Drowning in Derivatives
WHY YOU SHOULD CARE
The financialization of the water market could have a major impact on the world’s poor.
If you live in Ireland, you might be upset. Beginning in 2014, Irish citizens will finally have to pay for tap water. Gifted with an abundant supply of freshwater, Ireland has historically provided its citizens with unlimited free water. Denmark, on the other hand, has similar freshwater resources, and its citizens face the highest water prices in the world (they might be upset, too). If you’re struggling to reconcile this with your basic understanding of how markets work, you’re not alone.
Since 90 percent of global freshwater is provided by public utilities, there is no competitive market for water and thus no market price. Utilities are natural monopolies that set whatever price they want. This is how consumers can end up facing water prices that have no correlation to actual production costs, which the suppliers often conceal.
A new initiative from IBM and the aptly named startup Waterfund, however, could change that. The Rickards Real Cost Water Index (WCI) will benchmark costs for the development and maintenance of large-scale water treatment and delivery networks throughout the world, shedding some light on what pricing in a competitive market might look like.
Why would that matter? Well, it has to do with building water infrastructure. Population growth, agricultural trends, and climate change are putting an increased strain on the global water supply. The United Nations estimates that by the year 2025, 1.8 billion people will be living in regions with absolute water scarcity and two-thirds of the world’s population could be under water-stress conditions. The public sector in the developing world cannot single-handedly fund the projects needed to address this future demand. But, to date, private investors have been skittish to commit without having a sense of what their costs and potential returns would look like. By making the market more transparent and project risk more manageable, the WCI could play a valuable role in bridging the financing gap.
While the WCI will enable investors to evaluate projects on a comparable basis and discourage price-gouging by suppliers, it will also allow for the development of risk-reduction tools like derivative securities, including options and futures contracts. Consequently, important questions persist as to whether this initiative could ultimately influence the emergence of a full-blown global commodity market for water, like those for oil and gold.
The WCI could ultimately influence the emergence of a full-blown global commodity market for water, like those for oil and gold.
Would the proliferation of bets by Wall Street traders on water prices be an inevitable outcome? And if speculators dominate the water market as they did in the markets for soy and wheat in the late 2000s, could they drive up the cost of water just as they did for food, effectively pricing out the world’s poor?
The insurance policies and derivatives enabled by the WCI aren’t inherently problematic. In fact, they could be critical to convincing institutional investors to support infrastructure projects. If, as IBM suggests in an example scenario, the developers of a water delivery project were able to purchase a $50 million insurance policy priced according to WCI data, they might be able to reduce their project risk enough to entice private investors who otherwise would have been skeptical.
Such hedging tools would be valuable innovations assuming that they would be used primarily by those who have a vested interest in maintaining price stability. IBM and Waterfund list their target customers as water agencies and water users, although their definition of water users is still unclear (a compelling case could be made for just about anyone). This is a key consideration because these derivatives could theoretically also be bought and sold by speculators such as — you guessed it — investment banks, who seek to place bets on changes in the price of water. If speculators, who have no vested interest in ensuring price stability, become the predominant actors in a water market, then watch out. We’ve seen this story before.
The U.K.-based World Development Movement estimates that from 1996 to 2011 the share of the largest U.S. wheat futures market held by speculators increased from 12 percent to 61 percent. Speculative bets by big banks on the price of agricultural commodities became so rampant in the 2000s that they were actually influencing the trajectory of those prices; from January 2002 to June 2008 a monthly food commodity price index compiled by the International Monetary Fund increased by 130 percent. These price increases were passed on to consumers in the form of higher food prices and led to the food crises of 2007–08 and 2011. According to the WDM, in the second half of 2010 alone, more than 44 million people were driven into extreme poverty as a result of rising food prices.
At this point it’s unclear whether speculators will be able to purchase water derivatives.
So what does this mean for water? Is the same story going to play out? It all depends on what the players in the market end up doing. At this point it’s unclear whether speculators will be able to purchase water derivatives. The WCI is only in its initial phase, which will examine water costs in 10 cities. IBM and Waterfund will charge customers for access to data and receive licensing fees from financial products tied to the index, so they certainly aren’t incentivized to keep the derivatives scope limited or the investor base narrow. IBM suggests the WCI will expand to cover an area representing 25 percent of global gross domestic product.
And what about the Dodd-Frank goal of placing curbs on excessive speculation in commodities? In 2011, the Commodity Futures Trading Commission approved limits on speculative positions firms could take, providing what appeared to be a step toward stability. But, after pressure from Wall Street lobbyists, a federal judge overturned the ruling. A new CFTC vote on speculation limits is expected to take place sometime in the next month.
Is it premature to worry about another march down the path of derivative-driven destruction? After all, the WCI could very well be a good mechanism to support near-term investment. But anyone who has seen the impact of derivatives over the past two decades knows all too well that once a new market is created, the flood of speculation won’t stop until the levee breaks.