The major challenge of hedging climate risks: Protect the economic activity against the alarming climate change impact

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The multiplication of exceptional climatic phenomenon linked to the climate change proceeds for a few decades. Each year 200 million people are affected by climatic modifications and among them 70.000 people die of it. Even if we do not have enough statistics to prove the impacts of climate change we note a boom of the climate system. Extreme phenomenon and climatic anomalies are booming due to the increase of CO2 emissions; between 1970 and 1985 there were 50 climatic disasters while since 1995 there are already 120 disasters.

According to a 2015 United Nations report, 90% of natural disasters that happened for 20 years are linked to climate change. The real cost of those disasters including earth shakes and tsunamis would be approximatively 250 to 300 billion dollars per annum but some economists are even more pessimistic and estimate the cost at 500 billion dollars. The amount of resulting damage caused by natural disasters has strongly increased for a few years as the following graph shows:

Property damage caused by natural disasters (in billions of US dollars)

According to the last GIEC report launched in April 2014, this disruption affects all the economic sectors such as agriculture, public transport or tourism. An alternative to hedge those risks is to use indexed options on weather risks which is called climate derivatives. Using weather data, it is possible to calculate the risk of a natural disaster, to attribute a value et so to insure it.

Nowadays climate derivatives attract emerging countries and developed countries where it is seen as a complement of the traditional insurance program. India was one of the first country to use indexed insurance products aimed to protect farmers from climatic disasters with the help of the World Bank and the Indian State. In developed countries, the use of climate derivatives to hedge the decline of agricultural yields is more and more important. In the US, the sale of agricultural insurance based on weather indices boomed since 2011.

The weather sensitive aspect of the international economic activity is a reality and economic actors must hedge their climatic risks if they do not want to lose money. Thus, the hedge of natural disasters implications is a true problematic of the 21st century because we know that 30% to 70% of the world GDP is influenced by climatic disasters.

A newly emerging market

Nowadays firms need to hedge from the negative impacts of the climate and to include those instruments into their business plan. Still the creation of an index is complex, even when the sensitivity of an economic activity to weather conditions is confirmed, it can be difficult to identify precisely the link between the variability of weather conditions and income volatility. Furthermore, the climate derivative market still suffer from a lack of liquidity linked to the imbalance of the demand. Risk premium stay at a high level for climate contracts which is one of the major obstacle to the development of this type of product.

Climate is often seen as inevitable and impossible to curb. Economic actors regret negative impacts of the weather on their activity but they are not used to hedge this type of risk. The more the weather risks management will be expanded, the more data is available, risk premiums are low and the hedge is interesting for economic actors.

States and international institutions have a key role to play in the development of weather derivatives, including the definition of the regulatory framework that surround those new products through the judicial form or their counting way. Finally, States can also stimulate the development of weather derivatives by enabling the access to data by offering the deployment of weather stations network.

Climate risk as a new financial product

Nowadays this market remains narrow because there are too little actors to be effective. Many economic actors such as energy companies (electricity, gas producers and suppliers…), agribusiness manufacturers, entertainment companies, farmers or transport companies have to face the climatic risks and their impacts. More and more risks interfere with the economic activity accelerated by climate change but the market is now able to provide a solution to hedge it. This is for now a growing market for the next years due to the acceleration of climate change.

Even if prevention and the use of classic insurance policy remain the standard, companies will have to use these financial products in the future and build new hedging strategies to take into account the climatic impact on their activity.

How to lead a hedge strategy of weather risks?

The international financial system is composed of the bank system, the insurance system and the financial market system. Each of them are using the weather derivatives for now in a variety of ways but with the same goal: hedge against weather risks.

Among the users of the weather derivative, those who are the most interested are the end users but the role of the intermediates such as the brokers or the role of the risk takers such as hedge funds is establishing like a predominant role.

The end users are mainly weather sensitive companies which buy protections against negative impacts of climate change such as a decrease of their production or of their demand. Hedging this type of risk can be also a great opportunity to promote the image of the company.

Brokers mainly popularized this type of product offering their help to companies to find out the different vulnerabilities of the companies regarding weather conditions. Data suppliers are also important because they provide figured data to use this type of indexed product.

Banks use weather derivative as a hedge strategy to cover weather risks for their clients by offering them some advice. The measure and the transfer of weather risks is simply an extension of the intermediation activity of banks. This new market allows the banking sector to expand their activity range and so to attract more clients, interested by this new hedge type of product.

Hedge funds play a key role on the weather derivative market. Indeed, those alternative funds seek absolute performance and weather derivative is very interesting for those funds because their yield is not correlated with the market performance. However, hedge fund strategies are mainly based on performance and speculative yield and not on a real hedge. This use is nevertheless important for this market to have a better visibility and liquidity on the financial markets.

Weather derivative is an alternative to the classic hedge

Weather derivative allow the transfer of new risks such as the weather risks of companies. They can also advantageously complement some traditional hedge solutions mainly with natural disasters reinsurance contracts. Even if the basis risk still remains an issue in his application, the application scope of weather derivative remains important.

Human being have to adapt to the inevitable impacts of climate change, he has to get ready to an increase of total temperature on the earth and to a stronger volatility of weather conditions. With this increased risk linked with climate change, it is obvious that each company would have to hedge this type of risk for the future because the impact of climate change on the economic activity is even stronger.

To find out more:

  • Nicolas Martelin, “Comment le climat est coté en Bourse”, Le Figaro, 2008

  • Pierrick Fay, “Le réchauffement climatique dangereux pour les actifs financiers », Les Echos, 2016

Benoit ANGLADE

 

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