Can Derivatives Trading In Water Help Western US During Ongoing Drought? – Analysis


By Nilanjan Ghosh

The Colorado basin states in the western US are going through an unprecedented water crisis—a historic long-term drought. Early this week, the US Bureau of Reclamation officially declared a severe water shortage at Hoover Dam’s Lake Mead, the largest reservoir in the US. At around 1,067 feet above sea level, the lake is barely 35 percent full, the lowest since its construction in the 1930s. The water levels in the second largest reservoir, Lake Powell, also fed by the Colorado River, stands at 32 percent of the full storage capacity. Such low runoff conditions in the Colorado system will result in substantial deductions in downstream releases from Glen Canyon Dam and Hoover Dam in 2022 due to declining reservoir levels.

This will further lead to mandatory reductions in water allocations for all the three lower Colorado states, namely, California, Arizona, and Nevada as also for the downstream nation of Mexico. Based on the federal guidelines worked out for combating drought conditions in 2019, Arizona’s allocation from Lake Mead declines by 18 percent, while those of the state of Nevada and the nation of Mexico declines by 7 and 5 percent respectively. As such, Nevada has already reduced its deliveries to combat the scarcity conditions.

One needs to note here that the long-term trend of the Colorado system reveals a decline in the run-off, which has largely been attributed to the forces of human-induced climate change. A recent paper in Science claims that in the Upper Colorado system, the annual mean discharge is declining by 9.3 percent with every degree celsius of warming due to enhanced evapotranspiration mainly driven by snow loss and a consequent decrease in reflection of solar radiation. But this is not the only reason. Rather, Marc Reisner’s Cadillac Desert and Philip Fradkin’s A River No More bear ample historical accounts of river development and how a structural engineering paradigm for water governance as a response to increasing water demand in the western US  had serious long-term negative effects on the environment and water quantity. The decline in long-run run-offs has often been attributed to fragmentation of the flows caused by multiple constructions for storages and diversions. There is no doubt that the long-term trend of declining run-offs in the Colorado system has now further been aggravated and inflicted by an uncertainty posed by global warming and climate change.

Over time, the western US attempted various demand management measures through compacts and statutes, the latest one being the measure adopted in 2019 as mentioned above. However, the most interesting intervention emerged by December 2020, with the CME Group and NASDAQ launching the NASDAQ Veles California Water Index futures contract. The derivative contract is designed for California, which is endowed with a highly liquid and a buoyant physical water market worth more than US $1.1 billion in 2019–20. The futures contract is associated with the spot market price underlier in the form of Nasdaq Veles California Water Index—a price index estimated as the volume-weighted average price of water arrived on the basis of the transaction prices of water rights in California’s five most liquid markets. As against physical delivery, these futures contracts are financially settled, thereby, rendering better leveraging and reducing the transaction costs including those of delivery.

Benefits of a water futures market

There are various expected benefits of the water futures markets (WFM). First, water futures market will help discover price (through the scarcity value of the resource), thereby, leading to an efficient use of the resource. Thus, the market aids efficient allocation, helps proper distribution, and offers means of achieving social optimality in consumption and production. Second, water futures contracts will provide a price indicator for future stored water. This will assist investment decisions as also forward risk management. Third, the price realised at the futures market will be an indicator of the future state of availability of the resource, thereby, indicating the relative scarcity with respect to the demand. In that sense, price discovered in an efficient futures market for water will reflect on what has been delineated as “scarcity value” of water, i.e., the value loss at the margin due to scarcity. Fourth, irrigated as also rain-dependent agriculture, dependent on the availability of water, will be able to use the market (or products derived from the market) to insure themselves against droughts by locking in prices in the water futures market. Such risk transfer in the private sector will significantly reduce the burden of drought relief currently borne by governments. Fifth, water futures provide the financial tools required by investors and banks to confidently invest in the rural sector. This would result in long-term planning and investment that will actually deliver water to areas that need it rather than simply insure against its absence. In fact, banks and financial intermediaries can develop other products suitable for their customers by making use of the water futures market. Sixth, a water futures market will help in promoting the best water-efficient technology. Seventh, the price discovered in the futures market, thus, can offer a mechanism for extending justice and setting conservation priorities within a limited budget. The futures market is expected to align the supply side factors and the demand forces, stabilise price risks, and help price discovery.

Why confined to California?

Though recent frameworks attempt to predict water availability in the Colorado system with sufficient amount of precision, especially through a drift-free decadal climate prediction system using a fully coupled climate model that does not take away the risk associated with water availability. The utility of a water futures market lies there. However, in the present scheme of things, this phenomenon of water futures seems to be confined to California-specific product and the index may not be reflective of the situation in other parts of western US though the problem of drought can aptly be described as a “basin-wide regional common”: It affects all the states, all the sectors, and stakeholders negatively, though it may be in varying proportions. In that sense, all the states need such an instrument. More importantly, the futures contracts need to designed as per the needs of the states as the levels of scarcity are variable. Therefore, if market prices are supposed to reflect on the scarcity value, then a California-specific contract might not reflect on the drought situation in Upper Colorado or even Nevada and Arizona.

For broader applicability

Now the question that might arise is: What happens in a situation where physical water markets do not exist? Can we have a derivatives market even then? This question is true not only in the context of western US where there are already physical markets of water, and the trading occurs on the basis of a price index in California, but for all those water scarce economies across the world where such formal spot or physical markets for water are non-existent. This has been answered in an earlier paper that developed an index on the basis of water availability (or WAI) in the various reservoirs in the Karnataka state in the Cauvery basin in India. The study also estimated the scarcity value of water for paddy cultivation, and found something very interesting that goes very well with the economic logic of scarcity value. For the dry season or irrigated paddy, the correlation coefficient between the WAI and scarcity value was as high as -0.92, while the same for high monsoon paddy was -0.65. The negative correlation is axiomatic: Higher water availability or a higher value of WAI is reflective of a lower scarcity value. Even the higher negative correlation for dry season or paddy is axiomatic: It is entirely dependent on irrigation, and hence a low WAI will result in a high scarcity value than the high monsoon paddy that hardly depends on irrigation. The study also stated that between the years 1992 and 1998, WAI hovered between 0.8 and 0.9, while the scarcity value hovered around INR 0.4–0.6 per cubic metre. In the drought year of 1999 in the basin, a drop in WAI to around 0.71 was associated with a more than double increase in the scarcity value to INR 1.31 per cubic metre. Therefore, it is highly likely that even without physical markets, the futures markets can help but this will require the right type of regulatory instruments to control market cornering and inflationary pressures.

One needs to remember here that the water futures can act as a market-based insurance mechanism under scarcity conditions. In other words, if the farm community, banks, financial institutions who have a lot of exposure through provision of loans to the farm community, insurers, and reinsurers have their risks associated with water availability, then the water futures can be an excellent hedging mechanism for them. They protect their bottomlines and can get compensated for their losses (caused due to drought conditions) through such cash-settled futures contracts.

The views expressed above belong to the author(s).

Observer Research Foundation

ORF was established on 5 September 1990 as a private, not for profit, ’think tank’ to influence public policy formulation. The Foundation brought together, for the first time, leading Indian economists and policymakers to present An Agenda for Economic Reforms in India. The idea was to help develop a consensus in favour of economic reforms.

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