Eric Crampton admires the water management work of John Raffensperger and Mark Milke and hopes that it can provide the basis for substantial change in New Zealand

By Eric Crampton*

Peter Jackson took a few liberties with Tolkien’s text for the Lord of the Rings films. Most of them, I didn’t like. But one addition I rather liked came at the start. Frodo complained that Gandalf had arrived late, and Gandalf replied that a wizard is never late – nor is he early. He arrives precisely when he means to.

I’m not sure whether John Raffensperger and Mark Milke are wizards or not, but their book, Smart Markets for Water Resources, is precisely what is needed, and has arrived precisely when it is needed. So, maybe we should upweight the chances that they are wizards.

And I was very pleased to be able to help launch their book at the University of Canterbury last week.

Raffensperger and Milke’s book takes on what’s arguably one of the biggest environmental and economic problems facing New Zealand. How do we make sure that water is allocated properly across competing uses?

It’s not a small problem.

Just think about controversy around water bottling plants. The plants draw criticism for all kinds of reasons. But one of more pertinent worries is that bottlers aren’t paying for water. Now that isn’t really the case: if you buy land that has an existing drawing consent, you’ve already paid for the water. It was bundled into the price of the land you purchased. But that isn’t obvious to critics. Neither is it obvious that bottling water is really the same as irrigating: irrigated water does have some flow back into aquifers or into streams – though sometimes with added unwanted nutrients.

The bottom line is that it’s hard to tell whether water is more valuable being consumed by cows and turned into dried milk powder and nitrogen-rich rivers, or more valuable being put into bottles and shipped to places that are happy to pay a premium for New Zealand water.

If you don't know what your inputs are really worth, it's hard to know the real value of your product. Whether you build cars or make milk powder, that can cause problems.

When Germany reunified after the fall of the Berlin wall, legend has it that a West German auto executive emerged weeping from a Trabant car plant. Why? The value of the engine-block iron and the other materials going into the plant was higher than the value of the cars coming out the other end.

But nobody in Soviet-era Germany really knew it, because nobody really knew the value of those inputs. Building Trabants destroyed value.

How low does the price of milk have to be before it would make more sense to leave out the middle-cow?

It is a tough question to answer, and especially where water allocation is set by consent rather than through markets. East Germany allocated iron by something not that different from consents, rationing scarce resources across various industrial uses, and wound up making cars that were worth less than the inputs that went into them.

New Zealand allocates scarce water by consents, and hopefully does a better job of it. Trabants were ghastly; New Zealand milk is delicious. But it would be nice if the rivers were cleaner and if the aquifers weren’t getting nitrates in them.

Enter the excellent Raffensperger and Milke book.

Economics has a lot of sceptics. But one area that the critics have to concede to economics is market design and auctions. Al Roth’s designed markets have saved lives by helping allocate kidneys in transplant exchanges – and he won the Nobel for it. And the auctions Nobel-laureate Ronald Coase helped design for FCC spectrum have generated billions in value. And New Zealand’s spot electricity markets have been a great success.

Raffensperger and Milke take economists’ experience in market design, operations research’s specialisation in optimisation algorithms, and a deep understanding of underlying issues in hydrology to build smart markets for water.

The basic approach works as follows.

You start with a map of the underlying hydrology and river systems. From that, you know what the effects are of drawing water from different places – how it affects river flow, aquifers, and neighbouring wells. Those hydrological features get built into a smart market system. Then you decide on the environmental constraints that must be satisfied in any water allocation. The volume of water in adjacent rivers can be set as a flow constraint. And you can set constraints so that the aquifer pressure close to the ocean outfall is high enough to prevent salinity incursion.

All of those things should already be there in any decent water management system anyway – or at least any water management system where drawing pressure has been strong enough that use has to be constrained.

Then you turn to water users. Some people have existing consents; others might want to draw water but have no existing consents. People then submit their bids to the system, saying (for example) that if the price is $1 per unit, they want to buy a megalitre this period, but if the price is $2 they might want to sell back into the system some of their existing consent. The system runs the optimisation, figuring out the solution that provides the highest overall value of water.

The prices generated by the system provide a ton of information, and well beyond what you might expect. Most obviously, we find out whether it makes more sense for the next megalitre of water to go into pastoral irrigation or into water bottling plants. But we also find out a lot more than that. It would also tell you how expensive it would be to increase river flow by decreasing irrigation in different catchments. And that value can then sensibly inform discussion about the levels of those constraints.

A political moment is building for substantial change to water management. I hope that that change can be built on this work. But we also need to build on one aspect that Raffensperger and Milke only hint at: markets in water quality, as well as water quantity.

Canterbury has an existing water trading scheme. It isn’t a smart market, but it’s a start in water trading. If we look to Taupo, they’ve built a nutrient management regime that allows farmers to trade in nitrogen emissions, with a cap on emissions for the catchment as a whole. That too isn’t a smart market system, but it’s a start.

In our next research programme, The New Zealand Initiative will be looking at ways of combining smart markets in water allocation with smart markets in effluent. New Zealand led the world when we shifted to sustainable fisheries with the Quota Management System; we can do it again for water management.

Thankfully, John and Mark have already done much of the heavy lifting. Their book has arrived just when it’s needed. Now it’s up to the rest of us to run with it.

*Eric Crampton is chief economist at The New Zealand Initiative, which provides a fortnightly column for interest.co.nz