Managing Drought Related Financial Risks with Water Futures

Water is an essential resource for agricultural and municipal interests, and increasing water scarcity poses a fundamental risk for water users and suppliers worldwide. Although well-designed water markets can ease these pressures by reallocating limited supplies to high value uses, markets in water-scarce regions are often thin and volatile. Interannual hydrologic variability can drive sharp price fluctuations, exposing both buyers and sellers to significant financial risk. Using California as a case study, which operates one of the world’s most active and institutionally complex water markets, we combine water price indices with a century of streamflow data and a detailed simulation of California's supply system to predict future prices at 1-, 3-, and 6-month horizons that match typical decision timeframes. Our results reveal strong short-term predictability from lagged prices and increasing dominance of reservoir storage at longer horizons, with r² values of 0.90, 0.79, and 0.61 for 1-, 3-, and 6-month forecasts. Hedging strategies that incorporate forecast-uncertainty filters reduce tail risk and expected water costs by 14.1% and 16.7%, respectively, when using 6-month futures with a 50% hedging target. This scalable framework offers a structured way to quantify forecast capacity and assess financial risk management strategies in water markets.