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Inter-generational water grabbing – an unintended consequence of the Australian water market.

By Brian Chatterton.

September 2011

Abstract.

A water market was established for the Murray Darling River Basin in Australia during the 1990s. A basic requirement for a market in water is tradable rights. These were issued to irrigators free of charge and soon acquired a market value. During the first decade of the 21st century the Murray Darling River basin suffered from one of the worst droughts ever recorded and the price of water rights rose by three times.

Since the end of the drought the Australian Government has been advised to reduce water allocations by 20 to 25% through a process of buy back and cancellation of water rights. Such a buy-back scheme will underwrite high prices for water rights.

The initial allocation of water rights gave windfall profits to the generation of irrigators who irrigated in the 1990s. New entrants to irrigated farming have to purchase water rights from existing holders. Their capital costs have increased and their profits have been squeezed.

There is also evidence that the original recipients of free water rights did not immediately recognise their true value and large quantities of water in the Murray-Darling have been purchased by pension funds, overseas sovereign funds and others as an investment to lease back to irrigators.

This paper discusses the political problems associated with the generational water grab and ways in which speculative values can be controlled.

Background.

During the 1990s a water market was developed in Australia for the Murray Darling Rivers. At first it was restricted to certain states and parts of states but it evolved to cover the whole of the river basin. (Chatterton 2001) Water rights were granted to irrigators with varying levels of reliability of supply. These could be traded with other irrigators within the agricultural sector. Water exchanges, water brokers and the other paraphernalia of markets emerged to handle the trading in water.

During the first decade of the 21st century the Murray Darling Rivers suffered from one of the worst droughts ever recorded.


The above diagram shows the flow in the Murray River (the major river in the Murray Darling River system) but the picture for the Darling River was similar. (Source: Murray-Darling Basin Commission)

The volume of water traded increased dramatically and the price of water rights increased by three times. (Craik 2008) Irrigators tried desperately to buy water to save their perennial plantings of vines and fruit trees from death as their water allocations had been cut at times to as little as 5% of the amount they were entitled to according to their water rights. This was in spite of holding water rights which claimed high levels of reliability.

The granting of tradable water rights had already produced one unintended consequence which exacerbated the water shortage during the drought. Farmers who had improved their efficiency of irrigation over a number of years had a surplus of water rights above their water requirements. They could theoretically expand their irrigated area with the water released. In fact most were within irrigation schemes where expansion was not possible as there was no un-irrigated, suitable land contiguous with their existing farms. Usually they sold their surplus water rights to others who used it to plant new irrigated areas.

This was seen as a great benefit of the water market. The sale of the surplus water would provide funds for improved efficiency. (Topfield 2006) It was promoted as a win-win loop. Investment in irrigation efficiency created a saleable surplus of water which, in turn, paid for investment in more efficiency measures.

What was not foreseen was the increased demand for water. Improved efficiency was taking place independently of water rights and before the sale of the surplus became possible in the water market. South Australian irrigators had, for example, been converting their vineyards from furrow irrigation to drippers since the 1970s. This saved water, improved yields and reduced saline waterlogging and drainage. Without a sale of the surplus, farmers had created, in effect, an on farm reserve of water. That is they had more water rights than they really needed. A cut in allocations due to the drought would have had less impact if these farmers had been using say 80% of the water entitlement under their water rights. By selling the surplus 20% they needed every drop of the rest. The sale of the surplus water rights meant total demand equalled the total water rights as the purchasers did not buy the water rights to hold as a reserve but to use to the limit allowed.

The price of water.

The market made the price of the water obvious. Water was separated from the land and traded around the basin. Leaving aside the technical problems of turning a theoretical market model into a practical distribution of water, the water right was given free to existing irrigators. It can be argued that the issuing of separate water rights only clarified what was happening already. That is the price of water was previously incorporated into the price of the irrigated land and putting the land and the water on separate titles improved the efficiency of water allocation to the most profitable crops.

The problem with this argument is that it fails to realise that the water right and the actual water used were not necessarily the same. The market has forced the managers of the basin to supply the total water rights at all times. Before the granting of separate water rights any unused water remained on the farm as a reserve. Most farmers could not expand their area to use the surplus water produced from improvements in irrigation efficiency. Once the water was detached from the land it could be traded and the purchaser certainly intended to use it to the limit.

A single generation has captured the value of the community resource. It was a huge windfall profit that has never been taxed. No contribution was made to the community for this capital gain. No levy was introduced to provide more environment water or to share efficiency savings with the community.

Closure of the water resource.

The price of water rights did not arise spontaneously with the issue of a piece of paper or a digital record on a computer. It came from closure. As long as the water resource was open to new entrants water had no capital value. Why should one pay an existing irrigator for the right to water if you could apply for water directly from the State Government. One purchased the land, the house, the equipment, the planting of vines and trees from the previous owner but not the water.

Closure meant that new water was not available. At first water did not have a value because there were more sellers than buyers. (Chatterton 1996) In fact there were many dummy owners of water rights in NSW who had successfully established an historical claim to water but were not actually using their allocation.

The drought changed that completely. More water was traded and the price rose three times.

Source: Murray Darling Basin Commission.

The above diagram is a little difficult to interpret as the diversions vary considerably from year to year but the general trend was a sharp increase in South Australia (green line) during the early 1960s which led the established irrigators to protest about excessive water allocations. The State Government responded to the political pressure and began the process of closure. It can be seen that the line flattened out after 1970 and the overall increase was slight even though yearly variations were considerable.

Victoria (blue line) also closed its water resource but not as effectively as South Australia. In NSW (red line) the increase in diversions went on unchecked.

Resource rent.

Resource rent is the term used by economists for a free lunch. Economists spend most of their time proving that there is no such thing as a free lunch. They talk about capital investment, labour costs, rates of return and so on but nature does provide us with the occasional bonanza. There is no capital investment, little work just windfall profit. The classic example is someone picking up a gold nugget. The returns are huge and the costs are virtually zero but it is followed by a gold rush. Prospectors spend large amounts of money and time searching for the elusive nuggets. If they are found they will provide a bonanza to an individual but in overall economic terms the resource rent has been dissipated in a huge increase in costs incurred by the prospectors as a group.

Community resources such as fisheries, common grazing lands and water provide abundant profits when they are first exploited but this resource rent is soon dissipated through excessive costs.

Fisheries are a good case study. A newly exploited fishery such as the offshore prawn fishery of Kerala, India had extremely high profits some decades ago following the development of offshore trawling by a Norwegian aid program. These profits were soon dissipated through over fishing. Too many trawlers were built. Their activities were not controlled. The catch for each trawler dropped. The costs for the fishery as a whole rose and profits fell away. This is the familiar story described as the tragedy of the commons. It can of course be prevented by fisheries management as in the South Australian prawn fishery but this rarely happens until it is too late. (Chatterton 1981)

The same can be said of the rangelands of North Africa and West Asia. The grazing commons have not been closed and pasture productivity has dropped dramatically through overgrazing while costs of feeding and transport have risen for flockowners. The resource rent from these large naturally pasture lands has been dissipated and the rangelands are a liability not an asset.(Chatterton 1984)

Water is different as the increase in costs through over exploitation have been borne by the community not by the users. Initially there was cheap and abundant water available from rivers and lakes which provided a large resource rent to the early entrants into irrigation but gradually the community invested heavily in the infrastructure to maintain the supply water at a time and place that suited irrigators. The community paid the costs and the irrigators took the resource rent. As long as the resource remained open they could only take the resource rent while they used the water resource. They were not able to capitalise the future resource rent. Once the water resource is closed to new entrants (the same applies to fisheries) a single generation can capitalise the future resource rent and force new entrants to pay this capital sum as the price of entry into the resource. The first generation retire with a large capital windfall while the next generation enters with a large capital burden.

The distinction between users and owners is important when it comes to property rights. The property rights of Maoris in New Zealand and Inuits in Canada have been recognised as they have traditionally exploited the fisheries for many generations. The rights of other fishermen to convert their current exploitation of the fishery into a saleable piece of property (capitalised future resource rents) is still disputed (in most cases the fishermen have won) but the fishermen can support their case to a limited degree with the argument that the community has invested little in the fishery. In most cases governments have invested in some research and regulation but this is small in comparison to the very large amounts spent on water storage and distribution. The European Union subsidised fishing boat construction in Spain and Portugal with disastrous results. It was an investment in the destruction of the fishery not its conservation and management.

When it comes to water for irrigation, community investment in the infrastructure has been huge. Australian irrigators have certainly used the argument that they have accessed the water resource for generations and are therefore entitled to capitalise these user rights into saleable property but the reality is quite different. The water resource their fathers and grandfathers exploited (somehow mothers and grandmothers are never mentioned) has been destroyed by over-exploitation and the only reason there is a reliable supply of water (severe droughts excluded) is the community investment in the infrastructure. Australian farmers have traditionally privatised their profits and socialised their losses. The recent privatisation of future profits appears to be their greatest success yet.

Drought gives a new dimensions to resource rent.

The drought in the first decade of the 21st century showed that in spite of the investment in water storage that the supplies were not secure. In fact dryland farming in the Murray Darling basin did not suffer as greatly during the drought as irrigated production. A reduction in rainfall has a multiplier effect on runoff and river flows were reduced by a greater proportion during the drought than the reduction in rainfall. When the drought continued for a few years the storages provided by community investment proved inadequate. River flows were reduced to such low levels that water rights could not be met. Water storage and irrigation had been promoted half a century earlier as a means of “drought proofing” Australia but that proved to be a chimera.

Source: Murray Darling Basin Commission.

The managers of the Murray-Darling River emphasised the severity of the drought as their excuse for not meeting their obligations for the provision of the water stipulated by the water rights but the drought of 1939 to 1946 was almost as severe as the 2000s drought. The major difference is that three times as much water in the form of water rights have been issued since 1946.


The above diagram shows that water use was steady during the 1939 to 1946 drought but crashed in the first decade of the 21st century to the same level as the 1940's.

The over-allocation of water has been recognised by an expert review of the river basin. They have recommended a 20 to 25% reduction to the amount of water allocated under water rights.(http://thebasinplan.mdba.gov.au)

If the Australian Government accepts this proposal and buys back water rights on the open market and then cancels them it will have two effects. It will, in the short term, underwrite the higher prices that emerged during the drought. This is a simple market operation. As farmers retire the government will buy their water rights. If this were not the case one might see a fall in the water market due to the problems of over supply of wine grapes and the abandonment of many vineyards.

It will in the longer term help to restore the resource rent that had declined when water was supplied in such limited quantities. The drought showed that the reliability of water rights as stated on the title was not risk free. Even high reliability water rights failed. Buyers of water rights will reduce their prices if they perceive the water to be unreliable but that perception will be reversed if the government buys back and cancels 20 to 25% of the water rights.

The political players in Australia

Existing holders of water rights.

These are a powerful lobby and are fiercely opposed to any dilution of their property rights. They do not accept in any way that they have been the lucky recipients of community largesse or that they have grabbed a community resource and converted into a valuable capital asset. They choose not to see the enormous difference between the natural rivers that their great grandfathers may have irrigated from and the man-made irrigation systems of today. They have considerable political support outside the farming community among those who believe in the ascendency of private property at all times over community values.

New entrants.

The new entrants to irrigated farming are politically feeble in comparison. One group of new entrants will inherit their water rights and are not interested in the problem of increased capital costs. It is a purely notional accounting convention as Australia does not have any inheritance taxes. The other new entrants are not organised as a pressure group and are in any case ambivalent about the high price of water. Like many other property investors they have a naïve belief that the price will continue to increase faster than inflation and they can cash in their water rights when they retire at a considerable inflation-adjusted profit. The reality may well be different and the price may collapse after the government buy back is complete and the fear of drought has receded after a few more floods.

Outside investors.

I am reluctant to attribute any gnomic wisdom to the outside investors in water rights given their failures in the past to recognise the weakness of many other investments from South American debt to sub prime mortgages. They have probably invested in water initially to diversify their global resource portfolio but they have quickly realised that the government buy back will help considerably to protect the value of their assets. The buy back will underwrite the water market in the short term and restore the resource rent over the longer term.

Environmental lobby.

The environmental lobby has been very vocal during the drought as environmental water was sacrificed to try to sustain flows to irrigators. The buy back has been heavily promoted as an environmental measure. It will undoubtedly provide more water to the environment but it would be naïve to believe this water will not be sacrificed again if there is another drought.

Taxpayers.

They are being asked to provide billions of dollars to buy back water rights that were given away free only a couple of decades ago. They should be furious but in Australia they seem to be passively accepting the huge payments that are proposed from their pockets.

The administrators.

These are the guilty men (only a few women) who allowed excessive allocations of water in the last two decades of the 20th century. It was so much easier than fighting the irrigators in the courts and coping with protests. The administrators responsible seem to have moved seamlessly from the State administrations who granted excessive water rights to the new Murray-Darling Basin Authority who is now buying them back. They have recommend to Ministers a huge taxpayer funded bail out and resisted any investigation of their past mistakes.

Communities

Irrigation communities are on another collision course with the policy of buy back and cancellation. The government has reassured irrigators that the buy back would be voluntary. That is they would buy the water rights on the open market from willing sellers. The problem foreseen by the irrigation communities is that this would result in a random pattern of abandoned farms. There might be some small concentration in areas that are less suitable for irrigation but in general willing sellers will be farmers who are reaching retirement or whose plantings have reached the end of their economic life.

The effect of a random pattern of abandoned farms will be to increase costs for the remaining farmers. Water distribution systems will not be reduced in size – just in volume. That reduced volume will have to pay the cost of maintaining the whole system. More broadly the community services of education and health will have excess capacity for the reduced population.

This is in contrast to a planned approach (including perhaps some level of compulsion) where old pumping stations or distribution canals and pipes might be abandoned in total or even whole irrigation schemes.

The politicians

They provide a small glimmer of hope as both the major political parties in Australia have policies that favour a low level of national debt. At present the Australian national debt is less than 10% of GDP and the political class seem intent on keeping its current low level. For example the compensation for the 2011 floods in eastern Australia is being paid for through a tax surcharge not increased borrowings.

The buy back and cancellation of water rights would require billions of dollars and the obvious means of financing it is through borrowing but that may not be politically acceptable. An alternative is to finance the buy back through a Resource Rent Tax. The details of the tax are spelt out below. The proceeds of the tax could be used directly to purchase water rights on a more gradual basis or it could be used to repay borrowings if it was considered that buy back should be done more swiftly. The dedication of the tax receipts to repaying the debt would satisfy the political need to keep the national debt under control.

Resource rent tax on water rights.

In Australia it would be difficult to unravel the mistakes of the last two decades but the buy back of water rights provides an excellent opportunity to introduce a Resource Rent Tax.

The price of water rights represents the capital value of the future resources rent. Of course it is only an estimate based on current prices for crops and the current efficiency of conversion. A Resource Rent Tax would be levied annual on the average market value of the water. The government would set the level of the tax but the farmers would set the price of water rights.

For example the rate might be 5% of the average market price over the preceding year. If the price of water rights changes so does the amount paid in tax while the rate would remain the same.

The rate can be graduated like income tax with a tax free water allowance and then graduated levels until the 5% is reached.

The effect of the Resource Rent Tax should be to gradually reduce the market price of water rights. The price of water rights represents the capitalised value of future rents. If the future rents are reduced by the tax then the capital value will decline.

In addition to a Resource Rent Tax there should be a Stamp Duty on transfers to discourage short term speculation in water rights.

Over the last forty years the Australian tradition of equity has been in retreat and the tax base has moved from capital taxes to increased consumer taxes. Inheritance taxes have been abolished at state and federal level. Land taxes have disappeared as have financial transactions taxes. A general sales tax on goods and services has been introduced. A Resource Rent Tax on water would reverse the trend (it is similar to a land tax) and would not be considered feasible in the current political climate if it were not for the need to fund the buy back scheme.

What can be done elsewhere?

For countries at an earlier stage of closure than Australia (the Nile in Egypt for example) it is most important to maintain the link between the water and the user. The development of detached water rights owned by non-users should be resisted. It is not just foreign non-users but local non- users who should be banned from holding water rights. In Egypt if water rights were introduced and detached from the land the effect would be to reverse the land reform program of the last half century. Land without water is useless in Egypt. For a small farmer to own the land but a large investor to own the water would put the farmer back into the subservient position that land reform attempted to abolish.

I am sure that those who argue for water water rights, Australian style, to be introduced in Egypt will use the argument of nature's bounty from Lake Victoria and the Ethiopian highlands being the birthright of the hardworking Egyptian farmer not that of the bloated bureaucratic state. The reality of water being supplied from the Aswan dam and the canal network will be ignored or downplayed. This emotional appeal has been used in Australia but completely misses the point. I am not arguing for the state to take the water away from the farmers. The farmers must have security of water supply but that security of use should not include rent for future water to be used by future generations.

Perhaps the best example to demonstrate this come from some Australian fisheries. Some fishermen when they retire transfer their licenses to a family trust. The trust rents the license to a working fisherman. The trust provides a rental income to the retired fisherman, his children and grandchildren in perpetuity without any fishing activity. I have not heard of these trusts being established for water rights but legally they could be. Instead the Australia farmers have preferred to capitalise their future rents.

Conclusions

The Australian water market provides a good case study for other countries that are tempted to create water markets. Australia developed the water market on the advice of theoretical economists who identified efficiency arguments as a justification for the trading of water rights.

They completely ignored the unfairness of a single generation grabbing property rights over a community resource and extracting rental income in perpetuity from future generations. What is perhaps more surprising is that they failed completely to realise the economic disadvantages of the increased capital cost of irrigation. Water might be moved around the river basin to the most profitable crops and the most efficient irrigators but the industry as a whole would be burdened with the need to service a heavy capital investment. While the present generation could ignore the capital cost as an accounting convention over time this cost would become a real cost paid for with real money.

Other countries must be more careful when they close their water resources. Closure of water resources is happening or has happened around the world. On most occasions water managers are reluctant to admit that there is no more water to distribute for irrigation. In Egypt there is still talk of expansion but the water must come from existing irrigators. The managers have been trained and have worked during the era of the hydraulic mission when increased demand was always met by more engineering works and find it difficult to accept within their mental framework that engineering can no longer produce any more water supply or if it can the cost is prohibitive.

This delusion is not shared by irrigators who realistically position themselves to take advantage of closure.

The resource managers currently engaged in developing policies for the closure of the water resource must not let a single generation of irrigators walk away with a windfall profit that represents the capitalised value of the future resource rent. The fact that resource rent exists at all in today's modern irrigation systems is due to massive public investment. Once the resource rent has been capitalised as in Australia the political pain required to claw back some contribution for the community will be considerable.

References

Chatterton, Brian and Lynne 2001 ”The Australian water market experiment” Water International. Vol 26 No 1 March 2001 pp 62-68

Chatterton, Brian and Chatterton Lynne 2005. “WIER, WISER and WINER WATER” A paper published on the Food and Agriculture Organisation, Water Forum web site September 2005

Chatterton B & L (1996) Closing a water resource; some policy considerations. Ed. Howsam P. and carter R. C. 1996 Water policy; allocation and management in practice, London; E & FN Spoin pp 355-361

Chatterton B & L. (1984) "Grazing rights and grazing management in the Middle East and North Africa," Proc. 3rd Australasian Middle East Studies Association Conference, Macquarie University, Sydney, 7th-8th Sept. 1984.

Chatterton B & L. (1981) "How much compromise can fisheries management stand? Premiums and politics in closed coastal fisheries," Marine Policy Vol 5 No 2 I.P.C. London.

Craik, Wendy 2008 “Irrigated agriculture – managing with less” paper to Australian Bureau of Agricultural and Resource Economics Outlook Conference 4th March 2008

Topfield, Jewel, 2006 Melbourne Age “Efficient farmers to sell excess water” 2-11-06 http://www.theage.com.au/