Institutions, third-parties and water markets : an analysis of the role of water rights, the no-injury rule, and Water Code 386 on water markets in California counties

Abstract

Given the apparently large potential gains from the trade of water, why do we observe so few market transactions? This paper argues that policy-driven transaction costs are an important trade-hindering factor. More specifically, this paper examines the allocation of property rights under the No-Injury Rule, which gives rights to riparian users, and Water Code 386, which gives quasi-blocking rights to third-parties, making water rights less clear. Both laws are predicted to decrease the likelihood of observing an active export market and the volume of exports in the county. To test these predictions, this paper uses the cross sectional variation in the number of riparian rights holders and the number of third-parties to estimate their effect on all county-level water trades in California from 1990 to 2001. The empirical results show that the effect of Water Code 386 on exports is inconclusive. The results for the No-Injury Rule indicates that for the average county, a one standard deviation increase in the ratio of riparian rights holders to the total population will decrease the likelihood that the county will have an active export market by 30 percent and will decrease the ratio of exports to appropriations by 7.4 percent. This suggests that if California's goal is, as stated in the 1970's, to reallocate water to its highest valued use via water markets, the current allocation of property rights may be creating policy-driven costs that hinder reaching that goal.