By Ellen Hanak

California’s increasingly volatile warming climate is making droughts more intense, and complicating water management. A just-launched commodity futures market for the state’s water provides a new tool for farmers, municipalities and other interested parties to ensure against water price shocks arising from drought-fueled shortages.

Taking a Wall Street approach to an essential natural resource has prompted both fear and hype. Will California experience a new Gold Rush in water? Will speculation boost the cost of water? Perhaps both the fear and the hype are unwarranted.

To address the fear: this new market doesn’t allow hoarding or moving water out of the state. In fact, it doesn’t involve real water at all. It’s strictly a financial tool that allows participants to bet on the future price of water in California. Water users can lock in a price they are willing to pay. And although this market will also be open to investors, their involvement won’t change the amount of water that’s available in California or the price at which it’s ultimately sold. Crucially, the futures market won’t disrupt protections already in place to ensure actual water trades are done responsibly.

As for the hype, this new tool won’t alter the facts of California’s essential water challenges. The promise it brings is in helping water users manage the financial risk of droughts. Those who guess correctly about dry years and rising prices can then sell their shares for more than they paid and use the profits to buy actual water at those higher prices. In dry years, this market could also enable farmers who locked in a lower price to use their profits to cover some of the costs of fallowing farmland—like a type of weather insurance. Participants can also lose money in years when the rains are better and water ends up being cheaper than expected—like paying for insurance but not making a claim.

While this new tool may help manage the financial risk of droughts, the more important work ahead is to strengthen the state’s actual water market. Water trading has been an important management tool for several decades—helping cities, farms and environmental water managers meet evolving demands in our variable climate. Trading still makes up a relatively small share of total water use—about 4%. Yet it brings much-needed flexibility to California’s system of water rights, which determines how much water is allocated and where it is used.

The rights to use water in California were allocated decades ago, when the region had far fewer people and a very different economy. This first-come, first-served approach is simply too rigid to ensure that water is available to meet the most essential needs—especially during droughts. By compensating those with long-standing water rights for moving water to activities and places where the lack of water will be more costly, trading encourages partnerships and cooperation in the sustainable management of this vital resource.

Expanding trading can help California adapt to growing water scarcity. For example, we found that expanded trading could reduce the costs of ending excess groundwater use by about 60% in the San Joaquin Valley, protecting jobs for thousands of low-income families while ensuring that groundwater remains available for future generations.

Improving the fundamentals of the actual water market will require a combination of smarter regulation and infrastructure investments.

Smart regulation can facilitate flexibility while providing essential protections. Trading is subject to regulatory oversight because moving water from one place to another can harm other water users and the environment. But right now, the approval process is fragmented and inconsistent, with different rules for different types of water rights and agencies. A top priority is improving information about how much can be safely traded in different places. In addition, developing transparent water trading platforms is key to building buy-in for new types of groundwater trading in farming regions.

Smart infrastructure is about identifying cost-effective improvements in storage and conveyance networks to make it easier to move water between buyers and sellers. This matters not only during droughts, but also during wetter years, so that parties can bank water for each other in underground aquifers to prepare for future droughts.

Water trading can help manage growing water scarcity in ways that benefit the economy and the environment. Most importantly, trading encourages cooperative solutions, which are essential for addressing the challenges of adapting to the changing climate.

(Ellen Hanak is an economist and director of the Public Policy Institute of California’s Water Policy Center, [email protected].  This article was originally published in CalMatters. It is reprinted here with permission.)