‘Futures trading can bring efficiency to California’s water sector’

Chicago-based CME Group began trading in water as a futures commodity on Wall Street December 7, 2020. The company’s contracts are tied to the $1.1 billion California spot water market.

The CME Group is “the world’s leading and most diverse derivatives marketplace offering the widest range of futures and options products for risk management”, according to its website.

The contracts were announced in September as heat and wildfires ravaged the US west coast and as California was emerging from an eight-year drought.

After the move, water has officially joined gold and oil as a commodity being traded on the stock market.

Michael Kiparsky, director of the Wheeler Water Institute at the Center for Law, Energy & the Environment, University of California, Berkeley School of Law, spoke to Down To Earth about the long-term challenges and benefits of water trading.

Rajit Sengupta: Does trading water pose a risk to traditional stakeholders, especially small farmers?

Michael Kiparsky: Though there are risks involved, fears that the new index will commoditise water seem overblown to me. Farmers or stakeholders who are unsure can just stay out of the futures market and will not be affected if somebody else is making or losing money based on this index.  

The index could, in concept, be useful to agricultural producers. They could hedge their risk by investing in this broader water index, so that in a dry year, when their crops are poor, low profits can be offset if the index increases in value.

All of this, however, depends on how liquid and representative the index is going to be, how it correlates with conditions that matter to these participants, how many people participate in it and so on.

RS: Is this a worthy solution to the water crisis in California?

MK: Economic and financial instruments are likely to have a very important role in improving how California’s water on the whole is managed and how its systems are made more efficient and effective. But they are only a part of what needs to be a very multifaceted set of solutions.

Crucially, financial and market-based instruments will need to be carefully designed and operated with very close, adaptive oversight if they are to succeed.

Without that, we will be stumbling forward and the law of unintended consequences will rear its ugly head. We haven’t figured this out in California yet and the path forward is not yet fully apparent. But a part of it will need to involve a lot more clarity and foresight.

The challenge is that there are problems that could be revealed only when the damage is already done. However, a challenge is that if you put too many safeguards, you increase the transaction cost and lose the potential benefits of having a market.

We need to have a clear understanding of the goals of markets and financial instruments for water. These goals and their approaches need to be transparently articulated.

Sufficient information needs to be produced and made available and we need institutions that are effectively designed to support broader societal goals and manage these new approaches accordingly.

RS: What do you mean when you say that sufficient information needs to be produced?

MK: There is a lot of data opacity in California when it comes to the water sector. We do not know how much water is available to use, or who has the right to use it relative to all the other users, at any given time.

What information we do have is not contained in formats that allow for clear, careful, transparent, and timely analysis of where that water is.

In California, the state is working to make data available, which is a great thing. But startups entering this field are learning to process and analyse disjointed data to serve particular customers.

That is one way innovation will emerge from the increased availability of data. As mentioned earlier, you have to balance the question of information asymmetry.

For example, such for-profit, private sector efforts will, of course, need to make money and as a result, certain constituencies with greater means might end up with better access to data that could give them a competitive advantage.

Equity is, as always, an important concern for water. One way to think of this is that if we are creating a better playing field, is it going to be equally accessible to everyone?