Hedging the financial risk from water scarcity for Great Lakes shipping

Abstract

Low water levels in the Great Lakes have recently had significant financial impacts on the region's commercial shipping, which transports hundreds of millions of dollars' worth of bulk goods each year. Cargo capacity is a function of a ship's draft, the distance between water level and the ship's bottom, and lower water levels force ships to reduce cargo loads to prevent running aground in shallow harbors and locks. Financial risk transfer instruments, such as index-based insurance contracts, may provide an adaptable method for managing these financial risks. In this work, a relationship between water levels and shipping revenues is developed and used in an actuarial analysis of the frequency and magnitude of revenue losses. This analysis is used to develop a standardized suite of binary financial contracts, which are indexed to water levels and priced according to predefined thresholds. These contracts are then combined to form hedging portfolios with different objectives for the shippers. Results suggest that binary contracts could substantially reduce the risk of financial losses during low lake level periods and at a relatively low cost of only one to three percent of total revenues, depending on coverage level.

Evaluating financial risk management strategies under climate change for hydropower producers on the Great Lakes

“…This research builds off a previous exploration of using binary contracts on the Great Lakes for hedging the financial risks of commercial shippers which must reduce cargo carrying capacity during low lake level periods or risk running aground in shallow harbors or locks. A similar hydrological modeling platform is used in this work [ Meyer et al ., ; Brown et al ., ], but in this case hydrologic behavior is modified to consider a broad range of alternative climate futures. Hydrological modeling is performed using the Coordinated Great Lakes Regulation and Routing Model (CGLLRM) [ Clites and Lee , ], developed by the US Army Corps of Engineers.…”

“…In addition to the benefits of other index‐based financial contracts, binary contracts can be assembled in a manner that is easily adaptable to different risk profiles. This adaptability makes them potentially useful for the Great Lakes system because of the many firms and individuals who are impacted by variable water levels in different ways [ Meyer et al ., ]. Like other index‐based insurance contracts, a binary contract depends on a specified index, a “strike” level (i.e., the threshold), and a maturity date, but payouts, when triggered, are always a constant amount, such that where is payout ($), is the mean monthly lake level (m. or ft.), is the strike level (m. or ft.), and is the payout at lake level ($).…”

“…In this work, portfolios are constructed with target payout frequencies of 0.02, 0.05, 0.10, 0.20, and 0.33 (scenarios A–E, respectively). In order to accommodate the long hydrologic memory (i.e., high levels of autocorrelation) in lake levels [ Meyer et al ., ], a portfolio of contracts is bought 5 years before they are “in force” with a different “subportfolio” for each month in the insured year. Purchasing in advance leads to more stable portfolio prices over time, as otherwise, low lake levels at the time of purchase would lead to very high prices.…”

“…Recent research has explored the development of standardized contracts for reducing commercial shippers' financial risk resulting from low water levels, which limit ship carrying capacity in harbors and locks and can reduce shipping firms' revenue significantly [ Meyer et al ., ]. Nonetheless, a number of unanswered questions regarding the development and performance of these types of hedging contracts exist, especially pertaining to concerns over nonstationarity.…”

Effects of Geographic Diversification on Risk Pooling to Mitigate Drought‐Related Financial Losses for Water Utilities

“…Financial insurance contracts, often in the form of index insurance, have been developed to mitigate environmental financial risks in a number of other contexts. These include contracts designed to protect against financial losses associated with extreme temperatures (Cao & Wei, 2003;M€ uller & Grandi, 2000), low rainfall (Fuchs & Wolff, 2011;Martin et al, 2001;Stoppa & Hess, 2003;Turvey, 2001;Varangis et al, 2001), and low streamflow (Foster et al, 2015;Meyer et al, 2015), with application in the electric utility, agriculture, and hydropower sectors, among others. The success of these index insurance contracts in other contexts, coupled with the increased need for new solutions to deal with increasingly volatile weather, has increased the motivation for creating financial instruments (Polasek, 2014;Chesnutt et al, 2014;Eskaf et al, 2014).…”