Using Financial Contracts to Facilitate Informal Leases Within a Western United States Water Market Based on Prior Appropriation

The ability to reallocate water to higher-value uses during drought is an increasingly important "soft-path" tool for managing water resources in an uncertain future. In most of the Western United States, state-level water market institutions that enable reallocation also impose substantial transaction costs on market participants related to regulatory approval and litigation. These transaction costs can be prohibitive for many participants in terms of both costs and lengthy approval periods, limiting transfers and reducing allocation efficiency, particularly during drought crises periods. This manuscript describes a mechanism to reduce transaction costs by adapting an existing form of informal leases to facilitate quicker and less expensive transfers among market participants. Instead of navigating the formal approval process to lease a water right, informal leases are financial contracts for conservation that enable more junior holders of existing rights to divert water during drought, thereby allowing the formal transfer approval process to be bypassed. The informal leasing approach is tested in the Upper Colorado River Basin, where drought and institutional barriers to transfers lead to frequent shortages for urban rights holders along Colorado's Front Range. Informal leases are facilitated via option contracts that include adaptive triggers and that define volumes of additional, compensatory, releases designed to mitigate impacts to instream flows and third parties. Results suggest that more rapid reallocation of water via informal leases could have resulted in up to $222 million in additional benefits for urban rights holders during the historical period 1950-2013. In much of the developed world, there is little ability to sustainably manage water resources by building more dams or digging new wells. Water stressed regions are increasingly adapting to droughts through agreements to conserve or reallocate water between members of the community. In some places, markets make this easier by allowing users to buy and sell water. However, in most of the Western U.S., the legal system that approves these transactions makes them very costly and time consuming, reducing the benefits from trade. In particular, it is very hard to buy and sell short-term leases. Here, we propose a new type of leasing contract, "informal leases," that avoid the legal system by relying on contractual agreements between water users. Instead of buying water via the legal system water users pay other users to conserve, coordinated through simple index contracts. When these contracts are designed correctly, they can perfectly recreate the effect of a formal water sale, for a fraction of the price. In this manuscript, we show how contracts for informal leases can be designed and evaluated, creating savings for water buyers/sellers, additional revenue for their neighbors, and a win/win response to environmental stress (for everyone except the lawyers). Transaction costs related to regulatory approval are a significant impediment to water market leases in the Western United States Informal leases enable rapid short-term water reallocation during drought while reducing transaction costs The State of Colorado could have accrued $222 million in benefits using informal leases to reallocate water from irrigators to urban users