[Sponsored Article] By Professor CHEN Zhanhui, Professor George PANAYOTOV and CHU Zhuang Department of Finance, HKUST Business School Climate change threatens human societies with long-term catastrophic consequences. These threats must be addressed immediately. A delayed response to climate change will lead to further deterioration and a greater chance of irreversible and catastrophic damage. In this article, we discuss the possibility of using weather derivatives to manage climate-related risks. 1. Diverse climate risks Climate risks are diverse and complex, and are typically divided into physical and transitional risks. Physical risks arise from the direct material, operational, or programmatic impacts of climate shocks on economic activities, and the corresponding impacts on asset performance. Companies that face physical risks may incur direct climate-related costs due to extreme weather events or a rise in sea level. For example, insurance companies are exposed to higher losses from insured properties in coastal areas, while agricultural producers are exposed to extreme weather conditions. Transition risks are associated with the uncertain financial impact of a transition to a net-zero emissions economy. These risks stem from policy changes, technological advances, and changes in householder preferences and social norms, among others. For example, fossil fuel firms can be adversely impacted by carbon pricing or restrictions on carbon emissions. Technological progress and policy changes relating to climate change may also threaten the existing business models of some corporations - for example, electric or fuel-cell-powered vehicles could disrupt the traditional automobile industry. Climate-related physical and transitional risks have affected, or are expected to affect, almost all aspects of the economy. The severity of these climate risks depends on the time span, geographic location, industry sector, and relevant climate mitigation and adaptation moves. If these risks are misunderstood and inadequately managed, they may affect financial assets and threaten the functionalities of the financial system. Furthermore, climate-related risks affect disproportionately low- and middle-income communities, causing environmental injustice and undermining social welfare. In sum, the physical and transitional risks due to climate changes and weather conditions present unique challenges which require innovative solutions. Specifically designed derivatives can be among the tools that help to address such challenges. 2. Existing climate-related derivatives Derivatives have been used to manage some climate-related risks for over 20 years. Various over-the-counter (OTC) and exchange-traded climate-related derivatives are currently employed by agricultural, energy and metals market participants, as well as financial institutions. Existing tools include traditional weather derivatives, electricity futures, and relatively new tools such as ESG futures and carbon derivatives based on equity indices. Weather derivatives that help to reduce the risk associated with adverse or unexpected weather conditions have been traded since 1996. The payoff of a weather derivative usually depends on an underlying weather index, such as measures of rainfall, temperature, humidity, or snowfall. Different from the traditional financial markets, the weather derivatives market is incomplete because the underlying assets cannot be stored. Today, weather derivatives are mainly used by companies for hedging purposes to minimize the adverse impacts by unconventional weather, or for speculative purposes by hedge funds and others who are willing to take advantage of these volatile markets. It is clear, however, that these existing derivatives are not designed to manage global climate risks. Instead, they mostly allow risk sharing and the shifting of these risks to market participants who are willing, or better equipped, to handle them. Therefore, a different type of derivative is needed to address the global climate challenge. For example, innovative ESG futures products have been developed recently to address this challenge more directly. ESG ETF and index futures have been actively traded in the recent years, with growing trading volumes and open interest. In the first quarter of 2020, US$45.6 billion flowed globally into ESG funds (Morningstar, 2020). The further expansion of such derivatives products depends on the continued growth of ESG funds and the decreasing costs. 3. Challenges in derivative design and data issues Current weather derivatives face several limitations. First, most weather futures and options listed on exchanges are based on weather indexes which utilize aggregate catastrophic and non-catastrophic weather data from a specific location or region. Although these products can be helpful to manage local exposure to weather-related risks, they cannot address the broader impact of climate risks. Second, current weather derivatives are not very liquid. Investors are reluctant to actively participate in the market, because it is challenging to accurately model potential weather variables and price weather derivatives. Investors understand little about the weather derivatives market and the benefits it can provide. Third, the availability of quality weather data also limits the development of weather derivatives. Reliable and trustworthy data are necessary to measure the environmental attributes and characteristics of the related value chain to design weather derivatives. The ability to accurately quantify climate risk is critical for financial solutions ranging from assessing loan risks to pricing derivatives and developing sustainable financial products. In order to provide reliable, consistent, and comparable data, investors can rely on climate data platforms and climate financial technology solutions. A climate finance laboratory can help centralize climate risk data and analysis, and design innovative financial products. Recently, private firms like MSCI and Trucost have been exploring new ways to collect, process, and transmit lifecycle data sets to reveal the market value and risks associated with asset-level environmental characteristics. 4. The promise of climate-related derivatives Given the high demand for financial products to manage climate risk increases, derivatives exchanges are likely to expand, including ways to improve existing products and promoting new products. Derivatives exchanges are seeking to incorporate sustainability related and climate-related attributes into existing contracts. Firms and consumers are becoming increasingly concerned about the sustainability of the products that they make and consume. Therefore, firms want to monitor and better understand their supply chain in order to meet certain sustainability standards. As a result, derivatives contracts will need to be improved to reflect the changes in environmental standards. For example, the recent transition from high-sulfur fuel oil (HSFO) to low-sulfur fuel oil (LSFO) (to comply with the terms of the United Nations International Maritime Organization’s 2020 international agreement) calls for changes in existing derivatives. More recently, some OTC swap contracts have been modified to include new sustainability incentive mechanisms. Reflected first in OTC interest swaps in August 2019, and then in October 2019 in foreign exchange forward swaps, this mechanism reduces one counterparty’s payment in an event that it achieves certain pre-specified sustainability performance target. If applied across derivatives, this mechanism could provide market participants with a financial incentive to improve environmental performance. New futures contracts can also be developed to manage risks in wind and solar power generation, transmission and storage. Electricity prices are usually volatile, which poses challenges for smaller market participants who provide renewable energy. Currently, it is also difficult to receive funding for renewable energy power generation due to the inability to effectively hedge. New financial products would greatly improve the ability of power market participants to manage risks and stimulate the renewable energy market. 5. Conclusion To conclude, we see the potential of using weather derivatives as a financial solution to manage climate-related risks, provide economic incentive to address climate challenges, and improve social equality and welfare. Nevertheless, the further growth and functioning of weather derivatives markets rely on the continuous awareness of climate risk, quality weather data and modelling, and cooperation among various stakeholders. Reference Alexandridis, A., & Zapranis, A. D. (2012). Weather derivatives: modeling and pricing weather-related risk. Springer Science & Business Media. Bank for International Settlements (2020). The green swan. U.S. Commodity Futures Trading Commission (2020). Managing Climate Risk in the US Financial System. Morningstar (2020). Global Sustainable Fund Flows.