Smart markets for water allocation

How can humanity solve its problems of the environment? It seems they will have to be solved one at a time. The problem of global warming, to me, seems pretty simple - just cap and trade. It's the politics that we have to get past, unfortunately.

For water, I have been working on a concept for water markets that draws on the work of Vernon Smith, the Nobel Prize winner. With his colleagues, he developed the concept of a "smart market", which is an auction that manages physical constraints through a linear program (LP). Users submit bids via internet; a market manager then enters these bids as the objective coefficients. The constraints manage relevant interactions and externalities. The market manager solves the LP, and reports the primal values as the auction outcome, with the dual values as the market prices. Such markets are now in active operation for electricity and natural gas in Australia as well all over the world. Similar markets are operating for goods and services ranging from radio frequency spectrum to contracts to cater Chilean school lunches.

The analogy of electricity to water is quite natural. Despite the huge amount of work research and implementation on electricity markets, surprisingly, no one has implemented this type of market for water. It may be due to the technical requirements, which are daunting, but electricity markets are hardly trivial. Vernon Smith and colleagues are operating games for a trivial surface water system, but nothing more. So we have developed a system from scratch for ground water, and this naturally extends to combinations of surface and ground water, runoff, salinity, flood control, impervious cover, and land clearing. The system is based on the well-studied science of hydrological optimisation, but rather than minimise cost, the value coefficients come from the buyers and sellers. The system can use the best available hydrological science, which would come directly from a hydrological simulation such as MODFLOW. The LP constraints correspond to required environmental flows; the constraints directly impose sustainability on the market, which seamlessly clarifies users' obligations to the environment. Quantities and prices correctly reflect all relevant impacts of abstraction, without tax or subsidy. The result would be much more reliable environmental flows. The use of a smart market eliminates the transaction cost associated with reallocating water. Reducing transaction costs produces increasing returns to scale, as users enjoy both the lower transaction cost and gains from the more frequent trades.

Humanity needs to rewrite her contract with Nature, with an agreement to live under the constraint of sustainability. Our work describes in detail how to write that contract for the gift of ground water. As of this date, I am actively looking for collaborators with skills in hydrology or operations research.