Why doesn't California use a more market-based approach? It could simply decide how much water can be sustainably consumed and then auction-off rights to that amount of water.
Because it would have to first seize by eminent domain lots of permanently held rights in order to put them into an auction, and the costs of the initial purchases would be prohibitive.
In the US, a State can't just up and decide to conduct, say, an annual auction for use of property that someone already permanently owns, and that's how a lot of water rights are.
These are public resources, and in many other places you can own the land below a lake or river, but you do not have a right to divert or impound said water, and the Department of Natural Resources will serve you notice and take corrective action (eg: blowing up your dam, seizing your pumps and destroying your pipe/trench) if you do not comply.
So government did something stupid, not paying for it made the problem get delayed, and grow massively, and now it’s critical. The government, especially now that the problem is so much bigger, definitely doesn’t want to pay.
“The initial purchases would be cost prohibitive”.
Maybe it shouldn't be, but it has been historically, and reversing that under the US Constitution requires compensation for the value of the property thereby deprived, see the 5th Amendment. It is not something that can be reversed by state fiat without compensation to owners.
Short of a federal Constitutional amendment or California seceding from the Union, your desired model of water property rights can't just be willed into existence in the state.