Find out all about water trading and how it can help solve the issues of efficient distribution and sustainability.
During the third week of September this year, the Economic Times published a news article saying that the NITI Aayog will place a draft recommendation paper looking at various trading instruments for water for public consultations. Such instruments will entail spot trading and derivative instruments like futures trading of water and also tradable licenses.
The news, by itself, carried impressions from some stakeholders of the exchange ecosystem, who expressed apprehension about the feasibility of such trading given its political sensitivity, despite acknowledging that it is a "good idea".
This idea deserves much more discussion and debate at a policy and academic level, but except for an informed deliberation by Roopa Madhav and Aashirvad Dwivedi in The Mint last week, nothing really has come out.
There is no doubt that water trading is not going to be devoid of the intangible transaction costs. This "intangible transaction cost" will arise in the form of "wealth effects" or "income effects".
As per the classic definition of "wealth effects" provided by Paul Milgrom and John Roberts in their 1992 volume, wealth or income effects prevail when an individual faced with a choice to change or replace his position (or preference) with some other position (or preference), still sticks to his initial position.
The existence of income effects often makes individuals or groups overlook a more profitable proposition. In the case of water being traded at bourses, the situation will be more akin to the existence of such wealth or income effects.
Our water is not for sale rings from certain corners which may be grounded on religious or even anti-market or socialistic ideologies.
Water trading is not only politically sensitive, it is socially and ideologically sensitive too. These also have religious connotations. Therefore, there remains a very high resistance to water trading with a loud call. Our water is not for sale rings from certain corners which may be grounded on religious or even anti-market or socialistic ideologies. This is a clear reflection of the existence of "wealth effects".
From an equity and distributive justice perspective, there are, of course, apprehensions that development of such water markets will be iniquitous and the ruthless market forces will deprive many of the fundamental basis of life.
On the other hand, most arguments placed in favour of setting up derivatives markets in water are related to the efficiency element. The arguments are largely based on the fact that such derivatives markets can align demand-supply forces, bring in more certainty in price movements, and help price discovery.
First, prices discovered in the water futures market can lead to efficient water allocation across sectors, thereby helping achieve social optimality in consumption and production. Second, water futures prices can help rationalise investment decisions in water infrastructure.
Third, such derivatives markets help the farmer community to use the market (or products derived from the market) to hedge themselves against risks in water availability. In that sense, it can act as an insurance product, thereby shifting the load of insuring the farm sector from the governments in the developing world to the private sector.
From an equity and distributive justice perspective, there are, of course, apprehensions that development of such water markets will be iniquitous and the ruthless market forces will deprive many of the fundamental basis of life.
Fourth, derivatives trading in water also render the bandwidth to investors and banks to confidently invest in the rural economy, as they can also hedge their weather (especially water-related risks of their investments) risks in the innovative financial instruments linked with water. Fifth, a water futures market will help in promoting the best water-efficient technology.
All the above five points are related to the efficiency dimension of development as stated earlier. However, I would like to emphasise here that water futures trading also has the sustainability and the equity dimension built in it, if the markets are made to work properly with the right type of regulation.
The sustainability dimension emerges from the fact that if the water futures markets are truly efficient, then the future price discovered reveals the scarcity value of water. In that sense, the markets offer a way to reflect on the future physical availability or scarcity of water through the pricing mechanism. This helps in setting the right conservation priorities for the resource, taking into consideration the broader concerns of the landscape and the basin ecosystem.
The equity dimension arises from two sources one is for the rural farmer getting market-based protection like weather insurance even if they do not participate in the future markets, and second is creating processes and institutions for private investors to focus their investment in the largely ignored rural farm sector, thereby helping the cause of the rural poor.
Now, it is up to the governments and the regulator to prioritise water use for the basic needs, and that concern should be addressed by all means beyond the market framework. The creation of water markets is neither inhibitive nor inimical for the governments to play their own important roles in promoting distributive justice in water allocation for meeting basic human needs.
Therefore, if realised properly, water trading can be in conformity with reconciliation of the so-called irreconcilable trinity of equity, efficiency and sustainability, often considered the fundamental basis of the Sustainable Development Goals (SDGs).
One issue that has been raised by Madhav and Dwivedi is whether such trading should be rights-based. Indeed, that is an important concern. At the very outset, it needs to be acknowledged that if at all such trading takes place, it has to be cash-settled rather than being delivery-based.
Physical delivery based contracts will only increase the transaction cost of participation in the bourse, and will negatively affect liquidity of the contracts.
The creation of water markets is neither inhibitive nor inimical for the governments to play their own important roles in promoting distributive justice in water allocation for meeting basic human needs.
In a recent paper, I already showed how an index-based water futures contract can be traded, and this need not be associated with the physical market position of a market participant. Rather, the valuation should be based on the value of the associated product, as water is largely an input in the production process or in a utility function.
In that case, the initial allocation or rights is not relevant, but the index-based contract acts more as an insurance product that compensates the hedger during times of water crisis. This can be made possible through a Water Availability Index (WAI) as explained in the paper.
The second concern raised by Madhav and Dwivedi is with respect to water conflicts. In fact, futures trading can help in resolving many of the interstate water conflicts. A 2009 paper published in the journal Water Policy shows that water conflicts are more direct functions of the scarcity value of water rather than physical scarcity of water.
The Observer Research Foundation (ORF) paper mentioned above already shows that water derivatives trading can help reduce the scarcity value of water, and help the process of conflict resolution. There are other concerns of cartelisation, and market cornering that have been the perennial concerns of exchange-traded products. Modern regulatory mechanisms and instruments have already emerged to combat such issues in the case of most exchange-traded products, including commodities.
Water markets cannot be an unmixed blessing. It will have its own pitfalls. This brings in the importance of regulation. The big question here is: who will be the regulator?
This is because water derivatives instruments, when traded in an economy like India, need different types of expertise than mere financial or money market regulation. The regulator needs to have knowledge of water, the associated basin ecosystem, the waterscape, and also about the financial products. Such a knowledge base and skill-set is indeed rare in India!
This commentary Origially appeared in India Today.
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Dr. Nilanjan Ghosh is a Director at the Observer Research Foundation (ORF), India. In that capacity, he heads two centres at the Foundation, namely, the ...
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