Anticipating The Next Level Of Sophistication In Water Markets

Tim Cummins and Charles Thompson

Tim Cummins and Associates, Rosebank, NSW 2480.

Introduction

This 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.

Irrigators' 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.

Those 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.

Risk Management Responsibility Is Being Transferred to Irrigators

In 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.

The 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.

Caps 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.

At 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.

Three 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 irrigators.

The Chicken-and-Egg of Different Industries and Different Risks

Water 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.

Have 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.

The 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.

Rice

Rice 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 resource (water).

Low 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.

Risk 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.

Dairy production

Dairying 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 "sales".

Under 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.

The 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.

Cotton

Cotton 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.

Although 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

Perennial 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.

The 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 year specified.

South Australian horticulturists enjoy a very high level of security. The upper states are obliged to pass minimum flows into South Australia even in severe droughts.

Land 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

Irrigators 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 Murray-Darling Basin.

There 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!

Water 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."

Models 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 them.

The 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

Individual farmers have four broad strategies for managing irrigation risk. They can:

1 - Assess the risk in more detail

• Analyse probability of seasonal allocations being increased later in the season (eg using historic records of inflows to storages and tributary inflows)

• Forecast weather for the coming season (eg using Southern Oscillation Index data and climate predictions)

2 - Improve on-farm water use efficiency

• Improve irrigation management (e.g. improve irrigation scheduling)

• Improve irrigation technology (e.g. install automatic bay gates)

• Substitute with other inputs (e.g. buy in more feed for grazing enterprises)

• Change other cultural practices

3 - Use alternative water sources

• Groundwater

• On-farm storages

4 - Trade water

• temporarily - impacting on business cash flow

• permanently - impacting on business capital value and interest payments

This 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.

The 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 sellers.

Markets Can Help Manage Risk

The 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

Futures 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 prearranged price.

Bernstein (1996), gives a text book example of how futures work:

"The 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.

"That 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."

In 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.

In 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 industries.

Options 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 price.

The 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.

Australia's Water Markets Are Maturing

Market 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.

Water 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.

More 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.

Market-Based Approaches to Risk Management Will Drive Market Sophistication

Derivatives 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 supply.

They 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.

They 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.

Perhaps 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.

Introducing trade in water derivatives would invoke the same sort of controversy that surrounded the initial introduction of water trade.

Acknowledgements

The 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.

Peter 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.

Marsden Jacob Associates' (1999) review of Water Trading Development and Monitoring in NSW gave depth to the information needs that will drive market sophistication.

The Victorian Department of Natural Resources and Environment funded various studies that have contributed to Tim Cummins's understanding of water markets.