Hedging Supply Risks: An Optimal Urban Water Portfolio

Abstract

Although water portfolios have been proposed as a solution to water management under risk and uncertainty, the optimal mix of natural and manufactured sources of water remains largely unexplored. We develop a dynamic portfolio model of urban water supply that hedges against the supply risks from all potential water assets, by taking into account uncertainties of water flows as well as differences in supply costs. The optimal portfolio shares for an existing water supply system are derived and compared with the observed choices, revealing unexploited hedging opportunities between various naturally occurring water sources as well as an over-reliance on manufactured water in years of average and below average natural water availability. It is estimated that the optimization of the water supply portfolio for a medium-sized city results in cost-savings of between $43m and $165m per year.