Understanding the ebbs and flows of California's water markets

In this blog we explore how hydrologic information can better inform water market index values in California. As a part of this effort, we’re publishing a new weekly newsletter in partnership with WestWater Research that provides monthly updates on hydrologic conditions and forecasts in California’s most important reservoirs.

Dec 2, 2021
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Over the past century California constructed the nation’s largest state-built system of dams, aqueducts, and pumps to deliver water to its cities and farmers. While this engineered infrastructure has played a crucial role in supporting the country’s most populous state and most productive agricultural region (the Central Valley), climate change will cause extreme highs and lows in water flows beyond what California’s water infrastructure was built to accommodate. And, as the climate becomes more unpredictable, historical records of water flows will become less useful reference points for predicting water supply. 

As a result, water managers are looking beyond the concrete to explore new tools to allocate water and manage shortages. Water markets are one promising mechanism. New sources of water and weather data, if properly applied, can further improve their function to help organizations manage their water risk.

At Upstream Tech, we’re motivated by our work to improve forecasting skill and apply it to the world’s pressing environmental issues. In collaboration with NGOs, state agencies, and water resource engineers, we’ve used our HydroForecast application to improve hydrologic understanding of the American West. 

Drawing from this work, in this blog we explore how hydrologic information can better inform water market prices and trading activity in California. As a part of this effort, we’re publishing a new newsletter in partnership with WestWater Research that provides regular updates on California water market prices and trading activity, as well as monthly updates on hydrologic conditions and forecasts in California’s most important reservoirs.

California's San Luis Reservoir (credit: Fredrick Lee, Unsplash)

Boosting Market Participation

Water markets emerged in California in the early 1990s as a tool to address water scarcity associated with drought. In California, water market transactions are referred to as “water transfers.” A typical water transfer involves sellers leasing or selling a legal right to use water to buyers that need it. For example, in a drought year, a farmer may choose to fallow their rice fields and transfer their water to other farmers who need to irrigate permanent crops.

In California, water right holders transfer water in an active market. Although water market transactions happen frequently in California, prices are not reported or widely known and there has never been a financial tool to help market participants manage water supply and demand risk. 

In the last few years, two additions to this market sought to improve its transparency and to provide tools to manage financial exposure associated with water supply risk: In 2018, Nasdaq partnered with Veles Water and WestWater Research to create the Nasdaq Veles California Water Index (NQH2O) to track the spot price of water transfers in California. The Index allowed for the creation of a tradeable financial instrument, the NQH2O futures, which launched in December 2020. The NQH2O futures contracts are cash-settled* based on the NQH2O Index. The NQH2O Index and futures are intended to bring price transparency and risk management to California’s water market. While futures contracts are available for up to two years ahead, almost all open interest is currently in the shortest futures contracts.

How Hydrologic Information Can Inform Index Price

Known for its expansive reservoir systems, much of California’s water storage is allocated through the Central Valley Project (CVP) and the State Water Project (SWP)’s 17 reservoirs. To date, market participants have typically relied on a patchwork of sources to guide their buying and selling of NQH2O futures. These include, but are not limited to, organizational or personal experience, conventions derived from historical trends, and news reports on water availability throughout the state.

A new source of information is real-time hydrologic data, which can improve participant knowledge by providing standardized information that correlates with Index price. By understanding how inflows into these reservoirs correlate with the NQH2O prices, we can identify the value of hydrologic information for market participants. Figure 1 provides a map of the basins that account for 80% of the inflows into the CVP and SWP: Shasta, Oroville, Folsom, New Melones, and Millerton.

Figure 1. Location map of the five basins that contribute the greatest inflow volumes into the Central Valley Project and State Water Project.

Figure 2 illustrates the average annual observed inflow rate for each of these five reservoirs from 2000-2021. The patterns exhibit a signature spring snowmelt pulse, which occurs as the sun warms the mountain snowpack and generates flow into the reservoirs. This spring pulse is the most critical component in setting supply expectations for the year, as it dictates how much water is available for agriculture, environmental, municipal, and a range of other uses. Note how the spring pulse occurs earlier (March-May) among the big three reservoirs - Shasta, Oroville and Folsom - compared with New Melones and Millerton Lake, which receive inflow from further south in the Sierra Nevadas.

Figure 2: Average observed daily inflows into Shasta, Oroville, New Melones, Millerton, and Folsom, calculated from 2000-2021 observation records. Units are in thousands of cubic feet per second (KCFS). Data source: California - Department of Water Resources

These inflow patterns align with changes (deltas) in the NQH2O Index, as shown in Figure 3. This time series illustrates how much the Index price changed on average in each month between 2013 and 2021. Most of the changes in the Index (both up and down) occur from February to March and April to May with very little change in June, October, and the end of the year. For example, the increase in Index level in April is indicative of the seasonality of farming, where farmers will pay a premium to secure water around April so that they know it’s available for the irrigation season (from June to August).

Figure 3: Average absolute change in the Index price by month, using historical Index data from 2013-2021.

As Figures 2 and 3 illustrate, the timing of the largest increases and decreases in Index price occur at the same time as the rise and fall of the spring snowmelt pulse. Investigation of observed inflow volumes during this spring pulse - from March through May - indicates a strong relationship to the next month’s Index change. Further driving this point, a robust linear regression analysis resulted in an R2 of 0.35, with all coefficients showing statistical significance. 

This suggests that we’re seeing a correlation between Index price and the spring snowmelt pulse: hydrologic information consistently explains roughly a third of the future Index price change during this period of the year. Again, the snowmelt season in California is the most important time of the year for determining water availability for human consumption, ecosystems, and agriculture.

During periods when streamflow patterns diverge from the historical average, a change in the Index value is also observed. Visualizing the anomaly, which is the difference between the observed inflow and the long-term average, illustrates the relationship between changes in relative surface water availability and changes in the Index value during unusually wet and dry periods. Figure 4 illustrates this relationship between the inflow anomaly and the NQH2O Index from 2013-2021.

Figure 4: Time series of weekly observed inflow anomalies (colored lines), in units of flow rate (thousands of cubic feet per second) and the NQH2O Index value in dollars per acre-feet (black dashed).

Generally, the Index price goes higher during dry times and lower during wet times. This stands to reason: water is relatively more valuable when it is scarce. The Index price shifts often trail peaks in inflow, and the largest price shifts typically occur after anomalies in flows. Each substantial spike in the Index value (2014, 2015, 2018, 2020, and 2021) follows an anomalously dry period, especially following lower than usual spring melts. In wet years (2017 and 2019), the Index value dropped as a result of increased supply and lower market demand for water. 

Next Steps: Using HydroForecast to Improve Market Efficiency

The strength of the relationship between Index price and observed (current) inflows suggests that forecasts of the 1, 2, and 3-months ahead inflow forecasts would provide market participants with important foresight into the spring’s likelihood of being a ‘wetter’ or ‘drier’ year. 

To put these insights into action, beginning in early 2022 Upstream Tech will distribute a monthly outlook report to support California water users.

The newsletter will include current hydrologic conditions and forecasts for the next month’s inflow, as well as temperature and precipitation forecasts, for the five largest reservoirs in the state projects. 

In a future post, we’ll detail more thoroughly how HydroForecast’s forward-looking predictions can support market participants in making more informed decisions. HydroForecast takes a unique, theory-guided approach to hydrological modeling using artificial intelligence, remote sensing, and a behemoth of a data processing pipeline. Behind the tech buzzwords is the most accurate and flexible operational hydrological forecasting system operationally available. In short: we are the best at predicting how much water will flow through any river over the next 10 days, 3 months, and beyond.

Interested in more detailed data or further-into-the-future forecasts? Connect with us at team@hydroforecast.com.

*Most futures contracts traded across all commodity markets are cash-settled, meaning that there is no physical delivery of the commodity at the settlement date. Instead, the value of the futures contract is based on the value of the associated index at the settlement date, and the buyer/seller are credited or debited based on the settlement value. Similarly, the NQH2O futures do not cause the movement or delivery of physical water, but rather provide a financial hedge against movements in the spot price of water in California’s water transfer market.

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