Abstract:

How should we manage water during droughts of unknown duration? Prices induce people to economize, but uncertainty about the duration of droughts makes setting appropriate prices problematic. We propose a pricing mechanism in which the price of using water at any time during a drought is a market-based estimate of the price for time t, determined after the drought has ended. Our mechanism requires water users to purchase bonds for the highest reasonable estimate of the post-drought-determined price. The bond’s redemption value would be the difference between the bond’s face value and this price. To inform water users of the cost of water, and to ensure that buying bonds did not create undue burdens, these bonds would be tradable. The net revenue from the bonds would be distributed among water users.