How market design can address the world's water crisis

There’s a water crisis in the world. According to World Wildlife Fund (WWF), 1.1 billion people lack access to water and a whopping 2.7 billion people have difficulty accessing water. Water scarcity affects the economy, the environment, and people’s health. Nobel Laureate Paul Milgrom thinks the underlying market design of water allocation needs to be adapted to properly address this situation, and believes time is of the essence.

There are a few key economic implications to the global water shortage. Local businesses suffer which then leads to a reduction in employment opportunities, tax revenue decreases putting a strain on local and regional economies, and communities and populations ultimately decline often due to relocation. More dangerously, it impacts the physical health of people in communities struggling with water scarcity. Exposure to diseases increase and otherwise very treatable ailments, including diarrheal diseases, turn fatal. According to the World Health Organization (WHO), diarrheal disease is the second leading cause of death in children under five years old.

Water allocation is a key component of addressing the world’s crisis. With many of the existing rights to freshwater grandfathered in, the result is often highly inefficient water allocations and incredibly complex judicial processes required to intervene. It’s these water markets that Milgrom thinks need to be redesigned.

“Everybody knows we need new water market designs,” he says. “I believe if I can make a good proposal and approach the Governor of California and say I have a solution to this problem, I think I can get heard. And so that's the way I want to use this.”

“Places that once had plenty of water, like California, simply don’t. The rain is falling in different places,” says Milgrom. “In 2020, there were droughts on all six continents. Places that used to have water didn’t because of changes in the rainfall pattern. So that’s problem one. Problem two is that in many places, water rights were determined historically.”

Milgrom is referring to a somewhat antiquated system where once people set up a farm, they had rights to take water from there and priority over people who came later. It was a convenient way to allocate water rights in early history but the issue is that those types of rights are very difficult to transfer.

“We have new high value uses,” continues Milgrom. “Moving the water from its old, less valuable use into a higher value use is made hard. It’s hard to create markets to do that and so buying the old uses and creating the new uses requires some market design. We have to create markets where there were none before because the prerequisites for markets didn’t exist. And that’s what I’m trying to do.”

For now Milgrom and his team are focusing on California, as water rights and the legal environment around those rights differ greatly around the world. The only similarities amongst jurisdictions, according to Milgrom, is that everybody’s water rights are different and very complicated.

“One of the things that makes the markets very hard to design is that normally, if you're studying basic economics, you think a bushel of wheat is a bushel of wheat. It doesn't matter if I buy it from you or from somebody else,” says Milgrom. “Or a share of stock is a share of stock, you don't really care who you buy it from. Whereas with water, everything is different. So we needed to design the system that allowed us to buy combinations of these very heterogeneous rights and combine them into things that we could make homogeneous for further sale. We need to do that for water.”

Milgrom and his team are co-leading an academic project focused on reforming water rights, and he’s also recently secured a grant approved by the Stanford Doerr School of Sustainability.

“My co-principal investigator is an expert in water law and we are going to get together with hydrologists who understand the workings of the water system,” he says. “We are going to get engineers and representatives of interest groups to try to understand who the winners and losers might be and what kinds of alternative uses of water might be possible.”

The goal is to have a more generalized plan that could be copied and implemented in other jurisdictions, to help solve water problems that are resulting from climate change in locations around the world.

“In addition to understanding the economics of market design, which is what I bring, the hope is that over the next year or so, hopefully even sooner if we're really lucky, to come up with something that's a serious proposal. And then take it and try to get it implemented,” says Milgrom. “That's the goal. I feel like that would be a great project to finish my career with.”