A model of spatial and inter-temporal water trade in the southern Murray-Darling Basin

ABARES Working Paper

Published 25 February 2021

Authors: Neal Hughes, Mihir Gupta, Linden Whittle and Tim Westwood

Abstract

This paper presents an economic model of water markets and irrigated agriculture within the Australian southern Murray-Darling Basin (sMDB). A unique data set, detailing irrigation activity, water supply and prices over the period 2000-01 to 2018-19, is used to estimate a set of water demand functions by catchment region and irrigation activity. These functions are placed within an economic partial-equilibrium framework which accounts for both inter-regional and inter-temporal water transfers (water trading and storage / ‘carryover’). Limits on inter-regional water trade and annual carryover are imposed, reflecting water market rules currently in place across the sMDB. Numerical methods are employed to solve for a dynamic market equilibrium, assuming stochastic water supply and demand, and ‘rational’ forward-looking expectations.  The resulting model can realistically simulate the market prices of water, carryover volumes and trade flows across the sMDB along with irrigation water use and area planted by region and activity. The model is applied to simulate distributions for water prices in the sMDB, and to estimate the economic benefits of interregional water trading and carryover. Water markets are estimated to generate benefits to water users in the sMDB of $117m per year on average (around 12 per cent of the market value of water rights in the region). The benefits of water markets are reduced by around half in the absence of carryover.

Introduction

Like many of the world’s major river systems, the Australian southern Murray-Darling Basin (sMDB) faces both significant environmental problems and acute water scarcity (Vörösmarty et al. 2010; Davies et al. 2010; Leblanc et al. 2012; Grafton et al. 2013).

Water supplies in the region are projected to decline under climate change due to lower average rainfall and higher temperatures (CSIRO 2008). Already, the sMDB has seen large reductions in average streamflow linked to climate change (CSIRO 2012; Cai and Cowan 2013; Cai and Cowan 2008; Potter and Chiew 2011), with inflows to the Murray river reducing by more than 40 per cent since 2000 (relative to conditions during the preceding century, see MDBA 2020).

At the same time, governments have introduced policies—including the Murray-Darling Basin (MDB) Plan—to recover water rights from agriculture, with the aim of addressing long-term environmental problems from over extraction (see Crase, O’Keefe and Kinoshita 2012; Leblanc et al. 2012; Hart 2016). Since 2008 the MDB Plan has recovered more than 1,700 GL of water rights in the southern basin (DAWE 2020), around 20 per cent of water supply.

The development of water markets has been a key institutional response to reduced water supplies, ensuring limited water is allocated to the highest value use, and helping the irrigation sector adapt to climate, policy and technological change (see Kirby et al. 2014; Wittwer and Griffith 2011; Peterson et al. 2005). The water markets of the sMDB are now among the most developed of their kind in the world, involving large numbers of participants, low transaction costs, and large volumes of water trade both within and between regions (Debaere et al. 2014; Grafton et al. 2012; Grafton et al. 2011; ABARES 2018; Hughes and Rathakumar 2016).

A more recent development has been the emergence of carryover rights—which allow water users to hold water allocations in storage across years. Since 2008, rule changes have led to large increases in the volumes of water carried over by irrigators (Hughes, Gupta and Rathakumar 2016). These larger storage reserves have helped to reduce water supply volatility in the face of increasing climate variability.

Despite all of this, water markets in the sMDB remain under significant pressure. A combination of lower water supply and higher irrigation demand has seen water prices increase dramatically over the last decade (see Goesch, Legg and Donoghoe 2020, Hughes 2019). In addition, large changes in the mix and location of irrigation activity are testing the ability of the system to support inter-regional transfers (Gupta and Hughes 2018; Hughes, Gupta and Rathakumar 2016). These issues have contributed to growing concerns over the operation of the water market, culminating in a government inquiry (ACCC 2020).

Understandably then, there remains significant interest in economic models of the water market, which can separate the effects of different climate and policy changes. In particular, there is interest in: measuring the effects of the MDB Plan and other structural changes on water markets; demonstrating the benefits of water trading and carryover; assessing the effects of changes in trade and carryover rules; and forecasting future water prices under future climate and policy scenarios.

Historically, mathematical programming models have been used to simulate water markets both in Australian and elsewhere (see for example Qureshi et al. 2013; Draper et al. 2003). A number of these models have been developed for the MDB (Hall, Poulter and Curtotti 1994; Hafi, Thorpe and Foster 2009; Adamson, Mallawaarachchi and Quiggin 2007; Grafton and Jiang 2011), often being applied to measure the economic benefits of water trade or to simulate the effect of changes in water supply. Similar models have been developed for other regions including California (Draper et al. 2003; Howitt et al. 2010). In some cases, water market models have been integrated with bio-physical hydrology models (see Draper et al. 2003; Qureshi et al. 2013). More commonly these models adopt economic partial equilibrium frameworks: where water is allocated across multiple regions and uses subject to a set of water supply constraints.

While these models have proven useful, they remain subject to some widely acknowledged limitations, including limited empirical validation (see Howitt et al. 2010; Qureshi et al. 2013). Typically, past water market models have been ‘underdetermined’: with more free parameters than data points. While various calibration methods have been employed (see Qureshi et al. 2013) these methods are not without limitation (Heckelei and Wolff 2003; Doole and Marsh 2014).

With the availability of water market data increasing, statistical analysis of water markets has become more common. A number of authors (Bjornlund and Rossini 2005; Brennan 2006; Wheeler et al. 2008) have econometrically estimated water demand functions in the sMDB using time-series data on water market prices and water supply levels.  More recently Connor, Kandulu and Bark (2014) estimated a reduced-form model of irrigation production in the MDB using historical agricultural data.

In this article, we present an econometric partial equilibrium model of water trade and irrigation activity in the sMDB. A set of annual water demand functions are estimated by region and irrigation activity, using a combination of water market and agricultural data. These functions are then placed within a spatial partial equilibrium framework, where water is traded subject to inter-regional trade constraints. Such an approach provides a middle ground between traditional mathematical programming models and water demand regression studies.

Many existing economic models of water trading are typically ‘static’: allowing for water trade between regions but not accounting for inter-temporal water storage decisions. Economic analysis of water storage has usually involved single decision-maker Stochastic Dynamic Programming (SDP) models (see for example Dudley 1988; Brennan 2010a). In this study, we combine a multi-sector and region water trade framework with dynamic water storage (carryover) behaviour, by adding a set of inter-temporal equilibrium conditions. The dynamic model is then solved using approximation techniques following Williams and Wright (1991).

Historical scenarios are presented to test the ability of the model to recreate past market behaviour and prices across the sMDB. The model is then applied to simulate water market outcomes, assuming current water market conditions (current trade and carryover rules, environmental water recovery levels and irrigation development) under a repeat of recent historical climate conditions. Scenarios with no water trading and no carryover rights are also presented to demonstrate the benefits of water markets in the region.

1 Brennan (2010b) (unpublished) took this a step further, estimating demand curves for multiple regions and placing them within a partial equilibrium framework.

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Last reviewed: 25 February 2021
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