Blue Gold: The Commoditization of Water (Part III)

Currently, there are no contracts on water or water rights that could be considered a futures contract because they are individually negotiated and, therefore, lack the standardization and fungibility necessary for a futures contract. However, such futures markets can be very useful for market participants for whom water is one of their major inputs, e.g. farmers or thermoelectric power plants. A well working futures market would enable them to hedge against price fluctuations. For instance, a farmer who knows that his water demand during summer month is higher, could enter into futures contracts for hedging purposes. Furthermore, a futures market would contribute to an effective pricing of water.

In order to establish futures markets on water or water rights, market creators have to consider the regulatory requirements of futures contracts. The court in CFTC v. Erskine made a distinction between forwards and futures and specified the elements of a futures contract. The court held that “Futures contract, for purposes of Commodity Exchange Act (CEA), means (1) the “contract” is standardized so that it can be traded on an exchange, and is (2) a fungible agreement to buy or sell (3) a stated unit quantity of (4) a stated commodity (5) at a stated unit price and (6) at or before a stated future time.

The last part identifies the issues for establishing a futures market on water and water rights with regard to current regulations and proposes solutions to such issues.

I. Current Issues for Establishing a Futures Market for Water and Water Rights

The statutory framework for water rights in the United States is very fragmented. Even within singles states, water laws are very opaque with riparian water rights existing alongside appropriated water rights. Some states have created their own hybrid water right systems. These circumstances give each water right a unique nature. In contrast, futures must be fungible meaning that traders have to be able to offset their positions by simply entering into an opposite position. Under current water right systems this is hardly possible. A riparian water right holder will never be able to enter into a contract with someone who holds an appropriated water right. Riparian water rights in general are not suitable for futures markets because they are bound to the ownership of the corresponding land and, therefore, are not isolatedly transferable. For a well working futures market on water rights there needs to be a harmonization of such water rights. They all must have a similar legal nature.

However, even if water rights are harmonized, they are still bound to a respective water source. A right to withdraw water from the Rio Grande in Texas is not equal to a right to withdraw water from the Salt Fork Red River in Texas. Therefore, with water rights limited to one water source, the futures markets on such water rights must also be limited to that specific water source, e.g. a river or a reservoir in order to meet the fungibility requirement.

Additionally, water rights would need to be standardized with regard to quantity, time and quality. Perpetual water rights are not suitable for a futures market because they entitle its holder to withdraw water perpetually and not at or before a stated time in the future. Thus, water rights for a well working futures market would need to be limited to specific months, e.g. June, July and August. With respect to quality, the market authority would need to set standards. A guideline for such standards could be the definition of freshwater. Freshwater is defined as water containing less than 1,000 milligrams per liter of dissolved solids, most often salt.

As opposed to physical water, water rights are easily transferable between two parties. If a local water market is established, each party will need to open an account in which its water rights are administered. A central market authority oversees the accounts of all members and administers the transfers of water rights between different accounts. A role model for establishing a futures market for water rights could be the emission certificate market. Emission certificates entitled its holder to emit a specific amount of CO2. There are a variety of futures on these certificates. Take for instance EUA Futures which are traded on the ICE Futures electronic platform. According to the contract specifications, “contracts are physically settled and delivered by the transfer of the EU Allowances from the seller’s account to the buyer’s account at the Union Registry.” These settlement procedures involve low transaction costs and could easily be implemented.

Futures markets for physical water face the same issues than futures markets for water rights except that it is harder to deliver the physical water. These delivery issues can be minimized by limiting the market to a specific source of water. Often a well-functioning water transfer system with enough water pipes is available in such geographical areas. There must be a central delivery point, e.g. a reservoir or a pumping station alongside a river. However, both futures on water and water rights could also be simply cash settled. Cash settlement means that upon expiration of the future, the seller does not deliver the actual underlying asset, but instead transfers the underlying cash position. This would solve the difficulties of transferring physical water.

II. Conclusion

As it has been demonstrated, under the current regulatory framework water can be seen as an agricultural commodity that is mainly traded in spots and forwards. However, in order to establish a well working futures market, water laws have to be harmonized. If water markets turn out to be an effective remedy for the increasing water scarcity, lawmakers have to act quickly in order to prevent misuse and manipulation of a commodity that has such a high importance for the individual. Therefore, this paper encourages early legislative action that forms the foundation for a well working water market.

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.

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