Water markets enter a new phase with first trade in environmental water

This development represents the latest phase in the progressive evolution of Australia’s water markets. In this article Synergies explores the implications of the Commonwealth’s entry into water markets as a trader.

By way of background, over the last decade water trading has increased to a point where an estimated $1.5 to $2.5 billion of water is now traded each year, making this one of the largest and advanced water markets in the world. [1]  The two main water products traded – annual water allocation and ‘permanent’ water access entitlements – give irrigators and other water users the flexibility to vary their water requirements in line with changing seasonal conditions, commodity prices, structural business changes and so on.

The market has been widely acknowledged as having delivered substantial net economic benefits to rural Australia, particularly in times of water scarcity. The National Water Commission estimates that over the five-year period 2006-07 to 2010-11, water trading in south eastern Australia reduced the impact of drought on regional gross domestic product by $4.3 billion.[2]

Water markets are now being used to address environmental problems in Australia’s largest river system – the Murray Darling Basin. Since 2007 the Commonwealth has been purchasing water entitlements from irrigators as a means of returning water to rivers for environmental purposes. The water holdings are managed by the CEWH, a statutory position established under the Water Act 2007 (the Water Act).

Having accumulated a sizable portfolio of water entitlements, the CEWH has deemed it timely to start actively managing the portfolio through buying and selling water – as allowed for under the Water Act.  This is a sensible policy because environmental requirements for water are often counter cyclical to those of agriculture. For example, wetlands typically need a drying phase after a number of consecutive wet years. Therefore it makes economic sense to trade water to irrigators in years of below average rainfall – when water is highly valued for agricultural production – and retain water for topping up natural flows to wetlands in high rainfall years so as to mimic natural flood events.

The CEWH is using revenue from the sale of water to fund purchases of water in other locations, with the aim of generating additional environmental benefits. The trading of environmental water should also contribute to increased market liquidity, which is important for the efficient operation of a market.

For the first trade the Commonwealth has elected to sell 10GL of water allocation as opposed to the underpinning water access entitlements. Therefore, the sale does not diminish the CEWH’s future capacity to deliver environmental water in the Gwydir Valley.

The trading of water allocations represents a tactical approach to manage seasonal variation in environmental requirements. But there is also scope under the Water Act for the CEWH to sell water access entitlements as a means of re-balancing the mix of water entitlements held in different locations across the Murray Darling Basin. This offers additional flexibility to actively manage the water portfolio in response to, for example, progressive changes in knowledge about environmental watering requirements.

Potential risks

Notwithstanding the clear benefits of trading environmental water, the irrigation industry has expressed concerns. The National Irrigators’ Council warns there is a risk water markets could be distorted if the CEWH was to trade large volumes of water into a market over a short period of time. This is an understandable concern given the size of water holdings under management by a single entity. Based on information contained in the National Water Commission’s Australian Water Markets Report 2012-13, the Government now holds about 10 per cent of the total water entitlements on issue in the Murray Darling Basin, by volume. This is an average across all types of water licences and across all trading regions. In some segments of the market the proportion held by the Government is considerably higher. For instance, the Commonwealth holds almost 18 per cent of Victorian high reliability water licences.[3]

Concerns have also been raised about the risk of the Commonwealth gaining a competitive advantage due to its access to market-sensitive information in advance of other market participants, such as planned changes in policy settings that might affect water availability.

The Commonwealth Environmental Water Office (CEWO) has responded to these concerns by publishing the Commonwealth Environmental Water Trading Framework (the Framework), which contains operational rules and protocols that are to govern the CEWH’s trading activities. While the Framework is not a statutory instrument, a number of rules coincide with the Basin Plan trade rules, which are legally enforceable.  These relate to how trading entities are to behave if they are in possession of market sensitive information – namely a water allocation announcement. The rules limit the capacity of people or agencies to trade if aware of such information.

The Framework does not stipulate limits on the volumes of water that can be put onto the market in any given time period but it is stated that the CEWH does not expect to sell or buy more than a small proportion of water in any given year, and the approach to trade will be “conservative and managed so that unintended impacts are minimised.”

Minimising the risks

A key challenge for the Commonwealth will be to ensure that its trading activities do not undermine confidence in the market. This challenge is acknowledged implicitly in the Framework:

In undertaking trade, the CEWH will also have regard to social and economic outcomes; will consider any impacts on the market, and adopt strategies to minimise potential impacts on third parties.[4]

What is needed is a predictable and transparent process through which trading decisions are made in relation to environmental water.

The CEWO has stated that it will provide a public summary of trading intentions at the commencement of each new water year (or irrigation season). These trading intentions are to be reviewed and updated quarterly, or more regularly as required, to reflect changing conditions. This is a good initiative and should go some way towards the goal of achieving predictability.

There could be scope to strengthen confidence further if the CEWH was to inform market participants of the variables influencing the Commonwealth’s trading decisions and the weights given to each variable. For example, what are the main factors driving the decision to sell water allocation, as opposed to using the water for environmental purposes or carrying over the water to future years by leaving it in storage? What weight does the Commonwealth give to the holding costs of water relative to the value of having the option of using the water for future environmental flows? Holding costs include the foregone revenue to Government from not selling the water and direct costs of storage. There may also be a social cost dimension to consider. Withholding water from the irrigation communities in times of extreme drought may weaken the future viability of some country towns.

From an irrigator perspective, information about factors influencing the Commonwealth’s trading decisions would assist the market to develop rules of thumb about the threshold price at which the CEWH is likely to sell water allocation. This would lessen the ‘surprise element’ of environmental water sales and allow growers to better plan their production and trading strategies.

Another benefit of having a transparent process for guiding Commonwealth water trading decisions is improved accountability. It reduces the risk of arbitrary decision- making and counters the possible market perception that trades are being made for political purposes.

In a subsequent Insight article titled ‘Time to consider private water trusts for managing environmental water’, Synergies examines the potential for a more devolved model for managing the Commonwealth’s environmental water holdings. We propose that a portion of the water holdings could be leased to private, not-for-profit water trusts which would have the autonomy to trade water, raise revenue and manage water subject to contractual obligations to the CEWH to deliver defined environmental outcomes. Among other benefits, which are discussed in the article, this approach may alleviate irrigator concerns about the Commonwealth’s potential market power

[1] National Water Commission 2013, Australian Water Markets Report 2012-13, NWC, Canberra

[2] National Water Commission 2012, Impacts of water trading in the southern Murray–Darling Basin between 2006–07 and 2010–11, NWC, Canberra

[3] National Water Commission 2013, Australian Water Markets Report 2012-13, NWC, Canberra

[4] Commonwealth Environmental Water Holder 2013, Commonwealth environmental water Trading Framework, page 3.