Gillian Flaccus/AP Photo
Farmer Ben DuVal and his family stand near a canal for collecting runoff water near their property in Tulelake, California, March 2, 2020.
In September 2020, as wildfires lashed a drought-stricken West Coast and average water prices in California leaped to double what they had been a year earlier, the Chicago Mercantile Exchange and NASDAQ announced a new tool to bet on the price of water.
The exchanges were offering a futures contract—an agreement to buy an asset at a predetermined time—structured much like existing derivatives that allow investors to wager on changes in the cost of pork or palm oil. The launch prompted considerable distress from environmental nonprofits.
“My first reaction when I saw this was horror,” Basav Sen, climate justice project director at the Institute for Policy Studies, told the news outlet Earther. “What this represents is a cynical attempt at setting up what’s almost like a betting casino so some people can make money from others suffering.”
In response to criticism, progressive lawmakers including Rep. Ro Khanna (D-CA) and Sen. Elizabeth Warren (D-MA) last month introduced a bill that would ban water futures trading.
“It’s a matter of first principles,” Khanna told the Prospect in an interview, explaining his reasons for proposing the ban. “It makes no sense to open up speculation on an essential commodity that could lead to profiteering.”
Not all Democrats were equally alarmed. Rostin Behnam, who chairs the agency tasked with regulating derivatives, praised the contracts as a tool to help manage climate risk. Other proponents point out that, when prudently regulated, futures contracts can be beneficial hedging tools. Many believe that lawmakers seeking to ban the derivatives simply do not understand the financial instrument being offered.
But while the progressive critique often comes with a heavy serving of moral indignation, critics of the new derivative product have identified substantive reasons to curb trading. And the concerns they raise over water futures contracts—opaque pricing data, cursory regulatory review, and high position limits—are examples in miniature of flaws that afflict privatized commodity markets more generally.
IN CALIFORNIA, A GROWING agricultural sector vies with municipalities and industrial users over a dwindling water supply. During a drought that lasted from 2012 to 2016, farmers were at some points willing to pay more for water than cities. Weather and shifts in demand have driven dramatic swings in the price of water, which can vary from $50 to more than $2,000 an acre-foot.
Futures contracts offer one way for big water users to guard against losses. A farmer might purchase a contract to buy water during the winter, for a date six months in advance, at $700 per acre-foot. Come summer, if the cost of water has risen by $50, he will be paid the difference, and won’t be left shelling out the higher price. If water is plentiful and the price has fallen, he’ll owe the difference to the seller of the contract.
Crucially, the contracts do not confer rights to the water itself. They are based on the Nasdaq Veles California Water Index (NQH2O), which tracks the spot price of water entitlements in California, and they are cash-settled, meaning that traders cannot demand physical delivery of water. A farmer who holds a futures contract is just betting on which direction prices will move, so when it comes due, he will still need to find a seller of water on the market.
That makes water derivatives different from other commodity futures contracts, like crude oil, which let buyers demand physical delivery of oil barrels, rather than settling up in cash.
Still, critics have leaned heavily on the analogy to other commodity markets, arguing that it is a mistake to treat water as a commodity for price speculation like gold or soybeans. Even without a direct tie to the underlying resource, they argue that cash-settled futures could still increase price volatility and threaten water affordability and access.
REACHED FOR COMMENT while on safari in Namibia, Lance Coogan, the CEO of U.K.-based Veles Water, which runs the NQH2O, dismissed the possibility that trading cash-settled derivatives could have an effect on physical water markets.
“It’s like saying you buy the CPI index and manipulate the American economy,” he said, referring to the Consumer Price Index, a measure of the cost of average household goods. NQH2O is different from other commodity futures, he added, because water rights are so heavily regulated. “It’s not bullion, it’s not platinum, it’s not oil—it’s completely different.”
Economists have long debated whether commodity futures trading could increase price volatility or drive up costs. One paper examined 21 commodity markets and found that commodity market speculation does not unstick prices from supply-and-demand fundamentals. But other research, including econometric modeling and empirical studies of historical trading, has found that even cash-settled derivatives can increase incentives for manipulation and drive up prices.
For example, say a farmer buys futures contracts to hedge his price exposure to a commodity he’s planning to buy. When the contracts come due, he might have reason to buy more of the physical commodity than he actually plans to use, to push up the payoff of the contracts. Purchasing more than your total risk exposure can drive scarcity in the physical commodity.
Indeed, there are historical examples of traders using this tactic in markets from cotton to oil. Anthony Lee Zhang, an economist at the University of Chicago, modeled their behavior in a recent paper that examines problems stemming from a liquidity mismatch, in which the amount of trading in financial contracts far exceeds the volume of trade in the underlying asset.
That hasn’t happened yet with the new Veles water index. In fact, the economists Ellen Bruno and Heidi Schweizer pointed out, it has attracted relatively few traders compared with other cash-settled futures contracts like pork cutouts, which were launched around the same time. End users could be showing less interest since the contracts are cash-settled and don’t help secure physical water.
Critics argue that it is a mistake to treat water as a commodity for price speculation like gold or soybeans.
But the water futures market may not be illiquid forever. Another reason for the lagging uptake could be that farmers of commodities that have long been popular as futures already have accounts at the Chicago Mercantile Exchange (CME). Major users of water in California, by contrast, include almond farms and vineyards—sectors that have less experience with commodity trading. Recent signs do point to greater uptake of water futures. Last month, the number of open contracts spiked to 114, up from an earlier maximum of around 60.
Zhang said regulators could help prevent price manipulation by setting lower position limits, or the number of contracts one individual trader can acquire. Currently, CME rules say a trader can acquire 35,000 contracts per month. If one trader were to max out his position, he could hold contracts representing about 19 percent of the deliverable supply of water underlying the NQH2O, according to a memo by critics.
Coogan says manipulation of physical water markets through tactics like the one Zhang described is not feasible, since water is heavily regulated by watermasters and other bureaucrats, and it takes weeks to arrange for purchase and delivery of a large quantity of water.
But there are other risks attached to the NQH2O. Veles pulls its transactions data from Waterlitix, a proprietary database on water markets maintained by WestWater Research LLC. That estimate of California water pricing is compiled from a mix of regulatory filings, lease agreements, and other data including direct interviews with parties to transactions, according to a paper co-authored by WestWater Research’s managing director, Clay Landry. Without public data, however, there are few ways to independently verify the accuracy of WestWater Research’s private price estimates.
The Commodity Futures Trading Commission (CFTC), the regulator charged with overseeing derivatives, has not independently reviewed whether the water futures meet its requirements. The NQH2O was listed through the CFTC’s self-certification process, which requires no prior approval from regulators. Under current practices, the CFTC would not need to evaluate the contracts until there are more than 10,000 open contracts. That would represent around 9 percent of the water traded annually in California, according to a memo by groups critical of the contracts, who say the lack of scrutiny heightens the risk of market manipulation.
Describing the CFTC’s review process, one law professor in corporate finance argued that “self-certification allows exchanges—who have a financial incentive to list new products, regardless of how risky they may be—to quickly list complex commodity derivatives with no public or market input, and minimal regulatory review.”
In addition, while the contracts are available to all comers, from Wall Street traders to small farmers, it is unlikely that they will be taken up by water consumers who are inexperienced in financial markets.
“There is just a massive, embedded disadvantage for smaller end users in a commodity, in this case water, to be able to effectively participate in financial risk management associated with derivatives trading,” said Tyson Slocum, an advocate with the nonprofit group Public Citizen.
Large cities might have the resources to hire a commodity trading expert, but most municipalities would not have the sophistication to participate, Slocum said. Instead, he cautioned, small cities would be more likely to contract with banks or brokers to handle the trading—and similar relationships have opened up cities to risk in municipal bond markets.
Coogan disagreed. “A small city will have accountants, and engineers, and I can guarantee you all of them will be able to work out how this works, if they’re shown properly,” he told the Prospect. “Set up a talk show between me and these counterparties.”
PUBLIC STATEMENTS BY OPPONENTS of water futures stress that “water is not a commodity.”
That statement can sound metaphysical or even biblical. It is the sort of claim that makes neoclassical economists and market commentators roll their eyes at knee-jerk critiques of corporate greed. After all, they argue, this is just an insurance contract.
But the argument that water is not a commodity is not just a moral complaint—it is actually a legal objection.
“Water trade rights are governed first and foremost by public trust doctrine, so it’s not a pure commodity,” said Zach Corrigan, an attorney at Food & Water Watch who has worked on the group’s campaign opposing water futures. While states have allowed water trading within that principle, courts have long emphasized that water markets are embedded within state law—which can be rewritten. California is careful to stipulate, in every allocation of water, that it is extending a right that is not absolute.
Landry, the director at WestWater Research, declined to comment on the record for this article. But the paper he co-authored on water markets warns of political risks stemming from water trading that could potentially lead to backlash. “[I]f water transferred out of a region results in impacts on local employment and income, such third-party effects can lead to transfers being politically unattractive (and lead to limits on transfers).”
In the meantime, financial products related to water rights could become more attractive as investors in environmental, social, and governance (ESG) assets seek new offerings. A further concern is that the mere existence of contracts tied to changes in the price of water could encourage water markets to be privatized. McKinsey, a strategy consultant, has argued that an anticipated bonanza of public investment in aging water systems presents an opportunity for private capital. Private equity firms are beginning to approach public water utilities with proposals for private management.
For now, water entitlements remain hyperlocal, complex, and widely varied from basin to basin. An international futures market run on private exchanges and overseen by a federal regulator, Corrigan said, cuts against the intent of case law that has insisted that economic activity related to water rights remain local.
Coogan, the Veles CEO, was born in South Africa and is now based in the U.K. He describes himself as a “brilliant environmentalist” who got his start developing carbon credits for projects based in developing countries. Undeterred by the threatened ban on his water futures index, he is now considering getting into further work in markets related to ESG investing.
“I am trying to put together a leading community project that involves conservation of wildlife and biodiversity plus combining my water knowledge and the use of the carbon market,” Coogan added over text, following an interview with the Prospect. “Am designing a tradeable biodiversity index as well. Is a bit of a challenge but will get there.”
