On 17 September 2020, both CME Group and NASDAQ announced the plan to launch the NASDAQ Veles California Water Index futures contract by the last quarter of the year, subject to a regulatory review. The proposed derivative contract is designed for California, which has a buoyant water market with a total spot or physical market volume of more than $1.1 billion in 2019-20. This is indeed a great move given the uncertaintities that the western US state is encountering with water availability in the face of increasing urbanisation, agricultural and food needs, and industrial demands. The risk associated with water availability gets even more complicated with forces of global warming and climate change. This affects the scarcity value of water, and eventually results in volatilities in prices. Such uncertainty negatively affects urban consumers, creates uncertainties for agricultural water users, and dents the bottomlines of firms. The futures market is expected to align the supply side factors and the demand forces, stabilise price risks, and help price discovery.
The hydrological situations in India in specific and South Asia in general are even more complicated. The seasonal and temporal fluctuations in physical availability of water in South Asia are attributed to the fact that the monsoon months yield 80-90% of the annual precipitation and stream-flows, while non-monsoon summer months are lean-flow periods in a river basin in the Indian subcontinent. The British colonial rulers’ arduous attempts to understand the bell-shaped annual hydrographs of the rivers of the subcontinents as also the natures of the southwest monsoons on the basis of European hydro-meteorological and engineering models could not succeed. Even today, the predictive analytics of meteorology and its science, though improved substantially, is yet to make out the causes behind cloud bursts or flash floods in the Himalayan region.
The seasonal and temporal fluctuations in physical availability of water in South Asia are attributed to the fact that the monsoon months yield 80-90% of the annual precipitation and stream-flows, while non-monsoon summer months are lean-flow periods in a river basin in the Indian subcontinent.
Global warming and climate change have made a complicated problem
complex. This is because of the uncertain impacts that climate change is posited to have on streamflows in river basins and eventually water availability. The uncertainty and knowledge gaps exist for both the Himalayan and the peninsular river systems. Though some
estimates suggest variable impacts of global warming and climate change on the Himalayan rivers of Brahmaputra and the Ganges, another
estimate suggests a large-scale increase over time in the surface flows at their upper reaches. At the same time, the southwest monsoon, the largest provider of water in the region, is predicted to encounter
a large deviation in its seasonality which can impact temporal water availability and is prone to create water conflicts or even aggravate the situation further in zones where conflicts already exist.
On the other hand, there is clear evidence of the changing variability of precipitation in recent years. In one of my
previous research, a comparison of the variability of precipitation during south-west monsoon (given by standard deviation or sd of rainfall) between two phases, 1950-75 (phase 1) and 1976-2010 (phase 2) in two geographically dispersed districts in India, namely, the Tumkur district of Karnataka, and the Medinipur district in West Bengal exposes the same. The sd of precipitation increased from 147 mm in phase 1 to 171mm in phase 2 in Tumkur, while the same was estimated as 220 mm in phase 2 as compared to 188 mm in phase 1. This reveals a higher variation of rainfall in phase 2 as compared to phase 1 in both the districts, thereby implying an increased risk of water availability.
The uncertainty and knowledge gaps exist for both the Himalayan and the peninsular river systems.
Existing risk mitigation strategies
In the background of this painful reality, the existing risk mitigation strategies have largely been related to either supply-augmentation plans with greater interventions over flow regimes through structural interventions and micro-level augmentation mechanisms (e.g. rainwater harvesting), or demand-management mechanisms by the call for reducing water use in agriculture and urban sectors. The costs of supply-augmentation plans are way too many — from social to ecological and across time and space. Micro-level augmentation plans cannot resolve large-scale water problems on long distances, can only offer very localised short-term solutions, and can hardly work in drier parts of South Asia, where precipitation is negligible.
While definitely demand-management is the key to combat long-term water problems at various scales, it needs to be supported by a more holistic institutional thinking that can even compensate in instances where losses are incurred due to unavailability of water. None of the existing strategies do so. Weather derivatives have largely been a failure in terms of market penetration. Crop insurance mechanisms are confined to catering the farm community only, without having any relevance for urban and industrial sectors.
The costs of supply-augmentation plans are way too many — from social to ecological and across time and space.
Water derivative trading, however, is not new in South Asia. A
substantial body of literature suggests the prevalence of informal forward markets for water in many parts of South Asia. But again “forwards” are way too customised contracts to be sufficiently tradable like “futures” that are standardised contracts. It is here that South Asia needs to take a leaf from US in terms of seriously thinking in lauching water index futures.
The benefits of water index futures
It is not only the agrarian sector that is exposed to water risks for their crop failures. Rather, the intermediaries in the supply chain and financers associated with the valuechain are equal stakeholders. These include agro-based industries, marketeers, processors, investors, financial market participants, banks, etc. Interestingly, these are not direct stakeholders of the agricultural waters; neither do they have any desire in procuring or taking physical delivery of water to offset water availability risk. Yet, the loans offered by the lending institutions like banks bear “credit risk” that may get transformed to a “bad loan” if crop fails due to shifting monsoon or shortage of precipitation. The occasional farm loan waiver schemes of farmer-friendly governments in South Asia compound the risk for banks further. On the other hand, an agri-processing unit faces the water risk when a crop failure impedes on its procurement of the raw produce for processing. One needs to note here that the risk of water is not confined to those associated with the agricultural sector. It expands to municipalities/municipal corporations, water boards, private corporates, bottled water plants, soft drinks and beverage manufacturers, etc., for many of whom water risk is tantamount to input market risk. There is no doubt that for all of them in South Asia, a different kind of institution for hedging water risk is needed. Such an institution will not necessarily result in physical delivery of water but will financially compensate under circumstances where physical water availability is impeded.
The risk of water is not confined to those associated with the agricultural sector. It expands to municipalities/municipal corporations, water boards, private corporates, bottled water plants, soft drinks and beverage manufacturers, etc.
A water futures market fills this void. This market should trade in water futures in terms of indices, and the contracts need to be cash-settled without the clause of physical delivery. At the very outset therefore a robust water availability index (WAI) needs to be developed. This is due to two reasons. First, the cost of physical delivery might be prohibitively high so as to deter participation and inhibit liquidity. Second, most of the genuine hedgers are more concerned with covering for the losses due to water scarcity rather than water itself.
Further, the South Asian water futures exchange needs to be a transnational one with an electronic trading platform. This is because many rivers of South Asia cross national boundaries, while water risks within national boundaries have led to interstate or sectoral water conflicts. In that case, the river-specific contracts should be designed keeping in view the needs of the various stakeholders of the river or the system.
The South Asian water futures exchange needs to be a transnational one with an electronic trading platform.
There are numerous advantages of such a futures market. Firstly, it will help discover prices leading to better resource-use-efficiency. Secondly, the futures prices, under efficient market conditions, will reflect on the “scarcity value” of stored water at a future date, thereby assisting future investment decisions. Thirdly, the futures market (or products designed on its basis) will essentially create a market-based insurance mechanism for both irrigated and rain-dependent agriculture against droughts. Fourthly, it will create confidence among investors and banks to pump-in funds in the rural sector, as they find instruments to hedge against the risks associated with their loans/ investments. Fifthly, such a hedging instrument is prone to reduce the biggest social cost, i.e. the social stressor of water conflicts at various scales.
Conclusion
The proposal of water futures in South Asia envisaged in this essay might seem to be a distant dream and a fruit of capricious thinking, but indeed a need for the future. We need new ideas and institutional innovations to combat an uncertain hydrological future. This will require political will and erasement of the political differences between the South Asian nations. The process should begin with placing information on all water-related aspects in the public domain, marking a shift away from the present regime of data classifications. Better analytical methods and instruments for more accurate hydro-meteorological forecasting also need to be developed. These are barely necessary conditions to help in creation of an efficient water futures market to combat our uncertain hydrological future.
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