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Implementing Options Markets in California To Manage Water Supply Uncertainty

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  • Hansen, Kristiana
  • Howitt, Richard E.
  • Williams, Jeffrey C.

Abstract

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 over time and space. 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. In this simulation-optimization approach, we seek to determine the value of transferring water uncertainty from one party to another at several locations in California, given current water prices and the spatial and temporal distribution of water year types in the state. (Preliminary analysis covers northern California; future analysis will incorporate southern California.) We analyze within a mathematical programming framework whether increased trading among water agencies across time as well as space would result in significant gains from trade. We use output from CALVIN, an economic-engineering optimization model of the California water system which runs the current configuration of the California water system over historical hydrological conditions, to generate water's imputed price at different locations during different seasons. We also explore reasons why previous theoretical calculations of option value in the western United States have far exceeded option premia on existing bilateral contracts.

Suggested Citation

  • Hansen, Kristiana & Howitt, Richard E. & Williams, Jeffrey C., 2006. "Implementing Options Markets in California To Manage Water Supply Uncertainty," 2006 Annual meeting, July 23-26, Long Beach, CA 21218, American Agricultural Economics Association (New Name 2008: Agricultural and Applied Economics Association).
    • Handle: RePEc:ags:aaea06:21218
    DOI: 10.22004/ag.econ.21218
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    References listed on IDEAS

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    1. Ari M. Michelsen & Robert A. Young, 1993. "Optioning Agricultural Water Rights for Urban Water Supplies During Drought," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, vol. 75(4), pages 1010-1020.
    2. Villinski, Michele Terese, 2003. "A framework for pricing multiple-exercise option contracts for water," Faculty and Alumni Dissertations 162235, University of Minnesota, Department of Applied Economics.
    3. Richard E. Howitt, 1995. "Positive Mathematical Programming," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, vol. 77(2), pages 329-342.
    4. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
    5. Hearne, Robert R. & William Easter, K., 1997. "The economic and financial gains from water markets in Chile," Agricultural Economics, Blackwell, vol. 15(3), pages 187-199, January.
    6. Howitt, Richard E., 1994. "Empirical analysis of water market institutions: The 1991 California water market," Resource and Energy Economics, Elsevier, vol. 16(4), pages 357-371, November.
    7. Cox, John C. & Ross, Stephen A. & Rubinstein, Mark, 1979. "Option pricing: A simplified approach," Journal of Financial Economics, Elsevier, vol. 7(3), pages 229-263, September.
    8. Robert R. Hearne & K. William Easter, 1997. "The economic and financial gains from water markets in Chile," Agricultural Economics, International Association of Agricultural Economists, vol. 15(3), pages 187-199, January.
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    Cited by:

    1. Williamson, Brendon & Villano, Renato A. & Fleming, Euan M., 2008. "Structuring Exotic Options Contracts on Water to Improve the Efficiency of Resource Allocation in the Water Spot Market," 2008 Conference (52nd), February 5-8, 2008, Canberra, Australia 5992, Australian Agricultural and Resource Economics Society.
    2. Fleming, Euan & Villano, Renato & Williamson, Brendon, 2013. "Structuring Exotic Options Contracts on Water to Improve the Efficiency of Resource Allocation in the Australian Water Market," Papers 234295, University of Melbourne, Melbourne School of Land and Environment.
    3. Dolores Rey & Alberto Garrido & Javier Calatrava, 2016. "Comparison of Different Water Supply Risk Management Tools for Irrigators: Option Contracts and Insurance," Environmental & Resource Economics, Springer;European Association of Environmental and Resource Economists, vol. 65(2), pages 415-439, October.

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