Market mechanisms and efficient allocation of water: modelling water prices, option contracts on water and enhancing frameworks

Abstract

Issues associated with water scarcity are widespread and growing, making efficient allocation of this precious resource vital. In the face of these growing challenges, the creation of effective tools to enhance our ability to allocate water efficiently will help mitigate the impacts of water shortages and aid in the planning process. This dissertation endeavors to help develop tools for this purpose by harnessing the allocative power of market mechanisms and encourage strong supporting frameworks that aid the implementation of these mechanisms. Water is critically important for many reasons, chiefly it supports all life on the planet. To examine the possibility of treating water like a commodity, its value needs to be understood in terms that are less abstract, and the common valuation for commodities is price. Therefore, understanding what the monetary value of water is can help inform market participants and architects as to how a market could be priced. Chapter 1 formulates a price for water in the U.S. by examining Australian water market data, applying machine learning to that data to model price, then applying that model in the U.S. to generate a price for water. Water scarcity is a global issue, and Chapter 2 helps regions where cash water markets are already established by formulating a method to price options on water. Options are a financial tool whose value is based on an underlying asset (in this case water); so, to have a traditional options market it is helpful to have a robust cash market. Australia has a longstanding and active water market, but to date there has not been widespread implementation of options. Part of the problem is that the water market is highly volatile, making it difficult to price options using traditional valuation methods. Chapter 2 explores ways that the model from Chapter 1 can be tuned and combined with volatility calculations to help solve this challenge. By offering a method to price short-term options where robust cash markets exist, this chapter helps the global community and can offer a road map to future options trading in the U.S. In addition to short-term options, the development of longer-term options can be beneficial to market participants in the U.S. in general, and Texas in particular. Chapter 3 examines how options are traditionally structured, then modifies those elements so that they may be applied to water options spanning timeframes considerably longer than standard option contracts. Typically, option contracts last 3 months, and these options are designed to cover a span of 5 to 10 years. Initially the motivation for this work was to create a tool that would enable interested parties to deliver environmental flows of water downstream in times of need, but the application of the tool can be more broadly applied and used by any party interested in securing the opportunity to pay for—and take delivery—of water at a later date. There is another aspect to water markets that needs to be considered when attempting to scale up market operations; existing regulations and frameworks need to be evaluated to understand how well they support highly functioning markets. Chapter 4 looks at current regulations and frameworks in Texas to establish how well they support water markets and notes places where improvements can be made. Some of the suggestions are fairly simple and some of the suggestions are more complex, but the hope is that by looking at what is—and is not— working this chapter will help to move policy makers and potential market participants along a trajectory that can help markets flourish.