Applying Climate Derivatives to Flood Risk Management

Abstract

As part of a new approach to dealing with flood risk, we demonstrate that index-based derivatives can provide a hedge to protect sea front developers and governments against financial disruption in the aftermath of adverse climate events by allowing risks to be transferred between entities having to manage the costs associated with sea level rise. Given the large number of processes affecting global temperature in the climate system and the fact that these processes operate on different time scales, one cannot assume that a single time scale characterises either the interannual variability of climate or the response of climate to radiative forcing imposed over decades to centuries. Therefore, when modeling climate, we must consider different regimes for the time scale depending on the external forcing. We do this by introducing uncertainty to the characteristic time and to the sensitivity of climate to the stock of greenhouse gases in the atmosphere. We also make allowance for the possibility of jumps in global temperature. As a result, we improve a simple model introduced in earlier work by presenting three different jump-diffusion models for solving the estimated time constant problem and accounting for non-linear climate forcings. Finally, we apply such climate derivatives to flood risk management by assessing the costs and benefits on two projects: one relating to a rolling easement and the other incorporating the concept of a real option.

Keywords: Climate Risks, Climate Derivatives, Adaptation, Jump-Diffusion Models, Semi-Empirical Sea Level Models