Center on Financial Risk in Environmental Systems (CoFiRES)

Center on Financial Risk in Environmental Systems: U.S. Water Utilities

U.S. Water Utilities

Title:
Risk pooling to mitigate drought-related financial losses for water utilities


Summary:
Greater reliance on temporary conservation to manage drought has made water utilities in the U.S. much more financially vulnerable. Geographic diversification can make risk pooling via index-based financial instruments an effective tool for managing drought-related financial risks.

Comparison of distribution of payouts, required reserves, and opportunity cost of reserves for risk pooling versus risk shifting.

Comparison of distribution of payouts, required reserves, and opportunity cost of reserves for risk pooling versus risk shifting.

Description:
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 U.S., 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 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.


Collaborators:
University of California, Davis: Dr. Jon Herman

Department of Environmental Sciences and Engineering, UNC: Dr. Marc Serre


Publications:

Baum, R., Characklis, G.W., and M. L.Serre. (2018) “Effects of Geographic Diversification on Risk Pooling to Mitigate Drought-Related Financial Losses for Water Utiliites”, Water Resources Research, doi.org/10.1002/2017WR021468


Funding:
National Science Foundation: Graduate Research Fellowship Program

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UNC Institute for the Environment
UNC Institute for the Environment