Formal risk‐transfer mechanisms for allocating uncertain water resources: The case of option contracts

Water allocation in Mediterranean basins is characterized by increasingly uncertain availability. Mechanisms that facilitate water transfers and efficient risk sharing are critical for dealing with cyclical water shortages. An option contract can be an appropriate instrument for aiding such exchanges based on specific water rights attributes. Access to certain amounts of water under preestablished conditions could provide the basis for the option contract. The main objective of this paper is to test the hypothesis according to which an option contract may be a viable instrument for achieving efficient sharing of hydrological risks. A dynamic, stochastic, and discrete time model is developed to characterize the contract from the viewpoint of the selling party. The application of this methodology can find the compensating premium, which is computed as a risk premium. The premium ensures adequate compensation for the seller as well as for the additional risk imposed by the contract. The hypothesis is empirically tested by simulating the contract as a partial solution to the problems faced by the urban supply system of Seville (Spain). The other party is an irrigation district. Results show that the option contract would be a viable solution for both parties. For Seville's urban water supply system the option contract provides a more cost‐effective alternative water supply than those presently considered by the city's water company. We find that mixed strategies including company's drought plans and option contracts are the most efficient, leading to less severe and less likely water shortages within the city supply system.