In this paper we discuss the stylised problems relating to water and irrigation in India and argue that most of the inefficiencies, misuse and environmental damage have their roots in the mispricing of water and electricity. Since the only kind of subsidies thus far used are price based input subsidies they end up distorting the allocative prices, from which the other distortions follow. The problems of the sector can be overcome by changing the method of subsidisation. Converting price based or tariff subsidies to direct subsidies and endowments with improved tradability would solve most of the problems in the water and electricity sectors. Administrative and managerial initiatives by themselves would not succeed without this crucial tariff and subsidy reform. Such reform would also result in political capital for its initiators, and should make private and public financing of water (and electricity) projects possible. The issues related to pricing, water rights, subsidies and financing are deeply interlinked, and the correct pricing would necessarily have to recognise the financing dimension. Water being a scarce commodity with major composition and coordination economies in its use, its pricing cannot be discussed without a consideration of the rights (implicit or otherwise). This study, unlike many previous diagnostic studies, has been led by the need to find solutions to a fast deteriorating situation: rising implicit subsidies, movement away from optimal use in a major way, huge distortions and resulting social costs in the use and misuse of water, and as much as 30% of the irrigation water supplied being wasted. The environmental effects of such inappropriate use and waste increase by the day. Our approach to the problem calls for a strategic shift in so far as we argue that reform is not possible if the present approach to work around major policy and design infirmities rather than remove them in the first place continues. This is because the distortions have been so deep rooted as to have fed back into the governance and institutional structure of water management in the country. We also argue for solutions that are incentive compatible in the sense that the designs for pricing & regulation and financing (within the appropriate policy and rights framework) are internally consistent and would work without depending continually upon political commitment, administrative initiatives and managerial energies. Incentive compatible policies are those which by design meet the criteria that the actors, civil servants, proposed water companies and cooperatives, electricity companies, farmers have the correct incentives to do what is right for efficient production, management, allocation and consumption of the resource without administrative direction or urging or demanding the presence of persons with exceptional morals, or leadership qualities. Key elements of our recommendations are: The right to water of a state to the rivers and other water bodies should include the right to trade i.e. to sell the water. This would be consistent with the fact that the bulk of he water is for commercial use today. A formal, perhaps constitutional basis of sharing the waters of interstate rivers rather than national level optimal use being pursued weakly through agreements as is the case today is important. The irrigation sector at all levels is opened to the private sector through frameworks for various kinds of private finance initiatives including the DBF /DBFO type initiatives. Rather than cost plus, it would be far more useful to institute regulation which is incentive in approach and price cap in form, though uniform caps across the country would not be possible nor desirable. Price caps could be the same across fairly large regions. All subsidies whether for electricity or water would have to be direct subsidies delivered to the farmer. An identification exercise carried out once that allows the endowments of a farmer to be fixed, so that he can be issued electricity coupons and water coupons periodically, is necessary. This ensures the political commitment of the farmer since now he has nothing to lose but a lot to gain. Without such commitment and certainly with their hostility as the current agenda to eliminate or reduce subsidies implies, no reform is possible. With all subsidies going direct, there need not be restraints on commercial behaviour and orientation of all participants in the market. The productive organisations-bulk water companies, retail companies and distributors including (WUAs), and farmers can all relate to the regulated bulk, and retail market prices. Current subsidies in irrigation are converted to endowments in units of water and provided to the farmer in the form of coupons with which (as also with cash) he can buy water, and even sell the same subject to certain restraints. Thereby prices are allowed to perform their function of ensuring allocative and use efficiency. Since water supplies may be limited (because of natural factors, and because of limited existing capacity to produce /store) bulk water rates ought to be regulated, with only small opportunity for water companies (bulk and distribution) to gain out of the (high) retail water market prices. Regulated prices could be long run marginal cost (LRMC), in which case the difference between the commercial viability prices and the LRMC prices is made up for the private /commercial bulk water producer through annuities in an appropriate private finance initiative (PFI) deal. The benefit of the difference between the regulated retail prices at which water is supplied to the farmer and the retail water market prices in the command area/ayacut is to the account of the farmer. Since the farmer is able to internalise this benefit with reference to the price, there are strong incentives for judicious use, and optimal trade. In water scare regions it would restore and enhance the incentives for even investments in water saving technologies. A little of the same benefits is designed to be internalised by the water distribution entity so that it has strong incentives to save water in distribution, recover losses, and make investments for repairs, rehabilitation and augmentation Tradability across an entire command is a desirable objective, which can be introduced as experience is gained of the system. Cross command tradability should also slowly emerge subject to certain safeguards against the monopolisation of access rights to water. Water distribution companies are ideally structured as WUAs i.e., cooperatives but with some allowed asymmetry in shareholding. But they ought not to be limited to WUAs or even to farmers' companies. Bidding for distribution business should be open to entirely private companies too, so that the process of decentralised distribution does not necessarily have to be constrained by the 'free rider' problem in cooperation. For entirely new projects requiring construction of new distribution assets, the access rights can be sold at prefixed prices/market prices but strictly limited to farmers with operational/own holdings of land in the command area/ayacut, to raise the capital to construct the distribution system. This can be done separately for each of the distribution areas, since the bid prices are likely to vary depending upon such factors as the alternative supplies including from ground water available. Such purchase of the rights to water would lead to much flow of finance into the sector, and in a way that is functional and entirely incentive compatible. Banks and rural development finance institutions without any subsidy could then support the participation of farmers in the equity of distribution companies. Tanks systems would also require a certain recasting with formally defined rights and prices for use of ground water and surface irrigation. The need here is to minimise the free-rider problem that is inherently a barrier in the management and judicious use of tank irrigation (a common resource in many ways). Herein the key to reform is to lead the system to an explicit relative valuation of the direct and indirect output of the tank (canal water and ground water) through bids restricted to farmers from within the ayacut. A prior fixation of the shares of each farmer in the 'tank' business that includes already existing use of wells is the key. Tradability among members of such 'rights water' would ensure its judicious use, and the expansion /savings in supplies would follow from the large profits that farmer would make in avoiding leakages and siltation.
