Climate Hedging Explained
38 Pages Posted: 13 Sep 2010 Last revised: 7 Oct 2010
Date Written: September 13, 2010
The causal relationship between atmospheric CO2 concentrations and global temperature is well established, but the degree of sensitivity of future temperature rise to both existing levels of CO2 and continued carbon emissions is still subject to a high degree of uncertainty. Governments have responded to the future threat of further global warming on economic growth by proposing a variety of carbon emission mitigation approaches such as cap-and-trade or carbon tax mechanisms. Yet, such approaches have two central weaknesses: 1) they are targeted at the wrong variable, C02 concentration rather than temperature, and 2) by their very design they create incentives for high carbon emitters to circumvent the regulatory systems established and become free riders on those pursing aggressive mitigation policies. Building on the sea level climate derivative concept proposed by Bloch, Annan and Bowles, the authors propose a new range of Climate Derivatives such as Climate Coupon Bond and Climate EOption whose pay-offs are dependent on global temperature rise. The Climate Derivatives would create both a vehicle and an incentive for high carbon emitting companies, industries and countries to help finance new technologies and industries that will reduce carbon emissions in the future. Moreover, the instruments would dynamically reflect and incorporate any new information that helps predict the path of temperature rise through time and, in effect, would put a price on the probabilities associated with a variety of climate change scenarios.
Keywords: Climate Risks, Climate Derivatives, Carbon Emissions, Global Warming Risk, Catastrophe Risk, Discounting Rates
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