Experimental evidence on the relative efficiency of forward contracting and tradable entitlements in water markets

Abstract

This paper experimentally tests if adding forward trading or tradable entitlements to already commonly used spot trade in water markets improves allocation and production efficiency. We find that forward contracts significantly increase efficiency, while tradable entitlements do not. The advantage of forward contracts increases further after a climate change shock, which reduces the expected total water supply. However, tradable water entitlements are rather more damaging than beneficial. Due to the complexity involved in pricing entitlements they not only fail to increase efficiency, but are often seriously mispriced, which results in concentrated holdings and considerable wealth inequality across market participants.