The Value of Risk Pooling for Mitigating Water Utility Financial Risks Arising From Water Scarcity

Abstract:

Water utilities across the United States face growing supply risks as demand growth and extreme weather events make water scarcity more common. As it has become more difficult and expensive to build new supply capacity to accommodate these events, many utility managers respond by either imposing conservation measures, which reduces revenues, or acquiring additional water from other sources, which increases costs. These actions lead to changing financial trends that are difficult to predict and that utilities are currently ill-equipped to manage. As a result, adaptation strategies and tools are being developed to reduce utility vulnerabilities, ensuring both financial stability and continued access to low cost financing, a critical consideration for a capital intensive industry. Previous work in this area has involved the development of utility specific financial hedging tools. However, the time and informational requirements associated with developing these individualized strategies may be a limiting factor for widespread implementation. The objective of this research is to develop more generalized hedging instruments that can be applied simultaneously to multiple utilities across the United States, thereby increasing the potential for widespread implementation. This work first analyzes the financial risks of water scarcity for a large set of water utilities across the country and then proposes a financial hedging solution to mitigate these risks through hydrologic index-based financial insurance. Results provide insights into the most effective indices, the potential for risk pooling to reduce insurance costs, and the performance of these contracts in managing utility financial risk arising from drought.