WATER: THE NEXT INVESTMENT OPPORTUNITY

A lot of heads must have turned, and a lot of eyebrows raised reading the topic for this article. But water constituting 71% of the total earth’s surface, is a vital and an undervalued commodity whose scarcity is felt daily. According to growing number of traders globally, the market for water could be the next big investment opportunity of the next decade. 

Water futures are financial instruments that can be used by organisations or individuals as part of their risk management strategy to reduce risks associated with adverse water conditions. Theoretically, water contracts would be an agreement to buy or sell a certain unit of water at a pre-agreed price on a certain future date. Water contracts can be used to hedge risks against water, i.e. water would be unavailable at a particular point in future. 

Importance

Water contracts will transform into an innovative financial tool. Since water derivatives have not gained much traction in other commodity exchanges, the launch of such contracts in a domestically registered exchange could benefit all stakeholders. The risk of water availability is the painful reality of life in Nepal. Risks are borne not only by the users but by all parties in our economy. 

It may not seem important at first, yet the implications of this missing piece of infrastructure are profound. Farmers with water availability risk do not have the means of hedging against drought conditions. Consequently, service providers to these farmers will assume similar exposure and add the requisite risk premium, thereby increasing the cost of doing business for farmers. 

Finally, investors seeking large 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. 

Benefits

The benefits of Water Contracts could include the following:

• Water contracts will encourage water savings, better pricing and an efficient usage of available water resources. 
• Better community understanding of the need to preserve Nepal’s scarce water resources. 
• Promotion of water-efficient technology to comply with the highest international standards. 

Developing Water Contracts 

The first step in the development of the contract is to identify the commodity or index on which the market is based. The key task is to create recognised benchmarks that mirror the risk profile of parties with exposure to water availability. These can be concluded as the water indices. Such an index needs to be independently and objectively priced and, in doing so, ensure that it is not manipulated artificially. Once an index is established, a market is created on which the price or value of the index is formulated. 

The Water Index will reflect aggregated water reservoir storage in the key water storage systems of the capital city, Kathmandu. The index will incorporate storage data reflecting the percent of full capacity for the storage units in the index. In the instance of multiple storage facilities, these will be weighted average according to capacity. 

The index will represent the actual storage in the reservoir as a percentage of the Full Capacity or Total Capacity. The index will move up and down in response to the actual water stored. The maximum index value will be 100, and the minimum will be 0. As storage increases in response to water inflows, the index will also rise and vice versa. 

Hedging against drought conditions

Assume the following situation exists in May 2025. 

A farmer in the outskirts of Kathmandu Valley is planning to plant crops in June 2025 but is concerned that if dry conditions prevail, water will either be unavailable or too expensive. He calculates that the loss from failed crop conditions would be approximately Rs 50,000 whereas the profit from favourable conditions would be Rs 100,000. 

Here are a few details of the contract specifications:

• Contract Size: Rs 10,000 based on an index value of 100
• Price Quoted: Rs/0.01
• Minimum Price: 100
• Current Water Index in May 2025: 50

Due to the fear of failed conditions, the farmer sells 20 Water Contracts at 50. 

Outcome 1

During autumn, the farmer’s fears prevail and there are drought conditions. As a result, storage in the Water Index falls to 25. The farmer’s crops fail due to the drought conditions. The Water Index contract expires at 25, resulting in a profit of Rs 50,000 (50-25*100*20 contracts). 

Outcome 2

During autumn, if there is adequate rainfall and the level in the reservoir actually rises above what was expected with the Water index attaining 75. The farmer has a successful crop season earning the expected profit of Rs 100,000. However, the Water Index contract expires at 75.00 resulting in a loss of Rs 50,000 (75-50*100*20 contracts). This is offset by the profit earned from a successful crop season. 

However, in the second outcome, the farmer will close out the contracts before maturity by buying before the expiry of the contract, thereby reducing the losses incurred. 

Conclusion 

The exact way that water contracts would fit into the commodity market ecosystem is still ambiguous. It could be comparable to CME Group’s Water Futures. Launched in December 2020, CME Group started the Nasdaq Veles California Water Index Futures, a financially settled futures contract that allowed traders to manage their exposure to water. 

What does this mean for the future of traders with no significant exposure? 

That is uncertain, but for those who want to profit from the liquid of life, water, the next big investment opportunity may be around the corner.