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'buybacks' and their use to secure environmental flows - National ...

'buybacks' and their use to secure environmental flows - National ...

Figure 14:Trading

Figure 14:Trading allocations - costs and revenues $80 $60 Total cost ($M) $40 $20 $0 0 20,000 40,000 60,000 80,000 Quantity purchased (ML) Revenue from selling Cost from buying Upfront cost of entitlement As larger volumes of entitlement are purchased, then the need for purchasing seasonal allocations falls and the environmental manager effectively becomes a regular seller of water allocations each year. Although the different combinations effectively result in the same water being transferred from irrigation use for environmental use, because of differences in how water markets value seasonal allocations and entitlements and respond to the trading actions of the environmental manager, the overall cost varies. That is, as described in Box 2, the cost-effectiveness of purchasing entitlements relative to allocations depends on several factors. In the context of our case study, entitlements initially represent good value for money for the environmental manager, however at a point this reverses and additional entitlement purchases serve to increase overall budget costs. The (net present value) budget cost of an entitlement holding and active allocation trading is minimised with an entitlement holding of about 8GL at a cost of around $19 million. Purchasing an entitlement holding of greater than 400 GL would incur a cost of around $25 million. With this buyback strategy, governments are also likely to be interested in identifying differences between combinations that minimise overall costs with combinations that are self-financing beyond the initial entitlement purchases. That is, what quantity of entitlements would mitigate the need for subsequent budget support as the revenue from selling allocations becomes sufficient to meet allocation purchases? In our case study this would be achieved at an entitlement holding of about 25 GL. Natural resource ‘buybacks’ and their use to secure environmental flows BDA Group 42

Box 2: The opportunity cost of water sourced for environmental purposes The opportunity cost of water sourced for use as environmental flows should be reflected in the prices at which water trades, which in turn should reflect its marginal value to irrigated agriculture, as irrigation entitlements have represented virtually all water sold on water markets along the Murray in recent years. As noted earlier, prices for seasonal allocations vary considerably reflecting expectations of seasonal conditions, entitlement allocations, commodity prices, and so on. Entitlement prices reflect longer term expectations and are broadly the net present value of anticipated allocations and seasonal prices for those allocations. However entitlement prices may diverge from this summation of potential revenues from selling allocations under an entitlement due to risk preferences. So for example, entitlement values could be discounted where market participants perceived there to be a (negative) element of sovereign risk – that is, a chance that governments may lessen entitlement rights and hence their worth. Alternatively, entitlement prices may attract a premium where irrigators placed a ‘hedging’ value on it given perceived supply threats, such as from climate change. Based on our data on entitlement and allocation prices, and historical allocation profiles, we have estimated that the internal rate of return on the purchase of one ML of entitlement is around 6% in both the NSW and Victorian Murray regions. If the opportunity cost of capital were 7%, then this suggests irrigators are paying a premium to hold entitlements. In this study we have assumed governments are risk neutral and face an opportunity cost of capital of 7%. Therefore sourcing water through the purchase of allocations will, all other things equal, be cheaper than through the purchase of entitlements. However the position can be reversed, as it is in our case study, due to the timing and extent of actual water purchases and sales. If the profile of purchases is skewed by large early expenditures and/or by price effects when purchasing large quantities of allocations, the net present value of a trading approach may exceed that of holding at least some entitlements whose market price was based on expectations of irrigator to irrigator trading. Of relevance to this study, is that environmental managers should modify their purchasing patterns to take advantage of any differences in their risk preferences and those of other water market participants, but also with consideration of potential price effects of their trading activity. However the small holdings of entitlements identified to minimise overall budget costs means large quantities of allocations still must be purchased on allocations markets in peak years, raising doubts as to the workability of this strategy. Indeed peak volumes required differ little than under the previous scenario where there was a total reliance on allocation purchases, with the same challenge of sourcing allocations over a short period of time early in the season. Natural resource ‘buybacks’ and their use to secure environmental flows BDA Group 43

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