The financialization of water: has California found an answer to shortage?

Face with water shortage in California, the Nasdaq and the Chicago Stock Exchange are waging on a financial instrument to improve the situation. The two institutions are preparing to launch futures contracts on this precious resource from now to the end of the year. A novel approach but which lacks unanimous support.

 

An innovative solution for a worsening situation

In 2019, the World Resource Institute blew the whistle on hydric stress occurring worldwide, with nearly a quarter of the population faced with extremely severe water shortage. California is particularly affected by this phenomenon. Its large population, the characteristics of its climate and the importance of the agricultural sector make it highly vulnerable to the depletion of water resources. The drought of 2012-2015 left a mark and resulted in the Sustainable Groundwater Management Act in 2014, the first step in regulating groundwater that supplies 85% of the State’s water resources.

Faced with persistent shortages, the CME (Chicago Market Exchange) and the Nasdaq are preparing to launch futures contracts that make water an asset like any other, in the same way as raw materials like oil, and commodities like wheat and cocoa.

These contracts set a price for a future transaction. The price is quoted by the Nasdaq Veles California Water Index, founded in 2018 and based on the purchases of water made the previous week from the State’s five largest water reserves. The price is expressed in dollars per acre-feet, which is to say 1.2 million litres. The value of the transactions on this market, currently estimated at $1.1 billion, should be more legible thanks to these contracts. The contracts will be settled financially and will not involve the physical delivery of the water, meaning that investors cannot purchase in advance or amass water reserves.

This innovation is intended to protect large water consumers, municipalities and farmers against market volatility. In spring, the price of water tripled following a severe drought during February. The intensification of climatic variability drove the CME to develop environment-related risk management tools, such as these contracts. Carter Malloy, the founder of AcreTrader, an agriculture investment platform, told Bloomberg that “the lack of visibility regarding prices is the big challenge of the moment”.

It should also make it possible to provide more precise information on the availability of water.

For Tim McCourt, financial index manager at CME “the fact of having a solid and transparent futures market for water will contribute to aligning the supply and demand of this vital resource”.

A lack of unanimity

However, not everyone has reacted favourably to this innovation. Certain academics and investors have pointed out the system’s inefficiency and the ethical problem it raises.

The market is extremely localised and therefore risks being limited. The water rights that are currently traded every year amount to no more than 4% of total consumption in California. Nor can investors consider trading beyond the State’s borders, given the nature of the resource and regulations specific to each territory. “Drought in one region has little chance of influencing availability in another” said Aanand Venkatramanan, ETF investment strategy manager at Legal & General Investment Management.

Therefore, risk coverage will be rather poor. Jon Reiter, founder of Calvarey, a consultancy specialised in agriculture and water, is rather in favour of this financial tool; nonetheless he pointed out that “farmers will always have to purchase water at the cash price during drought because the contracts do not allow complete control over volumes of water or the lead-times of their availability as a function of need”.

The limited efficiency of this innovation leads Mike Wade, the executive director of the NGO California Farm Water Coalition, to say that it is an investment instrument rather than a management tool such as the European carbon market. Since the market is open to actors other than the main users, investors who seek only to make a profit could participate in the auctions. The organisations hostile to the system fear the deformation of the value of water and increased prices for all the consumers.

Lastly, some are opposed to the very principle of transforming water into any kind of financial product. They declare that water is our most basic resource, and that it should be kept outside financial markets as much as possible.

In Australia, water has been a financial product for several years. The Water Act was adopted in the 1980s, allocating quotas to the largest users (cities, farmers, industrial companies) and authorising the financialization of water. The CEO if Waterfind, the world’s largest water exchange, suggested that giving a price to water can be  a good thing: “by fixing a price for it, we’ll learn to respect it better”. However, the financialization of blue gold has had disastrous effects in Australia. Exposed to speculation, water has become inaccessible to certain farmers, who have been forced to sell their farms since they can no longer obtain supplies.