Climate risks & Finance innovation

By Carl Spilker

Climate change is driving innovation across sectors; many tools and initiatives that have been used over time are being rethought or re-designed to address climate risks.  Climate variability and its consequences is already affecting all sectors of the economy – name me one, and as a risk expert I can relate any economic activity to climate!

 

The finance sector is also part of this innovation, in fact could be the greatest innovator.  Over the past year we have worked on developing instruments and products that can be deployed in developing countries, with emphasis in the Tropical Andes Region. For those that have had the pleasure of visiting you will know that climate variability happens on a day to day basis.

 

For example, in Colombia between 60-80% of electricity is provided by hydroelectric, varies with the year, and mostly with the precipitation regime.  Grupo Laera and ECOSAGA joined with a US firm to build a hedge program for one of the Hydro Electric companies in Colombia.  The program offered was a scheme to decrease the risk of price moments caused by weather events (think El Nino which causes long droughts).  The approximate offer terms were a 10-year, $400 million USD risk mitigation program, in which during extreme droughts the company is paid or receive replacement money to buy energy in the market to comply with their energy contracts.

 

What was included in this analysis?  The team captured 30+ years of daily satellite data, considered topographical issues specific to the locations energy production and converted into water flow to measure the impact to electric production.  Financial modeling using a number of approaches such as Monte Carlo, allowed the team to build levels of confidence that provided key inputs for the insurance providers of the hedge.

 

When written in a few paragraphs, the process seems very logical and intuitive.  However, we have come a long road addressing several barriers, most of which are related to differences on prioritizing risks and understanding national and local environmental, institutional and cultural contexts.  Such contexts and realities were very different for each member of the team: the scientist, the energy provider, the sales person, the overall risk manager, the actuary etc.

 

In the near future, these types of transactions will be much more common and not an isolated case driven by natural sciences and risk scientists and optimistic actuaries but part of the portfolio of insurances and reinsurances.

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