Center On Financial Risk in Environmental Systems (CoFiRES)

Environmental Financial Risk Management 101

Center on Financial Risk in Environmental Systems: Environmental Financial Risk Management 101 Systems Diagram

Environmental Financial Risk Management 101 Systems Diagram

Environmental uncertainty poses a growing number of financial risks on society, with droughts, floods, extreme temperatures and violent storms imposing global costs that approach $500 billion per year. While structural forms of mitigation (i.e. dams/reservoirs) will certainly play a role in limiting the financial impacts, these are large investments whose value is often realized only on rare occasion. Furthermore, the value of such long-lived measures becomes increasingly uncertain in a changing climate, raising the issue of whether they will even be effective 20-30 years hence. Financial instruments, such as index insurance or other types of hedging contracts, can provide increased flexibility by providing compensation for losses only when they occur, and limited contract periods allow terms to be modified in a manner that responds to changing conditions (i.e. climate change). Financial instruments can also be effectively combined with infrastructure to create integrated solutions in which structural approaches mitigate the losses associated with more moderate events, with financial tools designed to compensate for more rare, but extreme, events.

While there is a long history of environmentally-related insurance and hedging instruments, to date these have mostly been based on straightforward observations, such as the frequency and severity of hurricanes, which can be used to structure and price a contract. More recently simple correlations between time series involving some observable metric and a financial loss, or a close proxy, have been used to structure index-based financial contracts. Links between temperature and electricity demand, for example, serve as the basis for contracts that are used to limit the financial exposure of power generators to low revenues that occur during unseasonably warm winters or cool summers. Nonetheless, these products remain relatively unsophisticated, and very few instruments exist for mitigating the impacts of a broad and growing number of environmental financial risks. This is largely due to the limited number of environmental financial risks that can be linked to one simple metric, but with a more advanced understanding of the environmental systems that give rise to these risks, opportunities abound to develop more innovative contract structures for a range of applications.

The financial risks of drought, for example, are often poorly correlated with straightforward metrics such as rainfall. Many hydrologic factors and human interventions mean that simple indices prove to be inadequate proxies for financial risk. However, more refined metrics, including consideration of both runoff and reservoir storage, can be used to develop highly correlated, yet still transparent, indices that track drought-related losses very well and can therefore serve as the basis for effective hedging instruments. Energy production is also threatened by environmental events, with hydropower representing a prime example linking water scarcity and financial risk. In this case, financial impacts on hydropower producers are a function of both water scarcity and the costs of replacement power (often derived from natural gas), so some form of composite metric is required if it is to serve as an effective foundation for an index-based hedging instrument. Many other opportunities exist to develop advanced risk mitigation tools and strategies for other sectors (e.g., thermal energy generators, inland navigation, any water intensive manufacturer) by combining models from both natural and human/economic/financial systems.

Pursuing this line of research involves several primary components requiring significant interdisciplinary expertise in the areas of environmental modeling, economics and finance, including:

(1) the identification and characterization of financial risks linked to environmental events;

(2) the development of financial instruments and strategies designed to mitigate these risks,

(3) The transfer of these concepts and approaches into practical application through
relationships with the financial risk management community.