Blue Gold: The Commoditization of Water (Part II)

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In response to increasing scarcity, water markets have evolved in many states of the United States. According to data gathered by the “Water Strategist” the first water transfers have been conducted in the late 1980s. Over the course of more than two decades, people have entered into different water contracts, customized to their individual needs. Whereas only limited data on the details of the contracts is available, one can identify general types of contracts. The following part analyses such contracts with respect to the various commodity interests that are subject to the jurisdiction of the CFTC.

Introduction to Water Rights

In order to get a better understanding of current water contracts, it is helpful to have an overview of the different water rights in the United States. They are determined by two major principles. The eastern United States, where water is historically sufficiently available, is dominated by the riparian water right system. Riparian water rights grant landowners whose land borders a body of water certain rights “to use the water in a manner considered reasonable relative to all other right holders.”

In contrast, states in the west, naturally drier, are predominantly governed by prior appropriation water rights. Prior appropriation is based on the “first come first serve” principle and allows usage of water to whoever first puts it to a beneficial use. Since appropriation rights are not dependent on land ownership, they can be transferred to the extent that they do not prejudice the rights of others. The acquisition of riparian water rights can only be conducted by means of purchasing the actual property. Nowadays, both riparian and appropriation rights often require an additional permit to use the water issued by the state.

Many states have developed hybrid water rights composed of elements of the appropriation and riparian system. Due to different individual water systems, it is inevitable to consult the respective water laws in the states in order to determine how water rights can be acquired.

Types of Contracts and The Concept of Commodity Interest

Market participants have developed a huge variety of different types of contracts. Only a few of them are subject to the jurisdiction of the CFTC. Generally speaking, contracts which include actual physical delivery of the commodity like spots or forwards are generally not regulated by the CFTC. However, they are still subject to the CFTC’s anti-fraud and anti- manipulation authority. A spot is a contract to buy or sell a fixed quantity of a commodity at a specific price for immediate delivery. In a forward contract buyer and seller also agree upon the purchase and sale of a fixed quantity of a commodity at a predetermined price. But as opposed to a spot, delivery is deferred. It is important to emphasize that, both in a spot and a forward, the counterparties enter into the contract with the intention to make and take delivery. They are trading in the actual commodity. This element distinguishes spots and forwards from contracts where buyer and seller are trading without the intention to make or take delivery. These contracts encompass futures, swaps and options. Section 2 (a) (1) (A) of the CEA grants the CFTC exclusive jurisdiction over such contracts. Futures contracts are not explicitly defined. Generally, they are contracts for future delivery which are listed and traded on Designated Contract Markets (DCMs). Futures contracts differ from forward contracts in that the former are executed without the intention of actually making or taking delivery. They are highly standardized and traded on exchanges permitting traders to offset their position easily in order to avoid physical delivery.

Swaps are defined in section 1a (47) of the CEA. Generally speaking, in a swap contract the counterparties agree to the exchange of one or more payments based on the occurrence of an event or the value of one or more interest or other rates, currencies or commodities. The probably most classic example for a swap are interest rate swaps. In an interest rate swap the parties exchange cash flows based on a notional principle (which is not exchanged) in order to hedge against interest rate fluctuations or to speculate. The definition of swaps also includes option contracts. Options give a buyer the right but not the obligation to buy or sell a specific quantity of commodity at a specific price within a determined period of time.

Analysis of Current Water Contracts

Since water trading is still in its beginnings, there is limited data on the actual contracts available. However, the Texas Water Development Board has published a guide on water marketing which is the basis for the analysis in this article. This guideline describes different forms of transferring water and water rights. They include basic principles that are applicable to other water markets in the United States. You will get an overview of how water transfer in the future might look like. It is important to emphasize that this article focuses on the transfer of surface water and surface water rights.

Water Marketing in Texas

Located in south of the United States, Texas has a very dry climate making water a scarce source in the Lone Star State. Texas Water Development Board (TWDB) expects that the statewide demand for water will increase 18%, from 17 million acre-feet to 20 million acre-feet, between 2000 and 2050. Simultaneously, water supplies are expected to decrease 19%, from 17.9 million acre-feet to 14.5 acre feet. In order to tackle the upcoming water problems, the Texan government is taking a variety of measurements, including the facilitation of water marketing. In its 2002 State Water Plan the TWDB explicitly recommends to “consider any changes needed to create more certainty in the water rights amendment process, thus facilitating water marketing transactions.”

Starting with the adoption of the common law system in 1840, Texas has a very long history of water rights, changing from the riparian system to the appropriation system. With passing the Adjudication Act in 1967, both systems were merged together on a statewide basis. The new system requires anyone who wants to use surface water to hold a certificate or receive new permission from the state in form of a water right. These water rights are granted by state license under a unified water permit system. The license allows the holder the use of a specific amount of water at a specific location, and for a specific purpose. These rights can either be perpetual or limited, including term permits, temporary permits, seasonal permits, contractual permits and emergency permits. Diversion of water for domestic or livestock use, wildlife management purposes, and for emergency or some other specified use are exempt from the requirement to hold a license.

Sale and Lease of Surface Water Rights

Appropriated water rights entitle its holder to withdraw a specified volume of water per year. They can either be perpetual or limited in time and are not bound to a corresponding land ownership. Thus a holder of such a water right can decide to transfer it. If he decides to sell the water right, he transfers his ownership in the water right to the buyer. These transactions are subject to the approval of the Texas Commission of Environmental Quality (TCEQ) if they require a change in purpose or place of use of surface water. If the terms of the water right stay the same, a simple change of ownership is required to be filed with the TCEQ.

The holder can also decide to lease his water right to a lessee in return for monetary compensation. This might be the case if the holder has temporarily no need to withdraw water. During the term of the lease, the lessee obtains the use of the water right. At the end of the lease term, the use of the water right would revert to the lessor, who would regain full use of the water right. Like contracts for sale, lease contracts are only subject to approval by the TCEQ if they involve a change in use, location or amount of water.

The subject of both leases and contracts for sale is not the physical water, but the water right. Thus, under the terms of the contract the seller is obliged to transfer the right not the water. This raises the question whether a water right can be a commodity under the CEA. Section 1a (9) of the CEA includes “all services, rights and interests in which contracts for future delivery are presently or in the future dealt in.” According to this definition, there must be some futurity involved for such rights to be considered a commodity. In the contracts for sale and the lease contract the water right is transferred right away. There is no futurity. Therefore, they might constitute a spot contract, but there is no commodity involved since there are no contracts for future delivery of water rights.

Contract of Sale of Surface Water 

Instead of transferring the underlying water rights, a party can also transfer the physical water separately. Typically, one or more entities that own underlying water rights develop a water supply and then sell the water to others. Although such transactions do not require approval by the TCEQ, they are still subject to its oversight. Contracts of sale of surface water are required to “specify a per unit cost of water; effective date and termination date; allowable diversion rate; annual average quantity of water to be furnished, location of purchaser’s diversion point, and a general statement of compliance with applicable rules and statutes.” Moreover, they have to be consistent with the terms of the underlying surface water right.

Without having access to individual contractual agreements, contracts for the sale of surface water can appear in forms that meet the requirements of the definitions of the various types of contracts as discussed above. The counterparties enter into the agreement with the intention to actually make or take delivery of the water. Each agreement is negotiated on an individual basis and there are no standardizations. Without standardization and reliable exchange markets, these contracts lack the fungibility required for offsetting a position. Therefore, they cannot be deemed futures. With their specific characteristics they rather constitute either a spot or a forward. The applicability of these two types of contracts is dependent on the individual delivery agreement of the counterparties. The parties can agree that the buyer is entitled to withdraw the water from the reservoir immediately. They would then set the effective date and the termination date close to the date the contract is entered into. The contract would be settled within a couple of business days, as it is usual for spots. Contrary, if the parties agree on a delivery period that lies in the future the contract rather constitutes a forward. For instance, a farmer who knows that he will have a higher demand for water during the summer month could enter into a contract of sale of surface water with the owner of a local water reservoir in January for a specific amount of water to be withdrawn during a period in June. Delivery would then be deferred, as it is common for forward contracts.

Dry-Year Option Contracts – Surface Water

A very interesting type of contract that is used in Texas is the so-called “dry-year option contract”. The Texas Water Development Board describes the contractual form in its water marketing guide as follows:

“Generally, dry-year option contracts are used by municipalities to secure reliable sources of additional water to augment their existing supplies during times of drought. A municipality does this by negotiating an agreement with a water right holder (generally an irrigator) to acquire the use of the water right holder’s water, during and only during, a specified dry-year period. In this way, the municipality augments its ability to meet its water supply needs during a drought and the water right holder enjoys the financial benefits of the contract and the right to continue using the water during non-dry year periods. These contract normally entail compensation for the option to use water plus a payment for the quantity of water used, when the option is exercised.”

A special characteristic of this contract is that the obligation of the seller to provide the buyer with water is triggered upon the occurrence of an event. The buyer pays the seller a premium to obtain the right to withdraw the seller’s water in the case of a dry year. Under the Commodity Exchange Act contracts in which the purchase, sale, payment or delivery is dependent on the occurrence of an event are considered to be swaps. However, a few distinction have to be made.

First, from the description above it appears that the buyer of the contract does not have the obligation to actually withdraw the water. The contract gives him just the option to do so. Additionally, part of the payment the seller receives is determined by the per unit cost and the amount of water that is actually withdrawn. Under these circumstances, the contract rather constitutes an option. But, as opposed to a plain vanilla option, the right to exercise is not dependent on a specific date, but on the occurrence of an event, in this case a dry year. Therefore, the dry-year option combines elements of an option as well as a swap. It is important to note that from a regulatory perspective the distinction between an option and a swap is basically irrelevant because the Commodity Exchange Act defines an option as a specific type of swap.

Secondly, whereas a usual commodity option gives the buyer the right but not the obligation to sell a certain quantity of that commodity at a particular price after a particular period of time, it lies at the discretion of the buyer of a dry-year option how much water he actually wants to withdraw. There is a maximum, but not a fixed amount. As a consequence, the total price the seller is obliged to pay is not predetermined since it is a product of the final quantity that is withdrawn and a per unit price. A usual commodity option contract contains a per unit price and a fixed amount of the commodity. The total price is dependent on how many contracts one purchases. However, the fixed amounts in usual commodity options are a result of standardization. There is no statutory provision that requires an option to have a predetermined quantity. Moreover, each contract contains a provision for a maximum amount that can be withdrawn. Eventually, it is just a matter of the individual agreement. Instead of negotiating a floating amount that is dependent on the buyer’s actual need, the parties can equally set a fixed amount, so that the contractual terms would be similar to regular commodity options.

Alex is a student at Bucerius Law School and Georgetown Law and currently majoring in capital markets lawIf you have questions or comments, get in touch with him via email  or Linkedin.

 

Access the Texan Guide to Water and Water Rights Marketing here.

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