Using the SFE State Water Indexes to hedge the risk of water availability

 

If you would like more information about the issues raised above and SFE's plans to list Water Futures Contracts, please click on the image to the right to send an email.

 

The risk of water availability is a reality of life for much of the Australian rural economy. In this sector, risks are borne not only by users of water, but by all the parties who make up that rural economy, including banks, insurers, processors and suppliers. And unlike other markets such as equity, money or commodity markets, there is currently no market into which users and investors, exposed to water availability risk, can effectively hedge that risk.

 

The implications of this missing piece of economic infrastructure are profound. Farmers with water availability risk have no means of hedging against drought conditions. Service providers to these farmers also assume similar exposure and add the requisite risk premium, increasing the cost of doing business for farmers. And finally investors seeking large scale capital investment opportunities either avoid this sector, or are forced to price this risk accordingly. The result is increasingly high costs compounded by even greater inefficiency.

 

The Sydney Futures Exchange (SFE) has conceptualised a market in water availability risk, which provides a tool to hedge this risk. Key features of the concept are:

 

	The development of a series of market benchmarks or indexes of water availability, the SFE State Water Indexes, based on the logical aggregation of key water storages. These indexes are excellent proxies for water availability for those parties facing such risks.
	The listing of futures contracts on each regional index to provide a market mechanism for parties to hedge against the future value of the index.

The listing of futures contracts on water indexes creates an indicator of forward water storage expectations against which parties are able to hedge water availability risk.

The ultimate objective of implementing such a market is to provide parties that have exposure to water availability risk, with the means of hedging that risk, and to reduce the risk premium for parties wishing to invest in rural economic activity and water resource infrastructure. As such, the SFE State Water Index Project is about building a critical piece of national economic infrastructure that will: