Water is about to hit financial markets for the first time, with the launch of futures contracts tied to prices in California. But academics and investors fear the derivatives will offer a poor hedge for water users and may end up distorting prices for the vital resource.

Developers CME Group and Nasdaq say the contracts will help farmers, municipalities and other big water users to hedge their water costs as the world warms up and droughts become more common. Senior US regulators have welcomed the contracts as a risk-management tool.

But critics say the contracts may prove difficult to trade, given the highly localised nature of water pricing and regulation. Some are also uneasy with such a basic resource becoming a speculative financial-market asset, fearing that trading, which would not be restricted to industrial users, could distort water prices for everyone.

“The one asset class that I don’t want to see open to potential manipulation or upward price pressure via financial markets is the one resource that all of humanity needs for its survival,” said Simon Puleston Jones, former head of Europe at the Futures Industry Association, a US trade body.

“We need to think now about the potential direct and indirect negative consequences of treating water as an asset rather than a resource.”

Under the plans, announced last month and now pending regulatory approval, futures prices will be derived from the Nasdaq Veles California Water index, tracking the spot price based on trading in water rights — entitlements to divert water from natural sources — in the state’s five largest water markets. They will be financially settled, meaning traders never take physical delivery and cannot forward-buy or stockpile water. 

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But the contracts may prove tricky to trade, since the market is likely to be small.

Line chart of Nasdaq Veles Water index ($ per acre foot) showing Price of water in California rose during this year's drought

“It’s not a global water market. It’s not even a state water market. It’s barely really a regional water market,” said Peter Gleick, president emeritus at the Pacific Institute, a think-tank. Water markets tend to be local since the resource is difficult to move, he added.

California water rights change hands through short and long-term leases and sales. But each year only about 4 per cent of the water used by cities and farms in the state — or 1.85bn cubic metres — is traded, according to California’s PPIC Water Policy Center. Nasdaq water index prices for 2019 were based on contracts equivalent to 833m cubic metres of water, enough to fill over a third of a million Olympic swimming pools, but still just 221 transactions.

Ellen Hanak, vice-president of the PPIC Water Policy Center, said futures could theoretically help farmers hedge water costs in the short term, but added that one key issue was “how liquid the futures market will be”.

Aanand Venkatramanan, head of ETF investment strategies at Legal & General Investment Management, pointed out that governments often subsidise water and that prices vary by location. It would be “pretty much impossible” to use Californian water futures to hedge the price of water elsewhere, and scarcity in one region is unlikely to influence availability in another, he said.

One concern is that speculative trading by hedge funds could drive up the cost of water for the population of California. A 2009 report by the International Food Policy Research Institute found that speculative, short-term trading may have helped drive rising agricultural commodity prices in 2007-08.

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The developers of the new futures said some degree of speculative trading was an important part of creating a vibrant market for those seeking to hedge water costs. “It’s important to keep in mind that hedgers and speculators go hand in hand. If you took one away, there simply would be no market,” said Tim McCourt, CME’s global head of equity index and alternative investment products.

“There are many factors that can impact spot water market prices, including supply and demand of physical water, weather and others,” he said, adding that a “tremendous” amount of risk management was essential for users of this crucial resource.

Unlike carbon credits, which attach a cost to CO2 and aim to reduce emissions, water futures have not been designed to prompt users to cut back on water use to address a scarcity problem.

“This type of water futures market is an investment tool more than a water management tool,” said Mike Wade, executive director at the non-profit California Farm Water Coalition. “There likely will be non-farm people who try it out to see if there’s money to be made.”

Jon Reiter, founder of agricultural and water consultancy Cavalrei, said something that helped farmers hedge their risks was needed. Farmers would still need to buy water at the spot price during a drought, he added, since the contracts do not enable forward-buying. Still, futures trading could be used to smooth out some of the pain from rises in costs, he said.

An options product that gave users the right to forward-buy water for delivery under certain conditions would be “more interesting”, Mr Reiter argued. The current futures, he said, were “not a whole heck of a lot more than betting on the weather”.

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Via Financial Times