California's water system is crashing. The Golden State is headed into the fourth year of drought conditions, and it's time investors readjusted their portfolios for the long run. Here's what you need to know.

When the water's gone
Investors have a lot to learn from the California drought: It's a real-life lesson in the importance of diversification and hedging. While the drought and ensuing regulations have actually left Big Ag relatively untouched, its energy sector is undergoing a rapid revolution.

Hydropower accounted for around 20% of California's in-state generation from January to July (the wet months) for the past decade. But recent data suggest that hydropower's "new normal" may be more like 10%, or perhaps even less. For the 2014-2015 winter, officials now estimate that California's snowfall clocks in at just 6% of normal rates. 


As Californians have continued to consume electricity, other energy generation sources have ramped up in recent years to cover hydro's hiatus. Most notably, natural gas, wind, and solar power have all increased significantly over the past decade. Natural gas currently accounts for around half of California's utility-scale generation. Wind energy has expanded from 4% of generation capacity in 2011 to 8%, and solar recently hit a new record of a 5% contribution


Diversify the drought
Hedging isn't a sign of weakness in your investment theory -- it's an open opportunity to reduce risk. In California's case, investors can "hedge" hydropower investments with other energy investments. As generation capacity growth has shown, when it doesn't rain, it shines.

One pure solar investment is SolarCity Corp (NASDAQ:SCTY.DL). With 30 customer centers across the Golden State, SolarCity Corp is California's largest rooftop solar panel kit installer. The company operates in 15 other states and Washington, D.C., but its latest annual report notes that the majority of its solar systems are located in California. Partnerships with Best Buy Co Inc (NYSE:BBY) and The Home Depot Inc (NYSE:HD) have helped push SolarCity Corp's clientele beyond its normal market base, and CEO Lydon Rive has set a goal of one million solar customers by July 4, 2018. 

But while solar investments can offset hydro assets, there's something to be said for investing in companies that are already diversified for the California drought. Utility companies are hedging their own energy portfolios to keep investors balanced across energy assets.

Source: Edison International. 

Edison International (NYSE:EIX), through its subsidiary Southern California Edison, has made the switch away from owning hydropower assets (and assets, in general). While hydropower comprised more than a third of Southern California Edison's owned capacity last year, those assets accounted for just 16% of its overall energy needs. The company's total energy requirements relied on hydropower for just 2% of its electricity in 2014, down from 6.2% in 2011 .

Instead, Edison International has increasingly entering into long-term power purchase agreements, hedging its investments with renewable energy purchases. In 2013, renewables accounted for 22% of the utility's portfolio, and the company expects to increase those purchases by 60% by 202 0. And while investors wait, Edison International lives up to utilities' dividend stock reputation with a 2.6% annual yield .

Hedging for the future
Even with California's new water use limits, the state doesn't expect to reach a sustainable water use equilibrium until 2040. This "new normal" is a wake-up call for how investors evaluate California. Its economy and energy are changing forever, and those who readjust and diversify now will remove unnecessary risk for their portfolio's future profits.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.