Transboundary externalities and the river sharing problem
Population increase and economic growth have caused competing demands to occur over transboundary water resources. The property rights on such water resources are not well defined, and therefore competing demands give rise to conflict among riparian states. In this thesis, we focus on successive transboundary rivers (transboundary rivers where riparian states are ordered one after another along the river). By virtue of this geographic structure, the states along the river have asymmetric access to the river water. In a setting like this, it is necessary to allocate water in an equitable and self-enforcing fashion. The literature advocates the usage of the Pareto optimal (efficient) allocation of water as a water allocation scheme. This formal problem in economic literature which deals with efficient water allocation and self-enforcement is termed as the River sharing problem. However, the river sharing model in literature does not address several externality issues which occur along a transboundary river. In this thesis, we extend the traditional river sharing model so as to accommodate the negative externality aspects of pollution, storage, and flooding. These aspects may be seen to have a profound influence on the propensity for conflict on a transboundary river basin. In Part-I of this thesis, the issue of pollution and its implication on water allocation on a transboundary river is addressed using a two-agent static model. We examine the allocation under non-cooperative behaviour and propose two methods for cooperation. The first method is a bilateral trading mechanism in which the agents interact as buyer and seller and thus arrive at an efficient allocation of the water resource. This bilateral trading approach would ensure that the resulting payoff allocation is self-enforcing. The cooperative equilibrium which arises from the trade process facilitates in understanding the interplay between water quality and the amount of water traded. We find that the presence of pollutants restricts the extent of water trade. This means that proper pricing policy on traded water could lead to pollution abatement since the payoff of both the agents would increase when water becomes cleaner. This idea is pursued further in an investigation of different pricing policies for cooperation. It is argued that the market equilibrium price may be unattractive due to its asymmetry as well as its inability to guarantee abatement. This leads us to believe that cooperation facilitated by an impartial arbitrator would be more appealing in real life negotiations, and it should involve considerations of symmetry and abatement. In order to accomplish this, we make use of the Nash Bargaining Solution. The Nash Bargaining Solution proposes a price which has an egalitarian nature and is thus interesting because of its symmetrical treatment. However, we notice that even this Bilateral Egalitarian Solution may fail to induce abatement efforts from the upstream agent. In order to address this limitation, a Nash Abatement Price, which provides incentives for the upstream agent to abate pollution, is proposed. We show that if Nash Abatement Price does not exist, then there is no pricing policy which can motivate abatement. In Part-II of this thesis, we take up the problem of dam ownership and its welfare implications. We consider a two-agent river which faces two seasons in a hydrological year. The upstream agent has an option to build a dam to store water for its usage in the dry season. We investigate the economic behaviour of upstream agent in anticipation of bilateral trade, and discuss the consequences of this behaviour. We find that the upstream agent can store water exclusively for engaging in trade, and thus increase the downstream agent's willingness to pay. This extra storage is termed as Strategic Storage in our analysis. This would reduce the downstream agent's welfare and also reduce the social welfare. It may be argued that this strategic storage behaviour is a negative externality on transboundary rivers. Part-III of this thesis tackles the issue of flooding on transboundary rivers. Flooding is an externality on transboundary rivers. The cumulative effective of water releases from the upstream agents causes flood damages in downstream agents. Flood damages have a large magnitude. Therefore, flood damages should be allocated across administrative boundaries. Further, the flood damages should be allocated amongst the agents in a manner which reflects their respective water releases. With this motivation, we propose a Sequential Upstream Proportional Allocation (SUPA) scheme. We discuss an algorithmic means of achieving this allocation, and axiomatically characterize this scheme. We show that the SUPA rule is the only flood damage allocation rule that satisfies the axioms of Downstream Independence, Efficiency, and Proportionality simultaneously. The SUPA scheme is found to coincide with the Shapley value of the Flood Cost Sharing Game which is constructed on the basis of the Extended Producer's Responsibility principle. We also show that the SUPA rule belongs to the Core of the flood cost sharing game. Using a repeated game formalism, we try to construct self-enforcing fixed payment agreements on two-agent rivers with flood risk. These agreements should sustain the efficient allocation of water and allocation of damages as per SUPA rule as a Subgame Perfect Equilibrium. We determine the condition on the discount factor which makes this possible. This condition reveals that agreements on flood prone rivers are at least as unstable as agreements on a similar river without flood risk. Through our study of the externalities of pollution, storage, and flooding on transboundary rivers, we were able to come to the conclusion that cooperative mechanisms with side-payment can lead to self-enforcing agreements on transboundary rivers. These cooperative agreements may be market based mechanisms or agreements facilitated by an impartial arbitrator.