An illiquid market in the desert
August 31st, 2016
Dr. Eric C. Edwards, Utah State University, U.S.A.
Summary of the working paper: An Illiquid Market in the Desert: The Role of Interest Groups in Shaping Environmental Regulation by Eric C. Edwards, Oscar Cristi, Gonzalo Edwards, Gary D. Libecap. Available at http://www.nber.org/papers/w21869
In arid regions, environmental groups are increasingly advocating for the conservation of natural water systems to protect environmental and cultural amenities. To explore the tradeoffs associated with these protections, we examine a case-study of the regulations on access to freshwater in the hyper-arid Antofagasta Region of northern Chile.
Case study background: the Antofagasta Region, Chile
Remarkably, the Antofagasta region produces 17% of world copper supply. Mining firms have traditionally purchased water rights from the local agricultural sector to support ore milling and processing. Although Chile has an active water market, since around 2003 environmental rulings have denied firms the ability to use agricultural water rights. Restrictions were imposed by the Chilean water authority, the Dirección General de Aguas (DGA), to protect water access for small, indigenous farming communities and regional wetland ecosystems. Wetlands encompass an area of around 6,904 hectares, around 0.2% of total land area, providing important habitat for many species. There is also agricultural land in these areas directly linked to the traditional lifestyles of indigenous communities; approximately 2,000 hectares are irrigated out of a total of 12.6 million hectares in the region.
The map of the region (Figure 1) shows the main local water source, the Loa River, which forms a “U” near the border with the Tarapacá region. The small triangles are the approximate locations of indigenous agriculture and principle wetland sites are represented as well, although only a portion of the mapped areas are active wetlands. Mining firms extract water from surface dams and groundwater in the highlands above the seeps and diversion points that feed wetlands and villages. Mining diversions are 100% consumptive and directly reduce the availability of water for other purposes, although the extent of the impact is not fully understood.
Mining is the region’s main economic activity, directly accounting for 65% of regional GDP. However, the agricultural sector uses around 25% of the region’s water despite producing significantly less than 1% of GDP. The market restrictions have caused mining firms to switch production to desalinated seawater pumped as far as 150 km inland to altitudes as high as 3,000 meters above sea level.
Method and findings
This study estimates the environmental cost of desalination and provides an estimate of the private policy cost. It is not intended to provide a full benefit-cost analysis of the policy. The benefits of protecting the water supply of indigenous villages are difficult, and controversial, to quantify. An anecdote from the region helps illustrate the potential impact of water use by mining firms: The Ojos de San Pedro (OdSP) area of the highlands in the Antofagasta Region was once the location of a lake and wetland system that supported a unique ecology and small village. Water development by mining firms up to 1970 led to severe impacts, including the complete desiccation of the area and the abandonment of the village.
We estimate the costs of the policy by assembling a dataset on surface water transfers between 1995 and 2009. We find that while the DGA approved water right exchanges between sectors, prices paid by agricultural and industrial buyers were not statistically different from each other. However, after the DGA began rejecting transfers from agriculture to mining in 2003, the purchase price paid by mining firms increased 388% relative to agricultural buyers. Because we observe the market both before and after the policy change, we are able to isolate the effect of the policy on prices. The fact that we find an increase in prices among mining firms, relative to agricultural buyers, indicates the presence of market segmentationagricultural users primarily trading rights that are restricted to agricultural use and mining firms primarily purchasing rights already being used in mining or with a higher probability of being approved for transfer.
The cost of this type of restriction is the lost surplus from voluntary trades: mining users are willing to pay more for water than the income it generates in agriculture. To estimate the policy costs, we combine existing estimates of the price elasticity of water demand in agriculture with our regional dataset. Because mining firms face an unknown probability of rejection with any freshwater rights purchase, market prices represent only a fraction of their willingness to pay. To arrive at an actual willingness to pay, we construct estimates of the in-use backstop cost based on the distance from the coast and elevation of mining operations using desalinated water. We assume that if the policy restricting transfers was relaxed, agricultural water would initially offset the most expensive desalinated water. The movement of water out of agriculture into mining would allow prices to equalize and all gains from trade to be realized.
Our research has both practical and conceptual implications. Practically, our estimates indicate that the direct cost of this policy is around $6.15 billion (a sensitivity analysis is provided in the full paper). The increased use of desalination as a result of the policy creates 4.62 million metric tons of additional CO2 emissions per year. Using even low estimates for the social cost of carbon, the environmental damage from this additional pumping is estimated at $198.5 million per year. Conceptually, the high direct policy cost of the moratorium, mostly borne by mining firms, suggests that groups lobbying the government for local environmental goods can be effective, even when the policies for which they advocate are costly. However, non-local environmental costs do not receive the same level of advocacy, resulting in a policy that delivers local environmental goods at the cost of global environmental damage.
In this sense, our results show more generally how some groups may have an incentive to lobby for regulations they value when they do not bear the costs. Given that in many cases those who would bear the cost may be at a disadvantage in organizing counter-efforts, policymakers must examine whether policies impose broad environmental costs. Such vigilance is especially important where environmental policies change market price signals, as these can cause a redistribution of costs and benefits that may unintentionally benefit one environmental group or outcome over another.
Eric Edwards is an Assistant Professor in the Department of Applied Economics at Utah State University with an interest in how social arrangements or structures, what economists call institutions, solve environmental and natural resource problems. Eric is also part of two large projects encompassing several institutions and disciplines, the NSF-funded iUTAH project and the USDA-funded Native Waters on Arid Lands.
The views expressed in this article belong to the individual authors and do not represent the views of the Global Water Forum, the UNESCO Chair in Water Economics and Transboundary Water Governance, UNESCO, the Australian National University, or any of the institutions to which the authors are associated. Please see the Global Water Forum terms and conditions here.