Incorporating Instream Flow Values into a Water Market

We use laboratory experiments to test three different water market institutions designed to incorporate instream flow values into the allocation. The institutions are (1) a baseline with fixed minimum flow constraints, (2) an environmental agent contributing to the cost of providing instream flows, and (3) creating an instream flow right in which an environmental agent can sell the right to reduced flows. Using a "smart" computer-coordinated market, we find that direct environmental participation in the market can achieve highly efficient and stable allocations. A particularly attractive and practical feature of the third institution is that it nests the status quo in the sense that, should the environmental agent choose not to participate in the market, the default minimum instream flow constraints will be maintained. Although flows may be lower in this institution relative to a fixed constraint on minimum flows, because these flow reductions are voluntary and compensated, all deviations from the status quo (i.e., binding flow constraints) are necessarily Pareto improving in the sense that no agent, including the environment, is made worse off.