Can New South Wales fix its water market?

The legislative council of the New South Wales parliament has established a select committee to inquire into and report on the status of water trading in that state. The inquiry is an opportunity to clarify what has gone wrong with the water market, and to map out high-priority reforms. The committee is due to report by 30 November 2022.

On 6 October 2022, Scott Hamilton and Stuart Kells appeared as expert witnesses?before the committee to give evidence about their research on the Murray-Darling Basin (MDB) water market.

This article is based on their submission and evidence.

A lot at stake

The impacts of climate change are intensifying around the world. In the northern hemisphere this year, one-third of Pakistan has been underwater, with millions of people displaced. In the United States, Californians are living in their driest period on record.

In Australia, winter rains have brought relief to many parts of the Murray-Darling Basin (MDB) river system. The focus of governments has turned from drought and bushfires to recovery from floods. But it won’t be long before Australia experiences another severe drought. Urgent action is needed to fix how we manage our water resources, and that includes the MDB water market.

In February 2021, Australian Competition and Consumer Commission (ACCC) deputy Mick Keogh delivered a damning 700-page report to treasurer Josh Frydenberg. The report of the ACCC inquiry into the water market had taken 19 months to produce and it set out 29 recommendations aimed at repairing Australia’s most important natural resource market.

Daryl Quinlivan was tasked by the previous government to ‘develop a phased implementation plan (“roadmap”) for water market reform that is practical, cost-effective, and supported by Basin states, by September 2022’. Time is running out. Waiting until the next drought might seem easy, but it will make reform many times harder.

A fundamental design flaw

Right back at the beginning of the water market, in early milestones such as the National Water Initiative and the creation of tradable rights, the intention (and the rhetoric) of politicians, policymakers and regulators was that unbundled water rights would flow to their highest and best uses. The market, so the story went, would maximise economic returns from irrigated agriculture.

But through the flawed market design, what actually happened was that the market instead serves the arbitrage profits of external traders.

Governments originally allowed external traders in to make the market work better, and in particular to increase liquidity. In reality, the market is not very liquid, and the external traders are reaping very high profits at the community’s expense.

The results of the failed water market can be seen in the enormous expansion of the almond industry, for example, which has grown by 1500% since 2000, with 30% of the almonds trees being planted in the five years to 2021. As the almond trees mature, there will be increasing demand for water — and the situation will be exacerbated by climate change.

The role of hedge funds in the water market highlights a larger problem in our systems of economic and financial regulation. Paradoxically, the riskiest areas of finance are subject to the weakest regulation. The state of the water market also has wider implications for political accountability, environmental regulation, and how effectively the different spheres of public life — urban and rural communities, politicians, regulators, officials, academics — speak to each other.

A multi-point failure of public policy

1. Australia’s water market designers did not pay enough attention to market governance or to trader conduct or integrity. There are few controls in Australia on water exchanges or water brokers. Behaviours that are prohibited in other markets are widespread in water trading. Greater transparency, compliance and enforcement is needed. NSW might consider the recent changes implemented in Victoria to improve water ownership and trading, including that the names of the largest water owners are published on the water register.
2. Australia’s water market is overly fragmented. There are multiple trading platforms, and for every type of water right there is no single ‘market price’ and no single source of truth at any given moment. Information is fragmented, and the overall market is in a permanent state of disequilibrium. As we told Ben Ryder Howe for the?New York Times, the result is ‘a paradise for arbitrage’.
3. The ‘cap and trade’ model doesn’t cover the whole river system. Some farmers engage in large-scale unregulated capture of water. This undermines the basic purpose of the trading model and reduces confidence in the market.
4. Water policy is too important to be left to water regulators.?The morphing of water trading has not been matched by the competition regulator’s capability to oversee such a market. We agree with a lot of the ACCC’s findings, but they have pulled their punches, in part because they have an effective conflict of interest from reviewing their own work. The powers and the expertise of the Australian Securities & Investments Commission are needed in this market, including the power to ‘follow the money’ and unpick relationships between arbitrageurs, agribusinesses and managed investment schemes.
5. There is a huge power imbalance between farmers and professional traders. Big advantages in speed, computer programs and market expertise allow professional traders to dominate the market, while farmers need to spend time actually farming.

Australia has paid too much (in the form of lucrative arbitrage profits at farmers’ expense) for the limited liquidity provided by the external traders. The liquidity itself is of poor quality, and the market does not function well despite the presence of external traders. Ultimately, we may need to phase out pure traders by having them sell down their holdings to farmers and irrigators.

There is great frustration among people in Basin communities, who feel that few parliamentarians and regulators have heard their concerns about the everyday reality of the water market. The present inquiry is an important step in hearing what has gone wrong in the water market, and in mapping out urgent improvements.

By Scott Hamilton & Stuart Kells

This is an excerpt from an article first?published in The Mandarin (Premium) on 12 October 2022.

Read more: Water policy is too important to left to water regulators

Read more:?Water-markets reporting highlights problem with jargon

Read more:?How to undo Australia's epic water fail

Scott Hamilton?and Stuart Kells are the authors of ‘Sold Down the River’ (Text Publishing).