Center on Financial Risk in Environmental Systems: Great Lakes
Managing the financial risks of low water levels in the Great Lakes
Low water levels in the Great Lakes have significant financial impacts on regional shipping and hydropower production from interlake flows. Index insurance based on lake levels can be used to effectively manage the financial risk to both shippers and power producers, and seem to be a reasonably robust risk management tool even in the face of climate –related uncertainty.
Commercial shipping in the Great Lakes transports hundreds of millions of dollars’ worth of bulk goods each year. Cargo capacity is a function of a ship’s draft, the distance between water level and the ship’s bottom, and lower water levels force ships to reduce cargo loads to prevent running aground in shallow harbors and locks. Financial risk transfer instruments, such as index insurance based on lake level, may provide an adaptable method for managing these financial risks. In this work, a relationship between water levels and shipping revenues is developed and used in an actuarial analysis of the frequency and magnitude of revenue losses. This analysis is used to develop a standardized suite of binary financial contracts, which are indexed to water levels and priced according to predefined thresholds. These contracts are then combined to form hedging portfolios with different objectives for the shippers. Results suggest that binary contracts could substantially reduce the risk of financial losses during low lake level periods and at a relatively low cost. Hydropower on the Great Lakes makes up a substantial fraction of regional electricity generation capacity. Hydropower producers on the Niagara River (flowing between lakes Erie and Ontario) operate as run-of-river, and changing lake levels alter interlake flows reducing both generation and revenues. Index insurance contracts offer a tool for mitigating this risk, but pricing of financial insurance is typically based on historical behavior of the index. However, uncertainty with respect to the impacts of climate change on lake level behavior translates to increased (or decreased) risk for those selling or buying the insurance. Portfolios of binary index-insurance contracts are developed for hydropower producers and Climate Informed
Decision Analysis is used to inform the sensitivity of these portfolios to potential shifts in longterm, climatological variations in water level behavior. Trade-offs between portfolio cost and the frequency of underperformance are investigated over a range of climate futures.
Meyer, E. S., Characklis, G. W. and C. M. Brown (2017). “Evaluating Financial Risk Management Strategies Under Climate Change for Hydropower Producers on the Great Lakes,” Water Resources Research, 53, doi:10.1002/2016WR019889.
Meyer, E. S., Characklis, G. W., Brown, C. M. and P. Moody (2016). “Hedging the Financial Risk from Water Scarcity for Great Lakes Shipping,” Water Resources Research, 52, pp. 227-245, doi:10.1002/2015WR017855.
Hydro Research Foundation (U.S. Dept of Energy funded program)
UNC Institute for the Environment