Capacity sharing enhances efficiency in water markets involving storage

•‘Internal water spillage’ is an externality arising in a capacity sharing system.•Detailed analysis of internal spillage is currently lacking.•We study how individual water users make the storage decision and what causes internal spillage.•We show that with a zero transaction cost spot market, internal water spillage can be avoided.•Appropriately designed capacity sharing systems attain socially optimal outcome.

Due to the asymmetric information problem, inter-temporal water allocation efficiency requires a water allocation institution that allows water right holders to store their allocated water. Capacity sharing has been recommended, but the problem of internal spillage that may arise in a capacity sharing system causes concerns for the implementation of such institutions. In this paper, the optimality of water allocation within a capacity sharing system in presence of a spot water market is studied. We show that in the presence of a spot water market with zero transaction cost, an appropriately designed capacity sharing system will result in optimal water allocation.