Using Seasonal Forecasts to Inform Water Market-Scale Option Contracts

Abstract

Option contracts have been successfully established in water-scare regions to facilitate temporary transfers of water between users. The benefits are clear when the contract water quantity can be guaranteed by the seller. Where water right allocations are subject to interannual variability, guaranteed delivery may not be feasible. Skillful season-ahead forecasts of water right allocations and crop market prices have the potential to inform option contracts in such circumstances. Here, two theoretical growers’ cooperatives, representing high-value and low-value cropping within a basin, are modeled as exclusive water-trading partners. A two-firm demand equilibrium model is developed from a coupled crop yield and economic model, conditioned on each cooperative’s production inputs. Subsequently, several combinations of single-stage and multistage season-ahead forecasts of allocations and crop prices inform both the demand and an option contract model. Evaluating combinations of forecast and persistence-informed models against a perfect foresight-informed model, both the efficacy of the forecast-informed option contract framework and the value of forecast information are determined. Results indicate combinations including multistage season-ahead forecasts of allocations produce results that most closely represent expected trade volume, direction of trading, and market-scale joint profitability across a range of intercooperative water rights ownership scenarios. The multistage allocation forecasts exert more influence over option contract utility than forecasts of product market prices. This work highlights the value of forecast-informed decision making as it pertains to promoting market-scale economic and water use efficiency.