Summary

This report represents the first part of a two part project investigating the management of irrigation water storages. The report focuses on the economics of storage management and the potential advantages of a capacity sharing approach. The second part of this project examines in detail two capacity sharing schemes implemented in Queensland – St George and MacIntyre Brook. The results of the second part of the project are to be presented in a subsequent ABARE research report: Capacity sharing in the St George and MacIntyre Brook irrigation schemes in southern Queensland.

Water storage management

Water storages (reservoirs) play a vital role in the supply of water for irrigation farms. Storages smooth variation in the supply of water and in the value of water over time. Appropriate management of water storages is particularly important in Australia, given the extreme variability of inflows and predictions of lower and more variable inflows within the Murray-Darling Basin because of climate change.

The management of irrigation water storages involves comparison of the benefits of consuming water today against the expected benefits of storing water for future use. In Australia, state governments have traditionally centrally managed the major water storages, making decisions on water allocations (water released for consumption in the current period) given prevailing storage levels. However, determining what proportion of available water to store for the future (and how much to consume now) is a complex problem given the presence of substantial uncertainty over future inflows and water demands.

Centralised storage management

For a centralised storage management policy to achieve an efficient allocation of water across time and across irrigators, a number of conditions must be met. First, the dam manager requires complete information on the water needs of irrigators. Second, trade in water allocations must be efficient and costless. Under these conditions, the optimal aggregate amount of water would be released each period and this would be efficiently allocated across individual irrigators via trade in water allocations.

In practice, these conditions may not be met and a centralised approach may lead to an inefficient allocation of water. In particular there may be asymmetric information between the storage manager and irrigators, and transaction costs in water trade.

Asymmetric information

Asymmetric information means that irrigators are likely to have information on their water demands that is not available to dam managers. Obtaining information on water preferences from individual irrigators may be difficult for a number of reasons. First, water preferences are likely to vary significantly across different irrigators because of differences in crop types. Second, irrigators’ water preferences are likely to be subject to significant change over time. With asymmetric information, a central manager may implement a sub-optimal release (allocation) policy, that will ultimately reduce average returns to irrigators in the long run.

Transaction costs in water trade

Transaction costs refer to costs incurred when making an economic exchange. There is evidence to suggest that irrigators face significant transaction costs when trading water allocations in the Murray-Darling Basin. Water trade can be subject to both direct financial transaction costs such as government and brokers’ fees, and non-financial indirect transaction costs such as time costs incurred by irrigators. Under a simple announced allocation system, substantial temporary trade in water allocations may be required to achieve an efficient allocation of water across different irrigators in each time period.

High and low reliability entitlements

High and low reliability entitlement systems (referred to as general and high security entitlements in New South Wales) are relatively common in the Murray-Darling Basin. High and low reliability entitlement systems have the potential to reduce temporary water trade requirements, and reduce irrigators’ exposure to transaction costs, by providing water rights which more closely match the reliability preferences of individual irrigators (Freebairn and Quiggin 2006). However, systems of high and low reliability entitlements do have a number of practical limitations.

Implications for investment

While not considered in detail in this report, in practice it is likely that storage management policies will have important implications for irrigator investment decisions. For example, storage management policies, by influencing the yield-reliability of water entitlements, will tend to influence the relative attractiveness of different irrigated activities. In the long run, a fixed centralised storage policy may act as a constraint on irrigator investment, for example preventing an optimal distribution of low and high flexibility irrigation activities.

A water storage model

As a part of this study, an economic model of the water storage problem facing a representative irrigation system was developed. The model incorporates representations of the demand for water by irrigators and the irrigation water supply system (e.g. inflows, storage and associated losses). The model is stochastic, in that inflows into storages and rainfall onto irrigation farms are subject to random variation, based on a defined probability distribution estimated using historical data. A detailed discussion of the model is contained in appendix A.

The optimisation model developed was applied to a case study region to demonstrate the potential benefits of improvements in storage policy. The case study region is based on the Murrumbidgee region in New South Wales. Although the case study is intended to be illustrative in nature, the results presented in this report are intended to be broadly applicable to other regions. Model parameter values were set with reference to historical data and estimates from econometric literature. A summary of model assumptions is contained in appendix B.

Results

Using the model, an arbitrary ‘aggressive’ release (allocation) rule was compared with a theoretically optimal release rule. The estimated optimal release policy involves holding more water in storage reserves, relative to the aggressive policy.

The estimated optimal release rule involves a small reduction in mean water use, in turn for a substantial increase in mean storage reserves. The optimal release rule acts to minimise variation in the supply and value of water over time. The model demonstrates that optimal storage policy can lead to an increase in mean irrigator incomes and a substantial reduction in variability of incomes. The model results show an estimated increase in the mean economic value of water of 11.8 per cent and a reduction in variability of more than 63 per cent.

A sensitivity analysis conducted using the model also demonstrated that the gains from optimal storage management (both in terms of mean and variability of incomes) increase substantially as water availability reduces. The results confirm that with greater water scarcity, there is more to be gained by improving the management of irrigation water storages. That is, when inflows are lower and less reliable, there is more to be gained by holding water in storage to insure against drought conditions. This is an important result given predictions of reduced water availability across much of the Murray-Darling Basin in the future because of the effects of climate change.

Carryover rights and capacity sharing

An alternative to centralised storage management is a decentralised approach, in which individual irrigators are given greater control over storage decisions. Decentralised approaches have the potential to address the problems of centralised storage management. In this report, two decentralised approaches to storage management are considered: carryover rights and capacity sharing.

Carryover rights

A carryover right allows water users to hold over a proportion of their seasonal water allocation for use in future seasons. Carryover rights have been in place in many New South Wales and Queensland irrigation systems for some time and have recently been introduced into a number of Victorian and South Australian systems.

While carryover rights may help irrigators overcome some of the problems associated with central storage management, carryover rights are an incomplete solution. Carryover rights are incomplete because they do not explicitly define rights to storage capacity or to associated storage losses. As such, individual carryover decisions have external effects which influence other users of the same storage. In an attempt to minimise these external effects, significant restrictions are often placed on carryover rights, which further weaken their effectiveness. Access to carryover water may also be subject to sovereign risk, as has been demonstrated in a number of recent instances where irrigators have been denied access to carryover water during drought periods.

Capacity sharing

Capacity sharing is a system of allocating property rights to water from shared storages proposed by Dudley (Dudley and Musgrave 1988; Dudley and Alaouze 1989; Dudley 1990a; Dudley 1992). Under capacity sharing, each entitlement holder in an irrigation system is assigned a share of the total system storage capacity and a share of total inflows. Users are free to manage these capacity shares independently; determining how much water to use (or sell) and how much to leave in their share of storage.

Capacity sharing results in water entitlements which more closely reflect the physical realities of the water supply system. Unlike carryover rights, capacity sharing ensures that storage space is efficiently rationed and losses are internalised. Capacity sharing has a number of other potential benefits relative to systems of carryover rights. Capacity sharing replaces the traditional announced allocation system and, in doing so, removes a layer of regulatory uncertainty. Capacity sharing also involves redefining water rights at the source, which offers a number of potential efficiency improvements, including the potential to internalise water delivery losses.

One complication with capacity sharing is the occurrence of internal spills – where individual water accounts reach capacity and forfeit their inflows to other water users. However, the economic costs of internal spills are negligible and internal spills are likely to occur infrequently in practice. Another important consideration in the transition to capacity sharing will be to minimise any actual or perceived distributional effects, by ensuring the newly defined capacity share water entitlements adequately preserve all existing irrigator water entitlements.

Capacity sharing is typically considered in the context of relatively simple water supply systems, where all water is sourced from a single storage. While there may be some concerns about the suitability of capacity sharing in more complex systems, it is not obvious that the concept could not be sufficiently generalised. The ability of the capacity sharing framework to be applied to a range of more complex water supply systems remains a subject for potential future research.