Proceedings of the 25 th International Conference of Agricultural Economists (IAAE) 16 – 22 August 2003 ISBN Number: 0-958-46098-1 Durban, South Africa Proceedings produced by: Document Transformation Technologies Conference Organised by: Event Dynamics THE EFFECTS OF SPOT WATER MARKETS ON THE ECONOMIC RISK DERIVED FROM VARIABLE WATER SUPPLY Javier Calatrava 1 and Alberto Garrido 2 1 Departamento de Economía de la Empresa, Universidad Politécnica de Cartagena, Paseo Alfonso XIII nº48, 30203 Cartagena, Spain. E-mail: j.calatrava@upct.es 2 Departamento de Economía y Ciencias Sociales Agrarias, Universidad Politécnica de Madrid, Ciudad Universitaria s/n, 28040 Madrid, Spain. E-mail: agarrido@eco.etsia.upm.es ABSTRACT Water availability in semiarid regions commonly exhibits patterns of extreme variability. Even in basins with large infrastructure development, some users are subject to low levels of water reliability, incurring economic losses during periods of scarcity. More flexible instruments, such as voluntary exchanges of water among users, may help users reduce their risk exposure. Recent changes in the Spanish water Law have given an initial impulse to allow for lease-out contracts of water use rights. This paper analyses, from theoretical and empirical standpoints, the effect that establishing water markets has on the economic risk caused by water availability variations. The empirical study is performed on an irrigation district of the Guadalquivir Valley (Spain) with fair levels of average water availability but a high probability of periods of extreme scarcity. A non-linear programming model is used to simulate irrigators’ behaviour and derive water demand functions. Another spatial equilibrium model is used to compute market exchange and equilibrium. These programming models are combined with statistical simulation techniques. It is shown that the probability distribution of profits for a representative irrigator is modified if water exchanges are authorised, resulting in unambiguous risk reductions. Results also suggests that if the market would be extended to several irrigation districts and users, each characterised by different hydrological risk exposure, the occurrence of extremely low benefits events would become more unlikely. In sum, it is shown that exchanging water in annual spot markets allows for the reduction of farmers’ economic vulnerability caused by the variability of water supply across irrigation seasons. JEL codes: Q12, Q25, D80. Keywords: water markets, economic risk, water availability, irrigated agriculture. INTRODUCTION Many authors have analysed the economic outcomes of water markets, simulating water exchanges and evaluating profit and welfare improvements for water users. However, most studies are static or pay little attention to the temporal variability that profits present as a consequence of variations in water availability. In semi-arid climates, where inter-annual variations in the resource availability are extreme, the development of large water infrastructures has proved insufficient to mitigate the economic effects of scarcity periods. Traditional policies to mitigate these losses have usually been either of a preventive nature (development of new infrastructures or improvement of irrigation technologies) or a compensatory one (drought compensation schemes for farmers, such as the ones in Australia, Spain or Israel, consisting basically on tax exemptions and lump sum payments). Market based water policies may reduce the economic losses that users suffer in scarcity years, fostering other policies’ economic efficiency. Establishing water market schemes is not only compatible with other policy measures, but can also create economic incentives to stimulate their development making water’s opportunity cost more explicit to users. 536