Streetwise Professor

September 26, 2020

Water, Water, Not Everywhere and Still Not a Drop to Drink, Or, The Very Natural State

Filed under: Climate Change,Derivatives,Economics,Exchanges,Politics,Regulation — cpirrong @ 2:53 pm

The WSJ reports that the CME Group is launching a cash-settled futures contract on California water, with Nasdaq providing the cash price index. I predict, with a high degree of confidence, that this will not be a commercial success. That is, it will not generate substantial trading volume.

Why not? For the same reason that listed weather derivatives hardly ever trade. Information flow is a necessary (but not sufficient) condition to make people want to trade. For weather derivatives, there is very little information flow until shortly prior to the pricing month. For example, what information arrives between today and tomorrow that leads to updates in forecasts about what the weather in Chicago will be in December 2020, let alone December 2021? Virtually none. Given the nature of weather dynamics, information flow occurs almost exclusively quite close to the contract date (e.g., in late-November 2020 or 2021, if not in December itself). There is little information that arrives today that would motivate people to trade today contracts with payoffs contingent on future weather, even for a future only months away.

So they don’t.

I predict a similar phenomenon for water derivatives. Most of the fundamental shocks are weather-driven, and those will be concentrated close to the pricing month, leading to little demand to trade prior thereto.

Moreover, successful futures contracts rest on functional physical markets. As this recent article from The American Spectator summarizes, it is a travesty to characterize the means of allocating water in California as “a market.” Instead, it is an intensely politicized process.

If you don’t consider the AmSpec reliable, do a little digging into the scholarly literature about water allocation in the West, notably things written by my friend Gary Libecap. The conclusions are depressingly similar.

The politicization of water allocation is not new. It has existed since the beginning not just in California, but the West generally. Control of water confers enormous political power. You think politicians are going to give that up?

Again, this is not a new thing. Read up on the “California Water Wars.” Or, for a more entertaining take, watch Chinatown, which is a fictionalization/mythologization of the conflict of visions between William Mulholland and Frederick Eaton over water in Los Angeles. Spoiler: the romantic vision died (literally drowned), and the corrupt vision prevailed.

California politicians will become charismatic Catholics before they give up control over water. In a way, it reminds me of the effect of sanctions in say Saddam’s Iraq. Restrictions on supply resulting from sanctions empowered the regime. It could use its power to grant access to a vital resource in order to obtain obeisance. Similarly, California politicians can use their power to grant access to the vital resource of water to obtain political support, and exercise political power.

In a way, this is the quintessence of something I used to write about in regards to Russia: “the natural state.” Here, the analogy is even more trenchant, given that it relates to a natural resource.

The natural state operates by creating artificial scarcity, which in turn creates rents. The natural state allocates those rents in exchange for political patronage.

To do things that would undermine the rents–that is, to alleviate the scarcity–would undermine political power. That will NOT happen voluntarily. Markets for water would be a good thing–which is precisely why they don’t exist, and are unlikely to exist, especially in places like California where water is scarce and hence real markets would be most beneficial.

So CME/Nasdaq California water futures face two huge obstacles. First, even if even a simulacrum of a cash market for water existed, the nature of information flows is not conducive to active trading of water futures. Second, there is not even a simulacrum of a water market in California. What exists in place of a market is a political, and highly politicized, mechanism. That is also inimical to building a successful futures contract on top of it.

PS. Riffing of the Rime of the Ancient Mariner in the title provides an opportunity for another Python reference!

Albatross!

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9 Comments »

  1. I was on the CME board when we introduced weather derivatives. Academically, it makes sense. In practice, it hasn’t. At the time we talked about trading water futures but water is so highly regulated we didn’t attempt it. Interesting they are doing it now. Agree, probably won’t be a commercial success, but academically trading water futures makes a lot of sense. Trading futures on things like cloud storage etc seem like a good idea too.

    OTOH, I watched the Social Dilemma last night and a Harvard Prof said Facebook, Google, Amazon, Twitter are trading in human futures. Interesting.

    Comment by Jeffrey Carter — September 26, 2020 @ 3:12 pm

  2. @Jeff–I’m sure that CME did this primarily as a PR thing. It succeeded in getting a lot of attention.

    Physical water trading makes economic sense. But not political sense. Which is why it doesn’t exist except in extremely distorted forms. And futures on top of a Frankenstein cash market makes no sense.

    Comment by cpirrong — September 26, 2020 @ 4:04 pm

  3. California’s commoditized water is a classic case of special interest groups under massive political patronage successfully privatizing profits and democratizing losses.

    Comment by Sudhir Rao — September 27, 2020 @ 12:45 am

  4. “The politicization of water allocation is not new. It has existed since the beginning “: by which you presumably mean Sumer. Bet you’re right too!

    Comment by dearieme — September 27, 2020 @ 5:49 pm

  5. @SWP…Off topic, but you would be particularly interested to read this thread: https://twitter.com/MagaKarma1/status/1310380781769035777?s=20

    Comment by Richard Whitney — September 27, 2020 @ 9:20 pm

  6. Interesting and persuasive article as always.

    As I was reading, I was thinking, “what that market really needs is to have a LNG moment”, copying the disruption that we have already seen on the pipelined natural gas market, which for years was also highly politicised and lacked its own market-pricing mechanism. On the face of it, that’s a silly idea: It just isn’t going to make economic sense to have ships ferrying freshwater from Canada to California (or whatever).

    But what about desalination? Solar electricity ought to be very cheap in California (even without subsidies: Private companies frequently bid crazy-low prices per MWh for new-build solar farms all over the world), and we can ignore solar’s usual time-displacement issues here since they wouldn’t apply.

    I assume that there isn’t a statewide grid as there is for electricity, but is it possible to choose one or two areas with the largest water shortages, pipeline in seawater to a desalination plant and to use a solar farm for the sole purpose of that desalination. That entity could be a spot-provider, adding water to the network in one point of the network (and storing it there for a few days, thus mitigating the solar intermittency), which it can then sell at some other point in the network (minus a transit fee). The presence of this entity would create a real market price, which then starts to make the existing pipeline network pricing look very archaic indeed, and maybe leading to some degree of reform, again, like in the natural gas pipeline market.

    I’m sure there’s many problems with that idea, but A: I’m an engineer, not a business-person and B: It was fun to think about 🙂

    Comment by HibernoFrog — September 29, 2020 @ 9:30 am

  7. HF: Israel’s been doing some of that.

    https://www.irishtimes.com/news/ireland/irish-news/how-israel-used-desalination-to-address-its-water-shortage-1.3959532

    Comment by ColoComment — October 4, 2020 @ 10:09 am

  8. @ColoComment: Thanks for sharing. Interesting to see this being done by a non-petrostate in the Middle East. Presumably they have a decent commercial basis for it. That then begs the question of why it doesn’t happen in the USA – capital ought to be easy to get, the technology is well understood and demand is clearly there. I guess it’s like the Prof says – vested interests don’t want to give up their control…

    Comment by HibernoFrog — October 5, 2020 @ 3:11 am

  9. Like water, the radio spectrum is a public resource, and most of what you say about the politicization of water allocation also applies to spectrum allocation. Even with the shift to assigning spectrum licenses for commercial wireless services by auction, the natural state persists. Proposals for so-called market-based reforms abound, and some politicians claim to support such reforms, but they are not going to give up the political power that control over spectrum allocation confers.

    Comment by Koshmap — October 6, 2020 @ 9:29 am

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