2.3.2 Tradable rights
An alternative approach to addressing market failure is to establish a set of property rights that enable markets to develop. The approach is a direct attempt at correcting ill-defined property rights. Once again, we can use Figure 1 to illustrate the idea. Assume that the environmental agency establishes rights to discharge X = OB units of pollution over a given period of time. Firms must hold a right in order to use the environment’s assimilative capacity. Rights are assumed to be tradable. From the point of view of economic efficiency it does not matter who gets the initial entitlement of rights, provided they are tradable. Thus, the community (C) could initially hold all the rights XC = OB and industry have no rights XI = O. Moving from OB, the community would be willing to face pollution to the point where it received compensation equal to MD, industry of course would not pay more than the addition to profit it enjoyed as a result of being able to increase production. Trade would establish MD = MB, 
and the price of right would be P*. A similar result holds if industry initially held all the rights XI = OB. This result is attributed to Coase (1960).
2.3.3 Water pollution
Transferable discharge permits (TDPs) were first applied as an instrument to manage water pollution in 1981. The assimilative capacity of the Fox River (Wisconsin) was inadequate to maintain water quality standards even when point source discharges satisfied federal standards. Additional proportionate reductions were introduced to meet water standards. The TDP system came into operation once this initial allocation of daily pollution was set. In order to achieve a least-cost outcome a policy instrument would have to account for differences in both the impact of discharger wastes and in marginal abatement costs. O’Neil, David, Moore and Joeres (1983) show that TDPs allow annual cost savings of around US $6.8m relative to a regulation achieving the same standard of water quality.
2.3.4 Air pollution
Tradable rights have proven to be superior to traditional methods for dealing with acid rain in the US. An important departure from traditional CAC was introduced by the Clean Air Act 1990. The Act established the first large-scale environmental policy based on tradable emissions permits (Schmalensee, Joskow, Ellermand, Montero and Bailey 1998). This program was designed to cut acid rain by reducing sulphur dioxide (SO2) emissions from electric generating plants to about half their 1980 level, beginning in 1995. Legislation established two phases: in phase I total emissions from the dirtiest generating units had to satisfy a fixed cap by 1999; in phase II (beginning in 2000) virtually all existing and new fossil-fuelled electricity generating units became subject to a tighter cap on total emissions. Generating units were given fixed numbers of quantity-based (tons of SO2) tradable permits following rules that depend primarily on historic emissions and fuel use. The allowance can be used in the year issued or banked for use in any subsequent year. Auctions were used in subsequent years to allocate permits. The SO2 program not only over-achieved the emissions cap, but it did so without extensive litigation and at costs lower than had been projected. It took a number of years for a “competitive” market to develop and the development may have been sensitive to program design. Schmalensee et al (1998) note that the program rests on accurate monitoring and enforcement of the property rights involved.
2.3.5 Pricing access to natural resources
Pricing access to natural resources can be achieved through tradable rights.
Water rights
In New South Wales, the Water Management Act 2000 introduced licences for 10-year periods. The terms are the same for all users. The regulated river licences are either high security or general security. High security licences get 100% of the entitlement in all but bad drought years. General security licences get an allocation each year, which is less than 100% of the entitlement. This is determined and announced annually based on storage volumes. Water licence costs are determined administratively by the Department of Land and Water Conservation (DLWC). The Natural Resource Pricing Unit is currently preparing a submission to the Independent Pricing and Regulatory Tribunal so it can set licence fees (DLWC is a monopoly). Price is set at a maximum of the cost of delivery and it varies from valley to valley. Prices on the temporary and permanent transfer markets are set by the market (in addition to government water charges) and are generally well in excess of water charges.
Water can generally be traded within a valley subject to some geographic rules. Once water is available, licencees have the choice of using or trading their water (temporary transfers). Redistribution is on a commercial basis – it goes to the highest bidder. Licences can also be traded permanently. The Department plays a limited administrative role in the water market. Restrictions in flow or other “natural chokes” can limit transfer. There are many traders/brokers in the industry.
In NSW, Victoria and South Australia markets are developing quickly. For example, the Central Irrigation Trust offers 1,2,3,5, and 10 year leases through their water exchange. Internet exchanges exist, and broker services are available. Most trades are temporary and prices reflect variations in duration. Producers of grapes and citrus require long-term secure access to water. Farmers producing annual crops such as rice and vegetables are happy sourcing their water from temporary markets. Interviews with buyers and sellers in Victoria, NSW and South Australia indicate that up to 65% of irrigators who lease out water rather than selling it, do so because they believe that the value of their property will be disproportionately affected by sale. A similar proportion of buyers lease water simply because they cannot afford to buy water. Policy uncertainty is another factor influencing temporary trades. Uncertainty arises over environmental standards and Native Title. These uncertainties are reflected in the lower price of permanent water.
The Murray-Darling Basin Commission implemented an inter-state water trading trial in 1998. The first permanent inter-state trade was completed in September 1998. Over the next two years, 51 transactions have seen a total of 9.8 GL has been traded among states (Young, MacDonald, Stringer and Bjornlund 2000). The total value of the trades exceeds A$9.9 million, more than 90% of the water has moved to South Australia. The volume traded represents about 1% of the total water applied in the area. Intra-state trading drives the market for water.
The existing arrangements for inter-state trade are complex because it involves transferring an entitlement to water among quite different licensing systems. It can take up to 32 days to settle. In part this arises out of differences in water legislation across states. Exchange rates – that take into account losses through transmission in the river channel and losses in changes in the security of supply of water resulting from transfer – add a layer of complications. For example, to protect supply security trades involving sellers in SA Murray (high security) to NSW Murray (high security) occur at 0.9. Brokers argue that establishing a simpler, quicker and more transparent water registration system is the most pressing issue in lowering the transaction costs of trade.
Inter-state trading is increasing the value of water in the Murray-Darling Basin. Almost 90% of the water sold was not being used by sellers. Most of the water has gone to high value uses. Around three-quarters has gone into new irrigation development using state-of the art technology. In South Australia, water prices have ranged from $500/ML to $10,000/ML in the McLaren Vale. Murray River licenses in South Australia are currently trading for $1,000 to A$1,500/ML. Wine is the key driver. Although water is key to wine production, water costs are a small proportion of production costs – 5-20% for grape growers.
Inter-state trading has produced no measurable adverse social impacts. The environmental impact has “probably” been positive but the volume traded is small in flow terms. Over the long-term inter-state trading is expected to increase river salinity and the impact of trade on the environment will depend on the environmental standards in place and their enforcement.
Brozovic, Carey and Sunding (in press) report on water trading in the Westlands Water District in California. Water is allocated according to a priority system – first in time – senior rights through more junior rights where right holders get their water only after the more senior claims have been satisfied. The system is hierarchical and analogous to a queuing system. One of the distortions to occur with this system of allocation is that junior right holders – who often own superior quality land – are unable to obtain secure rights to grow high value tree crops. There are few administrative barriers to trading and an informal market has developed. By informal, it would seem that farmers must locate potential trading partners – this distinction is not particularly significant because presumably brokers would fill the gap if there was money to be made from a more formal market.
During the 1993-96 study period 10-14% of the district’s total allocation was traded. Trading patterns suggest that some farmers rely on the water market to allow production choices that would not otherwise be feasible. Brozovic et al conclude that the large volume of water traded suggests large benefits to those farms participating.
One prerequisite for water marketing is that the right to water can be bought or sold separate from ownership of the land. In Chile, Easter, Rosegrant and Dinar (1999) report on gains from trade – measured as the difference between the value of water to the seller before the sale and the value to the buyer after the sale – for agricultural purposes (urban supplies were adequate) in the order of US $2.47 m3 with a transaction cost of US $0.069 m3. In California transaction costs were US $0.041 m3 in 1991.
Fishing rights
New Zealand’s quota management system (QMS) is a world-leading model of a rights based system of management in which profitable enterprise can operate within the constraints of sustainable harvest (Sharp, 2002). With respect to individual quota, competition will ensure that the more efficient firms get to harvest fish. Furthermore, the market value of quota provides summary information about current conditions and future expectations in the fishery (Batstone and Sharp, forthcoming). The basic idea of the QMS is illustrated in Figure 5 using a shared fishery.
Each year the Ministry of Fisheries sets a total allowable catch TAC = Q* and after making an allowance for recreational and cultural needs, sets a total allowable commercial catch (TACC). Fishers hold a proportional right to the TACC. Full economic efficiency depends inter alia on whether Q* maximises rent and net-benefits across competing interests are equalised. If the right to harvest is not differentiated, then competition will result in a uniform price P*. Commercial fishers will harvest 
and the non-commercial
. Provided the TAC is set at the optimal level Q* use of the right is immaterial to achieving efficiency. In the uncertain world of fisheries management it is highly unlikely that Q* will be discovered.
