Exploding municipal, energy, agricultural and environmental water demands are colliding with limited or declining supplies. New infrastructure to increase water supplies has become economically prohibitive and environmentally indefensible. Environmental issues and changing patterns of water use are forcing water managers to search for new ways to reduce demand and redistribute supply. Agriculture, being the least valued and largest water user—over 80 percent of water diversions in the West—is often viewed as the principal target of reallocation. While the prior-appropriation no-harm rule addresses many third-party impacts, there is no comprehensive methodology for addressing the economic and hydrologic connections that result from the changes in the form, place, and timing of water supply and demand that accompany water reallocation. The result exacerbates conflict in water reallocation, symptomatic of market failure.

Defining hydro/economic externalities

Economic externalities occur when the activities of one entity affect the activities of another entity and no pecuniary remuneration occurs. The divergence between private and social benefit/cost resulting from externalities results in price/market institutions failing to sustain desirable activities or curtail undesirable activities (Bator, 1958). Using the classic example of apples and honey, Meade(1952) illustrated the concept of interrelated production functions and externalities. A bee-keeper whose bees obtain nectar from apple blossoms is the recipient of a one-way positive externality. However, the bees reciprocate by fertilizing the blossoms for an apple grower. Thus the apple grower also benefits from a reciprocal positive externality. In Meade's example, the effects are externalities because the interrelated production relationships are unpriced and uncompensated, that is, the property-rights are not assigned.

Similarly, surface/groundwater connections can result in either one way or reciprocal externalities. The surface water to groundwater hydrologic connection can recharge aquifers via canal seepage and/or in-field percolation. When the aquifer is nothydraulically connected to the water course—river, reservoir, or canal—water passively seeps through an unsaturated zone, providing water to groundwater pumpers. If the passive seepage is unpriced, the pumper is the recipient of a one-way positive externality. The interrelated function that defines this one-way externality is that demand for canal water, and therefore canal delivery quantities, partially determines the groundwater supply for the pumper.

When the aquifer intercepts the zone of saturation of the canal, surface water is hydraulically connected to groundwater. The interaction is no longer one-way, but two-way; lowering of the water table by groundwater pumping induces additional seepage from the canal. Noting the water temperature differential between canal and groundwater, these connected wells are aptly labeled “warm water wells” (Strauch, 2009). With a reciprocal externality, groundwater pumpers not only enjoy the positive externality of passive seepage which is independent of pumping, they reciprocate by inflicting induced additional canal seepage by pumping water from the aquifer. The interrelated functions that define this reciprocal externality are that demand for canal water partially determines the groundwater supply for the pumpers while demand for well water partially determines water supply to the canal water users. Reciprocal externalities exist upon specific reaches of canals and many riparian aquifers.

We should caution that a negative or positive hydrologic externality depends solely on the production function of the externality recipient not on the externality producer. When canal seepage raises the water table and pumping costs are reduced, the externality is positive. When the rise in water table saturates soil and damages crops, the externality is negative. As an historical note, construction of many canal projects throughout the West was soon followed by construction of extensive drain systems to alleviate the negative externality of water logging.

Aquifers created or sustained by incidental recharge from unlined canals extend over vast areas in every western state. In the mammoth aquifers of Idaho’s Snake River Plain and California’s Central Valley, the increased recharge is virtually all from “infiltration of irrigation water” (Alley, Healy, LaBaugh, and Reilly, 2002 ). And the principal source of recharge to the Snake River Plain Aquifer is from canal seepage. Similarly, aquifers in Nebraska’s North Platte, Washington’s Columbia River Basin, Idaho’s Boise Valley and others are created and/or sustained by canal seepage.