Why markets fail: Part II

February 21, 2016

People often misunderstand how markets work—and why they fail. As our team has gone around the world to learn about them, two primary, and underappreciated, issues emerge. In this two-part series, we highlight them with some examples.


Confidentiality and Trust

A lot of water agencies have tried to help their water users to trade more cost-effectively by establishing markets. While this is done with the best of intentions, coupling of the financial and permitting sides of water transactions can be problematic. At best, there is uneasiness among farmers to disclose sensitive price information to the very agency that regulates their water rights; farmers worry that this information may be used against them in the future. At worst, it creates a conflict of interest when the water agency itself is a participant—buyer or seller—in the market it operates. The agency, as a result of being the market maker, has access to insider information on prices that it can use unfairly.

You can think of concerns around fairness, confidentiality, and trust as “pain points” that water users have when hoping to participate in water markets. A lot of times, farmers will outright refuse to participate in markets even though it would be profitable for them to do so. Ensuring fairness, confidentiality, and trust are transaction costs that most economists and market designers don’t consider, or forget all about. In our experience, these are some of the biggest hurdles to well-functioning water markets today.

Instead, we envision a public-private partnership to popularize water markets. The water agency should retain control of the permitting and regulatory aspects of the transaction. It’s vital for a water agency to maintain records of water rights and the quantities and locations of transfers. But there is no need for that same agency to maintain records about the financial aspects and value of transferred water. On the other hand, a private and neutral third-party can manage the financial aspects of water transactions, keeping sensitive price data confidential. Most water users already have many confidential contractual agreements with private companies—this is how businesses function every day. This is exactly what we’re doing for our customers in Nebraska and Washington States—and we’ve seen early success with happy customers.