How Well Do U.S. Western Water Markets Convey Economic Information?
The ability to quantify the efficiency of water rights transfers as a whole provides an opportunity to measure progress in market development, learn from better-functioning markets, and as a result, advance policies to reduce barriers to water trading. Market efficiency requires that prices reflect available information about scarcity and value in use. Therefore, an important area of study—which has been largely missing in the water market literature—is the role of pricing mechanisms in water rights markets. The purpose of this study is to assess the efficiency of western U.S. water rights markets by utilizing the asset pricing model to measure how well prices reflect long-run returns to permanent water rights. We exploit the variation in prices and quantities for water trades in the western United States between 1990 and 2010 to assess water markets’ capacity to incorporate available information about long-run returns.
We find that water market efficiency is highest in one of the most active U.S. water rights markets located in the Mojave Basin Area—markets that are known to have lower barriers to trade. The coefficients on water lease prices are higher in the Mojave markets than in other water markets and, in the case of the two most active areas of the Mojave market, the coefficient on lease prices is almost as high as those in New Zealand fishing quota markets. This difference in results suggests that there is significant potential for efficiency improvements in water rights markets in the western U.S., which could lead to higher welfare gains from the reallocation of water.
An efficient market implies that potential gains from trade are fully captured. Achieving this requires a well-functioning market where prices reflect all available information. In the case of water rights markets, this implies that the permanent water rights transfer price reflects the sum of discounted returns to this asset (i.e., the lease price), the market interest rate, and a risk premium that reflects potential future water scarcity. The purpose of this study is to assess the efficiency of western U.S. water markets by utilizing the asset pricing model to measure how well prices reflect long-run returns to permanent water rights.