Fixed vs. floating supply - a thought experiment about water assets and volatility smoothing

Water utilities provide a key service - reliable, clean water.

Is there parallels between how water utilities deliver this reliability, and how investors swap fixed and floating interest rates to create smoother returns?

Fixed vs. floating

Investors swap floating rates for fixed rates using an interest rate swap, a financial contract where two parties exchange interest payment structures for a specified period, based on a notional principal. Typically, one party agrees to pay a fixed rate while the other pays a floating rate tied to a benchmark like SOFR or LIBOR. Investors use these swaps to hedge against interest rate volatility, stabilizing cash flows and locking in predictable payments even if market rates rise.

Water supply volatility

Clean water, as it occurs in our world, is uncertain. Riverflows are volatile.

River flows - Murray River

The implication is water supply has a floating rate appearance - it is not clear what the next day will bring.

Water utilities, therefore, construct infrastructure that store water (and, more recently, manufacture water) to create a more fixed rate of supply.

The utility pays a construction company to build an asset (the cost of the contract).

The utility then sells the reliable supply of water based on its asset which negates (to a large extent) the volatility of the water supply from rain and/or rivers.

Volatility smoothing

This volatility smoothing, where the water assets derive a smooth supply from a volatile source (at least in Australia) is the hallmark of the water utility. It is not like the electricity company where demand is the more volatile (changing) variable.

What we get then is the preference to upsize the assets so that the volatility is further reduced. Think of water security measures that focus on mega dams. The view being that the storage volume provides even greater volatility smoothing.

Loss of the smoothing

Attempts to avoid large, volatility smoothing assets such that the supply is matched to demand in a tight band seem to often be where people experience water restrictions. It may be that the asset is large but during long periods of low volatility, supply of the demand is apportioned to other uses (agriculture, environment etc.) such that the supply allocated to human consumption is close to demand.

When the volatility kicks back in, there is mad scramble to re-jig the allocations as the reliability of supply for human consumption is threatened or consumption is actively curtailed through restrictions.

These restrictions are politically unpalatable and the government then kicks off a round of ‘water security’ projects that try to expand the volatility smoothing capacity of assets or create new assets so that the community is comfortable that water supply is reliable.

If volatility is seen to permanently increase due to a lack of additional smoothing, then the cost of solutions has to be higher than the previous cost under lower volatility.

Droughts that result in increased volatility should increase the cost of solutions due to the changed perception of volatility.