John Burroughs (1837-1921), an American naturalist and nature essayist, once said: “When a herd of cattle see a strange object, they are not satisfied till each one has sniffed it; and the horse is cured of his fright at the robe, or the meal-bag, or other object, as soon as he can be induced to smell it. There is a great deal of speculation in the eye of an animal, but very little science”. Speculation in two different meanings is pervasive in a number of discussions these days: both in the form of conjectures without firm evidence and clumsy and not accountable investments. Both entail significant risks.
Back on September 27th, 2020, CME Group, the world’s leading derivatives marketplace, and Nasdaq Stock Market (formerly US National Association of Securities Dealers Automated Quotations), a global public technology company serving the capital markets and other industries, announced plans for a new futures contract, pending regulatory review, on the basis of Nasdaq Veles California Water Index (NQH2O), launched in turn in 2018.
This water futures market based on Nasdaq actually kicked off shortly after: on December 8th, 2020. The announcement of this first-of-its-kind tool travelled at light speed. Stereotypes sprung up: “blue gold”, “the ultimate commodity”, “water traded on the stock exchange”, “trading water for the first time”, “water set to join likes of gold and oil” … As Hannah Arendt (1906-1975) put it in The Life of the Mind, clichés “protect us against reality”.
The futures contract is an agreement between two parties who commit to exchange an asset at a set future date and a certain price. That asset is called the underlying asset: in this case, a water use right.
NQH2O tracks the spot price based on trading in water rights (both leases and sales) in California's five largest and most active regions in terms of water use right trading, within the US$1.1 bn California water market. This includes five markets of water use rights: the surface water market and four groundwater basins: Central, Chino, main San Gabriel, and the upper stretch of the Mojave basins. The index value reflects the volume-weighted average water price, at source, excluding conveyance costs and water losses in underlying markets, after adjusting for idiosyncratic price factors specific to each of the five eligible markets and rates of transactions.
Advocates of this initiative argue that it will be a very useful tool to provide agricultural, commercial, and urban water users with greater transparency, a sort of clearing house mechanism for price discovery, and a risk management and transfer scheme to address a major global challenge: long-term water security within the context of climate change. It is believed that a dynamic (liquid), transparent futures market would contribute to creating a forward curve so that water users can hedge future price risk. In other words, if properly working, this futures market would be a way of protecting oneself against water price volatility and potential financial loss as per water use.
The futures contract is an agreement between two parties who commit to exchange an asset at a set future date and a certain price
Opponents rather fear the derivatives will offer a poor hedge for water users and may end up distorting prices for water, thus affecting human rights to water and sanitation as established by the UN General Assembly back in 2010 and 2015. Critics say futures contracts may prove difficult to trade, given the highly site-specific nature of water pricing and regulation. There is also uneasiness with such a vital resource becoming a speculative financial asset. They would actually not expect to see water open to potential manipulation or upward price pressure via financial markets. In fact, denying potential externalities of water use right trading does not make them go away.
Unlike often stated, though, this new California water futures contract is financially settled based on NQH2O (an index); hence no physical water will be traded. This financial settlement means traders never take physical delivery and cannot forward buy or stockpile water.
Almost any water legislation in the world establishes that water resources belong to the public domain. Sensibly enough, this is not at stake this time either. A wide range of water legislations also establishes the possibility to define water (use) rights under a water access license as personal property. It is important to note, though, that whether the water rights amount to property rights depends on the specific terms of each legislation. Through granting licenses or entitlements or via any other form of administrative action, the public sector gives water users (be they legal or physical persons) the right to use water (either in terms of withdrawal or, less frequently, the discharge of treated wastewater effluents). In not many countries, though, there are legal provisions to allow for the trading of those water use rights. Rights change hands through short- and long-term leases and sales. The most remarkable experiences worldwide are in Australia, Chile, and the western states of the USA.
This futures market is far from being a global market. It is not even a California water market as such. This does not make it a negligible one, though; California is the most populated state in the USA (39.37m inhabitants) and the third-largest state by area (423,970 sq. km). In fact, were California a sovereign nation, in 2019 it would have ranked as the world’s fifth-largest economy (US$ 3.2 tn), ahead of India and behind Germany. The US ranks second in water consumption in the world (first, if measured per capita).
Advocates of this initiative argue that it will provide agricultural, commercial, and urban water users with greater transparency
Nevertheless, each year only about 4% of the water used by cities and farms in the state is traded, according to California’s PPIC Water Policy Center. It would certainly be almost impossible to use this water futures market to hedge the price of water elsewhere and scarcity in one US state is very unlikely to influence long-term availability in another. Farmers, for instance, would still need to buy water at the spot price during a drought event.
As a matter of fact, the launch of NQH2O underlines a growing focus from investors and regulators on the impact of water security and climate change adaptation on the stability of the world’s financial system. Investors are actually waking up to water risks, particularly in water-intensive industries such as food, mining, textiles and, of course, water utilities.
It is almost impossible not to fear bearish speculative behaviours, which earn more the more price volatility increases, with potential implications beyond those directly engaged in water use right trades. Speculators need to be expelled from such a market. Salman Rushdie (1947- ), in The Ground Beneath Her Feet, said: “Once you have been in an earthquake you know, even if you survive without a scratch, that like a stroke in the heart, it remains in the earth's breast, horribly potential, always promising to return, to hit you again, with an even more devastating force”.
Discussions about the role of the market (either as a good master or a useful servant, to paraphrase the felicitous expression by Joan Robinson, from Cambridge’s post-Keynesian school: 1903-1983), are somehow meaningless. At best, water use right markets would be a means to an end. Discussing ends without further exploring means is not politics; but neither is emphasising on instruments, no matter how valuable they are, without linking them to policy objectives. A paradigm shift is needed: one that moves away from the futile attempt to mitigate uncertainty towards embracing complexity and uncertainty itself, which are here to stay, thus focusing on managing risks rather than only crises. This can only be done through the alignment of individual interests and collective goals and that is the role for public, independent regulation. Only if this fails, fears will be more than justified.