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For the Colorado River and beyond, a new market could save the day

Stanford economist Paul Milgrom won a Nobel Prize in part for his role in enabling today’s mobile world. Now he’s tackling a different 21st century challenge: water scarcity.
Troubled waters: Stanford researchers are devising a new market approach to help resolve the vexing allocation battles of the Colorado River and other waterways.

The Colorado River, “the lifeblood of the West,” is in trouble. Decades of overuse and drought have sharply reduced its water supply, threatening an ecosystem that supports 40 million people and 5.5 million acres of farmland in nearby states and parts of northern Mexico.

Steep cutbacks in water use are critical. But the seven states that rely on the Colorado River can’t agree on how much less each of them needs to take over the long run, in large part because it’s not entirely clear who holds what legal rights to the river and who should get priority over others to its available water. If the states can’t agree, the federal government is reportedly threatening to make the hard choices for them.

Paul Milgrom, a senior fellow at the Stanford Institute for Economic Policy Research (SIEPR), has encountered intractable problems like this before. In 2020, he won the Nobel Prize in Economic Sciences for his pioneering work creating markets for goods and services that can’t be sold in traditional ways.

Water management, he says, is ripe for a market fix — not just for the Colorado River Basin but around the world as water shortages, made worse by climate change, become a defining issue of the 21st century. It’s no longer enough to leave decisions around water use up to federal, state, and local governments alone.

“We are trying to meet a 21st century set of challenges with 20th century technology and 19th century laws,” says Milgrom, the Shirley R. and Leonard W. Ely, Jr. Professor in Humanities and Sciences in Stanford’s Department of Economics in the School of Humanities and Sciences. “What we have, fundamentally, is a market design problem.”

Milgrom is part of an interdisciplinary Stanford team — led by Billy Ferguson, a PhD student in economics at the GSB and a former SIEPR undergraduate research fellow — that has developed an elaborate plan for how new markets for trading water could overcome key policy challenges around water allocation while providing incentives to high-volume users to find ways to do more with less.

SIEPR Senior Fellow Paul Milgrom, above, shared the Nobel Prize in Economic Sciences in 2020 with Robert Wilson of Stanford for their pioneering work in auction design. 

Milgrom and Ferguson recently highlighted their proposal in a working paper released by the National Bureau of Economic Research. Their use case is California, one of the Colorado River Basin’s biggest stakeholders and whose system for divvying up surface water, which comes from rivers and streams, is especially complex and opaque.

Much of their blueprint is drawn from Milgrom’s work a decade ago helping the Federal Communications Commission (FCC) overcome obstacles in delivering more radio wave frequencies to wireless companies so they could meet exploding consumer demand for mobile services.

Milgrom led a team of experts in economics and computer science through his company, Auctionomics, in the creation of a voluntary market for trading a new type of radio spectrum license, which is credited with enabling mobile communication as we know it, today. The two-part auction process he helped engineer so that the FCC could make those trades possible also delivered $20 billion in total to the radio and TV operators that gave up their old licenses and another $10 billion to the U.S. Treasury.

Milgrom, who is also a professor, by courtesy, at the Stanford Graduate School of Business (GSB) and at the Department of Management Science and Engineering in the School of Engineering, says there are lessons from the 2017 Broadband Incentive Auction that apply to water scarcity in the United States and around the world.

Water rights are broken

As a second-year PhD student in 2021, Ferguson was already interested in water scarcity when he took Milgrom’s market design course and thought that lessons from the FCC’s broadband fix could apply to water. His class project on California’s convoluted system of water rights caught Milgrom’s attention and they started talking about working together. Ferguson then enrolled in a water law course taught by Barton “Buzz” Thompson, a Stanford Law School professor and water rights expert who had also been thinking about the potential role of markets. Thompson is also the faculty director of the Water in the West program led jointly by the Stanford Woods Institute for the Environment and the Bill Lane Center for the American West.

“I really need to get Buzz and Paul in the same room,” Ferguson recalls thinking. With Thompson on board, the team pressed ahead.

At its core, their idea for a water market starts with creating a new type of property right — one designed to overcome many of the drawbacks with current policies. California, for instance, has a “first come, first served” approach to surface water in which the earliest rights holders — among them, farms and ranches dating 100 or more years ago — have been given priority to rivers and streams over the water-hungry entities that came later, notably coastal cities like Los Angeles and San Diego.

California also has a “use or lose it” provision that requires rights holders to consume their yearly allotment or surface water or risk getting less water in the future. They can technically sell any excess water to other users, but in practice, it’s really hard to do, according to Ferguson: Sellers first have to show that no one downstream from where the water would otherwise go — a phenomenon known as “return flow” — is harmed.

“The system is set up in a way that you have every incentive to use your entire allocation and no incentive to conserve,” Ferguson says.

Catalyzing Student Research

Going all in with econ

Billy Ferguson was part of the inaugural cohort of undergraduate research fellows at SIEPR. He learned, as a sophomore at that time, about the power of economic tools and data-backed research and never looked back. Today, his PhD work with advisor Paul Milgrom boldly introduces a novel approach to a longstanding issue over the allocation of water rights.

A solution designed for optimal flexibility

A more efficient approach, write Ferguson and Milgrom in their working paper, would be to establish a new property right aimed at delivering water to those who need it most and are willing to pay for it. Among other features, this new right would be based on how much water gets consumed, not diverted, and adjust as precipitation levels change from one year to the next.

This new water market, Ferguson says, would give rights holders incentives to save water — maybe by switching to low-water crops or installing more efficient water treatment systems — and sell off what they don’t need without damaging downstream users. And because water would then be a financial asset, Ferguson and Milgrom say farmers and other rights holders would have easier access to loans or other capital to pay for investments in water-saving technologies.

To kickstart the market, in which participation would be voluntary, the Stanford team is borrowing another page from the radio spectrum playbook: a one-time auction in which governments, in a process known as a “reverse” auction, first buy back water rights from those who are willing to give them up in exchange for the new right. In a subsequent “forward” auction, governments would sell the new water rights to the highest bidders, who would then be free to privately trade their entitlements going forward.

“Our whole approach is to ensure a level of flexibility in allocating water that’s needed but currently missing,” Ferguson says.

Government, he adds, also has a critical role to play in adopting policies to protect vulnerable populations. This includes, for example, limiting how much farmland can be fallowed in pursuit of water profits so that local communities aren’t impacted by job losses and other economic fallout.

Why the timing is right

Milgrom and Ferguson aren’t harboring any illusions: As the Colorado River impasse shows, water scarcity is rife with political, economic, and technological challenges.

But they are also optimistic that their vision for a water market will gain traction — in large part because there’s an urgent need to figure out how to make better use of dwindling water supplies.

“There’s both pressure and possibility,” says Milgrom, just like there was when he took on the challenge of freeing up radio spectrum for wireless companies. And like then, technology has reached the point where water supplies can be measured in new ways and with enough accuracy to give users confidence in their ability to get the water they need.

“There’s every reason to think this can work,” he says. “While it won’t reverse climate change or make it rain, it would go a long way toward providing long-run water resilience.”

The biggest roadblock, says Milgrom, is the politics around water — at the federal, state, and local levels. This is one reason why Milgrom sees introducing water markets as an even bigger problem to solve than reallocating radio spectrum.

The challenge is also deeply personal for Milgrom. “I’m 75 years old,” he says. “If I’m lucky, I have one really big project left in me and I’d like this to be it.”

A conference on Advancing Sustainable Water Management — organized by Milgrom and Thompson, and hosted by Stanford Graduate School of Business and the Stanford Doerr School of Sustainability — will be held on April 18-19. Find info on the event here

Policy challenges of the Colorado River was one of the topics at the 10th Annual Eccles Family Rural West Conference organized by the Bill Lane Center for the American West. See coverage of the March 27 event here.