The future of water rights in California: water futures trading?

In December 2020, the Chicago Mercantile Exchange (the "Merc") began allowing trading of water futures through a new futures contract on the Nasdaq Veles California Water Index. This contract tracks the price of water rights leases and sales transactions across the five largest and most actively traded regions in California. This new development allows market participants to hedge against the future price of that commodity in order to manage financial risk.

Its supporters see water futures trading as a market-based solution that provides greater transparency, price discovery, and risk transfer for water users. However, others view it as a dangerous path toward benefitting from correctly predicting possible natural disasters such as drought and wildfires that cause water scarcity and human suffering. As this new market offering takes off, it will be interesting to see how it will interplay with the State's drought management efforts and existing California water law principles.

What Is Water Futures Trading?

Statewide in California, almost 1.5 million acre-feet of water are traded annually -- about 4% of all water used by cities and farms. Previously launched in 2018, the Nasdaq Veles California Water Index tracks water entitlement transactions from the surface water market and four adjudicated groundwater basins -- the Central Basin, the Chino Basin, the Main San Gabriel Basin, and the Mojave Basin Alto Subarea.

Futures trading is the practice of hedging on the future price of commodities in order to manage financial risk. The concept with the Merc's water futures trading contract is that market participants can buy or sell water at a predetermined price at a specified time. This essentially allows water users to lock in a spot price for water in the future that they are willing to pay -- thereby shifting the risk of price swings to the counterparty of the contract. The hope is that futures trading will create more certainty for those who rely on water in California, particularly in the face of climate change.

What Are the Concerns Voiced About Water Futures Trading?

Some have expressed concerns about the creation of the world's first futures market in water. They say it could invite speculation from financiers who would trade it like other commodities such as gold and oil. For example, Pedro Arrojo-Agudo, the United Nations' Special Rapporteur on the right to safe drinking water and sanitation, cautioned that "it is a serious mistake to consider water as a commodity ... such a futures market could also lure speculators such as hedge funds and banks to bet on prices, repeating the speculative bubble of the food market in 2008."

More broadly, the increased marketization of important commodities like water raises questions of whether this will lead to a situation like the 2000-2001 California electricity crisis. There, Enron took advantage of the deregulation of the State's electricity market and was involved in economic withholding. The company's actions inflated price bidding in California's spot markets and resulted in rolling blackouts caused by the artificial scarcity of electricity supplies.

Why Might Water Futures Trading Be Different than Trading Other Commodities?

Critically, however, water futures are cash-settled as opposed to physically settled, meaning that the contract is settled with the cash payment of the value of the contract rather than through delivery of the underlying asset. Therefore, as noted in a recent Los Angeles Times article on the Merc's new water futures trading contract, "[t]he futures contract will do nothing to increase the supply of water. Nor will it facilitate moving water from one place to another. Holders of the contract upon expiration can't take delivery of water, and sellers of the contract won't provide any. That's distinct from the terms of futures on gold, oil, wheat and other physical commodities, which can be settled by delivery of the underlying items." Ellen Hanak of the Public Policy Institute of California's Water Policy Center also suggested in a recent piece in Cal Matters that perhaps both the fear and the hype associated with the trading of water futures are unwarranted.

This distinction means that the new water futures contract likely will not implicate the traditional principles of beneficial use under existing California water law, which perhaps insulates the underlying use of such water rights from these market forces. Article X, Section 2 of the California Constitution requires broadly that the water resources of the State be put to beneficial use and that waste be prevented. Under that principle, as provided in Water Code Section 1240, the appropriative use of water in California "must be for some useful or beneficial purpose, and when the appropriator or his successor in interest ceases to use it for such a purpose the right ceases." The potential loss of one's water rights under this doctrine incentivizes the underlying water users to continue using such rights for useful or beneficial purposes.

Moreover, the transfer of water rights in California occurs in a complicated regulatory framework subject to extensive scrutiny and oversight. These rules differ significantly depending upon not only the type of water right at issue, but also where in the State these trades occur. These existing regulatory barriers further insulate what happens with precious water supplies from potential market forces.

Notwithstanding those legal and regulatory limitations, it remains to be seen how, if at all, the financial incentives possibly created by the new water futures markets may influence the actions of water users across the State. For example, in a recent set of blog posts, Cora Kammeyer and Michael Cohen at the Pacific Institute analyzed the new water futures market and explored the risks of market influence. They noted that, "the futures market could distract from investments in on-farm efficiency and reuse, as some irrigators may feel that hedging the risk of water price volatility outweighs the returns of such investments."

With the looming possibility of more frequent droughts and water scarcity in the future caused by climate change, Californians should keep a close eye on this new market development for water rights and work to ensure that one of our most precious resources, water, is ultimately used prudently and wisely. 