Testing the efficiency of dry-year water options with market experiments

February 10th, 2014

Kristiana Hansen (University of Wyoming), Jonathan Kaplan (California State University Sacramento) & Stephan Kroll (Colorado State University)

Water markets have become an increasingly common method for transferring water from existing uses (e.g., low-value agriculture) to higher-value uses (e.g., urban water supply). Water transactions typically take the form of water rights transfers, entitling buyers to the water associated with a water right every year in perpetuity; on the other hand, spot leases give buyers short-term access to specified amounts of water. Urban water agencies, primarily concerned with securing reliable water supplies, prefer water rights ownership to reliance on spot leases or even multi-year lease contracts. These goals among water agencies are confounded by uncertainty over water supplies, stemming from intertemporal variability in precipitation throughout many arid regions of the world.

Urban water agencies have developed types of flexible contracts to address reliability concerns; for example, the dry-year option allows urban water agencies to pay a premium before the rain season for the right to purchase water after the rain season if annual precipitation turns out to be below a pre-specified threshold level. These types of contracts have been implemented on a bilateral basis in California. For example, the California Department of Water Resources even implemented a Drought Options Bank at the tail end of a multi-year drought in the 1990s.1 These dry-year options are a form of water leasing; the underlying water right remains with the original owner, and water is only transferred in select years. The option value represents the value to the buyer of sharing the risk of water supply variability with the seller.2

Dry-year options can be preferable to water rights transfers because the right remains with a farmer who is often reluctant to relinquish water rights forever, and because the third-party costs associated with fallowing fields in the exporting basin (for example, reduced employment and local processing services) only occur during years in which water is actually transferred. Dry-year options can be preferable to a spot lease arrangement, as contracting occurs just prior to end of the rain season, when buyers face imminent water shortage and sellers are under pressure to make planting decisions (or already have made them).

While introducing an option market to an underlying forward contracting market could result in efficiency improvements3, several questions remain. Would adding the possibility of dry-year options facilitate the transfer from low-value to high-value users compared to a situation in which only water rights transfers and spot leases, but no dry-year options were permitted? How would these efficiency improvements be distributed among buyers and sellers? How would a dominant buyer alter market outcomes, with and without the presence of dry-year options? Answering these questions would lessen the uncertainty about how such markets would work.

However, lack of real-world data on dry-year options makes them difficult to study using conventional statistical analysis. We instead implemented a laboratory experiment to explore how dry-year options might affect trading outcomes.4 Experiments give policy-makers the opportunity to test alternative market institutions under controlled conditions, allowing for detection and mitigation of design problems before potentially costly institutions are implemented.5

In each of our experimental sessions, participants use water as input into a profitable production process. Half of the participants are able to purchase additional units of water from the other half through a continuous double auction. Participants trade water in a computerized market environment with reference to heterogeneous value functions assigned to them at the start of the session. Trading occurs for 20 periods. In each period water conditions have a 1/3 probability of being dry, normal, or wet. The number of water units endowed to participants at the start of each period is a function of the water year type (with fewer units in dry years).

One might expect more trades to occur during dry years relative to wet because water’s value is sufficiently high that buyers are willing to pay more for water, and sellers are able to command higher prices in the market than the water is worth in the underlying production process. Yet, since participants do not learn whether conditions are dry, normal, or wet until the conclusion of each period, they trade water without knowing its true value to them, just as urban water agencies must often operate under conditions of uncertainty in acquiring supplies to meet their excess demand.

Four experimental scenarios were undertaken to test the relative efficiency of dry-year options. In two of our scenarios, buyers (sellers) are able to purchase (sell) options in a second, concurrent double auction. Once each trading session ends and participants learn whether conditions were dry, normal, or wet for the period, buyers may choose to exercise options purchased during the trading session, for a pre-specified strike price equal to the expected value of a water unit in a normal year. Also, two of the scenarios have a single, dominant buyer rather than many competitive buyers. The four scenarios consequently vary by whether options can be traded and whether the market is competitive or concentrated.

Results indicate that an option market increases efficiency, as measured by participants’ aggregate session earnings. Buyers tend to exercise options in dry years, when water units are most valuable; the higher earnings associated with options are realized during dry periods, reflecting participant use of options to manage supply risk. This finding suggests that the benefits of an option market might be sufficiently large to counter the economic, political, and administrative costs associated with its introduction.

Dry-year option markets result in higher efficiency in monopsony markets as well as competitive markets; monopsony markets are characterized by markets with few buyers. This is an important finding for settings like California, in which a large buyer, specifically Metropolitan Water District of Southern California, is present. The results also indicate that overall earnings are lower in dominant buyer markets relative to competitive markets. The higher earnings associated with option markets may offset the lower overall earnings associated with the presence of a large buyer. The markets described here are thin (i.e. there are few potential traders present), as are many input markets. The results show that it is possible for thin markets to converge to relatively competitive price and quantity levels in the presence of input supply risk.

We also find that option trading equalizes the distribution of earnings between buyers and sellers, suggesting that dry-year option markets may be a politically viable alternative for policymakers who must be sensitive to equity as well as efficiency concerns.6 Water agencies and policymakers in water-short regions are likely to benefit from considering greater use of dry-year water options because such flexible contracting arrangements allow negotiation to occur well in advance of need and compensate sellers for sharing water supply risk.

References:

1. Jercich, S.A., (1997), “California’s 1995 Water Bank Program: Purchasing Water Supply Options.” Journal of Water Resources Planning and Management, 123:59-65.

2. Howitt, R.E., (1998), “Spot Prices, Option Prices and Water Markets.” In: Easter KW, Rosegrant MW, Dinar A (eds) Markets for Water: Potential and Performance. Kluwer, Boston, pp 119-140.

3. Tompkins, C.D., T.A. Weber, (2009), “Option Contracting in the California Water Market.” Journal of Regulatory Economics, 37:107-141.

4. Hansen, K., J. Kaplan and S. Kroll, (2013), “Valuing Options in Water Markets: A Laboratory Investigation.” Environmental and Resource Economics, 57(1):59-80.

5. Murphy, J.J., A. Dinar, R.E. Howitt, S.J. Rassenti and V.L. Smith, (2000), “The Design of “Smart” Water Market Institutions Using Laboratory Experiments.” Environmental and Resource Economics, 17:375-394.

6. Libecap, G.D., (2010), “Water Rights and Markets in the Semi-Arid West: Efficiency and Equity Issues. International Centre for Economic Research Working Paper 30-2010.

Kristiana Hansen is an agricultural and natural resources economist and extension water resource economics specialist in the Department of Agricultural & Applied Economics at the University of Wyoming. Jonathan Kaplan is an associate professor in the Department of Economics at California State University Sacramento who specializes in the application of experiments and simulation modeling techniques to examine water resource and agricultural issues. Stephan Kroll (Department of Agricultural and Resource Economics, Colorado State University) is an environmental and resource economist who uses laboratory experiments extensively to test the efficiency and acceptability of market institutions and environmental policies.

The views expressed in this article belong to the individual authors and do not represent the views of the Global Water Forum, the UNESCO Chair in Water Economics and Transboundary Water Governance, UNESCO, the Australian National University, or any of the institutions to which the authors are associated. Please see the Global Water Forum terms and conditions here.