June 16, 2015

By Garrett Baldwin

In April, GAI News discussed California’s water policy and resource management challenges, which have been brought to light by the state’s ongoing drought.

In a conversation with Sprott Asset Management, founder Rick Rule argued that the lack of a free-market pricing mechanism has led to misallocation of the critical commodity. With century-old policies that offer no incentives to save or trade water, farmers continue to use as much water as possible on low-value crops and grow cotton in the desert. That policy has pitted farmers against thirsty consumers.

Two months later, California policy makers have now imposed water cuts to farmers whose rights were staked prior to 1914 for the first time in roughly four decades. Meanwhile, farmers continue to drill into the bedrock of their lands, draining aquifers and continuing exploitation of a common resource. Some wonder what alternatives might exist to current policy.

Across the world’s largest ocean, in the Southern Hemisphere, the nation of Australia has shown that shifting policy toward a more properly regulated water industry is possible, particularly in times of drought.

The differences between Australia and the United States are stark when it comes to water policy, as Kim Morison of Blue Sky Alternative Investments Ltd., explained in a conversation with GAI News last month.

Over the last three decades, Australia’s transition to a water trading model has been tedious, but understanding how its policy works could provide a case study for states attempting to efficiently manage the use of their water resources.

Primary Differences Between Australia and the United States

An Australian drought crippled water supplies in the nation by 70% between 2002 and 2010. However, the nation’s production capacity declined by a meager 13%, raising questions of how this country – which experiences wild swings in weather conditions – was able to manage its water so efficiently.

The answer: The nation maintains efficient irrigation systems and allows the trading of water and water rights to better manage the flow of a scarce commodity.

Sustainability and regulation are at the heart of this system, according to Morison, a managing director at the Brisbane-based Blue Sky, an investment firm that operates a fund that holds and trades Australian water rights.

The most basic, and critical differences between the two nations is the regulation of land rights and their associated water rules.

“In the United States, when you buy land, you are purchasing all the water, oil, and other minerals that might be in the soil, as deep as one can drill,” said Morison. “In Australia, you don’t have a right to drill down past three feet. This is very highly regulated.”

Drilling past topsoil in Australia requires an entirely different set of permits and statutes. The result of that policy has been greater sustainability of critical resources like groundwater. Meanwhile, in California, the ongoing draught – coupled with personal drilling rights – has fueled a surge in farmers’ debt as many take on drilling equipment to explore deep into the earth. California not only allows all the water on the property to be used, but it creates a “use it or lose it” system that pits farmer against farmer. As a result, California’s precious aquifers are failing to replenish water resources at the pace of extraction.

But that is just the first startling difference between the two systems. As Blue Sky’s investor presentations explain, California is regulated by a wide range of federal, state and local water rules for surface and groundwater rights. That includes state laws that prevent anyone from trading water rights between State Water Project and Central Valley Project. In addition, California lacks any metering process that holds farmers and users accountable for every drop.

Australia’s rights system is dramatically different. Its water market is driven on scarcity and efficient markets. A diverse number of titles exist, allowing for the transfer of rights to a specific source. In Southern Australia, for example, the Murray-Darling basin has a fully “connected system” that allows the holders of water rights to trade titles across state boundaries and from different river systems.

Efficient Management Through Water Trading

The ongoing battle in California between consumers and farmers is the end-result of 100 years of unchanged public policy. Where California’s laws prevent a market place for water, in a market where plenty of capital is available, Australia’s water markets can efficiently manage a scarce commodity.

“Australia has a lot of variability in weather. Over decades, there have been floods and droughts for 120 years,” said Morison. “These are resilient environments, and there is regular debate about how much we allow to flow for farmers and for environmental purposes.”

The long process of creating water markets in Australia enabled the nation to overcome its worst drought since its European settlement. From 1995 to 2009, the country’s water storage levels cratered to nearly 25% of capacity. However, its trading system enabled its cities to mostly avoid serious cuts to water rights.

The process of water trading took a long time to evolve. However, policy makers, farmers, and traders all recognized the efficiency of markets to regulate water use. The nation’s National Water Commission is responsible for its water rights, while the market centers heavily on the flows from Southeast Australia’s Murray-Darling River Basin.

In California, the lack of a free market price mechanism has facilitated a transition to low-value trade crops that are highly water intensive. Without paying market value for water, farmers are growing alfalfa, almonds, cotton, and other crops that require intensive amounts of water.

Morison argues that the state should take a lesson from Australia. California “should create a framework that allows farmers with significant water rights to make money” instead of incentivizing the harvesting of low-value crops, he says.

Australia’s Water Rights Turn a Profit

Trading water has been lucrative for Morison and his team, particularly in a country with the most advanced water trading system in the world. The Australian Water Entitlement system (water rights) comprises the trading system of 32,000 gigalitres (GL), with an estimated value of more than A$25 billion.

His firm’s Blue Sky Water Fund has achieved 12% annualized returns (net of fees, gross of tax) since its inception. The firm generates its annual income in two ways. First, by selling annual volumes of water allocated to the water entitlements, and second by generating rental income from irrigation farmers who lease their water entitlements.

Given the scarcity of water and the associated water rights, investment in the sector remains highly favorable. With the recent trade agreement between China and Australia, increased demand for locally sourced agricultural products, particularly water-intensive ones such as dairy, will continue to accelerate. In addition, the agricultural sector is just one of several successful Australian industries that must rely on the trading system in order to secure supply.

Australia’s mining and energy sector is robust and requires significant water resources, and population growth continues to fuel increased demand. But in the end, agriculture remains the principle use of these water rights. Today Australia’s agricultural sector is growing many of the same water intensive crops – such as cotton and almonds – as farmers in California.

The primary difference: One nation with a GDP of $1.4 trillion (Australia) has created sustainable water trading system practices and a successful investment vehicle, while one state with a GDP of $1.9 trillion (California) still struggles for comprehensive, efficient water management and policy.

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