Optimising Reliability: Portfolio Modeling of Contract Types for Retail Water Providers

This paper considers the retail water provider’s purchasing decision of a portfolio of permanent contracts from wholesalers with multiple volatile water sources. We consider the reliability of two contract types: (1) fixed annual quantities, and (2) an inflow harvest function with storage. Our four-reservoir case in Sydney (Australia) has cross-correlated inflow data. To accommodate multi-reservoir cross-correlation we adapt Portfolio Theory from finance to lognormal reservoir inflows, re-framing traditional storage theory from the wholesaler’s optimal operating policy to the retailer’s optimal purchasing policy. We find that Reliability improves with access to a source pool (cf. fixed quantities from separate sources), demonstrating the ‘insurance effect’, and the portfolio that minimises lognormal variance also minimises harvest (and thus environmental impact). Reform direction in Australian (and other international) water markets is towards multi-provider vertical disintegration, which may reduce pool opportunities and negate the insurance effect. We consider diminishing reliability returns as reservoir harvesting increases, and conclude a retail portfolio of permanent contracts from reservoirs, plus short-term contracts from alternative sources (either independently or negatively cross-correlated) efficiently secures high reliability. The challenge in incomplete water markets remains in encouraging and sustaining supply diversification that may only be needed aperiodically during extreme droughts.