13-Oct-04 Flint River Basin TAC Impact of Weather Derivatives on Water Use and Risk Management in Georgia Shanshan Lin (presenting), Jeffrey D. Mullen and Gerrit Hoogenboom Agricultural and Applied Economics The University of Georgia May Funded by USDA Special Grant #PA

Background  Water scarcity is an emerging issue in Georgia  Agriculture is primary consumptive water user  Need to increase water application efficiency  Technology-based approaches have limitations

Objectives of this Presentation  Demonstrate irrigation is a viable risk management strategy  Examine effect of water pricing policy on optimal irrigation strategies  Investigate the impact of financial instruments on production risk and optimal water use

Methodology  Economic Model (Maximize Expected Utility).  Irrigation application criteria (plant-available water threshold)  Crop simulation model (DSSAT)  Design of the proposed weather derivative product (choice variables: i*, λ, x)

Data  4 Crops : Corn, Cotton, Peanut, Tomato  3 Soils : Wagram Sand, Tifton Loam Sand, and Norfolk Loam Sand  3 Locations : Mitchell, Miller, and Lee Counties  Weather Data : Daily Solar Radiation, Temp. (Max & Min), and Precipitation  Irrigation Cost per Application : Fixed and Variable

Results  (1) Impact of the optimal irrigation on producers’ Certainty Equivalent Revenue

 (2) Impact of Potential Water Pricing Policy on producers’ Irrigation Decision and Certainty Equivalent Revenue

Without Weather Derivative Contract

With Weather Derivative Contract

(3)Impact of Weather Derivative on Water Use (3)Impact of Weather Derivative on Water Use Cumulative water use for corn, cotton, peanut, and tomato in Mitchell, Miller, and LeeCumulative water use for corn, cotton, peanut, and tomato in Mitchell, Miller, and Lee

Impact of Weather Derivative on Farmer Welfare  Regardless of risk aversion, better off even though the premium included a 10% proportional load. even though the premium included a 10% proportional load. One exception in Lee County One exception in Lee County the decreases in CER are very small. the decreases in CER are very small.

Conclusion  Irrigation is as an important risk management strategy in agricultural production.  The proposed water pricing policy may have limited effect on irrigation water use. Even when precipitation derivative is offered Even when precipitation derivative is offered

Conclusions (Cont.)  A precipitation insurance contract could be an attractive risk management tool for a variety of crop producers in Georgia  May reduce water use while increasing farmer welfare.

 Thank you  Questions?

Economic Model Decision Criteria in the Presence of Risk  Maximize Expected Utility  Utility curve Risk Averse: concave utility Risk Averse: concave utility Risk Neutral: linear utility Risk Neutral: linear utility  Risk aversion : the degree of concavity of the utility function  Decreasing absolute risk aversion-

Presentation Outline  Objective : develop a dynamic model that conceptualizes irrigation and financial decisions of farmers who face weather uncertainty and vary in their risk preferences.  Methodology - Expected Utility Model - Expected Utility Model - Crop Growth Simulation Model - Crop Growth Simulation Model - Weather Derivative Design - Weather Derivative Design  Results and Discussions

Why irrigation in a humid area  Economic benefit to region (Makes land much more productive )  Allows year-round production  Offset the impact of rainfall variability on crop yield and to reduce the risk associated with weather variability.

Irrigation Growth timeline

Weather data Soil data Crop Property data Crop Management data Plant simulation model Weather Derivative Design NRwithout weather derivative Economic Model Precipitation data Payoff: f Premium: π

CER  U(CER)=EU(R)  U(R)=(R^(1-r))/(1-r)  U(CER)=(CER^(1-r))/(1-r)