The role of weather derivatives and portfolio effects in agricultural water management

Restrictive irrigation water policies established due to e.g. environmental concerns or water scarcity appear to result in declining farm income and arising risk exposure in terms of yield uncertainty. With this in mind, we investigate the potential of index-based weather insurance, which is also known as weather derivatives, to cope with the economic disadvantages for farmers resulting from a reduction in water quotas and increased water prices. By means of a whole-farm risk programming approach, we systematically compare crop portfolios without and with the possibility of purchasing standardized weather derivatives based on precipitation and temperature indices. In doing so, we allow for crop diversification as well as water reallocation between crops. Thus, overcoming some of the shortcomings inherent to previous studies in this strand of research. In an application to a representative cash crop farm in northern Germany, we found that the use of weather derivatives offsets the loss in the farmer’s certainty equivalent resulting from moderate reductions in water quotas and water price increases. Our results also indicate that weather derivatives have the potential to substantially alter farm plans and the optimal irrigation water demand. Far reaching environmental implications might be the consequence which require further attention and careful consideration by policymakers.