posted in
July 22, 2021

Enabling speculators to trade on life’s basic needs: letting the fox guard the henhouse?

written by Bart Vreugdenhil
Enabling speculators to trade on life’s basic needs: letting the fox guard the henhouse?

Last December, Bloomberg reported that California water futures are now a tradeable commodity on Wall Street. The idea behind this is that it allows farmers and municipalities to hedge the uncertainty of water prices in the future, as they should be able to budget for the resource more accurately.

The main driver behind this increased accuracy of future water price estimates is that the private projections of these businesses now also reflect the expectations of the market. This commodification of water is a response to the 2020 wildfires on the US West Coast and the California drought that stretched for over eight years. The damage associated with those events demonstrated the necessity of proper risk management in water availability and accessibility.

Financial complexity and bad incentives

The creation of this financial trading instrument started in early 2019, with the launch of the Nasdaq Veles California Water Index (NQH20). This index tracks the volume-weighted average water prices of five California water markets, which results in one uniform reflection of the current water price in that region.

It follows from that last sentence that the existence of water markets already implies to a certain extent that the price is determined by demand and supply, rather than the actual intrinsic value of the good. Since water is the number one basic necessity for life, one could argue that this is wrong from a moral perspective. Luckily, these water markets are typically heavily regulated by the government, in order to keep the prices stable and fair.

Another reason that these markets function decently is the fact that they are based on the actual physical exchange of the commodity, and this is exactly where the recent developments could become extremely problematic.

Futures, like other financial derivatives, such as forward contracts, options and swaps, are instruments whose value stems from an underlying asset (such as a stock or commodity), and which don’t require ownership of an asset. This opens up the market to investors who do not actually need water for their businesses but intend to make a profit on the price volatility of the asset.

To a large degree, financial markets are already based on expectations rather than actual valuations. But where for example a company’s stock price is often closely correlated to its actual performance, complex financial derivatives tend to rely even more on market sentiments. Combined with perverse incentives, the results can potentially be disastrous.

A great example is the global financial crisis of 2008. In the run-up to this crisis complex mortgage derivatives remained highly profitable, despite the fact that the default rate of the actual underlying subprime mortgages was increasing exponentially. The systematic underestimation of the risk was a direct result of the product complexity, but was also due to the incentives that large investment banks created for ratings agencies.

These agencies had every interest in providing banks with the inflated ratings they wanted, as providing accurate but worse ratings could jeopardise their business with these same banks. While mortgages obviously have little to do with water, the following section will describe the inappropriate incentives that will potentially be created by turning water into a financial instrument.

The dangers of attracting profit-driven players

If the aim is to better manage water supply risk and prepare for future water shortage, the last thing you would want to do is open the market for individuals and institutions that might benefit from higher water prices. This creates an undesirable incentive to create shortages in order to generate more profit from higher prices.

While many traders might not respond to such an immoral incentive, it is not a scenario that can be disregarded. The increasing water scarcity associated with climate change and population growth is bound to lead to increased prices, and private companies that have ‘skin’ in the (financial) water game at the very least would not be tempted to increase water supply as it would only hurt them (financially).

In the worst case it will lead to even more restrictive water supply. One might even imagine that the increased profit motive could also incentivise privatisation of water markets. There are numerous examples of how privatising common goods ended in disaster, the most recent one being the Texas power crisis in February. As the only privatised electricity network in the US, energy companies charged citizens thousands of dollars for their electricity, because the extreme cold caused major power outages resulting in limited supply.

Since we are talking about the most important utility for survival in today’s world, it goes without saying that risking these kinds of consequences should be avoided solely on moral grounds. 

Preserving the safety of water markets

While the water futures market undeniably creates additional price transparency for consumer businesses, enabling them to limit risk and budget more accurately, it also creates an opportunity for investors to speculate on high returns, thus creating an incentive for excessive risk-taking.

If there is one thing that game theory teaches us, it is that players respond to incentives, either good or bad. This makes it a necessity to design markets that incentivise the desired behaviour and take the right countermeasures to prevent undesired behaviour. This can be done by either preventing the latter from occurring, or creating the kind of incentives, e.g. “penalties”, that make pursuing that behaviour become highly undesirable for the players in the market.

It is questionable whether the water market that has been created has substantially addressed these undesirable incentives. In addition, this new water market might lead to increased corporate activity in water-related markets, which likely comes at the cost of local consumers.

By making water a tradeable commodity, local agricultural businesses and municipalities are facing off against Wall Street hedge funds and corporate institutions. If we want water to remain accessible for everyone, that is a gamble we should not be willing to take.