Water Derivatives: How Soon and How Many?

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I was discussing the article “Commoditization of Water: Straight Ahead to Financial Derivatives?” with a colleague of mine. As we got to the story of the riots in Bolivia brought on by a sharp increase in water bills following the privatization of the state water system by a foreign company, she asked me, “Is that what ‘The Quantum of Solace’ was about?” To be honest, the story of a South American nation was not exactly the centre point of my interest when I was watching this James Bond movie a few years ago. So last Friday I did watch the movie again and made sure that this time it was not just about Mr. Craig.

My re-acquaintance with the British secret agent’s exploits had a different flavor: this time I was watching people in a desert place with limited water resources having their lives hanging at a will of the handful of fate-holders. The story was fiction, with fictitious characters, warlords and military coups. However, after the closing credits, I was thinking: sixty per cent of nation water resources to be privatized by a foreign entity… that is actually not too far from the reality. The reality, however, is not that crude: it has international agreements, lawyers and contract clauses, settlement conditions and payment schedules.

Leaving aside the philosophical, humanitarian and social angle of the story, I am (as always) trying to concentrate on the data-related side.

Water availability and its quality is not a new item on the media plate. Pressed by growing population and industrial development, and contaminated by human activities, there is just not enough clean water to serve us in the near future. To aggravate it all, changes in precipitation patterns lead to redistribution of water reserves.

I love Las Vegas. I like the sense of affordable and somewhat artificial lavishness and abundance. But I know that the issues the local authorities have to deal with are not artificial, they are very real and valid. The issue is water shortage. Every time I take a shuttle or a cab from the airport, I hear another variation of the same joke from a driver: “Have you heard about water shortage in Las Vegas? To help us deal with this problem you are allowed to drink only wine (vodka, beer, etc.) during your stay here.” Can all those prophesying stories about Lake Mead be true? Could Lake Mead, the main source of water supply in the region, dry our within the next decade? If so, these drivers seem to be quite good at making lemonade from all the lemons given to them.

There are different approaches to deal with the impending scarcity of water: conservation, recycling, or making water a tradable commodity and letting market forces decide. Water trading is already becoming more common than we realize. No matter how strange it may sound, we have already passed several stages leading us in this direction. Private companies are assuming management of municipal water systems. In the U.S., about 14% of waterworks are owned by private interests. Worldwide, the share of privatized water systems is about 10%.

The privatization of water systems is putting us one step closer to trading access to water; the Canadian province of Alberta is an examples of this. The Water Act of 1999 in Alberta allowed transfers of water rights. Because the water right is traded between willing buyers and sellers, the number of transfers – brokered through commercial operations and dedicated websites – has been consistently increasing. As a result, the term “water market” is often used in Alberta.

It is not a great leap from a water rights trading system to the financial derivatives traded on public exchanges. We already see a lot of water-related products, such as those built on precipitations, and the majority are traded on the Chicago Mercantile Exchange (CME). CME trades snowfall futures and options contracts, as well as monthly and seasonal rainfall options and futures.

Another spin on the derivatives market was set in motion by Thailand’s worst flood in almost 70 years, which killed approximately 700 people and caused $41.6 billion of damage to the economy. On December 15, 2011, the Securities and Exchange Commission said that Thailand may start trading water derivatives, providing investors with a means of hedging against disasters.

No matter what our opinion may be, water is becoming a commodity. This is a slow process, but it is imminent. And quite soon we will be observing more and more derivatives built on this commodity and traded through public exchanges and brokers.

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