Water scarcity is promising to be one of the major challenges of the 21st century. With the global population growing at skyrocketing levels, global water demand is rising faster and faster. Already, some 1.1 billion people worldwide lack access to water, and a total of 2.7 billion find water scarce for at least one month of the year. However, domestic use is only responsible for 8% of the world’s water withdrawals. The majority is used for agricultural (70%) and industrial (22%) purposes. In agriculture, water withdrawals are not used very efficiently. Due to leaky irrigation systems, inefficient application methods and the cultivation of crops that are too thirsty for the environment in which they are grown, some 60% of such withdrawals are wasted. Low water prices heavily subsidized by the government disincentivize farmers to use the resource more efficiently.
In order to be able to meet the higher demand for food, farmers will have to rethink the way they use water. In the energy sector water is used for many purposes, including cooling of power plants, generating hydropower, production of petroleum fuels and hydraulic fracking for natural gas. In the United States, power plants withdraw 143 billion gallons of freshwater daily. The amount of freshwater consumed for energy production may double in the next 25 years. There are many different approaches to solve the problem of the supply-demand imbalance of water. Whereas a lot of them require expensive capital expenditures, there is one solution that is very cheap and can be deployed quickly: In recent years economists promoted the idea of pricing the water and establishing water markets. Pricing of water can drive consumers to put it to its most valuable and highest use, thus leading to higher efficiency. Many states, especially in the west of the United States, have started to introduce water marketing. Especially, well-functioning futures markets on water certificates will play a crucial role in efficient pricing.
However, new markets always pose the risk of abusive and manipulative market behavior. Since water is such an important resource for human beings, a well-functioning regulatory framework ought to be imposed. This article analyzes the concept of water marketing under the current federal commodities regulation and proposes regulatory changes for establishing a futures market on water certificates.
I. Historical Development of Federal Commodities Regulation
The definition of Commodity under the Commodity Exchange Act has evolved from encompassing only a few, enumerated commodities, all agricultural in nature, to emerge as a broad term that includes intangible assets such as interest rates and indices. With enactment of the Commodity Exchange Act of 1936, its predecessor, the Grain Futures Act, was amended and renamed. Congress struck out the term “grain” and inserted in lieu thereof the term “commodity”. In the new-born Commodity Exchange Act Congress set out a list of commodities that were comprised by the term, including wheat, cotton, rice, corn, oats, barley, rye, flaxseed, grain sorghum, mill feeds, butter, eggs and Solanum tuberosum (Irish potatoes). This list was final, thus giving the Commodity Exchange Authority, the predecessor of the Commodity Futures and Trading Commission (CFTC), jurisdiction over contracts only on such commodities, then being traded on exchanges.
With the development of markets, the variety of commodities being traded on exchanges increased over time. This led to subsequent amendments of the Commodities Exchange Act adding such commodities to the original list. All those newly added commodities had one thing in common: They were all agricultural in nature. With futures markets starting to deviate from its agricultural origins, Congress enacted the Commodity Futures Trading Commission Act in 1974. The Act created the Commodity Futures Trading Commission (CFTC), the successor of the Commodity Exchange Authority, as an independent agency of the United States Government. The CFTC had jurisdiction not only over futures transactions in such agricultural commodities enumerated in the Act, but also over “all other goods and articles, except onions . . . and all services, rights and interests in which contracts for future delivery are presently or in the future dealt in.” With this groundbreaking amendment, “for the first time, the CEA would apply to all U.S. futures exchanges and to the full range of commodities that were or could be traded for future delivery thereon, including many commodities that did not fall under the enumerated agricultural category—for example, coffee, sugar, cocoa, metals and energy products, as well as interest rates, currencies, and other financial commodities.”
With enactment of the Commodity Futures Modernization Act (CFMA) in 2000, “Congress for the first time made an explicit distinction between agricultural commodities and other commodity categories.” In addition to agricultural commodities, two new subcategories were introduced: exempt commodities and excluded commodities. Remarkably, the Act provided a detailed definition for only one of the three categories. Excluded commodities were defined to include currencies, indices, interest rates and other, similar financial commodities.In reverse, the term “exempt commodity” was defined as “a commodity that is not an excluded commodity or an agricultural commodity.” Although the Act made an explicit distinction between agricultural commodities and other commodities, it did not provide a definition for the former.
As reaction to the financial crisis of 2008, Congress enacted the Dodd Frank Act in 2010. Whereas it brought far reaching changes to the statutory framework of the CEA, it left the different definitions of commodities, as established by the CFMA, mainly unchanged. It only added “motion picture box office receipts (or any index, measure, value or data related to such receipts)’’as a second exception, along with onions, to the definition of commodity in §1a (19) of the CEA.
II. The Modern Definition of Commodity under the Commodity Exchange Act
The modern definition of the term “commodity”, as established by the CMFA in 2000, comprises five different categories.
The first category, found in section 1a (9) of the Commodity Exchange Act (CEA), contains a list of enumerated commodities, all of which are agricultural commodities. Additionally, the CFTC has issued rule 1.3 (zz) which indicates whether a commodity is included in the scope of the term agricultural commodity. The definition in section 1a (9) of the CEA explicitly carves out onions and motion picture box office receipts (second category) and provides a catch-all category including “all other goods and articles” and “all rights, services and interests in which contracts for future delivery are presently or in the future dealt in” (third category). Excluded commodities constitute the fourth category. They are defined in section 1a (19) of the CEA and include intangibles such as interest rates, currencies and indices. Finally, commodities that are not excluded commodities or agricultural commodities are defined as exempt commodities (Sec. 1a (20) CEA). This fifth category comprises minerals like crude oil, natural gas, gold, silver and ethanol, but also emissions.
Generally speaking, each category is regulated differently under the CEA. The rationale behind this idea is that Congress decided that certain commodities like agricultural commodities, which are in limited supply and are subject to price fluctuations, ought to be regulated differently from other types of commodities for which there is an exhaustible supply such as interest rates. This general idea for the differentiation of the single commodity categories ought to be one’s basis for the analysis of new commodities that do not easily fit in one of such categories.
III. Water as an Agricultural Commodity
In order to determine whether water can be deemed an agricultural commodity under the CEA, one has to look at the rule §1.3 (zz) issued by the CFTC. The rule establishes a four category definition of agricultural commodity. The first category refers to commodities explicitly enumerated in the definition found in §1a (9) of the CEA. Since water is not included in the enumeration, subsequently the general definition of the second category has to be applied.
It states that the term “agricultural commodity” also encompasses “all other commodities that are, or once were, or are derived from, living organisms, including plant, animal and aquatic life, which are generally fungible, within their respective classes, and are used primarily for human food, shelter, animal feed or natural fiber.” The purpose of this definition is to “draw a line between products derived from living organisms that are used for human food, shelter, animal feed or natural fiber (covered by the definition) and products that are produced through processing plant or animal-based inputs to create products largely used as industrial inputs (outside the definition).” With regard to water, its importance for human beings exceeds those of the commodities explicitly listed in the statute by far. Whereas humans can survive weeks without eating anything, the human body dehydrates within several days making water the most vital to human survival. This is is highlighted by the fact that the General Assembly of the United Nations explicitly recognized the right to safe and clean drinking water and sanitation as a human right on July 28, 2010.
Nevertheless, compared to all other commodities, water has a very unique nature. Whereas it is used both for human food and animal feed, it is not derived from a living organism like orange juice (plant) or milk (cow). It is a natural resource comparable to exempt commodities like oil with regard to its physical composition. Due to this unique nature, water is clearly not encompassed by the general definition of the second category, nor by its purpose.
The third category establishes a sort of “catch-all” provision which gives the Commission the authority to determine the status of a commodity by rule. It includes “commodities that do not readily fit into the first two categories, but would nevertheless be widely recognized as commodities of an agricultural nature.”
Although water plays a significant role in our daily lives, most of the water withdrawals in the United States are used for industrial purposes like irrigation or thermoelectric power. Only a small fraction of the total water supply in the United States is actually used for human needs such as sanitation or drinking. With its industrial purposes prevailing, it can be argued that water is not primarily used for human food as stated in the second category of the definition and, therefore, rather constitutes an industrial input, comparable to energy commodities like oil or gas, as an agricultural commodity. On top of that, most economists who are proposing water trading emphasize that only the water supply above and beyond the amount needed for basic hydration and hygiene purposes should be priced and traded on the market. With its nutritional purpose in the background, it seems questionable whether water falls within the general scope of agricultural commodities. Nonetheless, the unique nature of water makes it equally important for both the industry as well as humans. Therefore, it serves two purposes at the same time. Admittedly, there are other commodities in equal positions. For instance, pure ethanol can be used for human food (as an ingredient for alcoholic beverages) and is considered an agricultural commodity under the second category of the definition. In contrast, denatured ethanol is toxic for human beings and does not fall within the definition of agricultural commodity. However, strictly speaking, pure ethanol and denatured ethanol are two separate commodities because of the difference in their composition. The composition of water is always the same, regardless of whether it is used in the industry or for humans. Thus, it ought to be regulated equally in every respect, independently of the individual purpose it serves.
One has to recall the rationale for the different categories of commodities under the CEA. The reason for agricultural commodities being treated differently from exempt or excluded commodities from a regulatory perspective is that they are more likely subject to price fluctuations because of their limited supply. The high risk of fluctuations in the price of products that are crucial for basic human needs justifies stricter regulation. Although around 71% of the world’s surface is covered with water, only 2.5% of the global water supply is actually freshwater of which only 1.2% is readily available for human and animal use with the rest being locked away in glaciers, ice caps and underground aquifers. Freshwater is defined as water containing less than 1,000 milligrams per liter of dissolved solids, most often salt. Although for people living in developed countries like the United States where it seems that there is an unlimited supply of water, these numbers show the opposite. Water supply is scarce and this scarcity will increase dramatically. Additionally, water is a regional product. Its transfer is very bulky and involves very high transaction costs restricting the maximum transferable distance to 500 kilometers. As a consequence, regions do not have access to the global water supply but are dependent on their local one, resulting in further limitations. Limited supply is accompanied by the fact that there are no other commodities on earth that can substitute the important functions of water for plants, animals and humans. Water is non- substitutable rendering it probably the most important commodity of all.
It would be inconsistent with the basic principles of the definition of commodity to exclude water from all other agricultural commodities just because it is not derived from a living organism. As indicated, the importance of water for human beings exceeds that of all other commodities by far. The increasing limitation in sufficient supply exposes water to the risk of being subject to manipulation. Therefore, strict regulatory protection under the CEA is justified. Water ought to be a designated agricultural commodity under the third category of rule 1.3 (zz).
Part II of the article will discuss current water marketing contracts with regard to the concept of commodity interest under the CEA.