California Water on the Market: Q&A with Barton “Buzz” Thompson

By Felicity Barringer

California water has joined gold, energy and bitcoin as a commodity whose future value can be traded on a financial exchange and the first market trades on water futures took place three months ago. The market, based on values determined by NASDAQ’s Veles Water Market Index, was hailed by some as a useful tool so California farmers can reduce the risk of drought-driven escalation in water costs. It was sharply criticized by others, from a United Nations representative to racial justice groups as potentially limiting access to something essential to life.

Buzz Thompson, a Stanford Law School professor and founding director of the Woods Institute for the Environment, now directs the Water in the West program. He founded the law school’s Environment and Natural Resources program and served as a special master for the United States Supreme Court in Montana v. Wyoming, an interstate water dispute involving the Yellowstone River.

Here are his answers to questions about the development of thinking about water’s value and the possible impacts of this market in water futures.

Water is essential for life, the growth of communities, agriculture, and streams and their fish. California has about 40 million people and an agricultural economy worth $47 billion. How has the value of water fluctuated?

The “value” of water is a contentious issue. In some people’s mind, water cannot even be valued in economic terms because of its importance to human life and health and to the environment. Beyond the ethical questions of valuing water, the economic value of water and its price generally diverge. Water was the subject of Adam Smith’s famous water-diamond paradox. Because we need water to survive, the value of water is the value of life itself. Someone without any water would give everything they have for that water. But despite its high value in use, water typically has a relatively low market price because it is often abundant. Diamonds, by contrast, are luxury goods. Their actual “value” is quite low, but since they are rare, they command very high prices. Water therefore has a higher value in use, but diamonds cost more.

When most people talk about the “value” of water in California, they are asking about its price in the state’s fledgling water markets. How much does a farmer have to pay to get more water for her thirsty crops? How much does a city have to pay to ensure that it has the water needed for its residents. Prices have varied tremendously. From 2012 to 2020, for example, water users paid anywhere from $50 an acre foot for water to $2200 an acre foot. (Water managers in the West generally measure water in terms of acre-feet, which is the amount of water that would flood an acre of land to a depth of one foot. It is roughly equivalent to the amount of water to meet the needs of two households for a year.)

What has determined water’s value in any given situation?

Elk graze the dry bed of the San Luis Reservoir on the eastern slopes of the Diablo Range in Merced County, California in August 2016.   John Chacon / California Department of Water Resources

Scarcity has been the principal determinant of water prices. From 2012-2016, severe drought conditions drove some farmers to pay astronomical sums for water to keep permanent crops, like fruit trees or vineyards, from dying. That’s when you saw prices soar over $2,000 per acre foot. Indeed, during the height of the drought, farmers were willing to pay more for water than cities. Anything that leads to water scarcity will increase the price of water. Not only drought, but environmental protections like the Endangered Species Act, which reduce the amount of water that can be withdrawn from the state’s rivers and streams, push up the price.

California’s Sustainable Groundwater Management Act (SGMA), which will require Californians to reduce their pumping of groundwater to sustainable levels, will also lead to higher prices because it will lead to lower supplies. Demand is also a determinant. Because domestic water needs are relatively small, human use does not generally influence the price of water. Permanent crops like fruit trees, nut trees, and vineyards, however, help drive up the price of water during dry periods because farmers do not like to lose their investment in permanent crops.

Which variables have been most important to water’s value?

Two variables have been most important. The first, as just mentioned, is scarcity — whether from weather conditions, droughts, or regulatory measures. Water users are very concerned that a series of regulatory changes (reduced groundwater pumping as a result of SGMA, reduced diversions as a result of an update in the state’s Bay-Delta Water Quality Control Plan) could make water very scarce in the Central Valley, sending water prices there soaring. The second variable has been the hardening of demand. Historically, most farming in California was perennial crops like tomatoes and cotton. In droughts, farmers just planted less. Today, however, more and more acres are planted in permanent crops. Farmers are willing to bid much more for water to keep those crops alive.

Can we have a robust water futures market here, given the widespread lack of quantification or adjudication ensuring clear ownership?

We need to be careful when we talk about “water futures.” Water futures could mean a contract under which someone with a water right agrees to sell that water at a future point in time for a price that’s set today. By this definition, California has long had a limited form of futures market. The Metropolitan Water District of Southern California (MWD), for example, which supplies water to cities in the Southern California coastal plain, has an agreement with the Palo Verde Irrigation District (PVID) under which farmers in PVID agree to sell water during dry years to MWD. In this sense, we have long had a “futures” market in water.

What is new in California is a new futures derivative market by which all water users can hedge against increases in water prices. Now any water user who is worried that they might have to buy water at very high prices in the summer, if it doesn’t rain, can hedge against that increase. To do that, the water user buys a future for the price at which the market currently believes water will sell when the water user will need it. When the future expires, the water user gets the current price. If the price has risen, the water user gets more than he or she paid; if it dropped, the water user gets less. Importantly, this is not a future for the water itself. The water user must still find someone on the open market from whom to buy. If the price has gone up, the water user will now have more money to buy it.

The effectiveness of these new water futures depends on how accurately the futures track the real market price. The payout will be based on a composite of prices tracked by a private entity (WestWater Research). So anyone buying a future is betting on the accuracy of their calculations. In addition, remember that the value of water depends on location. The future is based on a composite, so it’s possible that the composite price might not rise as much as the price of water in a particular location — in which case water users who purchase the future will not be fully hedged.

Financial trades based on the future value of a commodity are a longstanding practice with metals, wheat, and energy. Now that California water futures are tradeable, will trades affect water’s value and availability? Will Californians pay more so traders get their cut? Or will trading stabilize their costs?

The fear, of course, is that the new futures market will increase the price of water during shortages by bringing speculators into the market. For decades, politicians and market critics have often blamed futures markets and speculators for run-ups in commodity prices. The evidence from other markets, however, does not support this contention. Supply and demand considerations will continue to determine the price of water on the open market in California, and changes in conditions will continue to lead to often large swings in water prices. The new futures product will simply allow water users to hedge against the risk that the price of water will rise before they need to buy more. While others are free to “bet” on the price of water by buying and selling futures, there is no reason to believe that this speculative trading will affect the actual price of water.

Water is heavy. State and federal governments have spent hundreds of millions of dollars on infrastructure to store, treat and move it. Will access to this infrastructure play a role in these trades?

The John R.Teerink Wheeler Ridge Pumping Plant, part of the state-run California Aqueduct in Kern County.   State Water Resources Control Board

Infrastructure availability does influence water prices. Water is not worth as much if you can’t get it to where the water is needed. So the price of water is highly local. Water in the Sacramento Valley, for example, is relatively more plentiful than water in the San Joaquin Valley. As a result, prices are lower in the Sacramento Valley.

California actually benefits from the large amount of water infrastructure that it has built. It allows water to move around the state as demand changes. In the Central Valley of California, there are two massive water projects (the federal Central Valley Project and the California State Water Project). In most times, their water rights are separate, limiting to some degree the ability to move water from one system to another. During droughts, however, California has often merged the water rights, so that it is easier to move water from one system to another. This has allowed water to flow the most needy areas, reducing the cost of droughts and other water shortages.

A Bloomberg columnist, David Fickling, recently wrote, “A price on low-value public resources is crucial to encouraging less profligate use.” True?

Sprinklers spread water on residential lawns in Bakersfield, California in 2015.   John Chacon/California Department of Water Resources

The price of water is frequently lower than its actual value to society. Indeed, water is the only important commodity for which we do not charge people! When you buy water from your local supplier, you are typically paying only for the cost of treating the water and getting the water to you. You do not pay for the water itself, which the state effectively gives away for free. But taking the water out of a river or groundwater aquifer often has a significant opportunity cost to society. For example, extracting water from a river can harm the local ecosystem. Some water suppliers even subsidize the cost of water.

To get people to conserve and to encourage effective water management, we should charge people the true value of the water that they use. This, of course, raises the concern that poorer members of society will not be able to afford it. The answer to is to charge people for water based on how much water they use — what is known as an “inclining block” rate structure. In my ideal world, water supplies do not even charge people for a small amount of water. California has recognized that there is a “human right to water,” and that right should include free access to the amount of water needed for a minimum standard of living.

Once one gets beyond this human right, however, water users should charge people more and more per gallon as they use more. People who are conservative in their water use might pay $X per gallon, but the most profligate users would pay $10X per gallon for their excess use. A large number of water suppliers in California are using these types of rate structures, but they generally do not charge the largest users enough to really make a difference in their calculus. California law, moreover, has made it difficult for other water suppliers to adopt such pricing structures.

Generally arguments revolve around who should pay. Polling has shown that the general public would support a small fee on their water bills to help pay for safe water for all. The water utilities were adamantly against it, seeing it as the “camel’s nose under the tent” for a bigger set of fees like we have in the energy arena, which is understandable but unfortunate. But using general funds for ongoing operations and maintenance is risky. It puts something that must be continually on deck into an annual argument over the general fund, competing with every other human-services need out there out of a pot of money whose size varies considerably, depending upon the economy. No matter the economy, people need clean, safe, and affordable water and sanitation.

Ellen Hanak, a water expert, said that investing in water futures is simply “betting on the weather.” Is she right? What else do traders bet on?

Ellen’s point is an excellent one. Remember that California’s new water futures are really just a financial derivative. They are not a contract for water. Instead, they are a bet on the future cost of water. As a result, anyone who invests in a water future is really “betting on the weather,” which is typically the primary determinant of future water prices. In theory, investors are betting on any factor, including regulatory changes, that might change the future price of water. Because water futures currently focus on relatively short-term changes in price, weather is the major bet.

Which category of water user will be most likely benefit from these trades? Corporate farmers? Small family farmers? Small towns? Who will be hurt?

An almond orchard north of the Sutter Buttes in Calif. on February 24th, 2015.   Kelly M. Grow/ California Department of Water Resources

The major water users who will benefit from water futures are those who can afford to pay for water futures. Remember that futures can go both up and down in value. If you are a small farmer, you might not invest in a water future because you do not want to risk losing the money you paid for the future if it suddenly rains a lot. I therefore expect that the beneficiaries of water futures will tend to be corporate farmers and other large users of water. In my view, the major losers will be those people who “bet” on water futures for speculative purposes and bet wrong. It’s hard to get too upset about them.

What’s your biggest hope for the impact of this market? Your biggest fear?

My biggest hope for the futures market is that they will actually help some water users hedge against changes in water prices and therefore take some of the risk out of their businesses. Futures derivatives are a form of risk insurance, and if they work properly, they can reduce the risk of engaging in societally valuable businesses. Farmers already participate in a variety of futures markets in order to reduce their risk. The new water futures are an addition to this portfolio of risk-reducing derivatives.

My biggest fear is that politicians and other market critics will seize on the new water futures as an indication that water markets are a danger to society and try to shut down or increase controls on such markets. Water futures and water markets are two different things. Water markets existed before the new water futures and are an important way by which society can ensure that water, particularly as it becomes scarcer, is used wisely. Water markets need to be carefully regulated to protect the human right to water and the environment. But with appropriate protections in place, water markets are an exceptionally important and valuable tool.

 

 

 

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