Precautionary savings as an instrument to hedge the risk of hydrological drought in irrigated agriculture

This paper explores the use of precautionary savings as a new risk management instrument that can be implemented to hedge hydrological drought risk in irrigated agriculture, a risk currently not covered by any policy instrument. For this purpose, the Drought Savings Account (DSA) is proposed as a personal savings account to which farmers make regular contributions, with withdrawals allowed in the event of irrigation water supply gaps in order to guarantee a minimum income. The implementation of the DSA is empirically assessed in a Mediterranean-climate irrigation district using an innovative simulation approach. Based on the results obtained, the DSA has proved to be a theoretically suitable policy instrument that can overcome the problems hindering the implementation of agricultural insurance, managing the risk in a more cost-effective way. This cost-effectiveness is a key advantage of precautionary savings over agricultural insurance, since the former instrument minimizes moral hazard and adverse selection problems, and the transaction costs of risk-sharing. Moreover, in this context, precautionary savings may play a significant role as an efficient climate change adaptation measure since the self-insurance strategy adopted does not distort the signals underlying farmers’ own risk exposure, leading to better individual assessment and an adequate management of water supply gaps.