Law and the New Institutional Economics: Water Markets and Legal Change in California, 1987-2005

Abstract

New Institutional Economics (NIE) focuses on the interaction between legal (formal and informal) institutions and economic behavior. Both directions of causality concern researchers in the field: how institutions influence economic behavior and how economic factors affect institutional change. As such, the NIE abandons standard neoclassical economics assumptions that individuals have perfect information about the market and important current or future events, as well as the assumption that transaction costs of exchange are zero. As a result, NIE introduces observed organization and information costs to neoclassical analysis, thereby providing more analytical richness and power for examining empirical activities. Institutions, such as written contracts, charters, constitutions, laws, and even unwritten norms and codes of behavior are devised to reduce information uncertainty and transaction costs. If effective, these institutions can promote efficiency by encouraging investment, production, and trade.

Institutions, especially laws and regulatory arrangements, may also be used to redistribute income, or be part of rent-seeking activities. If ineffective, these institutions may result in inefficiencies and reduced investment, production, and trade. At the same time, individuals engage in collective action as a response to exogenous changes in relative prices to make institutions more effective in promoting economical activities.

In the spirit of the NIE, we examine the interactions among regulation, property rights, and water markets in California from 1987-2005. We are interested in whether and how the definition of water rights and the regulation of water transfers has affected observed market activity in: the extent and pattern of water trades, their duration, and the nature of the contracts used (short-term leases, long-term leases, and sales).

There is growing pressure to re-allocate fresh water from historical uses in agriculture, where as much as eighty percent of water has been used, to meet greater water demands in urban areas, recreation (i.e. fishing and boating), and environmental requirements (i.e. protect endangered species and repairing aquatic and riparian habitats). Fresh water supplies are limited with little or no new sources, so meeting new demands necessarily requires re-allocation. Markets are institutional options for achieving such re-allocation. Land markets, for example, fairly smoothly and routinely shift land resources from one use (farming) to another (housing). But water is a more complicated resource than land. Due to its physical mobility, water cannot be easily bounded or partitioned across claimants and uses, making it more difficult to define and enforce property boundaries and rights. As a result, exclusion is extremely difficult and numerous parties typically access the same water either simultaneously or sequentially. Because it is difficult to segment water into its various concurrent or chronological uses, there is often a high degree of interaction among water claimants and applicants. For these reasons, water trading among some parties can have important and negative effects on others.

For instance, consider an upstream irrigator who diverts water for farming purposes. Only part of the water will be used, with the remainder percolating back through the ground to aquifers, streams, or to ditches for repeated access by other parties in the same watershed or basin. If the first farmer were to sell some or all of her water and ship it out of the basin for urban use, the unconsumed residual or tail water would no longer be available for use by subsequent claimants or environmental uses. They would lose access to water and be harmed by the trading process.

Accordingly, any trades that change the location of water diversion, nature of use, and timing, especially if they are large relative to the stream flow, are restricted by state law and regulated by state agencies. Because of the potential for harm, transfers of surface water rights in western states are predicated on there being "no harm or injury" to downstream rights holders. State water agencies, such as the California State Water Resources Control Agency, typically allow trades that involve changes in diversion and location only for historical consumptive uses (water that would not be available to subsequent users in any event) in order to minimize these negative third-party effects. In contrast, local, short-term water transfers among neighboring users, such as irrigators, typically do not require state approval because the water stays nearby and any changes are of limited duration.

California laws and regulations, as defined by the state legislature, courts, and administrative agencies, may promote water market transactions if they: (1) clarify the definition and enforcement of private water rights so that ownership is obvious; (2) streamline and make transparent the regulatory process; and (3) limit third-party protests to well-defined criteria and short time periods. Alternatively, California law may retard or change the duration and type of transactions if water rights are weakened and/or the regulatory process is made more complicated. For instance, California law could affect the relative costs and benefits of using particular contracts (leases relative to sales), and the length of transactions (short term versus long term or permanent) by the nature of the regulatory process.

In this Article, we examine the water market activities in California between 1987 and 2005 and analyze how the changes in the definition of water rights and regulation have influenced the extent and nature of water trading.

Keywords: New Institutional Economics, NIE, water markets, water rights, water transfers, water trades