Going with the Flow: Marketing Instream Flows and Groundwater Terry L. Anderson* Donald R. Leal* In the past decade there has been a remarkable shift in the eco- nomic thinking about the efficacy of water marketing. In the past because of a deep suspicion of markets, "th- general tendency in institutional development [regarding waterj has been to modify market procedures or completely replace them."' That attitude, however, is giving way to policy reforms that emphasize the use of voluntary water trading; "regulatory and pricing measures can be contrasted with what promises to be a more effective approach, namely facilitating voluntary market transfers of water." 2 Until recently it has been assumed that third party effects and problems of public goods have limited the utility of water markets. Frank Trelease, a leading legal scholar on water institutions, concluded that objections to water marketing result from exaggerated de- fects in the prior appropriation system, "a dislike of the property system, . . a mistrust of the market system" or "a dislike of the priority system .... To a large extent these objections are based on a lack of understanding-a failure to appreciate the flexibility and variety of operational methods available under controlled ap- propriation laws." 3 As Willey and Graff point out, this lack of un- derstanding is giving way to increased attention and reliance on the market process.4 In stressing the need of the western United States to adjust to the new realities of water allocation, former * The authors are associates with the Political Economy Research Center, Bozeman, MT, and Dr. Anderson is a visiting Professor of Economics at Clemson University. The authors wish to thank the Earhart Foundation for its support of this research. 1. L.M. HARTMAN & D. SEASTONE, WATER TRANSFERS: ECONOMIC EFFICIENCY AND AL- TERNATIrvE INsTrrUTiONS 3 (1970). 2. R. W. Wahl, Voluntary Market Transfers of Federally Supplied Water (February 13, 1987) (unpublished paper presented at the symposium "Evolving Issues in Water Policy: The Agricultural Connection," sponsored by the Congressional Research Service). 3. F.J. Trelease, Alternatives to Appropriation Law in WATER NEEDS 60 (V.P. Nanda ed. 1977). 4. Willey & Graff, Federal Water Policy in the United States: An Agenda for Economic and Envi- ronmental Reform, this volume. 318 COLUMBIA JOURNAL OF ENVIRONMENTAL LAW [Vol. 13:317 Colorado governor Richard Lamm described the change that has taken place: When I was elected governor in 1974, the West had a well-es- tablished water system .... Bureau [of Reclamation] officials and local irrigation districts selected reservoir sites and deter- mined water availability. With members of the Western con- gressional delegation, they obtained project authorization and funding. Governors supported proposals, appearing before congressional committees to request new projects, and we par- ticipated in dam-completion ceremonies.... In 1986, the picture is quite different. The boom in western resources development has fizzled, though tourism remains an economic mainstay .... Congress, including members of the western delegation, has to worry about how to cut spending, not which [water] projects to fund .... Farmers are trying to stay in business and are recognizing that their water is often worth more than their crops. Policy-makers recognize that the natural environment must be protected because it is a major economic asset in the region.5 Even the Bureau of Reclamation has recognized political reality regarding dam construction and is placing more emphasis on in- creasing the efficiency of existing water use. Recently it even went so far as to open an Office of Water Marketing. The revolution in water marketing concepts both intellectually and at the policy level has focused primarily on the allocation of offstream diversions rather than on instream flows or ground- water. Given that the prior appropriation system which domi- nates western water law evolved to accommodate offstream uses, this is hardly surprising. By the same token, the forces of scarcity which necessitated the shift from the riparian system are begin- ning to appear with respect to instream flows and groundwater. 6 The management of instream flows was once restricted to the maintenance of flow levels sufficient for navigation and power generation, but today such management encompasses the alloca- tion of a broad range of stream uses. Adequate instream flow levels are required to sustain fish and wildlife habitats, to mitigate damage from water pollution, and to provide recreational oppor- tunities. With groundwater use increasing steadily over the last 40 years, basin depletion is raising pumping costs and causing subsidence. With our increased understanding and use of water 5. Lamm, Foreword to B. DRIVER, WESTERN WATER: TUNING THE SYSTEM ii (1986). 6. For a discussion of this evolutionary process, see Anderson, Institutional Underpinnings of the Water Crisis, 2 CATOJournal 759 (Winter 1982). Going With The Flow marketing for offstream allocation, it is time to extend the market paradigm to the tougher problems of instream flows and groundwater. INSTREAM FLOWS Originally the instream flow issue concerned Only the mainte- nance of flow levels for navigation and power generation, but to- day's concerns are related to a broader range of stream uses including waste disposal, fish and wildlife habitats, and recrea- tional activities. As Willey and Graff point out, such uses in- creased in value from an economic standpoint; the problem, however, is that the existing institutional structure does not re- flect these values. Under the prior appropriation system, water ownership is de- fined in terms of diversion and consumption; water left flowing in the stream becomes available to downstream diverters. For ex- ample, when a Montana rancher offered the Montana Land Reli- ance a conservation easement in a diversion water right on the Madison River if the group would leave the water instream, their lawyer discovered that the easement would be of little value since the water would be considered abandoned under Montana water law. This "use it or lose it" principle eliminates any incentive for water owners to provide instream flows. Hence in the absence of private property rights to water left instream, the political process must be relied on to provide ade- quate instream flows. Such efforts predictably collide with tradi- tional agricultural, industrial, and municipal uses which compete for diversions. If political units reserve water for instream pur- poses, offstream users lose access to a potentially valuable asset and therefore oppose such reservations. This becomes especially true in states where there is little surplus water, i.e. where streams are fully appropriated for diversion. As a recent report of the Western Governor's Association notes: States are reluctant to try to use their power to regulate to pro- tect and enhance instream flow values on such [fully appropri- ated] streams because to do so may invite litigation. Additionally, where states have the authority to acquire [through purchase] existing water rights and to transfer them to instream flow rights, this authority has not usually been exer- cised because of budgetary constraints. ... -The gap in protec- 7. See Willey & Graff, supra note 4. 19881 319 COLUMBIA JOURNAL OF ENVIRONMENTAL LAW [Vol. 13:317 tion of instream flows on streams approaching full allocation and the absence of protection of these flows in some states, to- gether with water code provisions that encourage consumptive uses, leave instream flows only partially protected in western states. 8 Given the difficulties of using the political process to reserve instream flows, it is appropriate to ask whether water marketing can help resolve some of the conflicts. If any market is to work, it is necessary that property rights be defined, enforced, and trans- ferable. Economic theory can be used to show that a market for instream flows will not efficiently allocate water between instream and offstream uses because instream use rights cannot be defined and enforced; in other words, provision of instream flows is sub- ject to the free rider problem.9 Some economists simply assume that property rights in a natural resource such as instream flows cannot be defined and enforced, but the fact is that individuals will undertake establishing property rights when it is in their eco- nomic interest to do so. As the value of instream flows rises and the technology for monitoring water use improves, the likelihood of having instream flow rights increases. A comparison between instream flows and nineteenth-century grazing land is illustrative. Sophisticated technologies of streamflow monitoring can serve the law in insteam flow rights just as the technology of barbed wire served the nineteenth-century law of private rights in graz- ing land. Defining the parameters of a right to instream flows is no more difficult than defining the parameters of a right to di- vert water for agriculture or industry.' 0 Based on the free-rider argument that there is a potential for mar- ket failure, however, most states have not allowed private in- stream flow claims. The resulting problem is that the possibility of innovative private contractual arrangements by conservation groups like Trout Unlimited and The Nature Conservancy may be thwarted. The problem 'Created by the inability of private parties to con- tract for the provision of instream flows can be seen, for example, on the Ruby River, a blue ribbon trout stream in southwestern 8. See B. DRIVER, supra note 5, 33-34. ,9. For a complete discussion of the land and economics of instream flow regulation, see Anderson & Johnson, The Problem of Instream Flows, 24 ECONOMIC INQUIRY 535 (October 1986). 10. Huffman, Imtream Uses: Public and Private Alternatives in WATER RIGTrs: SCARCE RE- SOURCE ALLOCATION, BUREAUCRACY AND THE ENVIRONMENT 275 (T.L. Anderson ed. 1983). Going With The Flow Montana. During the spring of 1987 withdrawals for irrigation by senior rights holders reduced instream flows sufficiently to cause a major fish kill. To have prevented the kill, the flow of the river would need to have been increased by only 150 cubic feet per second for a few days. The Department of Natural Resources and Conservation eventually negotiated an increase in the flow but it was too little too late. If an organization like Trout Unlimited could have purchased or rented a relatively small amount of the low-valued water standing in the fields, the farmers would have had an incentive to compare the value of water for irrigation to the value for trout habitat. By allowing private ownership of in- stream flows, a catastrophe could have been avoided, water could have been conserved, and cooperation between fishermen and farmers could have replaced conflict in the political arena. Unfor- tunately, the laws of Montana stood in the way. Rather than advocating private instream flow rights, environ- mental and recreational interest groups are attempting to use the public trust doctrine to preserve stream flows and open access. The basic idea of this doctrine is that the public possesses rights superior to any private claims. Thus private rights are subordinate to public rights which are held in trust by the state. Initially this doctrine made sense when applied to commerce on navigable rivers and coastlines, but its extension to instream flows" and to recreational access 2 are only likely to generate more conflicts with diversion uses and reduce incentives to leave water instream. Reliance on this doctrine has prevented markets for instream flows from evolving and has ensured that even mar- kets for diversions will be clouded by the uncertainty of private tenure inherent in this doctrine. The time has come to make the marketing of instream flows possible by allowing the private es- tablishment and enforcement of instream flow rights. In this way these valuable uses will be able to compete with more traditional diversions. A positive alternative to the public trust doctrine and to public reservations of instream flows would be to allow private individu- als and groups to purchase water from diverters or to claim lim- ited amounts of unclaimed water where streams are not fully appropriated. State laws could be amended to allow retirement 11. Na' Audubon Soc y v. Superior Court of Alpine County, 33 Cal. 3d 419, 658 P.2d 709 (1983). 12. Montana Coalition for Stream Access v. Hildreth, 684 P.2d 1088 (Montana 1984). 1988] 322 COLUMBIA JOURNAL OF ENVIRONMENTAL LAW [Vol. 13:317 of prior appropriation rights so that water would be left in streams where upstream diversions create critically minimum flows. These diversion rights could be donated to or purchased by environmental groups who could in turn resell the rights to diverters below critical flow points. Such donations or purchases would only be necessary on streams which are fully appropriated. On streams with unappropriated water, private individuals or groups could be allowed to establish claims under the rules of prior appropriation. A potential problem with this proposal is that claimants could appropriate all water flowing past a given point, and block up- stream transfers of diversion rights. Thus, a downstream farmer could move his diversion above the instream flow claim, causing total instream flows to decline. The instream flow claimant would be impaired and eligible for compensation. If instream flow claims are free, therefore potential claimants have an incentive to use all they can, and existing diverters will resist instream appro- priations because of the restrictive effect on water transfers. To prevent excessive instream flow claims and to make the proposal for instream claims politically acceptable, water could be sold by the state or limits on the amounts to be claimed could be im- posed. I3 Under this system, legal changes allowing limited pri- vate ownership of instream flow claims would greatly increase the options for insuring sufficient flows wben those flows are scarce. GROUNDWATER The allocation of groundwater is another area where there has been practically no opportunity for markets to play a role. Before examining market alternatives, it is important to understand the two major problems associated with groundwater allocation. The first is the depletion of stocks in many basins. To many people, the fact that withdrawals exceed recharge is seen as bad, but the relevant economic question is whether depletion is efficient. Effi- ciency criteria require that water be left in the basin if its dis- counted future value exceeds the present value. Certainly if the basin is a common pool resource, efficient use over time is un- likely because any water left in the basin will be subject to capture by other pumpers and therefore of zero future value to the per- 13. For a more complete discussion of problems created when instream flow claims leave no unclaimed water, see Anderson & Johnson supra note 9. Going With The Flow son who conserves. Overdraft inevitably occurs in the common pool case. However, if property rights to water left in the basin can be established, decision makers will tend to move toward op- timal extraction rates. The second problem is pollution of groundwater supplies. In- stances of toxic wastes seeping into subterranean wells and threatening health have prompted the federal government to en- act the Comprehensive Environmental Response, Compensation, and Liability Act,' 4 better known as Superfund. The legislative price tag for clean-up which rose from $1.6 billion in 1980 to $9 billion in 1986 has been referred to as a "hazardous waste of tax- payer money."' 5 Again if property rights can be established, the need for Superfund can be reduced because liability would act to promote prudent disposal of hazardous wastes. Owners of haz- ardous waste disposal sites who can be held liable will have an incentive to take preventative measures rather than pay for dam- ages they cause. The infamous case of Love Canal illustrates how a liability stan- dard can work. Chemicals leaking from the dump formerly owned by Hooker Chemical allegedly were responsible for ad- verse health effects in the 1960s and 1970s. These leaks forced the evacuation of homes near the site and prompted legislative hearings that eventually led to the Superfund legislation. Closer examination, however, reveals that the company used state of the art disposal techniques even in the 1940s. Their concern over potential liability provided the necessary incentive to induce re- sponsible behavior.' 6 The chemicals dumped by Hooker re- mained enclosed until the land was taken over by the city of Niagra Falls which built a school on the site and sold surplus land to developers. Development meant sewers and sewers meant trenches through the toxic waste dump. What Hooker Chemical had tried to prevent because of potential liability, city officials un- did because no one was directly accountable. This story should provide an important lesson, but it has been ignored by most pol- icy-makers and environmental leaders. A system of property rights for groundwater can be patterned after unitization and oil pooling arrangements used to control oil 14. 42 U.S.C. ยง 9601 et seq. 15. F. Smith, "Superfund: A Hazardous Waste of Taxpayer Money," HUMAN EvENTs, 662 (Au- gust 2, 1986). 16. E. Zuesse. "Love CanaL: The Truth Seeps Out, ' 12 REASON, 16 (February 1981). 1988] 324 COLUMBIA JOURNAL OF ENVIRONMENTAL LAw [Vol. 13:317 fields. By assigning rights to stocks and flows and allowing trans- ferability, efficiency within groundwater basins can be enhanced. Transferability forces users to face the opportunity costs of alter- native uses. There would be greater opportunity to stabilize groundwater levels by allowing exchanges with outside water sources. Finally, with property rights and/or unitization, the owners would have the incentive to watch for and file suit against polluters. Unitization provides an effective arrangement for com- pelling individuals to act together in pursuing damages in class action suits. This proposal may not completely solve problems of groundwater exploitation and pollution, but it moves us from ex- pensive command and control legislation toward innovative coop- eration in the market place. CONCLUSION In order to take advantage of water markets, policy-makers must find ways to define and enforce water rights, make them transferable, and guard against doctrines which erode these three elements. While the prior appropriation doctrine provides many of these elements, the public trust doctrine now being advocated by some environmental groups is eroding them. By limiting the applications of the public trust doctrine; by expanding the appli- cations of prior appropriation to instream flows and to the East where water is becoming scarce; by unitizing extraction efforts and instituting clearly defined property rights to groundwater ba- sins; and by reducing the impediments to exchange, the water al- location system can be vastly improved. The possibility of developing political coalitions to bring about these necessary in- stitutional reforms is enhanced by the fact that water markets can reduce environmental degradation, thereby reducing public ex- penditures and limiting the role of government in a free society.