Richard Hartigan sets out a mechanism through which parties exposed to climate change may hedge their risk using greenhouse gas forwards
Climate change science and modelling are now reasonably advanced, largely under the auspices of the Intergovernmental Panel on Climate Change (IPCC) – the UN intergovernmental body responsible for advancing knowledge of human-induced climate change. However, the way in which society will respond to climate change is still extremely uncertain, as are other factors, such as the speed with which carbon dioxide removal technology will be developed and commercialised.
Despite this uncertainty, there must be a best estimate for greenhouse gas (GHG) atmospheric concentration in watts per square metre (W/m2) at future points in time (2035, 2040, 2045 and so on). This might be thought of as a crowdsourced GHG atmospheric concentration ‘forward curve’.
The 2019 GHG atmospheric concentration reading, as per the most recent IPCC report, was 2.72; as we are now in 2022, it will be a little higher. A reading of 1.9 in 2100 would be considered ‘very low’, while a reading of 8.5 in the same year would be ‘very high’; the actual reading will presumably fall between these two figures. Figure 1 shows a fictitious GHG atmospheric concentration forward curve that sits between these high and low values.
What a given GHG atmospheric concentration at a given point in time implies for temperatures, sea levels, droughts and so on is reasonably certain.
Emissions versus concentration
The reason for differentiating between GHG emissions and GHG atmospheric concentration is that GHGs are long-lived. A GHG emitted today will be around for some time. The mix of GHGs (for example CO2 versus CH4 versus NF3) makes a difference. The pace of getting from today’s GHG atmospheric concentration to the concentration at some future point in time (eg 2040) makes a difference.
Hypothesis
Having created the forward curve (via ‘futures’ contracts), it will become possible to ‘go long’ (for example 2070) or ‘go short’ (for example 2035) a given GHG atmospheric concentration contract.
Different entities (such as commercial enterprises and countries) will have different exposures to the consequences of GHG atmospheric concentration being different to the forward price, and can therefore ‘hedge’ against movements in GHG atmospheric concentration that would be adverse to them.
Example 1:
A low-lying Pacific nation
Various small island nations in the Pacific Ocean, such as the Marshall Islands, are extremely exposed to climate change – but, alone, can do little to affect the outcome of human behaviour. What they can do is prepare for climate change. This could take two forms: physically readying the nation for climate change effects (strengthening sea walls, relocating and re-configuring harbours, and so on), or a mass evacuation and resettlement of most or all of their citizens to another nation.
Let’s assume that plans for both forms of preparation are well-developed, but are based on the expected GHG atmospheric concentration at a given point in time. If things turn out worse than expected, considerably more funds must be found. To mitigate this risk, the nation might choose to hedge its exposure to this eventuality by ‘going long’ a given GHG atmospheric concentration contract (for example 2070).
Example 2:
A pension fund that owns vast tracts of forest
Forestry is a growing asset class. Forests’ ‘value’ is directly linked to their ability to positively influence climate change. The current value of forests is based on the expected GHG atmospheric concentration at a given point in time.
If the outcome of human behaviour regarding climate change is such that there is a sudden global awakening to the risks of climate change and concomitant urgent global action, the value of forests may decline. To mitigate this risk, the pension fund might choose to hedge its exposure to this eventuality by ‘going short’ a given GHG atmospheric concentration contract (for example 2035).
“Having created the forward curve, it will become possible to ‘go long’ or ‘go short’ a given GHG atmospheric concentration contract”
Mechanics
The mechanics of this proposal are no different to any other ‘futures’ traded on major financial markets around the world, such as Intercontinental Exchange or Chicago Mercantile Exchange (CME). In many ways, it is not so different to the traded futures on the CME’s Case-Shiller Index. The exchange sets trading rules, including margining rules (mark-to-market), and sets the ‘tick value’ per contract (minimum price movement).
The only difference might be that if a large enough position were established by a party, there may be some moral hazard in their attempting to influence the outcome. For example, China could establish a large long position in the 2030 GHG atmospheric concentration contract and then suddenly and unexpectedly announce it is abandoning its global obligations by choosing to expand fossil fuel energy. The exchange and/or other global bodies, such as the UN or World Bank, may wish to establish strong rules and/or oversight of position-taking to prevent this.
Once the GHG atmospheric concentration forward curve is established and ‘futures’ become liquid, it is likely that other financial innovation may follow, for example an options market.
While this proposal does nothing to change human behaviour and the path of GHG atmospheric concentrations at future points in time, it does do two things. First, it provides a credible best estimate for GHG atmospheric concentration at each given future point in time; this will help policymakers to assess the success of existing measures to combat climate change over time, and may spur them to do more. Second, it will form an element of resilience by allowing vulnerable parties to hedge their risk, mitigating their financial stress if the climate change outcome is different than expected.
Richard Hartigan is a general insurance actuary working in London
Image credit | iStock
