Commodities

Why India needs a futures exchange for water?

NILANJAN GHOSH | Updated on August 27, 2014

SERGEY NIVENS/SHUTTERSTOCK

The entire agricultural value chain, starting from the farmer to the consumer, will stand to benefit

The risk of water availability is a painful reality in south Asian agriculture including India. Any deviation from the monsoon causes problems for the farm community and poses threat to food security in the region.

The variability in precipitation in India has actually increased in recent years. While comparing the variability of precipitation (given by standard deviation) between two phases, 1950-75 and 1976-2010, in two geographically dispersed districts in India, it was found that in Tumkur, Karnataka, the standard deviation of precipitation during the South-West monsoon increased to around 171 in phase 2 from 147 in phase 1, while the same in Medinipur, West Bengal, increased to 220 in phase 2 from 188 in phase 1 – both cases revealing higher fluctuations in precipitations in phase 2. Fertiliser Association of India data for 35 select districts during 1989-2009 show that precipitation has varied between 77 per cent (in the worst case) to 119 per cent (in the best case) of normal rainfall (defined by long-term average value).

Moreover, between 1999 and 2008, rainfall has been scanty, and for eight years the precipitation has been less than normal. Because of this erratic nature of the Monsoon, the risk of water availability has increased.

Risk mitigation strategies, on the other hand, have primarily been confined to supply-augmentation plans and demand-management mechanisms. It is difficult for supply-augmentation plans (such as construction of big dams, water transfers, etc.) to succeed as water in most river basins in India has already been fully allocated. Moreover, none of the current risk-mitigation strategies financially compensate in those instances where water is unavailable. Rather, there is a value loss. Informal water forward markets are in vogue to a certain extent in many parts of South Asia, though they have not been successful enough to mitigate the risk of water availability at the river basin scale.

Parties with exposure to water availability risk are not merely irrigators, but also investors, financial market participants, banks, etc. Investors and financial market participants have no desire, ability, or interest in acquiring physical water to offset that risk; neither do they have any incentive to take up the hedger’s risk and take physical delivery of water. Yet, lending institutions like banks might bear an inherent risk with water availability.

Risk of crop failure

A bank may lend money to a farmer to invest in planting a crop, and gets exposed to risk of crop failure due to failure of rain. An agricultural processor also faces the risk as water shortage will affect his processing. Even re-insurers do not have any means of covering their exposure to floods.

None of these parties have any incentive in trading of physical water rights, and hence their risks do not get mitigated. Undoubtedly, South Asia presently requires a different institution to hedge against this risk. Such response can occur in the form of a water futures exchange. There are various expected benefits of such a futures markets. First, water futures will help discover price (through the scarcity value of the resource), leading to efficient use of the resource.

Second, it will provide a price indicator for future stored water, assist investment decisions as also forward risk management, and will offer an objective instrument of decision-making for project prioritisation.

Third, irrigated as also rain-dependent agriculture, dependent on the availability of water, will be able to use the market to insure themselves against droughts by locking in prices in the water futures market. Such risk transfer in the private sector will significantly reduce the burden of drought relief currently borne by governments.

Fourth, water futures provide the financial tools required by investors and banks to invest in the rural sector. This would result in long-term planning and investment to deliver water to needy areas.

Moreover, banks and financial intermediaries can develop other products suitable for their customers by making use of the water futures market. Fifth, it will help in promoting the best water-efficient technology. Sixth, the price discovered in the futures market can offer a mechanism for setting conservation priorities within a limited budget.

Beneficiaries

As a result, the beneficiaries from a water futures exchange are many. On the one hand, the beneficiaries include the entire agricultural value chain starting from the farmer to the consumer. Hedging in the water futures exchange will not only minimise the risks of the producer and the supplier, but will also enable passage of parts of the benefits to the consumers.

A futures market for water will act as a market-based “bail-out institution” for all the beneficiaries. In a similar vein, corporations producing hydropower may also benefit from the futures markets.

Municipal corporations, municipalities and water boards can also do so by taking positions in the futures exchange for water and use the funds for infrastructure development.

However, water futures should be traded in indexes and the final trade should be settled in cash. Physical delivery might not make sense and might deter trading for two principal reasons.

First, the cost of physical delivery might be high (due to infrastructure, movement costs, etc.) that it will deter participation and curb liquidity.

Second, a majority of the stakeholders (banks and other lending organisations) are not concerned with the physical availability of water, but more with value loss due to water scarcity.

Unfortunately, in India, till now it is not possible to trade an index in a commodity futures exchange, as the regulatory statute does not allow trading in commodity index futures. Hence, to enable futures trading in water availability index, either the existing statute needs to be modified, or a separate statute for creation of water futures exchange needs to be passed for quenching the thirst of a water-scarce economy.

(The writer is Chief Economist, Multi Commodity Exchange of India Limited. Views are personal.)

Published on February 25, 2014

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