Benefits of a groundwater allocation trading arrangement in a water-stressed environment

Abstract

The Gnangara groundwater system is Western Australia’s most important groundwater resource, but it is being depleted. Although Australia has been at the forefront of establishing water markets, Western Australia has been slow to adopt legislation that would support trade in groundwater. This study explores the impact of introducing groundwater trading within the horticulture sector for farms that extract water from the Gnangara system. We use a simulation-optimization framework to evaluate market performance. The model is based on detailed water allocation data obtained from the relevant water agency. A farm optimization model was used to generate supply and demand functions for water at the individual farm level, and the market clearing price for water was established via a uniform price double-sided auction. The level of water available for extraction was also varied. The model considers unrestricted trading and trading within relatively small groundwater zones that limit the potential for local over-extraction externalities. The results show (1) substantial economic gains from allowing trading are possible, (2) most of the gains from establishing a groundwater market can be realized from within-zone trading only, (3) industry consolidation follows the introduction of trading, and (4) without zonal trading restrictions local over-extraction externalities are present. Also, with groundwater trading, we find that reallocating water to the most efficient producers could reduce horticulture sector water extraction by 14%, while maintaining the existing value of agricultural production in the area.