Bureau of Meteorology Advisory Board

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The application of financial market mathematics
to translating climate forecasts into decision
making.
Harvey Stern Bureau of Meteorology
3rd International Conference on Climate Impacts
Assessments (TICCIA) Cairns, Australia, 24-27
Jul., 2006.
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THE RISING GLOBAL TEMPERATURE
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INTRODUCTION
Fund managers rate climate change as the second
most important influence (after globalisation) on
asset performance over the next five years
(Mercer Investment Consulting, 2006).
Increasingly, the application of financial
market mathematics in the context of developing
strategies to address the impact of climate
change is becoming the subject of research (Tang,
2005). The presentationFirstly, discusses
several issues raised by contributors to Tangs
(2005) publication on the finance of climate
change, and,Secondly, illustrates the
application of some of these strategies with a
case study presented to the 2005 Annual Meeting
of the American Meteorological Society.
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PART ONE
Several issues raised by contributors to Tang
(2005)
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CLIMATE CHANGE ANDTHE FINANCE INSURANCE SECTOR
Climate change will affect the finance sector
from lending to investing, and from advising to
financing.While not as pronounced as the
insurance sector with its direct impact on
property and physical assets, nevertheless the
impact on financial institutions could be
far-reaching.Lending institutions need to
include climate change systematically in their
risk assessment procedures.Banks need to
develop tools to quantify the risk management
implications associated with their lending
decisions. At present, there is an obvious lack
of innovative financing instruments.
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CLIMATE CHANGE AND CAPITAL
Investing capital in emission reductions, carbon
sequestration, and related clean technologies
brings return in climate policy delivered as well
as profits.Models can predict carbon market
fundamentals with some accuracy.Just as
companies are familiar with dealing with exchange
rates, interest rates and commodity prices, so
they will start managing the carbon market in a
similar way and start hedging their risks.
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POLICY CONDITIONS
The key requirement for policy designed to
promote renewable energy investment is that it is
loud, long, and legal, to positively affect
project bankability, and to reflect a strong
governmental commitment to delivery in this
arena. A solid (legal) basis for long-term
contracts. Conditions that lead to big, liquid
markets, if using tradeable market incentives.
Implementing a clear process for planning and
approval. Tackling existing subsidies, and
other distortions in the market. A strong
compliance regime
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RENEWABLE ENERGY
The investment models that support coal and oil
are so well established and profitable that
renewables with lower immediate returns are not
considered bankable.While the risk of
committing to the purchase of carbon credits is
limited, these funds are not able to finance the
development phase of projects.There are some
funds that will offer a partial prepayment
against future credits, but this is typically
only a small percentage of the overall capital
cost of a project.
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COMMODIFYING CARBON
Most carbon assets are based on a common unit of
1 tonne of carbon dioxide reduced or sequestered,
or an allowance to emit 1 tonne of carbon
dioxide.The carbon asset is becoming a material
consideration in the expected rate of return of
projects and, ultimately, the financial worth of
companies that are involved in projects that
create such assets ( for example, renewable
energy companies or sustainable plantation
developers).Emission reduction projects have an
ability to create a carbon asset that has real
value to investors for compliance purposes or as
a source of additional revenue.
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SECURING INVESTMENT
A cornerstone of the Kyoto Protocol is that it
should stimulate foreign investment in green
technologies in developing countries, thus
encouraging alternatives to fossil-fuel driven
growth. Because Carbon Dioxide abatement costs
among OECD countries can range from 5 to 30 times
that of developing countries, these offset
instruments also provide a low-cost source of
carbon credits to carbon-constrained buyers.
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LIABILITY - ATTRIBUTION
The distinction between weather and climate is
important because it it is impossible in
principle, because of the chaotic nature of the
weather, to associate a particular weather event
with externally driven climate change.A change
in climate can result directly in financial
losses when the losses in question result
directly from changes in weather-related risk,
rather than from events that actually
occur.This assumes a perfectly informed and
rational market response to changing risk.
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LIABILITY - IMPLICATIONS
Climate change is often cited a a paradigmatic
example of market failure.The climatic impacts
of GHG emissions occur decades to centuries after
the emissions occur.It is often taken for
granted that the only solution is either a
mandatory cap- and trade- system or heavy
government intervention in technology research
and development in order to steer energy markets
away from fossil fuels.However, by the late
2020s, more than half the excess carbon dioxide
will be due to emissions made after 1990 (when
the consequences of the emissions began to be
accepted).Will this allow a litigation based
approach to the social cost of carbon?
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DROUGHT
http//www.bom.gov.au/inside/eiab/reports/ar02-03/
index.shtml
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FLOODS
http//www.bom.gov.au/weather/qld/charleville/imag
es/cv9.jpg
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PART TWO
An application of financial market mathematics
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CASE STUDY
The cost of climate change
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INTRODUCTION
In a 1992 paper presented to the 5th
International Meeting on Statistical Climatology
(Stern, 1992), the author introduced a
methodology for calculating the cost of
protecting against the onset of global warming.
The paper, 'The likelihood of climate change A
methodology to assess the risk and the
appropriate defence', was presented to the
meeting held in Toronto, Canada, under the
auspices of the American Meteorological Society
(AMS). In this first application of what later
was to become known as 'weather derivatives', the
methodology used options pricing theory from the
financial markets to evaluate hedging and
speculative instruments that may be applied to
climate fluctuations.
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INTRODUCTION
Two illustrative examples were presented,
namely, protecting against the risk of
diminishing industrial output associated with
global warming and, protecting against the risk
of decreasing value of a company likely to be
adversely affected by global warming (e.g. a
manufacturer of ski equipment). Use of these
financial instruments leads to those concerned
being compensated provided they are on the
correct side of the contract. Conversely, those
on the wrong side of the contract would have to
provide that compensation.The methodology
provided a tool whereby the cost of the risk
faced can be evaluated (whether it is the case of
determining that risk on a global scale, or on a
company specific scale).
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INTRODUCTION
Published data from the Carbon Dioxide
Information Analysis Center were used in the
evaluation. Since the early 1990s, the global
mean temperature has risen significantly, and the
methodology was 'revisited' in a 2005 paper
presented to the 16th Conference on Climate
Variability and Change at the AMS Annual Meeting
of that year (Stern, 2005), with a view to
recalculating the cost taking into account the
additional, more recent, data.The same examples
were used in 2005 as were used in the 1992 study.
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PURPOSE
Using a data set of land, air, and sea surface
temperature anomalies from the United Kingdom
Meteorological Office the purpose of the current
work is to determine to what extent the cost of
protection may have been risingthe data set is
accessible at http//www.met-office.gov.uk/resea
rch/hadleycentre.html.
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METHODOLOGY
Firstly, one regards the global mean temperature
(GMT) in the same manner as one would a financial
commodities futures contract and values it, and
associated options, accordingly.On this basis
the theoretical value of a GMT futures contract
will equal the dollar equivalent of the current
GMT (for example, the theoretical value of a GMT
futures contract, when the GMT is 287.79K, would
be 287.79). Secondly, one assumes that GMT
futures contracts are available to be bought and
sold.
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METHODOLOGY
One also assumes that associated put and call
option contracts are available to be written or
taken, and so alter the risk-return
characteristics associated with the GMT contract.
The strategy, therefore, is to establish the
economic consequences of movements in the GMT.
These economic consequences are then applied
across the complete range of scales that is,
from the global economy down to the smallest
company.
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CALCULATION
Utilising the Black and Scholes (1973) call
option formula, as modified for future style
options (Gastineau, 1988) C HS B, where C
call option valueH N(d1), where N( ) is the
cumulative standard normal distribution function.
S price, X strike, R interest rate?
standard deviation of returns (volatility)T
time to expiryd1 ((ln(S/X)(R?2/2)T)/(??T),
d2 d1-??T, H N(d1)B Xexp(-RT) N(d2)
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GASTINEAUS MODIFICATION
Gastineau (1998) proposes a "future style option"
contract to replace many conventional options on
futures contracts where"unlike with
conventional options, the buyer of the futures
style option does not prepay the premium.Buyers
and sellers post margin as in a futures contract,
and the option premium is marked to the market
daily.Valuation differs from conventional
options primarily in the analysis of cash flows
associated with the buyer's premium non-payment".
For this reason one employs the assumption of
an interest rate of 0 in the calculation.
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PROTECTING AGAINST DIMINISHING INDUSTRIAL OUTPUT
Hypothetical Example 1 scenarioAssume that the
rate of increase in industrial output is
unaffected by global warming as the GMT rises,
until the temperature reaches 289.34K. A
temperature increase from this point is assumed
to adversely affect industrial output, causing it
to decline in a linear manner as GMT rises
further to 290.34K.At this point the annual
rate of increase in industrial output is zero.
Continued rise in GMT from this point is
assumed to lead to an adverse effect increasing
at the same rate.So, by the time the GMT
291.34K, the rate of decline in global industrial
output is equivalent to the current rate of
increase.
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PROTECTING AGAINST DIMINISHING INDUSTRIAL OUTPUT
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PROTECTING AGAINST DIMINISHING INDUSTRIAL OUTPUT
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PROTECTING AGAINST DIMINISHING INDUSTRIAL OUTPUT
Protecting against hypothetical Example 1
scenarioCalculate the cost of an American call
option contract on the value of a futures GMT
contract with the following characteristics
(protection is required for 100 years expiry
date)Spot Current GMT (this is regarded as
the GMT for the most recent year, 2003, which has
a value of 288.49K)Strike 289.34K Standard
Deviation of Returns (Volatility) 0.000436
(based on the United Kingdom Meteorological
Office data series) Interest rate 0
(assuming that the only money which changes hands
is that associated with variation margins).
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PROTECTING AGAINST DIMINISHING INDUSTRIAL OUTPUT
Calculation for protecting against hypothetical
Example 1 scenarioUtilising the Black and
Scholes (1973) call option formula, as modified
for future style options (Gastineau, 1988), the
calculation yields0.1878 for 2003.So, for
protection under the aforementioned
assumptionsThe full cost of protection is
18.78 for every 100 of the future rate of
industrial growth, or 18.78 of that rate of
industrial growth.
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PROTECTING AGAINST THE VALUE OF A COMPANY
DECLINING
Hypothetical Example 2 scenarioAssume that the
value of the company (a manufacturer of ski
equipment) is unaffected by global warming as the
GMT rises, until the temperature reaches
289.34K.A temperature increase from this point
is assumed to adversely affect company value,
causing it to decline in a linear manner as GMT
rises further to 290.34K.At this point the
value is reduced to zero.Continued rise in GMT
from this point has no further effect upon the
company's value, as it cannot decline in value
below zero. .
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PROTECTING AGAINST THE VALUE OF A COMPANY
DECLINING
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PROTECTING AGAINST VALUEOF A COMPANY DECLINING
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PROTECTING AGAINST VALUEOF A COMPANY DECLINING
Protecting against hypothetical Example 2
scenarioThis is equivalent to calculating the
difference between the cost of the following two
American call option contracts on the value of a
futures GMT contract with the following
characteristics (protection is required for 100
years expiry date) First contract
(bought)-This is the same contract as the one
valued in Section 5.2, hence, its value is
0.1878.
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PROTECTING AGAINST VALUEOF A COMPANY DECLINING
Second contract (sold)-Spot Current GMT (this
is regarded as the GMT for the most recent year,
2003, which has a value of 288.49K)Strike
290.34K Standard Deviation of Returns
(Volatility) 0.000436 (based on the United
Kingdom Meteorological Office data series)
Interest rate 0
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PROTECTING AGAINST VALUEOF A COMPANY DECLINING
Calculation for protecting against hypothetical
Example 2 scenarioUtilising the Black and
Scholes (1973) call option formula, as modified
by Gastineau (1988) for futures contracts, the
calculation yields 0.0399 for the second
contract.So, the cost of protection is the cost
of the first contract (which is bought) minus the
cost of the second contract (which is sold),
namely, 0.1479, or 14.79 of the future value of
the company.Note again that no money changes
hands initially, and it is possible that only at
the end of the options' life will settlement
occur.So, for protection under the
aforementioned assumptions, the full cost of
protection is 14.79 for every 100 of the future
value of the company.
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THE GROWING COST OF PROTECTION
The outcomes of calculations for the two examples
from 1861 to 2003 They show, in the case of
protecting against the risk of reduced industrial
output That the cost has risen from about 4
cents in the dollar circa 1860, To about 9
cents in the dollar 100 years later (circa 1960),
and thence To accelerated to reach about 19
cents in the dollar in 2003.
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THE GROWING COST OF PROTECTION
They show, in the case of protecting against the
risk of the value of a company decliningThat
the cost has risen from about 3 cents in the
dollar circa 1860, To about 7 cents in the
dollar 100 years later (circa 1960), and
thenceTo accelerate to reach about 15 cents in
the dollar in 2003.
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THE GROWING COST OF PROTECTION
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CONCLUSION
A methodology for calculating the cost of
protecting against the risk of financial loss
associated with global warming has been
presented.It has been shown - Both in the
case of protecting against the risk of reduced
global industrial output, And also in the case
of protecting against the risk of the value of a
company declining,That the cost of that
protection has risen over the years, and that the
rate of that rise has accelerated recently.
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TRANSLATING CLIMATE FORECASTS INTO DECISION
MAKING.
Thank You