The role of weather derivatives and portfolio effects in agricultural water management

Both rising competition for water resources and increasing environmental concerns have placed the need for an enhanced water resources management on the policy agenda. However, a stricter regulation of irrigation water tends to result in declining farm income and arising risk exposure. With this in mind, we investigate the potential of index-based weather insurance, which is also referred to as weather derivatives, to cope with the economic disadvantages for farmers resulting from a reduction in water quotas and increased water prices. By means of a whole-farm risk programming approach, we systematically compare crop portfolios without and with the possibility of purchasing standardized weather derivatives based on precipitation and temperature indices. In an application to a representative cash crop farm in the northeastern part of the German federal state of Lower Saxony, we found that the use of weather derivatives offsets the loss in farmers' certainty equivalent resulting from moderate reductions in water quotas and water price increases. Our results also indicate that the provision of weather derivatives may substantially alter farm plans as well as the optimal irrigation water demand.