Balancing Risks from Climate Policy Uncertainties: The Role of Options and Reduced Emissions from Deforestation and Forest Degradation

- Climate policy is likely to evolve in an iterative manner, producing significant adjustment costs, and creating a risk-management challenge
- Firms must balance the risk of investing in abatement today, which may lose value in the future, versus the risk of ending up short of abatement in the future.
- REDD + is unique as a large-scale reserve available in the coming decades to hedge climate policy uncertainties;
- Demand for hedging climate policy risks can drive a significant potential market for 'call' options on REDD + units.
- Options on REDD+ units can encourage tropical nations to defer deforestation before carbon markets that include REDD+ take off.

Progressively adjusting climate policies will entail adjustment costs for society. This paper develops a conceptual model and numerical example that illustrate the risk associated with exposure to the high costs of complying with future emissions controls and how this risks trades off against that from potentially premature investment into abatement. We then highlight the potentially unique role of tropical forest protection in helping to manage these risks by providing a cost-effective “buffer” of near term emissions reductions at a globally significant scale. This buffer would provide insurance against the risk of suddenly tightening targets, as well as providing other critical environmental benefits. We further examine how a version of a private finance instrument in the form of long-dated 'call' options on verified reductions in emissions from deforestation and forest degradation (i.e. REDD +) can help to operationalize this risk-hedging buffer creation. Options on REDD + could aid both regulated businesses and tropical nations to manage their respective risks. REDD + options could deliver sufficient abatement to significantly hedge exposure of regulated entities to potential corrections in climate policy while channeling financial resources to defer deforestation even as climate policies continue to evolve.