The Dual Function of Financial Market Instruments in an Environment of Climate Change Uncertainty: Protection and Speculation

The author, in a number of papers, most recently Stern (2017), has explored the role of financial market instruments in the area of climate variability and change. The current paper updates this previous work, taking advantage of the emergence in financial markets of very long term maturity (100-year) bonds.

By way of introduction, a 17-Feb-2017 speech by the Australian Prudential Regulation Authority (APRA)’s Executive Member (Insurance), Geoff Summerhayes, to the Insurance Council of Australia Annual Forum in Sydney, provides a very nice background to what follows.

He said, in part:

“To begin with a generalisation, while climate risks have been broadly recognised, they have often been seen as a future problem or a non-financial problem. The key point I want to make today, and that APRA wants to be explicit about, is that this is no longer the case. Some climate risks are distinctly ‘financial’ in nature. Many of these risks are foreseeable, material and actionable now. Climate risks also have potential system-wide implications that APRA and other regulators here and abroad are paying much closer attention to …

I think the days of viewing climate change within a purely ethical, environmental or long-term frame have passed. More and more, the conversations we are having are about the practical realities and consequences of a changing climate. One reason for this is that we now have a much more sophisticated, granular, quantifiable understanding of the impacts, risks and probability distributions around climate change …

We also have a much keener idea of impacts at a local level, and the implications for countries, regions, cities and, yes, companies …

(T)oday, climate change is not just the realm of scientists – but of planners, policymakers, businesspeople and economists …

In November, the Centre for Policy Development and the Future Business Council released an influential legal opinion on company directors’ legal obligations to consider the impacts of climate change. The opinion was authored by barrister Noel Hutley SC (2016). The opinion found that company directors who fail to properly consider and disclose foreseeable climate-related risks to their business could be held personally liable for breaching their statutory duty of due care and diligence under the Corporations Act …

The terminology I would like to adopt now, consistent with the FSB (Financial Stability Board) Taskforce, is physical and transition risks ...

(F)or the sake of clarity:

(1) physical risks stem from the direct impact of climate change on our physical environment – through, for example, resource availability, supply chain disruptions or damage to assets from severe weather.

(2) transition risks stem from the much wider set of changes in policy, law, markets, technology and prices that are part of the now agreed transition to a low-carbon economy …

A critical implication of what I have just recounted is the importance of considering, and modelling, the potential impact of climate-related risks under different scenarios and over different time horizons …

So climate risks will become an important and explicit part of our thinking. This is absolutely consistent with the approach that is being taken by regulators overseas. I hope the remarks I’ve made today show that we are very much alive to this issue too.”

The cost of protecting against, and speculating about, global climate change may be established by applying financial market mathematics to data associated with drivers of that change.

This approach is used to derive a risk management model that evaluates the cost of protection. Data employed to develop the model include long-term time series of measures associated with such drivers. The data are statistically analysed to establish their relative importance. Not surprisingly, it is found that Atmospheric Carbon Dioxide is of profound importance, but that other drivers do have an influence.

The findings are then applied to derive the statistical distribution of possible future trends out to 2100 of the Global Mean Temperature, based upon a set of Monte-Carlo-generated scenarios.

These scenarios show that it is much more likely for the Global Mean Temperature in 2030 to be higher than that in 2015, and almost certain to be higher than in 2015, soon thereafter.

The statistical distribution is then interrogated to provide estimates of what are the 'fair value' prices of put and call options on Global Mean Temperature futures contracts set to expire on Dec-31 in each year out to 2100.

The options considered include European style options (exercise only on expiry date) and Bermudan style options (exercise on any Dec-31 prior to expiry date) with the 'fair value' prices of the call options with particular expiry dates shown to be higher than those of the corresponding put options.

To summarise, the paper demonstrates how to evaluate the cost of hedging and speculative instruments related to climate change.

Their development provides the opportunity to protect against what could be dramatically escalating costs, should certain possible future climate change scenarios be realised.

Their development also allows those who wish to, to place speculative 'bets' on their views as to the likely future climate.

REFERENCE. Stern H (2017) Developing financial market instruments to protect against what could be dramatically escalating costs, should certain possible future climate change scenarios be realised. Australia & New Zealand Disaster and Emergency Management Conference, Gold Coast, QLD, 22-23 May 2017

FIGURE (below). ‘Fair value’ premiums (costs) of a set of call options purchased on 31-Dec-2015 all with a strike of 14.73°C (the 2015 Global Mean Temperature) and a premium (value) of $100 per °C at expiry.