Hedging Supply Risks: An Optimal Water Portfolio

Although water supply diversification has been proposed as a solution to dwindling water reserves, the optimal mix of natural and manufactured sources of water remains largely unexplored. We develop a dynamic portfolio model of water supply that hedges against the supply risks from all potential water sources, by taking into account the size of water reserves, 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 contributions to total water stock, revealing unexploited hedging opportunities between various naturally occurring water sources as well as a general over-reliance on manufactured water. The optimal solution implies that future supply augmentations should target natural sources of water ahead of manufactured water. It is estimated that the optimization of the water supply portfolio for a medium-sized city results in annual cost-savings of up to $463 million.