Effects of Geographic Diversification on Risk Pooling to Mitigate Drought‐Related Financial Losses for Water Utilities

Abstract

As the costs and regulatory barriers to new water supply development continue to rise, drought management strategies have begun to rely more heavily on temporary conservation measures. While these measures are effective, they often lead to intermittent and unpredictable reductions in revenues that are financially disruptive to water utilities, raising concerns over lower credit ratings and higher rates of borrowing for this capital intensive sector. Consequently, there is growing interest in financial risk management strategies that reduce utility vulnerabilities. This research explores the development of financial index insurance designed to compensate a utility for drought‐related losses. The focus is on analyzing candidate hydrologic indices that have the potential to be used by utilities across the US, increasing the potential for risk pooling, which would offer the possibility of both lower risk management costs and more widespread implementation. This work first analyzes drought‐related financial risks for 315 publicly operated water utilities across the country and examines the effectiveness of financial contracts based on several indices both in terms of their correlation with utility revenues and their spatial autocorrelation across locations. Hydrologic‐based index insurance contracts are then developed and tested over a 120 year period. Results indicate that risk pooling, even under conditions in which droughts are subject to some level of spatial autocorrelation, has the potential to significantly reduce the cost of managing financial risk.

Managing Financial Risk Trade‐Offs for Hydropower Generation Using Snowpack‐Based Index Contracts

“…The “market price of risk,” λ , governs the size of the risk loading. Following other work on weather derivative contracts (Baum et al., 2018; Foster et al., 2015; Wang, 2002), (“Baseline loading” in Figure 4) is used as the baseline value for pricing the contract in this study. However, values between 0 (“No loading”) and 0.5 (“High loading”) are included in the SA, as described in section 2.8.…”

“…Such contracts act like insurance, and are ideal when the index‐revenue relationship shows a strong thresholding behavior. Such contracts are popular in the water resources literature due to financial losses that occur below a drought threshold for many water‐reliant activities such as agriculture (Maestro et al., 2016; Turvey, 2001), water supply (Baum et al., 2018; Zeff & Characklis, 2013), and commercial shipping (Meyer et al., 2016).…”

“…However, index contracts that have been carefully tailored to the specific financial risks and needs of a user are more likely to be adopted in practice. For example, in recent years index contracts based on variables such as water level, streamflow, and the Palmer Hydrologic Drought Index have been demonstrated to effectively hedge the hydrologic financial risk faced by water utilities (Brown & Carriquiry, 2007;Baum et al, 2018;Zeff & Characklis, 2013), commercial shipping firms (Meyer et al, 2016), and hydropower producers (Denaro et al, 2018;Foster et al, 2015;Meyer et al, 2017) from adverse financial outcomes during drought. This work proposes an index contract based on snow water equivalent depth (SWE).…”

Bias Correction of Hydrologic Projections Strongly Impacts Inferred Climate Vulnerabilities in Institutionally Complex Water Systems

“…The planning and management of water resources depend heavily on projections of water supply and demand (Loucks and van Beek 2017;Wurbs 1995), strongly shaping water infrastructures and institutions (Malek et al 2018;Trindade et al 2019;Yoder et al 2017). The challenge of infrastructure investment for climate adaptation represents a balance between financial stability and the capacity to meet system demands (Baum et al 2018;Trindade et al 2019). Moreover, governments often confront high economic costs, political contention, and social conflicts (Gizelis and Wooden 2010;Petersen-Perlman et al 2017) as they seek to change waterrelated infrastructures or institutions.…”

Insurance Portfolio Diversification Through Bundling for Competing Agents Exposed to Uncorrelated Drought and Flood Risks

“…The idea of risk pooling megacities against natural disasters such as earthquakes, cyclones, and sea-level rise is explored in Hochrainer and Mechler (2011). Baum et al (2018) provide an evaluation of the potential for geographic diversification on risk pooling to manage the risk of drought borne by U.S. water utilities. In this case, hydrologic-based index insurance contracts are designed to cover the risk pooled across a broad spectrum of geographically distributed water utilities, resulting in significantly lower insurance premiums.…”