Derivatives for Environment: When Finance Meets Climate Change

While assessment of risk under uncertainty has been dealt with to a very detailed extent in the domain of finance, the same depth is not found in addressing the environmental problems. The idea of using the concepts from Finance in Environment via derivatives was popularized by Richard Sandor in his book Good Derivatives: A Story of Financial and Environmental Innovation, with the view that market instruments provide a better way to control emission levels than the Command-and-Control approach. Following his work in the Chicago Climate Exchange, the economists’ trials to further analyse the environmental markets like the financial markets have been pretty recent, given the growing environmental concerns.

It is a known fact that the everyday players in financial markets adopt various strategies to preferably avert, if not minimize the risks involved in various transactions. These strategies majorly involve the use of financial derivatives. Simply put, a derivative is an instrument that derives most of its value from some underlying asset, which may be classified as either commodity or financial. We commonly come across derivatives such as forwards, futures, and swaps. Financial derivatives are usually preferred to hedge risks as they offer moderate liquidity. However, the question is if it is possible for the environment and natural resources? And, how consistent and sustainable are the hedging measures? 

Derivatives in Environment: A Cursory Look

When it comes to environmental assets, the conservation value does not generally align with the extraction value. As such, these assets are subject to over‐exploitation and misuse. Management of natural assets within specific limits, while constantly facing the risks of crossing these limits is what is involved in conservation management. With such risks involved, it becomes imperative to tackle them using risk-minimizing measures, such as either through hedging or sharing these risks. 

Greece’s Sovereign Debt crisis of 2008 has questioned the reckless use and overshot speculation of financial derivatives. However, Sandor (1) has suggested that if correctly utilized, derivatives can address a variety of global problems, case in point the use of emissions trading to reduce acid rains, coming under the banner of Good Derivatives. These have found their use in the field of sustainable finance as well. As an example, Environmental, Social, and Governance (ESG) derivatives can make it possible to raise the capital necessary to invest in a climate change strategy. Another example in support of ESG derivatives is the idea of impact investing which involves investment in companies that provide possible solutions to the existing environmental challenges through recognized frameworks like the Sustainable Development Goals (SDGs).

Derivatives in Carbon Markets

Derivatives have found their use in carbon markets. For instance, consider the Regional Greenhouse Gas Initiative (RGGI), a market-based program in the United States designed to institute a cap on the carbon dioxide emissions from the energy sector. It also involves a futures market built and operated by the Intercontinental Exchange (ICE) with the objectives of setting the price and providing liquidity, both of which are necessary for the carbon markets to operate. It is a cap-and-trade system based, the cap limiting the emission levels, and the trade allowing for purchase and sale of allowances. The latter aspect of this system, the trade aspect, is similar to the functioning of financial options. An option gives the right to buy or sell, for a limited time, a particular good at a specified price, the good under consideration being the allowance to emit. Also, the notions of futures and forwards can be used simultaneously to limit carbon emissions. As an example, margin payments can be imposed per unit of the permits to cover for any possible damage to the environment (which comes from futures), and reversibility of the contract of trading the permits can be limited to only the party and the counterparty involved (called limited squaring off, a feature of forwards). This would firstly ensure reduced emissions, and secondly, allow the burden to fall entirely on the responsible parties.

Weather and Climate Derivatives

Another application of derivatives lies in the form of weather derivatives. These are contracts that make payments based upon realized characteristics of weather, to cross-hedge specific risks, attributed mostly to energy-related products. Contracts are let out (as either call, put, collar, or swap options) on a monthly or seasonal basis based on meteorological records and short-term seasonal forecasts, with the mean and standard deviation of the climate proxies assumed constant. Sometimes these are considered to be similar to weather insurance, but they are different; the former deals with low-risk and high probability events, and the latter with high-risk and low-probability events. It is known that changes in weather conditions have considerable effects on businesses that are related to agriculture, aquaculture, and energy. Weather derivatives would then be useful to formulate decisions regarding the production and sale of seasonal products. As an example, temperature put options are designed for food retailers as risk-hedging tools against adverse temperature impact on sales of beverages such as cooldrinks and ice-creams during summer. An extended version of weather derivative would be climate derivative, with the underlying asset commonly being the temperature, used to manage risks associated with climate change; in other words, where the mean and standard deviation of the climate are subjected to volatility. A study has found that climate derivatives can hedge against potential economic losses by considering the aquaculture industry in Tasmania. 

Derivatives and Biodiversity Conservation

There are also biodiversity derivatives, which claim to take the advantage of the market to reduce the costs of conservation, by allowing the governments to issue modified derivatives contracts to sell the species extinction risks to market investors and stakeholders, where the internalization of biodiversity-based externalities fails. These, being similar to insurance derivatives, would then allow for a decrease in the likelihood of the insured event (that is, species extinction) to occur, since the trigger of species decline would then call for its remediation and recovery via the principal paid by the investors. But then, is it logically possible to assign an appropriate price to the endangered species? This would depend on numerous factors, the important ones being the extent of the loss, whether the loss is replaceable or irreplaceable, and the risk of extinction. The last one of the previously mentioned factors is relatively difficult to measure, since that would require another set of factors, but is yet an important one to consider. One solution for this could be the use of swaps. A swap is an agreement to exchange an uncertain stream of payment against a predefined stream of payments. In this case, the uncertain stream would be the price associated with the risk of extinction (which can be greater or less than a predetermined reference price), while the certain stream would be the principal amount. 

Environmental Derivatives – The Road Ahead

It can be seen that the mechanisms involved in the functioning of financial derivatives are certainly applicable in addressing various environmental issues. And there is sufficient evidence to support this. Even though problems pertain in terms of deciding the underlying asset, determining the price in the presence of volatility, forming the type of contract (whether as options, forwards, or futures), difficulty in pricing the environmental assets, and so on, it very well would serve as a starting point to consider the use of derivatives for environmental conservation and risk-hedging for goods whose nature of the sale is contingent upon the environmental factors.

Key Takeaways:

  • Despite criticisms over the reckless use of derivatives, they can still prove to be useful in providing solutions to global environmental problems, like using ESG Derivatives.
  • Options, Forwards, and Futures can find their use in carbon markets, to control the emission levels.
  • Weather Derivatives can be used for risk-hedging in the case of seasonal products.
  • Swaps can provide an innovative way of conserving biodiversity, especially to counter the risk of species extinction.

Chennuru Sravan
Chennuru Sravan is a student currently in the 5th year of his 5-Year Integrated Masters in Economics at the University of Hyderabad, and is a student member at the Indian Society for Ecological Economics (INSEE). His research interests are currently in Microeconomics and its applications, particularly pertaining to Environmental Economics, Game Theory and International Economics.