Impact of Contract Structure and Risk Aversion on Interutility Water Transfer Agreements

Abstract

Water transfers are one method of allowing utilities to meet demand during dry periods while avoiding, or at least forestalling, the construction of costly new supply capacity. Nonetheless, transfer agreements must have clearly defined terms and decision rules to be effectively implemented. In developing these rules, careful consideration should be given to the risk tolerance of both the buying and selling utilities because these factors can significantly impact the nature of the agreements. This study uses a simulation approach to evaluate interutility transfer agreements that include different mechanisms to reduce risk for both the buyer and seller. For the seller these can include seasonal and volume-based transfer limits that ensure its ability to meet the demands of its own customers before making transfers. For the buyer, important features involve defining the conditions under which it can request transfers, a choice dictated by the buyer’s risk tolerance. Several potential agreement structures are considered, with the volume and frequency of transfers as well as the costs varying considerably depending on the risk-reduction mechanisms incorporated. Results indicate that more risk-averse contract structures can significantly increase costs relative to more risk-tolerant scenarios, even though the same reliability objectives are met. While some level of risk aversion is warranted based on uncertainties related to factors such as future demand growth and climate change, the degree of risk aversion justified is a question that deserves greater scrutiny in water resource management plans. In this case, even the most risk-averse agreements were still less expensive than comparable structural alternatives for improving supply reliability.