Pricing Options on Water in Texas

Abstract

Freshwater scarcity is a growing concern in Texas and the issues that surround it are expected to grow in the coming years. As climate change impacts the variability of precipitation patterns, some of the most useful tools to help allocate this precious, limited resource may be the tools that are most adaptable in the face of growing uncertainty. While market mechanisms are budding in the state, another market-based tool can create opportunities for efficient water allocation among stakeholders: the water option. An option is a financial product that provides a vehicle to interested parties (buyers and sellers) to create a contract that formalizes the terms of the possible future delivery of water. In cash markets for resources, the exchange of cash and the resource happens when the trade is made; in options markets, the flexibility of delivery is amplified considerably, making them useful for mitigating risk. The buyer of the contract is securing the right—not the obligation—to buy a specific amount of a resource, by a specific time, for a defined price and has the ability to decide if and when the contract gets exercised over the term of the contract. This work discusses the utility of these contracts and outlines a method to price them.