Formal risk‐transfer mechanisms for allocating uncertain water resources: The case of option contracts

Abstract

[1] Water allocation in Mediterranean basins is characterized by increasingly uncertain availability. Mechanisms that facilitate water transfers and efficient risk sharing are critical for dealing with cyclical water shortages. An option contract can be an appropriate instrument for aiding such exchanges based on specific water rights attributes. Access to certain amounts of water under preestablished conditions could provide the basis for the option contract. The main objective of this paper is to test the hypothesis according to which an option contract may be a viable instrument for achieving efficient sharing of hydrological risks. A dynamic, stochastic, and discrete time model is developed to characterize the contract from the viewpoint of the selling party. The application of this methodology can find the compensating premium, which is computed as a risk premium. The premium ensures adequate compensation for the seller as well as for the additional risk imposed by the contract. The hypothesis is empirically tested by simulating the contract as a partial solution to the problems faced by the urban supply system of Seville (Spain). The other party is an irrigation district. Results show that the option contract would be a viable solution for both parties. For Seville's urban water supply system the option contract provides a more cost-effective alternative water supply than those presently considered by the city's water company. We find that mixed strategies including company's drought plans and option contracts are the most efficient, leading to less severe and less likely water shortages within the city supply system.

Water option contracts for climate change adaptation in Santiago, Chile

“…Under markets for permanent water rights as well as temporal leases, agents react to market signals and scarcity levels using storage facilities more efficiently than in the absence of this economic instrument (Garrido, 2007a). Moreover, a combination of water options and traditional droughtmanagement measures may provide the most efficient approach (Gómez-Ramos & Garrido, 2004).…”

“…Option markets are a proven drought-management mechanism (Hansen et al, 2014b), and therefore act as insurance against specific situations where lack of water threatens significant negative economic impacts. In the context of water rights markets, water option contracts can be seen as a midpoint between trading water rights and water volumes (spot market), thus having the potential to reduce conflicts due to permanent transfers of water between sectors such as farming and water utilities (Gómez-Ramos & Garrido, 2004).…”

Developing portfolios of water supply transfers

“…This approach involves consideration of the expected value of water rights, a parameter that has been estimated as a function of various factors in previous research [Michelsen et al, 2000], but which in this work is computed using actual distributions of spot market lease data. While probabilistic approaches to option valuation have received some attention in the water literature [Gómez Ramos and Garrido, 2004], issues related to cost variability and trade-offs between expected cost and cost variability remain largely unexplored. This is an important issue, because while minimizing expected supply costs is certainly important, it is likely that cost variability will also play a role in decisions regarding a portfolio's suitability.…”

Managing Climate Risk in Water Supply Systems

“…In order to account for these competing user demands, Gómez Ramos and Garrido (2004) examined the use of options contracts to transparently transfer risk and compensation between irrigation and urban water users. In order to account for these competing user demands, Gómez Ramos and Garrido (2004) examined the use of options contracts to transparently transfer risk and compensation between irrigation and urban water users.…”