29 Dec 2020

Trading Water – a 21st century inevitability or a cause for concern?

If you think you have seen “everything” in 2020, well, think again!  This is the year that sees water traded on the stock exchange for the first time ever.  News from Wall Street that water is to be traded on the stock exchange spread quickly and overshadowed a raft of other, important financial stories.

This December the world’s largest financial derivatives exchange, the CME Group, launched futures contracts tied to the spot price of water in California, a market of $ 1.1 billion.  The very concept of trading water inevitably gives us all pause for thought about the reasons for and objectives of trading water.

Namely, over the past few years the issue of climate change, given the seriousness of the situation,   has been the subject of growing debate and decision-making. One of the consequences of climate change, but also of excessive human consumption, is precisely the lack of water.  With that in mind, it should be noted that the human right to safe drinking water was first recognized by the UN General Assembly and the Human Rights Council in 2010.

Countries that have already experienced water shortages include China, India, Mexico and the United States.  Moreover, it is estimated that water scarcity will affect the lives of as many as 5 billion people by 2050, which is not too far in the future.  In addition, the dearth of clean air also cranks up demand on clean water.  Water scarcity can lead to mass migrations, triggering further repercussions that manifest in the form of smaller or larger conflicts.

In this context, water scarcity would inevitably impact business in many industries.   One of the basic laws of economics applies here, so when there is limited supply, the price of the product rises.  Therefore, it is only normal that concerns about where water prices are headed in the future have prompted the market to seek a quick fix.

The fix was found in futures contracts. Futures contracts are contracts in which the sides agree on the purchase or sale of goods at a certain point in the future, and at a predetermined price.  This means that such contracts allow for the risk to be hedged, because the price has already been agreed, and will not fluctuate later with the variable factors that would have an impact on the price.  For the record, water has never been traded like this before.

For example, drought would definitely be one of the factors that would drive the price of water up. Under these contracts the agreed price would not change, regardless of the fact that there is a drought somewhere.  The conclusion of such contracts is a necessity whose very existence is conditioned by water.  In addition, the conclusion of this type of contract is also much more favorable for consumers who would undoubtedly bear the brunt “first-hand”, in terms of price hikes of products or services related to these businesses.

However, there is some skepticism as to whether futures actually reduce or increase risk when it comes to water as a traded good.  A United Nations expert expressed concerns over the creation of the world’s first water futures market, saying it invite speculation from financiers who would trade it like other commodities such as gold and oil.

Concerns about the (non) existence of a sufficient volume inevitably exist due to other factors, such as population growth.  In a way, trading water heightens this concern as it creates another risk in terms of sufficient volumes of water.

Critics of water futures argue that the necessity of water for human life is so great that it is absurd to put a price on water as if were just another good.  In this context, the importance of water as a resource during a global pandemic puts other resources necessary for survival under the spotlight.

Thus, the issues surrounding and criticisms levelled at this type of futures have, on the one hand,  one might say, a moral and solidarity aspect, while on the other is the economic treatment of public goods.

Leaving aside climate change and the fear that is evident where natural resources are concerned (otherwise, these futures would not exist), we must mention that this could be a very interesting opportunity for investors who want to diversify their portfolio.  Return on investment is expected to be very high in the future.

Given the innovation in the approach brought by futures when it comes to trading water, it is not possible to say anything with certainty for now.  It is our duty to keep an eye on the situation as it unfolds, in the hope that futures bring greater stability and actually allay concerns about water as an essential commodity that is crucial for both the economy and ourselves.

Authors: Mina Kuzminac and Teodora Ristić