At the Western Groundwater Congress hosted online by the Groundwater Resources Association, Audrey Arnao, an associate with WestWater Research, gave the following presentation on California’s surface water market, covering prices and trading activity in recent years and providing a forecast of spot market transfer prices in 2021.
WestWater Research is an economic and financial advisory firm specializing in water resources and water transfers. The organization is a nationwide practice with offices in five states. They maintain comprehensive research on water markets and water rights transactions across the Western US, and provide valuation and advisory services for water rights to a wide variety of clients across the public, private, and non-profit sectors.
Part 1. Overview of California’s surface water market
Water transfers are a water management tool to address scarcity. Market-based transfers of surface water have become increasingly important for satisfying competing agricultural, urban, and environmental water demands in California, and so an active water market has emerged in response to growth, water supply variability, and challenges associated with developing new storage.
The map on the slide shows water transfer activity in California by total dollars spent with the bright areas indicating areas where there was high value traded. This was in the South Coast area around Los Angeles and in the Central Valley and the Sacramento Valley due to agricultural production.
An appropriative water right is the right to divert a specific quantity to a specific location for specific uses. However, riparian rights must be satisfied first before appropriative rights can be satisfied.
There are two types of appropriative water rights: pre-1914 and post-1914. The Water Commission Act was created in 1913 to develop a system of administering and regulating water rights; all water rights perfected prior to passage of that Act are called pre-1914 and are not regulated or permitted by the state. Water rights perfected after the passage of the Water Commission Act are referred to as post-1914 and are regulated and permitted by the state. These rights are subject to a hierarchy of priority with priority based on the date of application.
“More junior post-1914 water rights are curtailed first during times of shortage, so pre-1914 are more reliable,” said Ms. Arnao.
Contractual entitlements are allocations of a portion of the State Water Project or Central Valley Project annual supply which provide the water conveyance infrastructure necessary to move water from areas in Northern California where water is relatively more plentiful to the drier areas in the Central Valley and Southern California.
Market drivers for water transfers
Ms. Arnao then turned to the factors that drive the water transfer market.
Water market activity responds to surface water availability. Prices and transfer activity typically increase during dry years, particularly for spot market transfers, which are single year transfers of surface water.
On the two charts on the slide, the light blue line is the Sacramento Valley index which is a measure of unimpaired runoff in the Sacramento Valley; higher indices mean more water.
“You can see, whenever there are dips in the index, there are spikes in total volume traded and average price in dollars per acre-foot,” said Ms. Arnao. “However, wet year transfer activity is actually expanded as agencies are procuring low-cost supplies for groundwater recharge and you can see that in 2019. It was a relatively wet year, but we had a significant volume traded. And this was mostly agencies procuring that low-cost wet year water for groundwater recharge.”
Delta export restrictions
The State Water Project and Central Valley Project export large quantities of water through the Delta to meet south of Delta demands. Environmental regulation can constrain the movement of water through the Delta and decrease the reliability of project water deliveries, which can in turn cause water transfer activity and prices to rise.
The dark blue lines on the chart show the average SWP allocation. “You can see it decreasing year after year, particularly since the biological opinions from the USFWS and NMFS were upheld in federal appeals court and these biological opinions recommended reducing the amount of water that is exported through the Delta,” said Ms. Arnao. “So water users are increasingly relying on water transfers to replace those dwindling allocations.”
Increasing urban water demand
Despite conservation, total urban water demand is rising each year due to population growth.
“You can see in this chart, despite gallons per capita per day decreasing, we have population growth and that’s causing increased urban water demand,” said Ms. Arnao. “Water transfers and development of new water supply projects will be necessary to meet those demands.”
Increasing agricultural water demand
Ag water users have historically been the primary suppliers in water transfer market, making water available through temporarily fallowing forage crops; however, forage crop acreage is diminishing, concurrently with the proliferation of permanent crops, which cannot be temporarily fallowed.
“This is constraining the supply of water available to the transfer market, and due to the demand hardening that we see with the expansion of permanent crops acreage, growers are increasingly acquiring water on the spot market in dry years to sustain those crops, which represent significant investments for growers,” said Ms. Arnao. “The chart shows field crops acreage decreasing and fruit and nut crop acreage in the Central Valley.”
Sustainable Groundwater Management Act
The state legislature passed the Sustainable Groundwater Management Act (or SGMA) in 2014, which requires California’s groundwater basins to be managed sustainably. The orange and yellow basins on the map are the high and medium priority groundwater basins that are subject to SGMA.
“These are located in areas with high water use and inflexible water demand,” said Ms. Arnao. “These are urban centers and agricultural centers. These basins need to become sustainable, and how can they do that? They can do that through decreasing groundwater use, using more surface water, or both. So as we see increased demand for imported and local surface water due to SGMA and this going to drive growth in the water transfer market.”
There are a variety of transaction structures for completing water transfers.
Spot market transfers are single year transfers of water. “These transfers offer flexibility to match dry year demands with available supply on short notice, but there is an execution risk if you’re unable to find a trading partner, and prices are uncertain and can be really high in dry years,” said Ms. Arnao.
Multi-year transfers can hedge against the uncertainty of spot market transfers. There are two types:
Firm delivery multi-year transfers are transfers where the buyer pays for a firm supply of water. “This represents a reliable long-term supply and cost certainty for buyers and revenue certainty for the seller. But these transfers tend to be higher priced due to the high value associated with that reliability, and it’s difficult to ensure firm supply from certain sources.”
Variable multi-year transfer agreements have more flexibility than firm delivery transfers as the price and volume schedules vary based on year type of water availability. “These kinds of transfers offer flexibility to match pricing and volume to hydrologic conditions similar to spot market transfers. So they also come with some uncertainty as prices and volume with vary each year based on hydrology.”
Permanent transfers of water entitlement. These can enhance water supply reliability and security for buyers who are able to acquire them, but they require significant capital outlay and tend to require extensive environmental reviews which can take a long time. “There’s also a lack of willing sellers, so there aren’t many people who are willing to permanently let go of their water rights.”
Part 2. Prices and trading activity
Spot market transfers
Spot market transfers exhibit price variability that’s largely attributable to hydrology. The dark blue line on the chart is the average price in dollars per acre-foot at the source; it doesn’t include costs associated with water conveyance or losses. The dry and critically dry years are shaded in gray.
“You can see that average price spikes during dry years and there’s a wide range of prices,” said Ms. Arnao. “For example, in the 2013-2015 drought, we see some prices approaching $2500 an acre-foot. In 2020, another dry year, we have prices approaching $1000 an acre-foot and averaging just below $500 an acre-foot.”
“The bottom chart shows the total volume traded,” she continued. “You can see we have south-of-the-Delta transfers occurring each year, and in dry years, we also see north-of-the-Delta to south-of-the-Delta transfers, so through-Delta transfers due to there’s capacity available in the Delta during dry years to facilitate those transfers. We also see increased demand in the Sacramento Valley during dry years or below normal years.”
With agricultural users outbidding municipalities for spot market transfers during dry years and the reliability of imported water supplies diminishing, urban water users have focused on diversification and acquiring water through multi-year transfers. On the chart, the dark blue represents firm water transfers and the light blue represents
“You can see the dark blue line is increasing year over year,” said Ms. Arnao. “This is because there is a high value placed on those firm supplies and the agreements are structured as the price will increase each year based on the CPI or another index or by 3% – some kind of continual increase like that.”
For variable multi-year transfers, she said that typically, the price and volume each year are dependent on the relevant water project allocation. “For example, if we have a variable multi-year transfer agreement between two CVP contractors, they will lay out over the next few years whether the allocation is 5% or 10% of so on, they will lay out what the price will be and the what the volume will be, so it will usually be that there will be higher prices during years of lower allocations as well as the volume of water transferred will vary each year under those agreements. You can see the dark blue on the bottom chart is those firm agreements, there’s a consistent volume traded each year.”
Part 3. Spot market price forecast
The data for the model comes from 1119 spot market surface water transfers in California from 1990 through August 2020 which are a proprietary dataset of water transfers provided by West Water Research. The model estimates the unit price of water in dollars per acre-foot as a function of various independent variables plus an error term. There were several variables that were identified as having a statistically significant relationship with price.
“The model has an R squared of .55 which indicates that the independent variables explain approximately 55% of dispersion in unit price for spot market transfers,” said Ms. Arnao. “All independent variables tested were statistically significant with a 99% confidence interval. The dependent variables is the natural log of the adjusted unit price of water in dollars per acre-foot.”
She then presented the regression results.
The first independent variable is NOD-NOD, which indicates transfers from a North-of-Delta seller to a North-of-Delta buyer. “The negative coefficient on this variable indicates that these transfers are priced at a discount and this is because water is less scarce north of the Delta, so prices tend to be lower north of the Delta compared to south of the Delta.”
Next, is NOD-SOD, which represents transfers from a North-of-Delta seller to a South-of-Delta buyer. “These transfers move through the Delta and they are also priced at a discount because water transfers through the Delta assessed losses, so losses occur – meaning that these transfers are priced at a discount at the source because those losses are a transaction cost.”
Next are the urban water buyers. “There is a positive coefficient there which indicates that urban water buyers paid premium. This is because they have more inflexible water demands and they have more capital to contribute to transfers.”
The next variable represents transfers within the Friant Division of the CVP. “These are buyers on the east side of the Central Valley. They tend to have lower water costs and more reliable allocations which is why they tend to pay less for transfers.”
State Water Project agricultural contractors are mostly in Kern County. “They pay relatively high prices for transfers because they have very unreliable surface water supplies and extensive acreage devoted to permanent crops.”
There is a variable for environmental acquisitions which have historically been lower priced. “In recent years, this was why we’re seeing fewer environmental transfers occur because it’s more difficult to compete with those high prices that agricultural buyers are paying. However, the Environmental Water Account, which is the next variable, has historically paid a premium for water, which is partly the reason why the Environmental Water Account was canceled in 2007.”
Total water project percent is the amount of water available from the SWP and the CVP the year in which the transfer occurred. “This variable has an inverse relation with price, that whenever the allocation is lower, prices are higher, and vice-versa.”
Last is the natural logarithm of the population. “The positive coefficient here indicates that water prices are rising year over year due to the growth that is occurring in California.”
Spot market water transfer forecast for 2021
The model is used to forecast spot market water surface water transfer prices in 2021 by water project allocation. South of Delta buyers and sellers are assumed.
“This table shows that forecast and it models prices under different ranges of allocations for urban buyers and ag buyers,” said Ms. Arnao. “If we have another dry year in 2021, then we can expect to see relatively high prices and relatively robust trading all across the valley and among urban buyers. If water supply conditions improve slightly, we will still see prices about where they are this year, and if it’s a relatively wet year, if we have a 50%-100% allocation range, we’ll still see pretty high prices estimated to be from $150 an acre-foot to almost $500 an acre-foot.”
To conclude …
“ … California’s surface water market is highly active and surface water transfers are an increasingly important component of groundwater management,” said Ms. Arnao. “Groundwater sustainability agencies are planning to increase their use of imported and local surface water for direct use and aquifer recharge under SGMA, and one way to increase surface water supplies is through market-based transfers of water. Competition of surface water is growing as water users focus on bringing basins to sustainability, and this is expected to cause surface water transfers to rise in both dry years and wet years.”