The Next Level Of Sophistication In Water Markets
Cummins and Charles Thompson
Tim Cummins and Associates,
Rosebank, NSW 2480.
paper is about “markets” in the sense of what demand there may be for
different sorts of goods and services. It is less concerned with the
market-place, or the actual process by which buyers and sellers connect with
each other. Similarly, it is about sophistication in terms of what needs
will drive markets in the future; more than it is about bringing buyers and
sellers together with the aid of new technology.
risk management needs will drive the next level of sophistication in water
markets. And they will do so quickly. The cap on diversions in the
Murray-Darling Basin is accelerating what otherwise may have been a relatively
slow process under the Council of Australian Governments (COAG) nation-wide
approach to water reform.
reforms guaranteed a market driven future for the water industry. Since they
were introduced, governments have also concluded that environmental
sustainability for many of our river systems depends on no further growth in
diversions. For example, the Murray Darling Basin Ministerial Council has
agreed to cap Basin water use at the volume required to sustain 1994 levels
of irrigation development. Caps on diversion have radically altered risk
management processes in the water industry.
Responsibility Is Being Transferred to Irrigators
the past, water management agencies calculated seasonal allocations
according to their understanding of storage levels (and probable inflows)
combined with their expectations of actual irrigation water use relative to
announced levels of availability. Prior to the introduction of water
transfers, water management agencies could be confident that not all of the
water announced for the season would actually be used. If they did
underestimate actual usage, the shortfall was offset (at least partially) by
reducing water for the environment.
introduction of water trade initially transferred even greater risk to the
environment. The increasing activation of “sleeping” and “dozing”
allocations meant that historic records were no longer reliable guides for
anticipating future water use. Consequently, actual water usage was more
likely to be underestimated, and water for the environment was more likely
to be reduced.
on diversion stop this growth in environmental risk. They also transfer more
risk to those irrigators who had been making full use of their seasonal
allocation. Trade makes it likely that with time all entitlements will be
activated. Total announced allocations are therefore more likely to match
actual total water use each season.
the same time, water management agencies are starting to take a more
conservative approach in calculating the total volume available for
allocation. Previously, seasonal allocations at the start of the irrigation
season took into account both the volume in storage and the probable inflows
expected later in the season. From now on, initial seasonal allocations will
only account for water actually in storage plus an allowance for the minimal
inflows expected in a dry year. Irrigators will have to make their own risk
assessments about the probability of allocations increasing during the
course of the season.
major policy changes: water trading; increased water scarcity (made clear by
the cap); and more conservative assessments of seasonal allocations, are in
conjunction. This is dramatically shifting risk management responsibility
away from water management agencies and shifting it towards individual
of Different Industries and Different Risks
allocation policies have always influenced irrigation farming systems, just
as irrigation farming systems have always influenced water allocation
policies. For example, it is interesting to compare and contrast how the
security of water supply systems have evolved in NSW and Victoria. The NSW
supply system operates at relatively low security to maximise water use in
any one year. Victoria’s supply system operates at a higher level of
security in an effort to ensure base levels of availability for at least two
years in a row.
the farming systems in the two states developed in response to the security
with which water authorities have managed systems? Or have the water
authorities modified the security in response to irrigator needs and wants?
Are irrigators in NSW willing to take more risk than Victorian irrigators?
The answer appears to be that security policy has been tailored to the needs
of the dominant irrigated enterprise mix. Rice, the major irrigated crop in
southern NSW can accept more risk than dairying, the dominant irrigation
enterprise in Victoria.
most cohesive irrigation industries in the Murray-Darling Basin are rice,
dairying, cotton and perennial horticulture. Each of those has a different
irrigation risk profile.
is the dominant irrigation enterprise in the
southern parts of NSW. Rice based enterprises are mostly irrigated using
ponded, contour irrigation systems. No other ponded irrigation enterprise is
currently viable. Switching out of contour irrigation is difficult and
expensive. Individual rice businesses are generally growing and viable, but
the dollar return per megalitre is relatively low for the most limiting
returns per megalitre places reliance on maintaining scale (megalitre/family).
Before the current NSW water reforms this was relatively easy to achieve,
but those reforms will reduce average seasonal allocations. This will make
it more difficult for irrigators to maintain their scales of production.
When market water prices are low, rice-based enterprises are likely to be
net buyers of water.
profiles for rice are dominated by the potential to vary the planted area
according to water availability. Rice
enterprises are characterised by: relatively low crop loss per megalitre of
water shortage, and a low cost/income ratio means that the benefit of
conserving current water for future seasons is low.
is the most important irrigation enterprise in
Victoria. On average, Victorian dairy farmers have until now geared their
enterprises towards a mix of feed sources that makes use of their entire
water right plus more than 80 per cent extra water in the form of
current reforms, average “sales” availability will drop by 20 per cent
and it will be available in fewer years. It seems likely that “sales”
will become better defined. It will become a separate property right with
lower security than basic water right. The bottom line is that dairy farmers
will have to adjust to very significant change. They are likely to be
significant buyers in the water market. But for the first time they will be
able to choose a mix of (well defined) high and medium security water
“products” to suit their individual risk management strategies.
high cost/high income ratio for dairying means that the benefits of
conserving water are higher than for annual cropping enterprises. There is
also limited capacity to use surplus water by increasing the planted area
(the enterprise capacity is usually constrained by a limiting resource such
as herd size rather than water). Moreover, each megalitre reduction in
seasonal allocation incurs relatively high loss.
is the most important irrigation enterprise in southern Queensland and
northern NSW. Capital investment for cotton production is very high, and
cotton markets want predictable throughput, therefore irrigators strive for
consistent production. However, the climatically suitable growing areas
happen to be within highly variable-flow river systems. Water storages on
these systems are small relative to average flows, and very small relative
to peak flows. Therefore, irrigators endeavour to keep water in (on-farm
& off-farm) storages as long as possible. They use off-allocation flows
first, in effort to obtain consistent production from “total available”
water reforms mean greater uncertainty about average annual allocations in
the medium and long term, the major seasonal risk management strategy is
likely to remain the same. More cotton will be grown when seasonal
allocations are high, and less will be grown when seasonal allocations are
low. Over the long run, some irrigators will try to maintain or improve
existing allocations by buying extra water. This reinforces the need for
interstate trade arrangements to be developed between Queensland and NSW.
Perennial Horticultural Crops
crops account for significant volumes of water use in Victoria, NSW and
South Australia. Water allocation policies in each state have traditionally
favoured these crops. Nonetheless, Victorian horticulturists now seem
certain to be exposed to the risk of drought. In a repeat of the last
hundred years of climatic records, they would endure four years below water
right. In one year they would be reduced to 60 per cent of water right.
prospect for NSW horticulturists appears better but it is subject to some
uncertainty. On the Murray they are told to expect 100 per cent of their
volumetric allocation ninety nine years out of a hundred. On the
Murrumbidgee, they are told to expect 100 per cent of their volumetric
allocation “in all but the worst drought.” What constitutes the worst
drought is not specified. Nor is the expected percentage allocation in that
Australian horticulturists enjoy a very high level of security. The upper
states are obliged to pass minimum flows into South Australia even in severe
not water is the limiting resource for horticulturists in normal years. They
are potential sellers in the temporary market in normal years. Victorian
horticulturists are likely buyers in the water market in drought years.
Depending on the true nature of their property rights to water NSW
horticulturists might also be potential buyers in drought years. However,
without interstate trade, they may have no one to buy from; because when and
if their high security allocations were reduced there would be no low
security water available.
Risk Management Is
Clouded by Uncertainty
must deal with many risks. This paper focuses on the risk of their seasonal
allocation being different to the volumetric allocation. In effect it
concentrates on the risk of drought. And, to make life simple, it
concentrates on the relative risks of drought for irrigators throughout the
is a difference between risk and uncertainty. To paraphrase John Maynard
Keynes: The game of roulette is not subject to uncertainty, but the rate of
inflation twenty years hence is. He went on to say that for some matters
there is no scientific basis on which to form any calculable probability
whatever. We simply do not know!
managers throughout the Murray-Darling Basin have invested heavily in
understanding the patterns of the past. As responsibility for risk
management is transferred away from water managers, irrigators are
developing progressively greater interest in “exceedance levels,”
“one-in-a-hundred-year droughts,” and the like. This is invaluable
information, nevertheless it is clouded by what Bernstein (1996) described
as “nature’s tendency to repeat itself, but only imperfectly.”
of potential water availability are powerful guides to developing risk
management options, but they can create a sense of unjustified confidence.
Models are only as good as the weakest source of data used to construct
business of risk management is clouded further still, in some jurisdictions,
by a perceived lack of transparency about the way the security of water
entitlements is being calculated. Therefore, for many irrigators, their
immediate concern is the social and institutional risk that their rights may
be eroded. They are uncertain about the true nature of their rights. The
urgency of these concerns makes it difficult for some irrigators to explore
fully the on-farm risk management options open to them. But if “the essence of risk management lies in maximising the areas where we
have some control over the outcome, while minimising the areas where we have
absolutely no control over the outcome …” (Bernstein, 1996), it is
vital that they do explore their own management options. It is also vital
for them to be involved in helping to resolve the policy issues.
Irrigators Have Four Main
Risk Management Options
farmers have four broad strategies for managing irrigation risk. They can:
Assess the risk in more detail
probability of seasonal allocations being increased later in the season
(eg using historic records of inflows to storages and tributary inflows)
weather for the coming season (eg using Southern Oscillation Index data
and climate predictions)
Improve on-farm water use efficiency
irrigation management (e.g. improve irrigation scheduling)
irrigation technology (e.g. install automatic bay gates)
with other inputs (e.g. buy in more feed for grazing enterprises)
other cultural practices
3 - Use
alternative water sources
paper focuses on the trading option. Water trading gives individual
irrigators considerable scope for irrigation risk management. In the past,
water management agencies effectively managed risk and assigned uniform risk
levels to all irrigators in each irrigation industry. From now on,
individual irrigators will be able to manage their own exposure to the risk
of drought by buying or selling water entitlements. In so doing, they will
be substituting the risk of receiving a particular volume of water for the
risk of having to pay more for that same volume.
market price for water as a percentage of the total cost of production is an
important driver in water trading decisions. In horticulture this will be
fairly low and is unlikely to change existing plantings, but it may
influence future development. In dairying it will influence replacement
strategies such as purchasing feed versus irrigating pastures. In rice and
mixed farms the market price for water may transform water users into water
Markets Can Help Manage
water market is still immature. Its risk management potential has yet to be
fully explored. For example, it is possible that markets for water
“futures” and “options” will develop over time. This is predictable
because trade in such derivatives is usually associated with risk
management, and the risk of individuals not receiving their full entitlement
is steadily being more clearly defined and more widely understood.
Derivatives do not remove the risks that go with owning assets subject to
volatile markets, but they can determine who takes on the speculation and
who avoids it
are contracts for future delivery at specified prices. Options provide the
opportunity for one side to buy from (or sell to) the other side at a
(1996), gives a text book example of how futures work:
farmer is helpless before the risk of weather and insects, but he can at
least escape the uncertainty of what his selling price will be. He can do
that by selling his crop when he plants it, promising future delivery to
the buyer at a prearranged price. He may miss out on some profit if prices
rise, but the futures contract will protect him from catastrophe if prices
fall. He has passed along the risk of lower prices to someone else.
someone else is often a food processor who faces the opposite risk – he
will gain if the prices of his inputs fall while the crop is still in the
ground, but he will be in trouble if prices rise and boost the cost of his
raw materials. By taking on the farmer’s contract, the processor lets
the farmer assume that agricultural prices might rise. This transaction,
involving supposedly risky contracts for both parties, actually lowers
total risk in the economy.”
the water industry, there is at least one example of opposite risks. In
highly regulated streams, for some of the environmental values serviced by
“environmental water entitlements,” water is effectively most scarce in
seasons of low to moderate flooding. (River regulation can reduce flood
height and duration and therefore it can limit environmental benefits.) In
drought, when water is most scarce for irrigators it is not necessarily
scarce for those particular environmental values that are being exposed to
their natural drying cycle. Potentially at least, this offers the basis for
developing derivatives in water markets. But it is not yet clear to what
extent “environmental entitlements” could, or should, be traded. Nor is
it clear how the price of delivering environmental water should be met.
practice, relative differences in risk will probably be just as important as
opposite risks in the development of derivatives. For example, the
differences in risk profiles between annual crops and permanent horticulture
in Victoria are certainly large enough to allow the exchange of risks. Even
within particular industries, risk preferences, risk management options, and
appropriate skills in decision making will vary. And often there is greater
variation in profitability within industries than there is between
make intuitive sense for the water market. Those with most at stake in the
event of water shortages, those with high cost/income ratios, could buy call
options. These options could give them the right, but not the obligation, to
call on the other side to provide them with water at a prearranged price.
Those with lower cost/income ratios could buy put
options that gave them the right to put, or sell, water at a prearranged
buyers of call options would
effectively be insuring their crop production and insuring against the price
of water rising. The buyers of put
options might be prearranging a return from water that is greater than they
can achieve by irrigating a crop. Or, they may be insuring against the price
of water falling.
Call options would
presumably be more attractive to those irrigators with contracts to supply
produce to food processors or wineries. Such contracts are becoming a common
feature of Australia’s irrigated agriculture.
Markets Are Maturing
mechanisms were introduced more than a decade ago when water entitlements
first became separately tradable. The process since then has been
evolutionary. Pre-existing arrangements have been adapted and modified as
they revealed themselves inadequate for the new demands placed upon them. In
that sense, the subsequent change process has itself been market driven. In
part this evolutionary approach has been deliberate; it has helped build
community acceptance. But it has also been unavoidable. Any other approach
would have required a fuller understanding of the market than was possible
at the time.
markets have gradually evolved to the point where formal market structures
are being developed to make trade more efficient. For example, water
exchanges are starting to bring buyers and sellers together in an
information rich environment. Even if most trade occurs outside these
exchanges, they still provide “price-posting” for all buyers and sellers
in the “temporary” water market.
than ten years after trade commenced, most jurisdictions are now initiating
thoroughgoing reviews of the way their water markets operate. There are many
specific examples of the need for review of institutional arrangements. For
example, water trade lacks the marketable instruments common to other
tradable property rights. Land markets are based around “titles,” stock
markets are based around “scrip,” but water markets are largely based
around entries in “registers” held by Water Authorities. It is difficult
to ensure that traded rights actually exist. A marketable instrument would
allow the overall system to be audited. It would protect against fraud, and
it would provide investors with confidence in the property right. Water
property rights need to be explicit (regarding volume and reliability);
exclusive; enforceable and tradable.
to Risk Management Will Drive Market Sophistication
have a value only in an environment of volatility. Water markets are
certainly volatile, but we have only a primitive understanding of what
drives that volatility. The potential buyers and sellers of options would
want a more sophisticated understanding of the drivers behind demand and
would want some information in advance. They would want to know the full
range of industries and valleys with which they might trade. They would want
information on the ownership and size of entitlements for each valley,
district and river reach. They would want to know at what stages of the
season different players were likely to enter the market. They would want to
know which dates were critical ‘locked in’ dates for different
enterprises. They would want to know the value of water to each of those
enterprises. And they would want to detailed information on the methodology
for determining seasonal allocations.
would have to have specific “real-time” information. They would want
detailed information on usage for each valley, district and river reach.
They would want information on trading prices, trading volumes and trading
sentiment. They would want climatic outlooks. And they would want the latest
readings for the factors affecting seasonal allocation upgrades.
most controversially, trade in water derivatives would invite the
involvement of people and organisations with sufficient reserves to weather
some losses in the short-run in the expectation of making money in the
long-run. Some stakeholders in the water industry would see this as akin to
insurance companies smoothing volatility for all market players. Others
would see it as naked speculation.
trade in water derivatives would invoke the same sort of controversy that
surrounded the initial introduction of water trade.
National Program for Irrigation Research and Development (1999) funded the
report, “Irrigation Risk Management
in Current and Future Water Policy Environments,” by Rendell McGuckian,
Tim Cummins & Associates and Read Sturgess & Associates. It provides
the basis for much of the information in this paper.
L Bernstein (1996) wrote the book “Against
the Gods: the Remarkable Story of Risk” (John Wiley and Sons) that
informed most of the concepts in this paper.
Jacob Associates’ (1999) review of Water
Trading Development and Monitoring in NSW gave depth to the information
needs that will drive market sophistication.
Victorian Department of Natural Resources and Environment funded various
studies that have contributed to Tim Cummins’s understanding of water