WATER MARKETS AS A RISK MANAGEMENT TOOL UNDER DROUGHT

RESEARCH OBJECTIVE AND HYPOTHESES This research project examines the role of water markets as a tool to share risk in uncertain water supplies among farmers during repeated episodes of drought. The research postulates the hypotheses that farmers differ in their risk preferences and in the relative costs of unanticipated drought. In a water market, this risk can be spread efficiently among farmers through water and water rights transactions.

CONCEPTUAL FRAMEWORK The purchase of additional water rights in a water market represents a form of drought insurance, given a proportional water rights system. Those farmers who are the most risk averse in the system will want to fully insure against drought contingencies. At the same time, less risk-averse farmers will under insure against drought – that is they will hold fewer water rights-thus freeing up water rights to provide insurance for their more risk-averse cohorts. The most highly risk averse farmers would tend to avoid relying on temporal spot water trades to augment their water supplies in times of drought. However, there will exist a group of farmers in the market with moderate levels of risk aversion that will use spot water trades to spread risk.

METHODS We test the hypothesis of water markets as a risk sharing instrument in drought by examining two parallel water markets in the Limarí River Basin of Chile: a spot water market and a permanent water rights market. Data were collected through an in-person survey of 332 farmers in the Basin. The survey was administered during an extreme three-year drought that had affected the region and which had depleted the interseasonal water reservoir system.

RESULTS Results show water rights trades occurred from farmers who were less risk averse and faced lower relative drought costs to those who were more risk averse and had made substantial investments in permanent plantations. In the spot water market, water also moved from less risk averse to more risk averse farmers. A surprising result was that some highly risk averse farmers in the sample participated in spot water trades, whereas it had been hypothesized that they would only purchase permanent water rights. This result may be explained by errors in expectations as to the severity of the drought.