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The Colorado River, “the lifeblood of the West,” is in trouble. Decades of overuse and drought have sharply reduced its water supply, threatening an ecosystem that supports 40 million people and 5.5 million acres of farmland in nearby states and parts of northern Mexico.

Steep cutbacks in water use are critical. But the seven states that rely on the Colorado River can’t agree on how much less each of them needs to take over the long run, in large part because it’s not entirely clear who holds what legal rights to the river and who should get priority over others to its available water. If the states can’t agree, the federal government is reportedly threatening to make the hard choices for them.

Paul Milgrom, a senior fellow at the ��ɫApp Institute for Economic Policy Research (SIEPR), has encountered intractable problems like this before. In 2020, he the Nobel Prize in Economic Sciences for his pioneering work creating markets for goods and services that can’t be sold in traditional ways.

Water management, he says, is ripe for a market fix — not just for the Colorado River Basin but around the world as water shortages, made worse by climate change, become a defining issue of the 21st century. It’s no longer enough to leave decisions around water use up to federal, state, and local governments alone.

“We are trying to meet a 21st century set of challenges with 20th century technology and 19th century laws,” says Milgrom, the Shirley R. and Leonard W. Ely, Jr. Professor in Humanities and Sciences in ��ɫApp’s Department of Economics in the School of Humanities and Sciences. “What we have, fundamentally, is a market design problem.”

Milgrom is part of an interdisciplinary ��ɫApp team — led by , a PhD student in economics at the GSB and a former SIEPR undergraduate research fellow — that has developed an elaborate plan for how new markets for trading water could overcome key policy challenges around water allocation while providing incentives to high-volume users to find ways to do more with less.

Milgrom and Ferguson recently highlighted their proposal in a released by the National Bureau of Economic Research. Their use case is California, one of the Colorado River Basin’s biggest stakeholders and whose system for divvying up surface water, which comes from rivers and streams, is especially complex and opaque.

Much of their blueprint is drawn from Milgrom’s work a decade ago helping the Federal Communications Commission (FCC) overcome obstacles in delivering more radio wave frequencies to wireless companies so they could meet exploding consumer demand for mobile services.

Milgrom led a team of experts in economics and computer science through his company, Auctionomics, in the creation of a voluntary market for trading a new type of radio spectrum license, which is credited with enabling mobile communication as we know it, today. The two-part auction process he helped engineer so that the FCC could make those trades possible also delivered $20 billion in total to the radio and TV operators that gave up their old licenses and another $10 billion to the U.S. Treasury.

Milgrom, who is also a professor, by courtesy, at the ��ɫApp Graduate School of Business (GSB) and at the Department of Management Science and Engineering in the School of Engineering, says there are lessons from the 2017 that apply to water scarcity in the United States and around the world.

Water rights are broken

As a second-year PhD student in 2021, Ferguson was already interested in water scarcity when he took Milgrom’s market design course and thought that lessons from the FCC’s broadband fix could apply to water. His class project on California’s convoluted system of water rights caught Milgrom’s attention and they started talking about working together. Ferguson then enrolled in a water law course taught by , a ��ɫApp Law School professor and water rights expert who had also been thinking about the potential role of markets. Thompson is also the faculty director of the Water in the West program led jointly by the ��ɫApp Woods Institute for the Environment and the Bill Lane Center for the American West.

A solution designed for optimal flexibility

A more efficient approach, write Ferguson and Milgrom in , would be to establish a new property right aimed at delivering water to those who need it most and are willing to pay for it. Among other features, this new right would be based on how much water gets consumed, not diverted, and adjust as precipitation levels change from one year to the next.

This new water market, Ferguson says, would give rights holders incentives to save water — maybe by switching to low-water crops or installing more efficient water treatment systems — and sell off what they don’t need without damaging downstream users. And because water would then be a financial asset, Ferguson and Milgrom say farmers and other rights holders would have easier access to loans or other capital to pay for investments in water-saving technologies.

To kickstart the market, in which participation would be voluntary, the ��ɫApp team is borrowing another page from the radio spectrum playbook: a one-time auction in which governments, in a process known as a “reverse” auction, first buy back water rights from those who are willing to give them up in exchange for the new right. In a subsequent “forward” auction, governments would sell the new water rights to the highest bidders, who would then be free to privately trade their entitlements going forward.

“Our whole approach is to ensure a level of flexibility in allocating water that’s needed but currently missing,” Ferguson says.

Government, he adds, also has a critical role to play in adopting policies to protect vulnerable populations. This includes, for example, limiting how much farmland can be fallowed in pursuit of water profits so that local communities aren’t impacted by job losses and other economic fallout.

Why the timing is right

Milgrom and Ferguson aren’t harboring any illusions: As the Colorado River impasse shows, water scarcity is rife with political, economic, and technological challenges.

But they are also optimistic that their vision for a water market will gain traction — in large part because there’s an urgent need to figure out how to make better use of dwindling water supplies.

“There’s both pressure and possibility,” says Milgrom, just like there was when he took on the challenge of freeing up radio spectrum for wireless companies. And like then, technology has reached the point where water supplies can be measured in new ways and with enough accuracy to give users confidence in their ability to get the water they need.

“There’s every reason to think this can work,” he says. “While it won’t reverse climate change or make it rain, it would go a long way toward providing long-run water resilience.”

The biggest roadblock, says Milgrom, is the politics around water — at the federal, state, and local levels. This is one reason why Milgrom sees introducing water markets as an even bigger problem to solve than reallocating radio spectrum.

The challenge is also deeply personal for Milgrom. “I’m 75 years old,” he says. “If I’m lucky, I have one really big project left in me and I’d like this to be it.”

A conference on Advancing Sustainable Water Management — organized by Milgrom and Thompson, and hosted by ��ɫApp Graduate School of Business and the ��ɫApp Doerr School of Sustainability — will be held on April 18-19. Find info on the event . 

Policy challenges of the Colorado River was one of the topics at the 10th Annual Eccles Family Rural West Conference organized by the Bill Lane Center for the American West. See coverage of the March 27 event .