Modern financial markets are extremely complicated. Not because all parts of the subject are complicated, but more of a result of a layer-upon-layer-upon-layer effect mixed with jargon.

Anyway, regarding this contract. What happens if a bunch of random people bet on water scarcity? Well, if there is no water scarcity they will simply lose all their money.

If there is water scarcity, however, this will be a clear signal of trouble ahead several weeks (or even months) before the scarcity becomes a real problem for real people.

Yes, these greedy speculators will earn a lot of money (from people hedging and from other speculators); but it will not be because of losses of ordinary people using water on a day-to-day basis.

Those people, if water scarcity sets in, will have to ask their supplier (the state I suppose? or are there private companies in CA?) why this is happening and solve the problem.