Funding climate adaptation strategies with climate derivatives

• Climate derivatives offer the potential to help fund climate adaptation strategies.
• Derivative prices indicate climate risk, and are shown in an example.
• Financially exposed parties could sell these contracts to investors willing to bear the risk.
• Money raised from the sale could be used to finance adaptation.
• Parties not expecting warming would perceive an arbitrage opportunity and have incentive to transact.

Climate adaptation requires large capital investments that could be provided not only by traditional sources like governments and banks, but also by derivatives markets. Such markets would allow two parties with different tolerances and expectations about climate risks to transact for their mutual benefit and, in so doing, finance climate adaptation. Here we calculate the price of a derivative called a European put option, based on future sea surface temperature (SST) in Tasmania, Australia, with an 18 °C strike threshold. This price represents a quantifiable indicator of climate risk, and forms the basis for aquaculture industries exposed to the risk of higher SST to finance adaptation strategies through the sale of derivative contracts. Such contracts provide a real incentive to parties with different climate outlooks, or risk exposure to take a market assessment of climate change.

A climate derivative contract: the investor makes an upfront payment to the writer (seller of contract). If the temperature exceeds the strike value at maturity (red line trajectory) then no payout to the investor. If the temperature, remains below the strike value at maturity (blue line trajectory), then the writer would be required to make a payout to the investor. Throughout the lifetime of the contract, the writer would use the upfront payment to develop new production technologies for coping with anticipated effects of climate change, such as offshore farms in cooler water, and in doing so increases the resilience of the business operation to whichever outcome eventuates.Figure optionsDownload as PowerPoint slide