets.

Our analysis has also shown how water markets have played an essential role in water reallocation throughout the Western US. In the recent data we analyzed here, most of the transfers are associated with leases as opposed to permanent water sales. Nevertheless, the overall amount of water that is transferred is small relative to the total water used, between 2% and 4%. This suggests that plenty of opportunities exist for the market to expand, which will require attention from market developers, regulators, and stakeholder input. For instance, during California's most recent drought, trading activity did not seem to respond in any appreciable manner, yet the price of both leases and permanent sales rose significantly (e.g., the price of permanent sales rose from \$3797 per acre-foot in 2013 to over \$9230 per acre-foot in 2014, yet actual trading activity in the state declined). There are multiple factors —that differ across states— that likely contribute to inhibiting the market from achieving its full potential, including high transaction costs associated with often multiple layers of approval, a lack of transparency, poor and incomplete information flows, along with conveyance and infrastructure limitations.. So while markets have been serving as a means to help change the temporal and spatial distribution of water allocations to their higher-valued uses, significant opportunities exist to both better understand the drivers that influence water market performance and expand the market through the creation of a more transparent, flexible, and user-friendly system.

While water transfers can lead to an overall increase in the net benefits water use from a social perspective, concerns of third-party effects and externalities on other users can create challenges and limit the full functioning of a water market [37]. For instance, if water transferred out of a region results in impacts on local employment and income, such third-party effects can lead to transfers being politically unattractive (and lead to limits on transfers). Of course, if the transfers occur within a particular region, then such third-party effects will be minimal. In response to these third party effects, governments often respond by limiting out-of-region transfers via mandates or fees. Alternatively, if transfers incentivize greater groundwater pumping in agricultural-based communities, this may have impacts on the availability of municipal water for those communities dependent on groundwater for health and hygiene [38]. Careful hydrological monitoring, or employment of a general water accounting framework, can help policy makers better understand the potential implications of transfers on groundwater levels and other users.

Note that the "water market" we describe in this paper is comprised of significantly different water trading and transfer schemes both within and across the three states analyzed. While our focus was on traded water entitlements, surface and groundwater rights are the most commonly traded asset class within the Western US market. However, there are other types of ownership interests in water that are also traded. For example, in Arizona and California, groundwater banking is also traded. Entitlement to use treated wastewater is traded in Arizona, California, and Colorado. Entitlement to store water for use in a surface reservoir, known as "Storage Water Rights", is observed in California and Colorado [39]. As such, there are many opportunities and forms of markets that can be used to help the Western US cope with rising water scarcity, but it requires significant planning, cooperation,

collaboration, and evaluation by policymakers with stakeholders to facilitate the development and implementation of such markets.

**Author Contributions:** Conceptualization, K.S. and M.N.; methodology, K.S. and M.N.; software, M.N. and G.Z.; validation, K.S., M.N., C.L., and G.Z.; formal analysis, K.S. and M.N.; investigation, K.S. and M.N.; resources, K.S., M.N., C.L., and G.Z.; data curation, M.N., C.L., and G.Z.; writing—original draft preparation, K.S. and M.N.; writing—review and editing, K.S., M.N., and C.L.; visualization, M.N. All authors have read and agreed to the published version of the manuscript.

**Funding:** This research received no external funding.

**Conflicts of Interest:** The authors declare no conflicts of interest.

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