Water markets critical to managing scarcity

As COVID started to spread, farmers and large cities in Southern California were hit with another blindside last March. Fires, drought, and the planting season drove up the price of California’s water market, over 220 percent in just three months. Crops failed and pastures were lost.

In September, CME Group Inc vowed to create a new  market to help with the risk of these price swings. Last month, the first contract connected to the future price of California’s $1.1 billion water market was inked.

Bloomberg’s reporting on the news struck the same ominous tone as nearly every other report, that “Water joined gold, oil and other commodities traded on Wall Street, highlighting worries that the life-sustaining natural resource may become scarce across more of the world.” Others derided this new market “as a foreboding indicator of the transformation of water from basic right into a luxury good.”

California’s water markets have existed since the 1980s and they are small, only about 2 percent of all water in the state is traded through them. Moreover, the total volume of trade has effectively flatlined. Critics of these markets have chosen an easy path of derision instead of understanding how these markets actually work. Water has always been scarce. Water markets are simply a means of understanding that scarcity by pricing it. What is new is the creation of a new financial instrument on top of those underlying water markets and it is called a futures contract.

To understand the new futures market, it is crucial to first understand the roots of the underlying water market, which comes about through water rights law. An 1886 court case in the state, Lux v. Haggin, effectively combined a traditional English common law system, known as riparian rights, with a conflicting system of use developed in mining camps in the Old West of the 1800s, known as prior appropriation rights. As a result, landowners near a body of water maintained a superior right to benefit from the water supply for use in personal and economic pursuits.

This layered rights system created the space for farmers in the agricultural heartland to transfer water to other users willing to pay for it. After a series of droughts in the 1980s, cities and large agricultural producers began to set up long-term contracts to buy this water, which effectively created a water market. Today, the biggest buyers tend to be Southern California cities, San Joaquin Valley farms with higher-value crops, and environmental projects throughout the state.

Critically, the water market isn’t a commodities market in the typical sense. In the case of gold and oil, participants can easily enter and exit the market, leading to price fluctuations. California’s water market is highly proscribed and most trades come from long term contracts. Market participants have to show that they own water resources and there are limits on what the traded water can be used for. Additionally, all purchases and sales are reviewed by a complex system of local and state regulators.

These added transactions costs make quick price jumps all the more likely, which happened this year when the price of water rose from $215.69 per acre-foot to $703.99 per acre-foot between March and June. Buyers and sellers have dealt with this kind of volatility for centuries by inking an agreement to buy or sell a good at a predetermined price, which will be delivered in the future.

The logic of futures contracts is easy to follow. If the market price is below the price of the future contract, then the buyer of the contract will pay the price differential to the seller. On the other hand, if the market price surpasses the contract price, then the seller would take a loss and be required to pay the buyer the price difference.

In the case of the water market, however, only cash will be exchanged and the contract will be limited to three months. However, both of these features give big buyers of water the reassurance that they will be able to smooth out the costs of buying water because they are guaranteed a price ceiling. As Stanford Professor Barton Thompson told Bloomberg Quint, this new market isn’t “changing the risk that exists out there that water in the future at some point will be in shorter supply, it’s simply responding to those things.”

The explicit water pricing is just one method of managing water in Southern California’s arid region, which has had clear benefits. Regional courts are seeing fewer court cases on the topic. Alfalfa and forage crops, which net less revenue per unit of water, are being shifted towards high-dollar crops like winter lettuce and vegetables because water prices are signaling scarcity. Meanwhile, cities in California have been growing in population while shrinking their total volume of water use. Water markets lead to more efficient allocation.

Many have decried the emergence of water markets because they are so repugnant. Water is a right, they claim. By claiming it is a right does not change the fact that it is still a scarce resource that has many different competing uses. Markets won’t solve droughts, but they do help farmers and cities to manage their repercussions.