Option Markets for Water in California: Effective Management of Water Supply Risk

In California, the tremendous spatial and temporal variation in precipitation suggests that flexible contractual arrangements, such as option contracts, would increase allocative efficiency of water. Under such arrangements, a water agency pays an option premium for the right to purchase water at some point in the future, if water conditions turn out to be dry. The premium represents the value of the flexibility gained by the buyer from postponing its decision whether to purchase water. In California, the seller of existing option arrangements is often an agricultural producer who can fallow land in the event that a water option is exercised.We seek to determine the value of transferring water supply risk from one party to another at key locations in California, given current water prices and the spatial and temporal distribution of water year types in the state. We utilize output from CALVIN, an economic-engineering optimization model of the California water system, to construct a mathematical programming model that runs historical hydrological conditions over the current configuration of the California water system.Our model allocates water between current-year agricultural and urban demand and future anticipated excess demand without knowledge of future water conditions. This limited foresight and the consequent storage levels results in a distribution of water’s imputed price at different locations throughout northern California. We utilize these distributions of water price to calculate annual option premia at key locations in California. Analysis performed to date covers northern California