March 9, 2021
 

By Michael Cohen 

In California’s Water Futures Market: Explained, Cora Kammeyer describes how futures markets operate generally and the particulars of California’s version. This new water futures market has attracted considerable attention and hyperbole. Here we explore the potential implications of this novel financial tool through the lens of California water supply reliability. 

The water futures market opened on December 7, 2020, intended to improve the transparency of water trade prices and to enable participants to hedge their financial risk. This futures market is still in its infancy. Daily trade volumes of futures contracts (on the future price of 10 acre-feet per contract) average 11; the maximum daily trade volume was 53 on February 10, though there have not been more than 17 in any day since thenIt is not clear how many of these contracts simply changed hands, rather than constitute new contracts; the net volume of futures traded could be much lower.  

To put this volume in perspectiveirrigated agriculture in California applies about 32 to 35 million acre-feet of water each year and around 1.5 million acre-feet of physical water are traded annually, a third in short-term trades. That is an average of about 1,370 acre-feet per day in short-term trades, which would equal a daily trade volume of 137 futures contracts. So at current rates, the average daily volume traded in the futures market represents about eight percent of the average daily volume of short-term physical water trades. Though the volume of futures trading may grow as the volatility of water costs continues to rise due to uncertainty of water supply availability in a changing climate and as people become more comfortable with the market, right now it represents a small sliver of California water.  

The futures market is a financial tool, removed from the physical challenges of diverting, conveying, and applying water. 

But comparing water futures volumes with physical volumes traded is misleading. While the futures market trade contract unit prices are set at 10 acrefeet times the price of water on the NQH2O Index, the unit itself is meaningless: it could as easily be a “Kraken” or a “Jengu,” with the value of one Jengu contract set at 10 times the NQH20 index price. Thinking of the futures market in terms of Jengu could help distinguish it from physical water trades and dispel the persistent mischaracterization of the water futures market as a threat to real-world water availability. The futures market is a financial tool, removed from the physical challenges of diverting, conveying, and applying water. 

Hedging Risk  

California’s Water Futures Market: Explained describes the financial benefits of the futures market for those seeking to reduce potential losses due to the volatility of water pricing (the “hedgers”) and for those seeking to profit from this volatility (the “speculators”). Hedgers could, of course, as easily seek to minimize their risk by participating in other cash-settled futures markets, or through other financial tools like crop insurance (where available). Analyzing the volatility of the NQH2O Index relative to that of other cash-settled commodities indices would make for an interesting comparison, once sufficient data become available 

Predicting the Weather 

The futures market offers an opportunity to gamble on the weather. Accurately predicting the weather — will this be a wet spring? will the drought continue? — increases the odds of success in the futures market. Irrigators may feel they have a better sense of future water prices than prices of conventional commodities, though the increasing variability of precipitation and runoff in California suggests that historical trends are not a reasonable guide for future conditions. Speculators may have more sophisticated climate models available to guide their investment decisions, as well as a higher tolerance for financial risk, affording an advantage in the market. One unresolved question is whether the water futures market could stimulate investment and innovation in better and more accurate weather and climate modeling in California, which could have benefits to other aspects of California water management. Trading volumes to date do not indicate that the potential profit from the market would justify the investment, but that could change if trading volumes and profits increase dramatically. 

One unresolved question is whether the water futures market could stimulate investment and innovation in better and more accurate weather and climate modeling in California, which could have benefits to other aspects of California water management.

Water Price Discovery and Manipulation 

While its proponents claim that the futures market can increase the transparency of California water prices, it is the NQH2O Index itself that offers that information. The volume of cash-settled futures markets contracts relative to the significantly higher volume of physically settled water trades suggests that the potential for a speculator to manipulate the price of water is quite remote. However, as we’ve seen recently with GameStop and years ago with the Hunt brothers, speculators can take outsize positions to influence the market. Given the current low number of trades in both the futures and physical markets, it’s implausible but possible that a speculator, faced with a significant financial loss, could subsidize an existing water trader to purchase or sell a large volume of water to influence the index. Again, quite unlikely, but the futures market’s link to the real-world index opens the possibility of investors attempting to hedge their exposure by manipulating market prices. More plausibly, real-world water traders will track contract prices on the futures market and could adjust their prices accordingly, though a host of physical factors have more impact on their decisions.  

Encouraging hedgers to limit their financial exposure to such price volatility could exacerbate water supply challenges, at least at the margins, as irrigators focus on financial risks rather than addressing the underlying physical conditions generating those risks.

Reducing Water Scarcity 

The water futures market, like other financial tools, could attenuate financial risk for irrigators, but its benefits for the state’s water supply reliability itself seem quite limited. The futures market could distract from investments in on-farm efficiency and reuse, as some irrigators may feel that hedging the risk of water price volatility outweighs the returns of such investments. Encouraging hedgers to limit their financial exposure to such price volatility could exacerbate water supply challenges, at least at the margins, as irrigators focus on financial risks rather than addressing the underlying physical conditions generating those risks. If the water futures market attracts significant participation from hedgers, then it would be interesting to analyze the impacts of such participation on irrigators’ decisions to invest in water efficiency improvements or to take other actions to reduce their water demand.  

…quite unlikely, but the futures market’s link to the real-world index opens the possibility of investors attempting to hedge their exposure by manipulating market prices. 

In a counter example, Colorado voters approved Proposition DD in November 2019legalizing sports betting in Colorado, imposing a tax of 10% on sports betting, and authorizing the state legislature to use most of the tax revenue to fund state water projects generating as much as $27 million annually to bolster Colorado’s water supply reliability. Colorado’s explicit link between gambling and water supply reliability stands in sharp contrast to the California water futures market. 

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