Stormy Weather

I'm the Whether Man, not the Weather Man, for after all it's more important to know whether there will be weather than what the weather will be. (Norton Juster, The Phantom Tollbooth)

Climate change. You know what we really need right now? Yeah, a solution.

But, failing that.. a mind map. Green technology, ESG investment standards, sustainable finance, environmental impact, climate change, resilience initiatives, global warming, development aid, disaster insurance....we often speak as if these things are co-extensive and must be addressed all at once or not at all. That's a bit like having a minister for women and expecting her to tackle domestic abuse, pay and investment gaps, sex trafficking and domestic slavery, the Glass Ceiling, access to financial services, labour force participation, carer support, sexual harassment, maternal morbidity, inequity in healthcare...

What? Really?

Okay then, well it's like expecting her to address all those things without adequate support or empowerment in government.

...?!

My point--*abandons contentious analogy*--is that one eats a frog, according to the usual gory and unpleasant axiom, one chewy bite at a time.

And my other point--which, frankly, I'm finding a tad difficult to shoehorn into an amphibian metaphor right now--is that some problems are so big, so pervasive and so complex that they require a whole-of-government solution.

Which brings us to my two favourite bits of the climate change frog:

• As extreme weather events become more frequent, do the capital markets offer a sensible alternative to natural disaster insurance?

AND

• Is it enough to address climate change through fiscal policy; and, if not, should the central bank be deploying monetary policy tools?

So, cards-table-on, I have always cherished the belief that the capital and derivatives markets are the right place for global catastrophe risks. I can still remember the childish excitement I felt when I heard that the World Bank was intermediating a series of rainfall derivatives for Malawi. 🎵Ain't no stopping us now,🎵* you might have heard me singing in some virtual shower cubicle in a parallel metaverse--sandwiched right in between Donald Rumsfeld singing 🎵I want the world with no consequences 🎵** while soaping himself up and Boris Johnson humming 🎵I can change (You know I can change, baby) 🎵*** as he rinses himself off.

My naive hope was that the international markets--almost infinite in their capacity and creativity--would make disaster risk mitigation financially palatable and facilitate sustainable treasury functions in developing economies the world over by doing what it is markets do best: slicing, dicing and pricing. What I got wrong, was to overlook...well, everything.

The first thing I overlooked was the eternal allure of the operational comfort zone. In the end, it was reinsurers who, in large part, invested in the Malawi derivatives. As one of my interviewees said several years ago: they're just more comfortable with, and experienced at, taking on large-scale complex commercial risks. Go figure. The difficulty this causes for alternative risk transfer as a solution to climate change, however, is that it necessarily creates a kind of credit-risk limitation and/or capacity bottleneck in the insurance sector. Yes, insurers can issue CAT bonds and pass certain risks on to capital markets investors but the investors in question must first want a product for which interest payments carry credit risk on the insurer. If risk cannot be laid off other than through insurance and reinsurance firms, then the amount of risk that the capital and/or derivatives markets can absorb is not determined by the size of the financial markets but by the size of the insurance sector. And it will not take investors very long to figure out that products which are originated, wrapped and brokered by insurers--as some are--represent a fair amount of collateral risk concentration.

The second thing I neglected to weigh carefully was the likely impact of a cultural shift away from the fuzzy, real life logic of insurance products to the precision-engineering of derivatives. The losses which crystallise from drought or precipitation are not financially isolated in real life. If my house is flooded, the damage that materialises is not "water volume" per se but broken appliances, rotted furniture and disfigured furnishings. My losses can only be measured by the value of those items and that is how insurance policies work. On the other hand, a weather derivative--while it may be sensitive to sophisticated indices linking several variables at once (eg, rainfall and crop volumes)--cannot efficiently accommodate the "insured" person's quantum of loss. A related point is that, by focusing on the medium of risk, rather than the quantum of loss, derivatives fail to address situations in which valuable agricultural assets, say, are exposed to not one but a whole range of risks (eg, drought, disease, pestilence and vandalism). This means that weather derivatives have limited use as risk mitigation measures in the retail sector and are, accordingly, probably not scalable for the mass market. (The indices referenced by weather derivatives also tend to be dependent on localised measuring and monitoring equipment which it may be difficult to roll out reliably in a retail context.)

And if weather derivatives are not scalable for the mass market then, as it turns out, products of this nature may not prove very sustainable for sovereigns either. Malawi was required to pay a premium upfront for the product, which it could not afford. The premium was financed by the UK Department of International Development (DfID) but this arguably perpetuated a cycle of dependency and left Malawi exposed to political risks in the UK as the options were rolled over. This issue should not be technically insuperable (derivatives products are one of the best means of transferring downside risk in exchange for a portion of future profits) but if investors continue to demand large upfront praemia for non-insurance products then, not only will it be difficult for sovereigns to justify preferring derivatives over insurance products, but it may place financial risk management tools out of bounds altogether.

And that, My Friends, was my intellectual journey from dewey eyed capital markets ingenue to disillusioned cynic.

Pshaw! "Stop with the fake self-pity and the pitiable fakery," you say "and tell us more of monetary policy and climate change." Ah well, now, that's a question for a world of asset purchases and weren't we going to talk about a taper...soon? Here's the Guv'nor endorsing the idea of a "framework for greening [the central bank] asset portfolio" in June. And here's Bill Dudley letting us know that it's really a financial stability issue, not a monetary policy one.

I think...they're both right. And, if you dare to say that one can't agree with two opposing views, then I shall retort that, clearly, you haven't had much practice. Why, sometimes I've held as many as six conflicting opinions before breakfast.

* Songwriters: Jerry Allen Cohen, Gene McFadden, John Whitehead. Ain't No Stopping Us Now lyrics © Sony/ATV Music Publishing LLC, Warner Chappell Music, Inc.

** Songwriters: Blake Harnage / Blake Preston Harnage / Matthew Lange / Sierra Kusterbeck / Simon Wilcox / William P. Lefler. No Consequences lyrics © Warner Chappell Music, Inc, Peermusic Publishing

*** Songwriters: Calvin Broadus / John Stephens / Dave Tozer / John Roger Stephens. I Can Change lyrics © Bmg Sapphire Songs, John Legend Publishing