DEVELOPMENT OF INTERSTATE WATER TRADING IN THE MURRAY-DARLING BASIN, AUSTRALIA

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1 DEVELOPMENT OF INTERSTATE WATER TRADING IN THE MURRAY-DARLING BASIN, AUSTRALIA Clarke Ballard Principal, Ballard Consulting Andrew Brown Water Trade Modelling Engineer, Murray-Darling Basin Commission Louise Rose Manager Interstate Water Trade, Murray-Darling Basin Commission. ABSTRACT The rivers of the southern Murray-Darling basin pass through three States and are highly developed for irrigation. They can be described as a semi-integrated system of storages, regulated rivers and irrigation areas. Water trade within States has developed over the past decade, and governments are keen to foster wider trade as a mechanism to make better and more flexible use of limited and highly variable water resources. However there are several obstacles to achieving a fully integrated water market: * It is technically quite difficult to devise trading mechanisms that will work between different valleys and different State water products with acceptably small third party effects * Landholders and the rural community generally are concerned about the possible adverse socio-economic effects in areas that water may trade away from * The legal form of irrigation companies tends to inhibit trade * Significant legislative reform and development of entitlement frameworks is needed in all States to achieve the trading mechanism that best minimises third-party effects. Despite these obstacles, there are significant benefits to be gained from a broader trading market and the problems are being steadily addressed. INTRODUCTION The Murray-Darling Basin covers about one seventh of Australia. It generates 40% of Australia s agricultural production and contains almost three-quarters of its irrigated land. The southern part of the Basin includes the Murray itself, the lower Darling and two major tributaries the Goulburn in Victoria and the Murrumbidgee in New South Wales. These rivers are highly developed for irrigation and can be described as a semi-integrated system of storages, regulated rivers and irrigation areas. The Murray forms the border between New South Wales and Victoria before flowing into South Australia. Water resource management is a State responsibility, and the three States in the southern basin have developed different forms of water entitlement (Ballard 2003), with different reliabilities and lengths of tenure. Irrigation areas were mostly developed by governments, with water rights tied to land ownership and hence tradeable only by trading the land. This made it difficult to move water to new locations. In more recent times irrigation areas have been privatised or corporatised, and all States have moved towards separating water from land and freeing up water trade. Temporary water trade (trading of this year s annual allocation) and permanent water trade (trading of the ongoing water share) within States has been possible for about a decade, and has steadily increased in volume. Temporary trade between States is also quite widely allowed. Permanent trade between States is more complex, because of different water products, large river distances and thus varying transmission losses between locations and different legal arrangements. The Federal Government is keen to promote water trade for reasons of economic efficiency. The Council of Australian Governments (COAG), as part of its National Framework for Water Reform, agreed in 1994 to introduce water trading arrangements including: * A comprehensive system of water entitlements, backed by separation of water property rights from land title * Clear specification of rights in terms of ownership, volume, reliability, transferability and quality * Interstate trading of water entitlements. A small interstate water trade pilot project has been operating since 1999 in a limited area and with limited water products. The aim is to expand this to the major water products in the Murrumbidgee, Murray and Goulburn valleys in 2004/05.

2 REASONS FOR PROMOTING WATER TRADE Trade has an important role to play in water reform. Water markets provide for the irrigation industry to make better and more flexible use of limited water resources and the opportunity for new investment in high value added agriculture, despite resource constraints and the very variable Australian stream flows. Trade helps individual irrigators to adjust to changing circumstances and to manage risk. With a well-developed market framework, trade should stimulate movement of water to higher value, more sustainable use. It is important to recognise that water trade in isolation will tend to improve the economic efficiency of the irrigation industry but not necessarily its water use efficiency. Nor will it necessarily lead to improved environmental outcomes; indeed, it has potential to achieve the opposite. However, if trade takes place within a properly regulated framework it should be a useful tool to help achieve those wider objectives. Most trade is currently within water systems. There are advantages in allowing trade between connected systems where this can be done without unacceptable third party effects. These advantages include greater depth and stability of markets and keeping the in-valley markets aligned in price. WATER SHARING BETWEEN STATES Sharing of the waters of the Murray between the States of New South Wales, Victoria and South Australia has been governed since 1917 by an apparently simple agreement - in essence, that: * Inflows above Albury are shared equally by the two upper States, subject to an equal obligation to supply South Australia with a fixed entitlement * The upper States have the right to their own tributary inflows below Albury * In times of shortage the fixed obligation to South Australia is replaced by a fixed share (one third each post Dartmouth) For many years the sharing was accounted annually; so that shares of water in store were equalised on the first of July each year. This was appropriate when headwork storages were small and overflowed every spring, but made less sense as Lake Hume was enlarged, the Snowy Scheme began contributing regulated flow, and Dartmouth was built. Water could then be saved in normal years for use in dry years. For that reason a continuous accounting arrangement was introduced in It has grown in sophistication and now documents for each upper State at monthly intervals: * share of inflows, water in store and evaporation for each storage * release from each storage and weir * internal spills of State shares within a storage when one State s share of the storage fills * tributary inflows, diversions and losses from each river reach * share of flow passed to South Australia. In 1995 the States within the Murray-Darling basin agreed to cap their usage of water from the Basin at 1993/94 levels of development. Each valley within the basin has a cap volume that represents permissible long-term average use. When water trades from one State to another, it is logical that State shares and valley caps must be adjusted accordingly. UNBUNDLING OF RIGHTS The holder of an ongoing right to use water really holds a bundle of rights. These are: 1. A water share. The nominal entitlement really means that the holder has the right to a share of the total water resource available to all the holders of the same class of entitlement. The actual water available each year depends on climatic conditions, but will be shared between entitlement holders in proportion to the nominal value of their entitlement. This water is specified via a seasonal allocation, which is in effect the annual dividend from the water share. Entitlement holders can, in concept, trade both water shares (permanent trade) and water dividends (temporary trade). 2. A right to delivery capacity. This has only one component for entitlement holders who divert direct from rivers a river capacity share. Entitlement holders in irrigation districts also have a distribution capacity share a right to a share of the

3 capacity of delivery channels, pipelines and pump stations. In theory these rights could be made separately tradeable. 3. A site use right. This is a right to use water on a particular patch of land. If the land is unsuitable for example because of groundwater accession problems, lack of acceptable provisions for drainage disposal, special environmental values permission to use the water on that site will be denied. Water trade is very cumbersome because these rights are bundled together. For example, a trade can be delayed because the purchaser needs to negotiate a channel enlargement with the supply authority, or make satisfactory arrangements to dispose of drainage. It can be argued that the rights should be separately held and separately tradeable, at least to the extent of separating water from land. All three States have moved or are moving along the path of unbundling rights to use water. In an unbundled environment, water trade would simply be the trading of the water share or seasonal allocation. TECHNICAL CHALLENGES These can best be illustrated by example. Suppose a diverter on the Murrumbidgee River has an entitlement of 100 ML of general security licence, and wishes to permanently sell it to a diverter on the Murray in South Australia. This seems straightforward enough the water can be delivered to the new owner by simply passing it downstream. However, the following factors need to be considered: 1. The nominal 100 ML is really a share of all the water available to Murrumbidgee General Security licence holders. It is fully available in about 55% of years, but restricted to some extent in 45% of years. In the worst drought year on record, modelling shows that it would be only 40% available, ie. the licensee could use only 40 ML. However, South Australia has a more conservative licensing regime than New South Wales does for general security, and a South Australian licence is fully available in almost every year. Should the buyer receive a lower nominal volume of entitlement, calculated by modelling, to adjust for the better reliability (retail exchange rate) or should he receive an entitlement of the original nominal 100 ML, but restricted according to the rules in NSW (retail tagged entitlement)? 2. The new licensee is several hundred kilometres downstream of the old one. Should he receive a lower nominal licence volume because of the extra river losses involved in transporting the water to him, or are the losses essentially fixed so that the extra loss is small enough to be ignored? 3. The above trade will create a valley account an obligation for the operator of the Murrumbidgee storages to pass to the Murray system an annual volume of water because of the trade. But what should that volume be? The nominal volume of 100 ML traded out? The average previous use by the seller? The same volume every year or a variable volume based on seasonal allocations in the selling or buying area? In theory, the adjustment to the valley account should be such that it minimises the third party reliability effects in both the selling and the buying valley. In practice, it is likely that an exchange rate calculated to preserve reliability in the buying valley would differ from the exchange rate that maintains reliability in the selling valley. 4. A retail trade will also require cap to be ceded by the selling river basin to the buying basin, and for an interstate trade will require an interstate movement of cap. Caps refer to long term average use, so in theory the amount of cap transferred should be equal to the long term average use of the retail user (seller or buyer? in the past or potentially in the future?) 5. Are there river channel capacity issues that may hinder timely delivery of the water to its new owner? 6. Are there undesirable environmental or salinity effects? For example, river flows will increase between the two diversion sites, but probably in the dry part of the year, which is the reverse of the natural flow regime. If the new location is in an area of saline groundwater, will drainage disposal and groundwater accessions be satisfactorily dealt with?

4 Interim answers to these problems have been developed for within-valley and within-state trade. For example: * Retail exchange rates of unity are often adopted, even when they are known to be incorrect. * Differential river losses are ignored. Differential losses within irrigation districts are ignored in Victoria (ie assumed to be fully fixed) and allowed for on a simple proportional basis in New South Wales (ie assumed to be fully variable). The reality lies between these simple assumptions. * Valley accounts are usually adjusted by the nominal value traded, modified by the seasonal allocation in the selling valley, except for the pilot interstate scheme, where the South Australian allocation is used. When water is permanently traded between States in the pilot scheme, a cap transfer of 90% of the nominal volume traded takes place. This corresponds to observed behaviour in horticultural areas. For temporary trade the figure used is 100% as it is assumed that the water will be fully used. This is simple, but is unlikely to minimise third party impacts given that it will not reflect either the long-term average reduction in annual diversion in the selling valley or the increased use in the buying valley. * There are numerous trading rules, often developed on an ad-hoc basis to fix problems as they come to notice. A long-standing and logical example is that no net trade is allowed downstream past a significant constraint in river channel capacity. * Environmental issues are assessed by authorities in the buyer s area, which can take time and may mean that a water sale does not go ahead through no fault of the seller, but to his disadvantage. In many cases these solutions have been acceptable while volumes of trade are small in relation to total water use. However, as traded volumes and the distance over which water trades increase, more sophisticated solutions are needed to limit third party effects. The main technical issue to be resolved (Ballard et al 2003) is whether to continue with a trading system incorporating retail exchange rates, or to introduce tagged trading of retail entitlements. The attributes of the two systems are compared in Table 1.

5 Retail Exchange Rates Retail Tagged Transfers Nature of buyer s entitlement Third party effects in seller s valley Third party effects in buyer s valley Possible timing of introduction Legislative amendments needed Entitlement registers Seasonal allocations and reliability the same as other entitlements in the buyer s area. Depends on rules for background accounts. Should be minimal over the period of record. Minimal in each year if valley accounts tagged (ie release obligation equal to what would have been supplied to seller) Should be minimal over the period of record. Likely to be significant in individual years. If valley accounts are tagged, seller s valley will subsidise buyer s valley when the latter is more heavily restricted ERs are under development. Model code changes are largely completed. Initial Scenario runs are near completion. Modelling is scheduled for completion 1 st quarter If all goes well, and with good will and commitment from all stakeholders, could possibly introduce for 2004/05 season Can be implemented under existing legislation Can just cope with existing arrangements, but development of more compatible registers a high priority Seasonal allocations and reliability remain the same as in the seller s area. Minimal in all years (ignoring differential transmission losses) Minimal in all years (ignoring differential transmission losses) Dependant upon completion of three pieces of work: legislative amendments; compatible entitlement registers development of business rules and administrative protocols If all goes well, and with good will and commitment from all stakeholders, could possibly introduce for 2006/07 season Legislative amendments required in all participating jurisdictions Could not introduce without development of more compatible registers Business rules No new business rules needed Requires usage to be allocated to each entitlement type via ordering rules. Not difficult to develop. Administrative requirements Water accounting Billing and financial arrangements Can just cope with existing arrangements, but development of more streamlined procedures a high priority Complex in principle but can be resolved Relatively simple if we continue to ignore correct principles, as at present. Will need to address as volume of trade increases Would require a number of new procedures Simpler in principle can be resolved Enforcement Use existing mechanisms Cannot use existing mechanisms need legislative change ditto Table 1 Comparison of retail exchange rates and tagged retail transfers

6 SOCIO-ECONOMIC ISSUES It can be argued that water trade has potential socio-economic difficulties. Those most frequently brought up (Dept Natural Resources 2001) are: The stranded assets problem. If there is net water trade out of an irrigation district whose customers pay to maintain the infrastructure, the rating base is diminished and the remaining customers are disadvantaged. In the wider context this leads to fears of dying communities as towns whose main activity is to service the surrounding irrigation suffer. Possibility of gaming. The water market can allow such behaviour as: * Selling the water permanently off a property and then temporarily trading it back in, and thus avoiding a proper contribution to infrastructure maintenance * Selling water permanently from a valley with low seasonal allocation (ie. in drought) to one of higher seasonal allocation, immediately trading it back to the original location on the temporary market, and increasing water available to the individual at the expense of others * Generally speculating at the expense of less worldly entitlement holders. Fear of water barons. Water trade makes it easy for large corporations to buy up water and take it to new greenfields locations, decreasing rural employment levels because of economies of scale and making the traditional family farm unviable. The idea of separating water from land adds to the argument the fear is that financially strong speculators might buy up all the water and rent it back at very high prices to farmers. There is real concern about putting the ownership of water a limited resource that is ultimately owned by the nation into the hands of those whose only interest is financial gain. Environmental concerns. Water trade has certainly increased the rate at which sleeper or unused entitlements are activated, reducing both instream flows and seasonal allocations. Some consumer groups justify the retention of unused entitlement on the grounds that it then stays in the river. Rational economics has answers to most of those concerns, and would argue that: * The stranded assets problem can be fixed by re-arranging water tariffs, or by imposing exit fees * Gaming is a matter of getting the rules right * The move towards large, company owned farms is happening anyway and should increase rather than decrease rural jobs and prosperity * Renting water from a water baron without land is no different from leasing a tractor from a finance company. Competition should prevent monopoly profits. In any case, New South Wales and South Australia already allow water to he held separately from land, so that genie is already out of the bottle * Holding unused entitlements actually increases allocations to lower reliability products elsewhere, rather than keeping water in the river * Water trade might speed up socio-economic readjustment, but does not cause it * Water trade provides real opportunities for less viable landholders to exit the industry with dignity and a financial stake intact. Nevertheless, the concerns are real, and have to be dealt with. There are certainly areas, possibly as large as 20% of the existing irrigation areas, that would benefit from restructuring. However, there is real potential for a win-win solution if governments can get it right. In areas that would be better off without irrigation (such as salinised, poor soils, floodprone, but with environmental values) it should be possible to let some or most of the water move out by trading. However, there will be a point at which Government should negotiate a structured package to enable remaining landholders to move over a reasonable but defined timespan, or perhaps remain but not as irrigators. This should result in a better outcome in socio-economic terms than a purely market driven readjustment. LEGAL ISSUES In Victoria, the legal entitlement holder is the individual holder of a primary right, and may be an irrigator, a commercial company, a town or some other legal entity. Rural water supply authorities are Government owned entities set up under the Water Act. They hold an umbrella bulk entitlement, which is really just the sum of the entitlements of their customers, plus an allowance for the losses incurred in supplying them. Trade is between individual entitlement holders and the covering Bulk Entitlement is not tradeable but is (in theory) adjusted as water moves in or out. Use of entitlements is measured at the point of supply the farm gate.

7 In New South Wales and South Australia, entitlements are legally held by individuals or entities who divert direct from rivers. Use of entitlement is measured at the point of diversion from rivers. The irrigation supply authorities are generally private companies set up under Corporations law. Thus Murray Irrigation Ltd, a large irrigation supply authority in New South Wales, legally holds a single licence to divert, and its many irrigation customers hold shares in that licence. The practical reality is that a farmer in Murray Irrigation may trade (temporary trade only at present) with one in Victoria. The legal reality is that the trade takes place between the Victorian farmer and Murray Irrigation Ltd, which then adjusts its farmer s share of its licence according to its own internal rules. In Victoria the State Government sets the trading rules between primary entitlement holders. There is currently a 2% annual limit on water permanently traded out of any irrigation area, which is considered to provide sufficient time for authorities to adjust to changing customer rating bases. In the other two States, the Boards of the irrigation companies set the trading rules in and out of their irrigation districts. In general they see it as their role to protect the rating base of their business and guard against stranded assets. They therefore generally prohibit or virtually prohibit permanent trade out of their areas. Even if Governments wish to ensure that water trade is as widely available as possible, it is difficult to force decisions on private companies. Legislation prohibiting anti-competitive behaviour, which is administered by the Australian Consumer and Competition Council, may provide some leverage. The desire of shareholders within the Company to participate in water trade to enhance their businesses may also foster change in time. A further issue is the extent of legal change necessary if a decision is made to introduce a tagged retail transfer trading regime. Preliminary legal advice (Dyson, 2003) is that: * It can be argued that existing legislation is flexible enough to permit trading in tagged retail entitlements * However, bearing in mind the significant financial investment involved (the current market value of water entitlements in the southern basin would be in the order of $5 billion,) existing legislation does not provide sufficient certainty that trading of tagged retail entitlements is legally secure * It would be preferable to use purpose built legislation to ensure that the legal framework is robust and beyond doubt, rather than attempt to squeeze square pegs into round holes by making minimal changes that might be subject to challenge * Development of suitable new legislation is a significant task. The simplest method legally would be a model that separates the various elements of rights to water, and trades only the water share * Such a framework would be consistent with trends in modern water policy (primarily unbundling of rights). In contrast, interstate trading using exchange rates is clearly feasible under existing legislation. CONCLUSIONS 1. While Federal and State governments are committed to the widening of water trade, there are still several obstacles to its implementation in the southern Murray-Darling basin. 2. Perhaps the most significant is the unwillingness of private irrigation Boards in New South Wales and South Australia to allow significant permanent trade out of their areas. It seems unlikely that Victoria would agree to expand trade without removing this obstacle in the other States, because trade would essentially be one way. 3. The dominant technical issue is the choice between retail exchange rates and tagging of traded retail entitlements. The latter is conceptually superior, minimises third party effects, and is preferred by most farmer groups. However, the legal and administrative impediments are such that it cannot be implemented rapidly. 4. The swings and roundabouts inevitably associated with retail exchange rates may turn out to be unacceptable. While it is probably possible to develop a technically justifiable set of rates, there is a real danger that parochial State interests may wish to accept favourable swings but reject unfavourable roundabouts.

8 5. While perceived socio-economic issues are not caused by water trade, and may be eased by it, they are nevertheless real, and water trade will increase the rate of change. Continuing dialogue between the various interest groups will be needed to work through these issues. 6. Despite the obstacles, there are significant benefits to be gained from a broader trading market, and the problems are being steadily addressed. REFERENCES Ballard, C. (2003) Volume, reliability and tenure of major irrigation entitlements in the Murrumbidgee, Murray and Goulburn valleys, Background paper for MDBC Interstate Water Trade Project Board, MDBC, Canberra, 20pp Ballard, C., Close, A., Garland, N and Hannan, G. (2003) Monitoring and accounting for water trade in the Murray-Darling basin, Australian Journal of Water Resources, 7 (1), Dept Natural Resources and Environment (2001) The value of water A guide to water trading in Victoria. NRE, Melbourne, 109 pp Dyson, M. (2003) Legislative issues associated with trading in tagged water entitlements, Report prepared for MDBC Interstate Water Trade Project Board, MDBC, Canberra, 27 pp