Contractual mechanisms to manage water supply risk in the western United States
Risk and reliability dominate water supply discussions in the arid western United States. To mitigate supply risk, water managers have traditionally built additional storage. The least expensive storage sites have now been taken, and there are strong environmental objections to new facilities. Reliability is further diminished due to concerns about endangered species and global climate change. Thus water agencies increasingly turn to water markets and contractual mechanisms to manage risk. This dissertation studies contractual mechanisms for managing water supply in the presence of significant temporal and spatial variation in availability.
First, a theoretical model to show the conditions that favor leasing water or purchasing rights is developed. Econometric analysis of 2,804 transactions reported in the Water Strategist over 1990–2005 demonstrates that institutions have influenced not only whether water trades occur, but also the style of the trades. The remainder of the dissertation focuses on annual dry-year options. Under a dry-year option, 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.
Second, the theoretical value of annual dry-year options within California is calculated using a very large hydroeconomic model that runs 72 years of historical hydrological conditions through the current configuration of the northern California water system to determine the economically efficient allocation of water under a range of stochastic water realizations. The model, a nonlinear mathematical programming model, optimizes with limited foresight of future water conditions and stores water according to a carryover value function derived within the model itself. The model indicates significant option value at the Sacramento-San Joaquin Delta for delivery to urban demand centers in southern California.
Finally, experimental economics is used to analyze the effect of annual dry-year options on water markets. How do market structure (competitive versus market power) and option contract availability affect water price and allocation within a market? Findings in this analysis may assist policymakers in preparing for the next multi-year drought in California.
0503: Agricultural economics