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Canadian Water Resources Journal Vol. 30(1): 65–72 (2005) © 2005 Canadian Water Resources Association
Revue canadienne des ressources hydriques
Mike Young1 and Jim McColl1
1 Policy and Economic Research Unit, CSIRO Land and Water, Adelaide, Australia
Submitted August 2004; accepted December 2004. Written comments on this paper will be accepted until
September 2005.
Defining Tradable Water Entitlements and Allocations:
A Robust System
Mike Young and Jim McColl
Abstract: Robust systems are characterized by a capacity to recover gracefully from the whole range
of exceptional inputs and situations in a given environment. They have a connotation of elegance.
This paper will highlight the importance of separating the different elements of any tradable property
entitlement and allocation system into its component parts. The result is a constellation of institutional
arrangements that can be expected to last, to withstand the test of time. Often, considerable reform is
required to put in place robust systems. Using examples from Australia, this paper will highlight the
importance of sequencing implementation of the reforms necessary to put robust systems in place.
Robustness is achieved by using three instruments rather than one instrument to allocate water and
control use, and coupling these three instruments with three separate planning instruments.
Résumé : Les systèmes robustes se caractérisent par la capacité de se remettre progressivement d’un
éventail complet de situations et d’entrées exceptionnelles dans un contexte donné. Ils possèdent une
connotation d’élégance. La présente communication soulignera l’importance de la division, en parties
constituantes, des différents éléments de tout droit de propriété négociable et du système de répartition.
Il en résulte une constellation d’arrangements institutionnels qui en temps normal devraient s’avérer
durables et résister à l’épreuve du temps. Souvent, la mise en place de systèmes robustes demande des
réformes considérables. S’appuyant sur des exemples de l’Australie, cette communication fera ressortir
l’importance de la mise en séquence de l’adoption des réformes nécessaires à la mise en place des systèmes
robustes. La robustesse s’obtient grâce au recours à trois instruments plutôt qu’à un seul instrument pour
l’affectation des ressources en eau et pour le contrôle de l’utilisation de l’eau, et par le couplage de ces
trois instruments avec trois instruments de planification distincts.
Introduction
Tradable permit and allocation systems, and other
market-based instruments, are being used around
the world to help deliver environmental and natural
resource policy outcomes at less cost than has previously
been the case. The focus of this paper is not on the case
for and against the use of these instruments. Rather,
it is about the design of such instruments to deliver
maximum benefits:
66 Canadian Water Resources Journal/Revue canadienne des ressources hydriques
© 2005 Canadian Water Resources Association
• across heterogeneous landscapes;
• through time as circumstances change; and
• when several “objectives” are being pursued
and several “problems” are being managed
simultaneously.
Essentially, the paper aims to set out the design
characteristics of tradable permit and allocation systems
that will deliver maximum benefits and are likely to
stand the test of time because their foundations are
robust. Although these robust systems apply to all
forms of resource use, this paper focuses on water
management issues, such as climate change, land-use
change, groundwater connectivity, and the need to
promote investment; issues that conventional systems
find difficult to deal with.
Robustness
Robustness is defined in the jargon dictionary as a
system that has “demonstrated an ability to recover
gracefully from the whole range of exceptional inputs
and situations in a given environment.” The dictionary
goes on to observe that robust systems are one step
below bulletproof, and that they carry “the additional
connotation of elegance in addition to just careful
attention to detail” (Anon., 1992).
Robust systems endure without the need to change
the foundations upon which they are built. They inspire
confidence. They persist, are adaptable and can stand
the test of time (Young and McColl, 2003a). Reform
or revision of them is not normally on any political
agenda. They have an architecture that can be expected
to produce efficient and politically acceptable outcomes
in an ever-changing world ( Jen, 2003).
Language
The first observation made is that, at least in Australia,
it is wiser to describe such water systems as tradable
permit, entitlement or allocation systems and not
describe them as tradable property right systems. The
words “property rights” have different connotations in
different audiences and disciplines. Communication is
easier if one uses terms that have the same meaning to
all involved in a discussion. In most cases, the debate
is really about the nature of peoples’ “interests” in a
resource or an “opportunity”.
The second observation is that greater progress is
possible if such instruments are described as market-
based rather than economic instruments. The key
characteristic of market-based instruments is that they
involve buying and selling. The establishment of such
a trading market, however, is heavily dependent upon
complex legislative and administrative arrangements.
Often, instrument design also relies on a considerable
amount of ecological science. When one replaces the
word “economic” with the word “market”, lawyers,
ecologists and other professionals do not feel dis-
enfranchised. After all, these instruments are as much
legal as they are economic.
While these observations may seem trivial, it is
this attention to detail that often makes the difference
between consignment of a proposition to academic
libraries or adoption and use in the real world.
Two Principles and a Theorem
The critical building blocks for the design of the robust
instruments of natural resource and environmental
management consists of two principles and a theorem.
The Tinbergen Principle
Tinbergen was able to show that there is a need for at
least as many instruments of control as there are goals
or important dimensions to a problem. Jan Tinbergen
was awarded the Nobel Prize in Economics (1959)
partly for developing this concept (Tinbergen, 1952).
The Tinbergen Principle is usually talked about by
those interested in macro-economic policy. A separate
instrument must be used to address each policy goal,
objective or target. The Tinbergen Principle suggests
that the answers to the design of tradable property
entitlement, allocation and resource use management
systems lie more with robust separation arrangements
than they do with the development of integrated
(fuzzy) natural resource management systems (Young
and McColl, 2002; 2003c).
If a system is to be robust in the sense that it
will withstand the test of time, it must be Tinbergen
consistent. That is, there must be as many instruments
of control as there are important dimensions to a
Young and McColl 67
© 2005 Canadian Water Resources Association
problem. Another way of expressing this important
concept is to state that “the variables in any workable
solution must match the number in the problem”
(Krehm, 2001).
Mundell’s Assignment Principle
The second principle of particular relevance to
the design of tradable entitlement and allocation
systems is Mundell’s principle of effective market
classification. Developed by Robert Mundell —
another Nobel Prize winning economist (1999) —
this principle states that if outcomes are to remain
optimal through time, instruments need to be paired
with the objectives “on which they have the most
influence”. If this is not followed, there will develop a
tendency either for a cyclical approach to equilibrium
or for instability (Mundell, 1960; 1962). Mundell’s
principle is perhaps more effectively described as an
“assignment principle”.
The Coase Theorem
The third building block in the development of a
robust entitlement, allocation and management system
comes from another Nobel Lauriat (1991), Robert
Coase. The much debated Coase Theorem stipulates
that if the transaction costs associated with the transfer
of property from one person to another are very low,
or effectively zero, then an efficient outcome can be
achieved irrespective of the initial distribution. The
clue from this theorem is that it is very important to
design a system so that the transaction costs of trading
are very low. If the constellation of instruments used to
deliver trade-offs involves low transaction costs then
they should be able to produce dynamically optimal
outcomes as values, costs, technology and understanding
change. The lower the cost of each adjustment (each
transaction) the greater the probability that the system
will prove to be robust.
Management Goals, Objectives and Targets
Goals or objectives typically associated with almost
any natural resource management or environmental
problem include:
• Distributive Equity – arguments about how the
cake should be cut up and distributed among
people;
• Economic Efficiency – arguments about how to
enable exchange so that the opportunities created
produce the greatest quantity of market benefits
for distribution according to rules developed
elsewhere; and
• Management of externalities – arguments
about how to manage the impacts of resource
use on those people not involved directly in
the transaction or the activity that causes these
impacts.
Instrument Design
The Tinbergen Principle requires that there be a
separate objective for each goal, objective or target.
Thus, for “goals” or “problems” for which there are no
externalities, commitment to robustness necessitates
that there be, at least:
• A wealth management instrument associated
with ensuring the equitable distribution of the
benefits associated with the opportunity;
• An exchange instrument associated with
attainment of efficient processes; and
• A third instrument enabling the management of
any externalities.
As a general rule, there must be at least one set
of these instruments for each significant natural
resource management problem, especially when one is
operating in an environment where the landscape is
not homogeneous. The art lies in determining which
objectives are significant enough to justify the use
of a separate instrument to manage them and then
arranging the detail so that minor problems can be
dealt with efficiently.
To make matters more complicated, both individual
irrigator and aggregate system irrigation impacts and
issues need to be managed.
68 Canadian Water Resources Journal/Revue canadienne des ressources hydriques
© 2005 Canadian Water Resources Association
In summary, for many if not most natural resource
and environmental management issues, robust
allocation and management arrangement systems
will involve the use of at least three instruments. To
manage both individual and aggregate system impacts
will require a minimum of two by three instruments
(see Table 1).
Table 1. Generalized framework for the
selection and assignment of instruments
for the management of natural resources.
Scale Policy Objective
Distributive
Equity
Economic
Efficiency
Externality
Management
Individual Entitlement Access
Allocations
Use licences
Total
System
Water
Allocation
Plans
Trading
Protocols
Catchment
Plans
Instrument Assignment
The next principle relevant to the design of robust
instruments is Mundell’s principle of effective market
classification or assignment. Mundell’s principle
suggests that as well as paying attention
to instrument separation, one must also
assign (pair) instruments to issues for
which they have the greatest leverage.
For insights as to the most effective
instrument assignment, Young and
McColl (2002; 2003a; b; c) turn to
history and experience. The essential test
they propose is that the instrument must
have withstood the test of time and be
characterized by low transaction costs.
Casting the net widely, they identify:
• the unit share structure used since
1862 to distribute entitlements
among a group of people and the
Torrens title system used to register
entitlements and legal interests in
them (Abbott, 2004) — assigned
to distributive equity;
• the accounting system used by banks to track
holding of money and the transfer among people
— assigned to economic efficiency; and
• periodically-reviewable conditions on individual
use licences as an effective way to manage
externalities caused by site-specific actions —
assigned to externality management.
The result is a three part structure that is quite different
from the single licensing or permit systems in use in
many countries (see Figure 1). Separate instruments
are used to achieve each policy objective. The result is
a structure that, because the attributes can be managed
independently, can be expected to remain robust.
Clues to the detail necessary to ensure that each
instrument is able to respond to changes as they occur
come from a wide variety of sources and from the rich
gallery of experiences derived from the analysis of
the reasons why previous systems had to be changed
(Young and McColl, 2002).
Application to Water Resources Management
Applied to the management of water resources,
the above framework reveals a series of policy
recommendations now being developed in Australia.
Figure 1. Generic elements of a robust entitlement, allocation and
use management framework.
Young and McColl 69
© 2005 Canadian Water Resources Association
On the recommendation of the Council of Australian
Governments (COAG) in 1994, titles to land were
to be separated from water entitlements and water
allocations were to be supplied at full cost, including
the cost of externalities (see Figure 1).
The unexpected result of implementing these 1994
reforms was the emergence of many new problems.
Essentially, the existing licensing systems were not
designed for exposure to market processes. In particular,
the extent of water entitlement over-allocation became
apparent and arrangements to deal with groundwater
and surface water interconnectivity and the effects of
water use efficiency and land use change were not in
place (Murray-Darling Basin Ministerial Council,
2002). Water traded into some regions has resulted in
environmental problems, and, in particular, significant
salinity problems have emerged. Trading has also
been accused of causing significant adverse economic
and social impacts, although there is little available
evidence to suggest that this may be the case. To
address these problems, a system redesign based on
a robust separation was clearly required (Young and
McColl, 2002).
First, drawing on the experience of the way
investors in companies define the size of their
stake in a business, the system should involve the
introduction of unit shares underpinned by registers
organized so that interests in them can be recorded
on an indefeasible register.
Second, under the above framework, entitlements
provide a share of allocations made in proportion to
the number of shares held. Casting the net for the most
cost-effective way to manage allocations, one option
is to use the accounting systems that banking systems
around the world rely on. The key characteristic of
these systems is that the cost of any single transaction
is very low. One of the reasons for this is the simple
accounting discipline that requires that for every credit
there is a corresponding debit (see Figure 2).
The third element of any separated system is
the design of instruments for the management of
externalities. Classically, licences are used to define
water entitlements and to manage the way this water is
used. By using this single instrument to do both tasks,
inefficient outcomes occur. Drawing upon the insights
offered by Mundell’s assignment principle, it can be
Figure 2. Example of a robust accounting system for the management and trade of water allocations.
Account Name: Aussie Irrigation
Statement No: 24
Date Debit Credit Balance
1/07/2001 Balance brought forward 400
1/09/2001 Periodic allocation 2000 2400
1000 shares translates to 2000 ML of water that may be consumed
12/10/2001 Transfer from XYZ Pty Ltd 500 2900
Cheque No. 1234 5678
3/11/2001 Use from 1/9/01 to 1/11/01 500 2400
(Pumped 1000 ML and deemed to have used 50%)
3/11/2001 Transfer from AB&CD Smith @ 0.9 ML per ML from South Australia 300 2700
Electronic RN 9876543
30/04/2002 Use from 2/11/01 to 30/4/02 660 2040
(Pumped 1320 ML and deemed to have used 50%)
30/05/2002 Unused water not available for carry forward to 2002/03 season 420 1620
5/09/2002 Credit for removal of forested area 10ha at 1.5 ML per ha 15 1635
5/09/2002 Debit for establishment of 50 ha of forest at 1.5 ML per ha 75 1560
70 Canadian Water Resources Journal/Revue canadienne des ressources hydriques
© 2005 Canadian Water Resources Association
seen that use licence conditions are most appropriately
assigned to externality management. The three
essential building blocks for a robust management of
water entitlements, allocations and use is summarized
in Figure 3.
• providing for a secure review closure mechanism
that requires advance warning of the nature of a
proposed change and provides for the use of an
independent arbiter if the review process is not
finalized within, say, five years before the current
arrangements expire.
National Water Initiative
In response, and as a result of
much of the research reported in
this paper and other deliberations,
Australia’s leaders agreed to pursue
a National Water Initiative (NWI)
that will seek to “implement a
robust framework for water access
entitlements” (COAG, 2003).
Subsequently (COAG,
2004), there has been agreement
to a National Water Initiative
(NWI) that contains actions
to be implemented with “the
objective of achieving a nationally
compatible, market, regulatory
and planning-based system of managing surface water
and groundwater resources for rural and urban use,
that optimizes economic, social and environmental
outcomes, and is able to adapt to future changes in the
supply and demand for water”.
This new framework defines water access
entitlements as providing perpetual access to a unit
share of a defined water resource, and specifies and
assigns risk between water users and governments.
Robust registry and accounting systems that take full
account of the water cycle and of hydrological processes
are to be established. These will take into account
interactions between surface water and groundwater
systems, and the effects of significant land-use changes,
such as forestry, that can decrease the quantity of
water otherwise available to water users. In addition,
regulatory approvals enabling water use at a particular
site for a particular purpose will be specified separately
to the water access entitlement. A key feature of such
systems are mechanisms in water allocation plans,
trading protocols and catchment plans that encourage
periodic review of deeming rates, exchange rates and
Figure 3. A robust structure for the management of water entitlements,
allocations and water use.
Having separated licence components, a process is
needed to enable the periodic revision of these conditions
and other planning and regulatory arrangements. The
main challenge is to find a fair and efficient way to
conduct and complete reviews without discouraging
investment. There is still considerable debate about the
most effective way to conduct these reviews and when
they should be conducted. The emerging view is that
it is most efficient to allow water users time to plan for
and adjust to a new set of conditions. When advance
warning is given of a change, existing equipment and
infrastructure can be replaced in an orderly manner.
Announcing changes to be implemented say five to
seven years later provides plenty of time for adjusting
to the new regime.
It is also becoming apparent that the costs of
periodic reviews and the uncertainty associated with
them can be reduced by:
• conducting reviews on a regional basis and
rotating them between regions so that the review
process is predictable and users can see the nature
of changes that are being phased in elsewhere;
and
Young and McColl 71
© 2005 Canadian Water Resources Association
assessments of the impacts of land use changes (see
Figure 3).
There is also interest in setting up the system in
a manner that will enable the introduction of separate
entitlement and allocation systems to allow people to
trade in peak demand period delivery capacity and to
also enable salinity entitlement and allocation trading.
If all these foreshadowed policy changes occur then a
framework similar to that set out in Figure 4 could
emerge.
perpetual shares and the guarantee of an entitlement
register. Consideration of these issues has led Young
and McColl (2003a) to recommend that reforms begin
with the introduction of robust bank like accounting
arrangements for allocations and arrangements to
manage hydrological interactions well before unit share
access entitlements are introduced and entitlement
registers guaranteed. In particular, land-use impacts on
water yield need to be managed, ground and surface
water interactions need to be accounted for, and the
impact of increases in
water use efficiency on the
quantity of water available
to others needs to be built
into the system.
Concluding Comments
Australian and other
experience reveals the
likely benefits of building a
robust entitlement system
from the outset. Moreover,
the administrative costs
of building a robust
entitlement, allocation and
use management system are
not significantly more than
the costs of starting with a
less sophisticated system.
The main costs of
establishing any system are determined by the number
of water users not how many pieces of paper are
issued and the detail associated with each entry. In the
longer run, if a robust system is put in place, further
costly reform and adjustment will not be necessary. If
a government implements a separated system, then
many such problems can be avoided and the long-
term costs to industry and the environment avoided.
The approach is also particularly relevant for those
interested in setting up emission trading systems, forest
harvesting systems, fish harvesting systems, etc.
In any environment where there is uncertainty and
these uncertainties cannot be avoided, entitlements
should be defined as shares and periodic allocations
made in proportion to the number of shares held. If
the transaction costs associated with allocation trading
are low, then almost all efficiency benefits can be
Figure 4. A separated system designed to enable independent management of
salinity and delivery capacity in peak demand periods.
Sequencing
The final issue for this paper to consider is the question
of the sequencing of any reforms. The transition from
a standard water allocation and use control system to
a robust one can involve many complex processes and
it can be tempting to implement the easiest ones first.
This, however, may not be the wisest choice of action,
especially if market-based processes are to be used and
if the available resource is over-allocated. In such cases,
implementation in the wrong order is likely to increase
the costs of adjustment.
As a general rule, those reforms that add the
greatest value should be implemented last and only
after over-allocation issues have been resolved. Reforms
likely to add value include definition of entitlements as
72 Canadian Water Resources Journal/Revue canadienne des ressources hydriques
© 2005 Canadian Water Resources Association
secured through the use of robust accounting practices.
Conceptually, most of the remaining efficiency gains can
be realized through the introduction of arrangements
for the efficient management of externalities.
Acknowledgements
We would like to acknowledge the constructive
comments made by Steve Hatfield Dodds and an
anonymous reviewer. The support of the Canadian Policy
Research Institute and its invitation to present to their
Policy Research Experts’ Symposium on “Economic
Instruments for Water Demand Management in an
Integrated Water Resources Framework” on June 14-
15, 2004 in Ottawa are gratefully acknowledged.
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