| Summary: | Temporary resource transfers, as achievable under option contracts, reduce transaction cost associated with the sale of permanent resource rights. As such, they facilitate the realization of gains from trade that would go unrealized under failed permanent transfers. In the California water sector, there has been considerable resistance to permanent water rights transfers. The advent of option trading has led to an increase in urban-agricultural water transfers and has the potential to stimulate the California water market. This paper develops a bilateral option contracting model for water, which includes the possibility of conveyance losses and random delivery. Seller-optimal and socially optimal option contracts are characterized in terms of relevant upfront and strike prices, as well as contract volumes, from an ex-ante and an ex-post point of view. Actual contract prices are compared to model-predicted prices, and the social welfare gains from option contracting in the California water market to date are estimated. The sensitivity of future gains to commodity prices and the cost of electricity, implying the marginal cost of water conveyance, is also discussed. |
