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control, hydropower production, recreation, fish and wildlife habi- tat, navigation, water quality, and domestic, industrial, and agricul- tural water supplies. Allocating reservoir capacity for one use af- fects other users within the hydro- logic system. Drawing down a res- ervoir for flood control, for example, may reduce available sup- plies when they are most valued for irrigation, hydropower produc- tion, navigation, or recreation. Managing these reservoirs in a way that best serves society is a daun ting challenge. In smaller river valleys where water uses are limited, capacity sharing, as prac- ticed in Victoria, Australia, is a way of defining marketable water rights. In a larger, more complex system, the interdependence among users is too great to ignore. Market allocation of water or reservoir ca- pacity in such a system would be inefficient and chaotic. While markets are not a pana- cea for achieving efficient and sus- tainable water use, they can play an important role in achieving these goals under some circum- stances. Water markets, whether formal or informal, have a long history of facili tating transfers. Chile and the western United States, two areas where marketing is most advanced, illustrate both the opportunities and limitations of water markets. Water market- ing in these countries has largely involved transfers from relatively low-value, inefficient irrigation use to higher-value domestic and in- dustrial uses. Moreover, the sales often provide incentives and funds for water-conserving investments to protect the economic base of the water-exporting community. Geography and institutional factors, however, have restricted development of water markets. Moving water outside of its natu- ral channels is costly and subject to economies of scale. Chile's riv- ers flow from the Andes to the ocean in a series of small, steep- gradient rivers separated by hills. Consequently, it is expensive to move water from one watershed to another or from downstream to upstream areas within the same basin.16 The frustrated efforts to sell water rights from the upper to the lower Colorado River ba- sins illustrate how institutional factors can limit potentially prof- itable transfers even where the in- frastructure is in place to move water at low cost. The successes and failures in transferring water emphasize that clearly defined, transferable rights are a necessary, but not sufficient, condition for market transactions. Once transferable rights are es- tablished, the most im portan t challenge for creating efficient water markets is developing pro- cedures for expeditiously and fairly handling third-party impacts. Unfortunately, these impacts are not always obvious or quantifiable. Both Chile and the United States allow transfers subject to consid- eration of these impacts. But the judicial and administrative proce- dures used to assess these impacts and compensate third parties of- ten impose a high hurdle for pro- spective buyers. In spite of the obstacles, the po- tential gains of transferring water for new uses are encouraging the development of water marketing in many areas. The incentives for vol- untary water transfers are strong and will continue to grow as the resource becomes scarcer and the costs of providing water for tradi- tional uses increase. A Hot Futur. e lobal warming would likely add to the po- tential benefits of water transfers. A warming world would alter the hydrologic system and increase the demand for water. The magnitude, timing, and even direction of climate-induced changes in a region's water sup- plies are uncertain. The costs of building dams, reservoirs, and ca- nals in anticipation of these un- certain changes are high. But re- examining reservoir operating rules, relaxing constraints on wa- ter use, and developing institutions to encourage voluntary exchanges of water through markets would create a system more efficient and able to adapt to whatever the fu- ture might bring. I? Kenneth D. Frederick is a senior fellow with Resources for the Future, in Washington, DC. NOTES 1. National Water Commission, Water Policies for the Future: Final Report to the President and to the Congress (Washington, DC: Government Printing Office, 1973). 2. World Bank, Water Resources Manage- ment: A World Bank Policy Paper (Washing- ton, DC: World Bank, 1993). 3. World Commission on Water for the 21 st Century, "A Report of the World Commission on Water for the 21st Century," Water InternationaI25/2) (June 2000), p. 284. 4. Ludwik A. Teclaff, Abstraction and Use of Water: A Comparison of Legal Regimes (New York, NY: United Nations, 1972}. 5. Kenneth D. Frederick, Tim VandenBerg, and Jean Hanson, Economic Values of Freshwater in the United States, Discussion Paper 97-03 (Washington, DC: Resources for the Future, 1996). Spring 2001 . 61