Production choices with water markets and risk aversion: the role of initial allocations and forward trading

We develop a theoretical model that describes risk-averse farmers'decisions whenfacing production risk due to uncertain weather conditions and when irrigation watercan be traded on a market. We focus on the role of initial water allocations granted toirrigated farms at the start of the season. The presence of water markets makes thefuture water price uncertain and hence the value of initial water allocations uncertain.We analyse the properties of this background risk and study how initial water alloca-tions impact farmers'land allocation decisions between an irrigated crop and a non-irrigated crop, both characterised by random expected net returns. We then extend themodel by permitting irrigation water to be traded ex-ante at a known price (forwardmarket). Finally, we illustrate our main theoreticalfindings using simulations. We cali-brate distributions of the random variables based on observed data from the Murray–Darling Basin in Australia where a water market has been in place for several decades.