Using two-way option contracts to facilitate temporal water re-allocation during drought

In the western United States, urban water utilities have acquired volumes of water rights exceeding that required to meet average demand to ensure supply reliability in dry years. In areas with rapidly growing urban populations, water rights are often acquired via water markets from irrigators at prices that far exceed the water’s marginal value in agriculture. In wet/normal years, urban utilities have excess water available, which can be leased back to irrigators, but at prices substantially lower than the annualized cost of the water right’s purchase price, making the administrative processes required to lease less attractive to utilities. These administrative burdens result in less water being used by agriculture in wet/normal years, and urban users paying a high net cost for supply reliability. In this study, we propose a novel two-way option contract that temporally transfers the priority of an irrigator’s more senior water right to urban users during dry periods, and a prearranged lease of surplus urban rights back to agriculture during wet/normal years. This does not require any changes to institutional rules and avoids the administrative burdens of outright water right purchases by urban utilities and their subsequent lease back to agriculture during wet/normal years. Our framework takes advantage of StateMod, a network-based water allocation model used within Colorado, which includes historical hydrology, current demands, infrastructure, and operating rules. Results suggest that these contracts can provide municipalities with improved long-term certainty with respect to supply reliability and financial stability, while also creating a consistent revenue stream for irrigators.