Managing Drought with Water Futures

Examining water price risk dynamics and hydrologic forecasting in California's water market

Managing Drought with Water Futures: Hydrologic Forecasting and Price Risk in California’s Water Market

Currently under review

This paper examines the dynamics of water price risk in California’s water market and evaluates the extent to which hydrologic conditions can be used to forecast the Nasdaq Veles California Water Index (NQH2O). Building on detailed simulations of surface water availability, Delta pumping constraints, groundwater banking storage, and regulatory operations, the study develops a modeling framework that links physical water system states to market price formation.

Study area: California's water system including surface water availability, Delta pumping constraints, groundwater banking storage, and regulatory operations.

By integrating climate and hydrologic variables with machine learning, the paper quantifies the predictive skill of short- and long-horizon forecasts and investigates how water futures can serve as a hedging instrument for agricultural and municipal users exposed to drought risk.

Modeling framework: A systems-based approach combining water system modeling, machine learning, and financial risk management to link physical water system states to market price formation.

The findings provide new insight into how physical scarcity and regulatory limitations shape price volatility, and they demonstrate the potential for hydrology-driven financial tools to strengthen drought resilience and risk management in water-stressed regions.

Key Challenge

However, the current financial market for water lacks transparent public disclosure of the physical and operational information that underpins price formation. As a result, water futures have not been widely adopted by agricultural or municipal users, limiting their effectiveness as a risk-management tool.

Implications

The findings in this study highlight the need for improved market design in which hydrologic information, regulatory constraints, and system operations are communicated more transparently, allowing water futures to more accurately reflect underlying scarcity conditions and better serve stakeholders exposed to drought risk.