Options for water market reform

Australian water markets are rightly viewed as one of the best examples of their kind in the world. For several decades now, water markets have played a vital role within the MDB acting to quickly and efficiently allocate scarce water resources between users particularly during droughts (see Kirby et al 2014, Hughes et al 2016).  Water markets are also crucial in supporting adaptation to a range of ongoing structural changes in the MDB (see Gupta and Hughes 2018) including long-term reductions in water supply related to climate change (see Hughes 2019, Cai and Cowan 2013), large scale environmental reforms and transformational change within the irrigation sector (Gupta and Hughes 2018).

In assessing the performance of water markets, it is important to separate the operation of the market itself from these large structural trends.  Reductions in water supply (due to drought, climate change and environmental water recovery) and increases in demand (due to expansions in horticulture) have contributed to large increases in water prices in the sMDB over the last decade (Hughes et al. 2019).  Past ABARES research has found that these increases in water prices can be largely explained by measurable changes in water supply and demand (see Hughes et al. 2016, Gupta and Hughes 2018, Hughes 2019).

Large increases in water prices have no doubt played a part in user concerns around the operation of the water market. However, high water prices on their own do not necessarily indicate failure or inefficiency in the water market. Rather, price signals are central to the function of water markets and help encourage efficient allocation and use of scarce water resources. Further, high water prices also suggest that water property rights are well defined and that compliance efforts in the sMDB are broadly effective (Hughes et al. 2020).

Notwithstanding this, the structural changes experienced in the MDB over the last decade have placed water markets under significant pressure and revealed some legitimate weaknesses in existing market rules and processes. For example, recent droughts and shifts in irrigation activity have started to push inter-valley water trade in the sMDB to its physical and administrative limits, leading to frequent trade closures (see Gupta et al 2018).  This has raised concerns both around the efficiency and equity impacts of trade closures, and potential third-party effects of high inter-regional trade volumes (e.g., due to increased river losses). 

Attention has also been placed on water sharing and carryover rules within the MDB; with concerns over the complexity of current rules and their potential to create uncertainty over the volumes of water allocated to water right holders. While many of these concerns are not new ongoing structural changes (particularly changes in climate conditions) are increasing pressure for reform.

Current carryover rules within the sMDB are less than ideal due to the annual water accounting framework (which leads to a range of inefficient carryover limits). Further carryover rules are inconsistent across the sMDB (particularly between NSW and Vic.).  In addition, water sharing rules (which set user allocations as a function of water resource availability) are highly complex and can create unnecessary uncertainty for water right holders.

This submission outlines a range of potential reform options to water sharing and carryover rules in the sMDB. Collectively these reforms would take current water accounting systems closer the ‘continuous accounting’ and ‘capacity sharing’ style systems currently adopted in northern NSW and southern Queensland respectively (see Hughes and Goesch 2009, Hughes et al. 2013). These reforms aim to set water sharing and carryover rules which—as far as practical—reflect the physical constraints of the water supply system, and then allow users to trade or carryover water subject to those rules.

Some key potential reforms for exploration include:

• Refinement of water sharing plans to ensure water allocations are determined by well-defined and transparent functions of physical water availability (ideally in the form of simple percentage shares).  
• Continuous (i.e., daily/weekly) water accounting with periodic reconciliations to ensure match user water accounts match physical water supplies.
• Carryover subject to user water account limits (and ‘internal spills’) as occurs in current capacity sharing / continuous accounting systems (and the removal of current annual carryover limits and ‘spillable water accounts’).

Collectively this approach could help to maximise user trade and carryover flexibility while minimising third-party effects (externalities). In addition, the closer alignment of water sharing rules with physical water systems helps to improve transparency and reduce uncertainty. The range of reforms presented in this submission, allow for significant flexibility to vary scope and timing of future changes. For example, an ambitious reform agenda could see the sMDB approach something resembling capacity sharing (as implemented in southern Queensland), while a more modest agenda could lead to an approach similar to that implemented in northern NSW under the label of ‘continuous accounting’.

Inter-valley water trade needs to respect physical constraints and losses associated with transfer of water between catchments (in-order to maximise gains from trade while minimising third-party effects). Current approaches to the management of inter-valley water trade in the sMDB are less than ideal as they don’t fully reconcile river operations (i.e., hydrological constraints) with the regulation of water trade. The existing system of Inter-Valley Trade (IVT) accounts is an attempt to address this issue, but it remains imprecise and can result in both inefficient and inequitable outcomes.

Managing inter-regional water trade via a rules-based approach is difficult, as river operations decisions and water trade flows are highly inter-dependent. In electricity, this problem has been addressed though the development of ‘smart markets’. Smart markets are automated computer- systems where physical constraints are combined with a user-based auction mechanism to determine optimal trade flows and prices. While there has been some theoretical research on applying this concept to water, there are significant practical barriers and few real-world examples.

In other countries (particularly the US) these issues have been addressed though more active centralised management of inter-valley water trade. This has included government ‘water banks’ which trade water between regions on behalf of end-users, taking into both account economic information (i.e., prevailing water prices in different regions) and hydrological (river operations) information.

This report outlines a possible hybrid approach, which would involve the development of an auction-based mechanism for inter-regional water trade into which users in each region could submit bids and offers to buy/sell water allocations. Then a centralised water board would make regular decisions on interregional trade flows drawing on their knowledge of river operations and data from the auction system. This approach could more tightly connect inter-regional trade flows with physical water transfers leading to improvements in efficiency and equity.

This report details some options for how this approach might be implemented, however further research would be required to fully develop this concept before it could be adopted in the sMDB.

ABARES recently published a report on the measurement of water market prices within the MDB (Sanders et al. 2019). This report documents high levels of noise in the prices reported on state government water trade registers.  This noise can arise for a variety of reasons including missing or inaccurate price reporting along with limited trade classification (e.g., failure to separate forward contracts from standard allocation trades). These problems are widely acknowledged and covered at length in the ACCC interim report, and ABARES is supportive of efforts to improve the quality of trade information recorded on government registers. 

While ABARES is not a direct provider of water market price information (as this responsibility now primarily lies with the BOM) ABARES continues to play a role in informing the water market via its regular Water Market Outlook reports.  This product makes use of ABARES Water Trade Model, taking into account assumptions on potential future water supply and demand (i.e., irrigation activity) conditions to present estimates of future water allocation prices. ABARES has also undertaken a number of longer-term assessments (see Gupta et al. 2018), which simulate potential future water prices in the sMDB taking into account structural changes (including growth in horticultural plantings, water recovery programs and changes in water supply / climate conditions). Both of these products offer useful information to market participants which could help to inform short-and long-run water market decisions. However, at present ABARES water market products are not integrated with any other market information systems and some participants may be unaware of them.

Finally, the market architecture reform options outlined above may have some implications for water trade processing systems in the MDB. In particular, the proposed auction-based mechanism for inter-valley water trading could require some form of centralised exchange.