This policy brief is part of a volume entitled “The Future of Water Markets: Obstacles and Opportunities,” published by PERC, which addresses timely water policy issues and offers ideas to enhance the future of water markets.
The American West has always been plagued with oscillating periods of dry and wet years. As a result, water users naturally face a level of risk and uncertainty associated with their water supplies and costs. In December 2020, the CME Group launched the world’s first futures market for water—the Nasdaq Veles California Water Index (NQH2O)—in an attempt to help buffer water price risk. The futures market is intended to provide a way for California water users to protect against fluctuations in the price of their water. The importance of this financial instrument is even greater in the face of climate change, which is predicted to bring more extreme and more variable weather.
The academic literature on futures contracts has established that commercially successful contracts meet several criteria. The most obvious are that a futures contract must serve as a hedging tool and attract speculator participation. In the case of California water futures contracts, however, spot market design may impede the futures market from successfully hedging risk and attracting market participants. Three factors in particular could prevent the futures market from becoming a commercial success: a thin underlying spot market, a lack of sufficiently inclusive price information, and minimal storability. Several policy reforms could increase futures market liquidity and improve its chances for success.
Highlights
- Water users naturally face a level of risk and uncertainty associated with their water supplies and costs. Futures contracts can allow them to hedge their risk by locking in a price today for water they will need in the future, eliminating uncertainty in the price.
- In the case of California water futures contracts, a thin underlying spot market, a lack of sufficiently inclusive price information, and minimal storability may impede the futures market from successfully hedging risk and attracting market participants.
- Several policy reforms could increase futures market liquidity and improve its chances for success.
Recommendations
- Increase liquidity with streamlined processes.
- Expand inclusiveness with better data.
- Improve storability through regulatory innovation.
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