Investors can now trade on and profit from California water — how might that work out? - San Francisco Chronicle

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It’s not just Californians paying attention to the state’s water supply anymore. It’s Wall Street.

In a sign of the growing value of water in a warming world, investors began trading futures of the coveted commodity, tied to California water prices, for the first time last week.

The novel marketplace allows speculators to make money betting on future prices of California water while allowing farmers, businesses and municipal suppliers to hedge against price swings and stabilize their costs.

How well this will work remains to be seen. While many say a commodities market can help those in need of water, finance and water experts say the new financial instrument may provide only limited risk protection and could even put upward pressure on water prices.

“It’s a cool concept,” said Jon Reiter, founder of the agriculture and water consulting company Cavalrei in Fresno. “I think it has a lot of potential, and I think this is the right direction to move in, but there are some challenges that still need to be worked out.”

Unlike oil, grain and other traded commodities, the new water futures aren’t about the physical exchange of a product. They’re about exchanges of money based on the value of the product. The trading of actual water will continue as it always has in California, between limited numbers of irrigation districts and urban suppliers that generally make insider deals to accommodate one another’s varying needs. Wealthy outsiders won’t be siphoning off the state’s water supplies.

But the financial wheeling and dealing, say the creators of the water futures, stands to improve the efficiency of real-world water transactions, starting with making prices more transparent, and perhaps ultimately facilitating more exchanges and putting water to better use.

“All of (this) can help California water users to more efficiently align supply and demand of this vital resource,” Tim McCourt, a managing director at Chicago-based CME Group, which launched the new commodity exchange Dec. 7, said in an email to The Chronicle.

In the futures exchange, investors buy into contracts that represent a specific amount of water at prices based on the Nasdaq Veles California Water Index (NQH20). The index tracks water sales across parts of California where water trading is common. Investors eventually cash out of the contracts, either benefiting from an uptick in the index or losing out if the index slides.

California water prices have typically gone hand-in-hand with precipitation, going up in dry times and down in wet periods.

“The futures are like a bet on the weather,” said Ellen Hanak, a senior fellow at the Public Policy Institute of California who specializes in water.

For farmers and other water users interested in managing risk, there’s the ability to lock in future water costs, at least theoretically. The water users can buy into the market at one price, and if the price goes up, sell the contract and use the proceeds to purchase real, higher-priced water. If the price goes down, the loss is made up by the lower cost of real water.

“We have some very sophisticated agricultural operations in this state with a lot of dollars involved, and they might be interested in using this as a hedge,” Hanak said.

Still, she and others say there are inevitable problems with a futures market that make it an imperfect place to reduce risk and invest.

Most fundamentally, establishing prices for futures that reflect true water costs in California is difficult given how much water prices vary with geography and water rights. What water users pay won’t always be in line with market prices, which are a weighted average, inevitably skewing investment decisions.

There’s also the possibility of speculators in futures driving up the actual cost of water.

“Our biggest concern is that if this becomes a profit-driven and popular way to trade on the value of water, it could eventually impact real water prices,” said Mike Wade, executive director of the California Farm Water Coalition.

Ultimately, whether this marketplace has a chance of succeeding depends on participation.

During the first week of trading, 36 contracts were secured. Water was priced at just under $500 an acre-foot, the amount of water that would cover an acre of land 1 foot deep, or about 326,000 gallons. That’s enough for two households for a year.

“With nearly two-thirds of the world’s population expected to face water shortages by 2025, water scarcity presents a growing risk for businesses and communities around the world, and particularly for the $1.1 billion California water market,” CME’s McCourt said. “Developing risk management tools that address growing environmental concerns is increasingly important.”

Kurtis Alexander is a San Francisco Chronicle staff writer. Email: kalexander@sfchronicle.com Twitter: @kurtisalexander

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Investors can now trade on and profit from California water — how might that work out? - San Francisco Chronicle
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