Assessing water options trading willingness in irrigation areas with heterogeneous resource endowments

Highlights

• A framework for assessing the willingness to trade water options is constructed.

• Optimal contracts are proposed to stimulate water options trading (WOT).

• Willingness of WOT is affected by the matching equilibrium of regional resources.

• The greater water endowment per unit of arable land, the more inclined of WOT.

Abstract

Water options trading (WOT) is an effective way to promote efficient allocation of water resources and to manage risks of water scarcity. Scientific prediction information can help hedge the risks brought by uncertain hydrological and market environment to WOT. However, confronting with the prediction information, irrigation areas characterizing with heterogeneous resource endowments often exhibit different willingness in WOT. Therefore, through using prediction information, this study provides a novel perspective to assess the water option trading willingness (WOTW) in irrigation areas with heterogeneous resource endowments. Firstly, according to multi-objective optimization and expected utility theory, a three-phase dynamic adjustment model involving tradable water prediction, expected return analysis of WOT, and WOTW calculation is constructed and integrated. Then, based on three sets of comparative analysis data from 2014 to 2020 in five irrigated areas, the influence mechanism of heterogeneous resource endowments on the evolution, intensity and improvement potential of the WOTW is analyzed and the option contract with optimal water demand to motivate the WOTW in heterogeneous irrigation areas is proposed. The results of the case study suggest that the WOTW is largely affected by the matching equilibrium of water and arable land resources in irrigation areas. Larger water resource endowment per unit of arable land indicates smaller fluctuation of the WOTW evolution and greater intensity and improvement potential of the WOTW. Conversely, larger inter-annual variation of the water resource endowment per unit of arable land implies more inclination of the WOTW intensity in irrigation areas to be weakened, in which situation the irrigation areas prefer the option contracts with less water demand. This study provides a new method and theoretical foundation for the optimal allocation and options trading of agricultural water resources.

Introduction

The crisis of water scarcity has been mushrooming in some developing and less developed regions worldwide, which not only limits their economic development but also prevents the living standard of people who inhabit in these regions from being improved. Elevating the utilization of water resources therefore becomes the most crucial and urgent problem to be solved in order to realize sustainable development for countries and regions suffering with water crisis around the world (Tan and Zhang, 2018). In recent years, the exercise of market economy and free competition enables trading water rights trading on the premise of water conservation, transferring water resources from low-efficiency regions to high-efficiency ones, under which circumstance water-consumption intensive industries and consumers are being pushed in the teeth of the storm (Svensson et al., 2021, Womble and Hanemann, 2020). It has reached a consensus that the distinctive feature of agriculture characterizes with high water consumption yet relatively low water utilization efficiency. For instance, the available water resources consumed by agriculture accounts for more than 60 percent of the total water consumption in China, whereas the effective water utilization rate remains merely 45 % (Wei et al., 2016). In this severe situation, one of the effective countermeasures to balance water supply with water demand is to vigorously develop water-saving agriculture while promoting the transmission of agricultural water to non-agricultural water (Arellano-Gonzalez et al., 2021, Fang and Zhang, 2020). For this, exploring the optimal allocation and rights trading of agricultural water resources has become an important issue.

Applying traditional trading mechanism which lacks flexibility to water options is rendered less possible to neutralize the risks caused by the uncertainty of water supply and fluctuating water prices. To hedge risks, the idea of water options is proposed, which gives potential traders permission to negotiate on water transaction price and volume, offering contract holders the rights to buy or sell a certain amount of water at an agreed price during the contract period (Hansen et al., 2014, Rey et al., 2016a). Comparing with other means of water trading such as spot market transaction, water bank, virtual water, the water option contract is more flexible and reliable. Owing to the ever-increasing popularity of water options in the research field of water management, the water option trade (WOT) exhibits great potential in various practical applications (Conrad and López, 2002, Delorit and Block, 2020, Yan et al., 2018).

The irrigated area is the relatively independent management unit of agricultural planting which is usually in the position of water right transferor, regulating water rights and water diversion as well as transmission and distribution system of the planting area. However, the market price of water trade still remains somehow uncertain, which attributes to various influencing factors involving but not limited to complicated hydrological and market environment, the information on tradable water of irrigated areas, the water demand of transferee, etc (Li et al., 2014). Therefore, the premise of participating in WOT is to adopt scientific methodology to guarantee accurate prediction, thereby realizing effective coupling of forecast information and water option contract (Delorit et al., 2019, Wu et al., 2021). Moreover, since the capability in risk prevention and profiting underlies the attitude of irrigation area toward the forecast information, their water option trading willingness (WOTW) is therefore affected by the attitude that closely correlates with the area's resource endowment (Delorit and Block, 2020). Heterogeneity is a notion that describes the characteristic differences among objects. Although some studies assumed that individuals in economic activities are homogeneous and can be regarded as fundamental economic elements that are mutually replaceable, however, in reality, this assumption fails to elaborate profound and volatile decision-making behavior of individuals, to which comprehensive analysis shall initiate from individual and/or group heterogeneity perspectives instead (Huang et al., 2020, Tan et al., 2020). Therefore, in order to activate the marketplace for trading agricultural water rights while improving water utilization efficiency, it is of significant necessity to analyze the influence mechanism of heterogeneous resource endowments in irrigation areas on their WOTW and to determine the optimal water option contracts maximizing the WOTW.

Willingness can be understood as the preference and intention that an individual is inclined to do something, which is usually based on interests and trust (Liu et al., 2019, Scholz et al., 2015). Some studies measured and analyzed individual willingness in water resource utilization and management through modeling and empirical approaches. Contingent valuation method and binary profit model were used to assess farmers' willingness to use treated wastewater (Deh-Haghi et al., 2020, Iftekhar et al., 2021). (Wang et al., 2017) proposed a two-level multi-objective planning model to obtain the optimal allocation of agricultural water resources and the transaction price of water options stimulating the willingness to save water in irrigation areas. (Conrad et al., 2017) conducted a discrete choice experiment to investigate farmers' preference concerning water use policies such as water rights allocation and water rights trading during drought periods. The study on WOTW and its influencing mechanism is conductive to analyzing the internal driving force of trading behavior and to realizing the efficient transfer of water rights. Unfortunately, few studies have discussed how to optimize the water consumption structure of irrigation areas to participate in WOT when the tradable water is insufficient, and the influence of the heterogeneous resource endowment of irrigation areas on their willingness to trade water options. The existing researches on water option basically concentrate on its trading and pricing mechanisms (Hu et al., 2021a, Ramos and Garrido, 2004, Rey et al., 2016b). (Seidl et al., 2020) conduct a quantitative survey of the water market in the Murray-Darling Basin, which suggested that financial investors and large corporates are more likely to offer highly sophisticated temporary water trading products similar to water options. (Vicuna et al., 2018) discussed the optimal option trading mechanism for agricultural water during droughts and short-term turbidity events in Santiago. A risk-hedging model was applied to WOT by (Yan et al., 2018), providing the optimal trading strategy for water consumers. (Ha and Gao, 2017) constructed an imprecise two-stage mixed integer programming model to study the case of WOT. A pricing model for water option was proposed by (Cui and Schreider, 2009) to activate the Australian water market according to the rationale of stochastic process with jumps. However, considering the trading and pricing mechanisms, the expected return of WOT with insufficient tradable water needs further investigation.

In order to eliminate uncertainties in WOT, accurate forecasting information and methods that can hedge risks in the trading were proposed (Wei and Xie, 2022). Among them, the grey model was proposed by (Deng, 1982), exhibiting characteristics of small sample but high prediction accuracy, which has been widely applied in various fields to predict population, water consumption, industrial output, etc (Hu et al., 2021b, Meng et al., 2021). Stochastic programming and the characterization of uncertain factors based on probability distribution are also effective methods. (Li et al., 2020b) applied Bayesian theorem to develop a forecasting model for tradable water and the probability distribution function (PDF) of water demand. (Womble and Hanemann, 2020) assessed the transaction costs of water options by analyzing the PDF of collected procedural transaction costs. (Zhang et al., 2018) developed a double-sided stochastic chance-constrained linear fractional programming model to analyze the consumption of irrigation water under uncertainties. Based on maximum entropy model and probability distribution theory, (Yan et al., 2018) effectively predicted the runoff and spot market prices in WOT.

As mentioned above, individual preferences and behaviors are influenced by heterogeneous characteristics. In the field of WOT, some scholars explored the influence of individual heterogeneity imposed on participant's decision-making. Based on panel data, (Fang and Wu, 2020) analyzed the performance of WOT in irrigation areas with heterogeneous water pressure by constructing time-varying DID model. (Wang et al., 2022) developed the BLTSFPPB model by integrating bi-level programming and Bayesian model, and explored the optimal allocation of water resources considering the subjectivity of water managers driven by water options trading. (Delorit and Block, 2020) explored the influence of farmers' heterogeneous risk attitudes on their water options investment and cooperation willingness in WOT. The tradable water involved in WOT is determined by water resources endowment and crop planting composition within an irrigation area. Therefore, the heterogeneity in arable land and in water resource endowments of irrigation areas must be considered in analyzing WOTW. Nevertheless, hardly can sufficient studies be found which propose specific research framework to explore the influence of heterogeneous resource endowments on the WOTW in irrigation areas.

In response to the above problem, this study aims at analyzing the influence of heterogeneous resource endowments imposed on the willingness of irrigation areas to participate in WOT by optimizing their water consumption structure, proposing the option contract with optimal water demand to activate the WOTW in heterogeneous irrigation areas by coupling the multi-objective optimal allocation model for crop planting water with the expected return and willingness calculation model of WOT.

The novelty and contributions of this study are elaborated as follows. (1) By coupling an multi-objective optimal allocation model for crop planting water, a model that calculates the expected return and willingness of WOT is established, providing a novel perspective with forecast information to assess the WOTW in irrigation areas characterized with heterogeneous resource endowments. (2) An interest-trust-motivated model that can dynamically update the WOTW is proposed, thereby enabling the model itself to accurately describe the evolution of WOTW in irrigation areas with heterogeneous resource endowments after action review. (3) Four scenarios of contracted water demand are designed to stimulate the WOTW in irrigation areas with heterogeneous endowments, making breakthroughs in practical scale limitations of the proposed model. In conclusion, driven by WOT, this study provides insights into the optimal allocation of water resources in irrigation areas with heterogeneous resource endowments and the increase in WOTW, which is conducive to the efficient utilization of agricultural water resources.

The remainder of this paper is organized as follows. Section 2 outlines the corresponding problem descriptions. Section 3 elaborates the detailed modelling process of our proposal consisting of tradable water prediction, expected return analysis of WOT, and WOTW calculation. Section 4 applies the developed model to Bayannur. Section 5 summarizes the conclusions and future works of this paper.