Managing Environmental Financial Risk Gregory W. Characklis Department of Environmental Sciences & Engineering University of North Carolina at Chapel

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1 Managing Environmental Financial Risk Gregory W. Characklis Department of Environmental Sciences & Engineering University of North Carolina at Chapel Hill Carolina Climate Resilience Conference, September 2016

2 Quarterly Streamflow (millions of gallons) Historic Hydrologic Records Year Used in analyzing the risk of a damaging event Primary concern is extreme events (e.g., drought, floods) which occur with low frequency, but are very costly

3 Quarterly Streamflow (millions of gallons) Historic Hydrologic Records Flood Level Drought Level Year Used in analyzing the risk of a damaging event Primary concern is extreme events (e.g., drought, floods) which occur with low frequency, but are very costly

4 Quarterly Streamflow (millions of gallons) Historic Hydrologic Records Flood Level Drought Level What if historic patterns are not reflective of the future? - Climate change - Changes in land use/land cover Year Used in analyzing the risk of a damaging event Primary concern is extreme events (e.g., drought, floods) which occur with low frequency, but are very costly

5 Quarterly Streamflow (millions of gallons) Historic Hydrologic Records Flood Level Drought Level What if historic patterns are not reflective of the future? - Climate change - Changes in land use/land cover Year Used in analyzing the risk of a damaging event Primary concern is extreme events (e.g., drought, floods) which occur with low frequency, but are very costly

6 Annual Reservoir Inflows (km 3 ) Hydropower Generation (GWh) Hydrologic Variability = Financial Risk (ex. Hydropower) Generation Inflows Year

7 Financial Risk Mitigation Managing Financial Risk Mitigation Self Insurance Financial Hedging Examples: - Bigger Reservoir - Pricing Risk Pooling Risk Shifting

8 Impact Ranking of Global Risks (as ranked by participants at the World Economic Forum in Davos) Likelihood Source: Global Risks 2012, World Economic Forum

9 New Reservoirs* Pace of US reservoir construction has declined * Capacity > 0.1 km 3 Source: GRanD database, at

10 Surplus capacity has traditionally ensured reliability 50% of capacity is used less than 8% of the time Maintaining rarely used capacity is costly and environmentally burdensome Both capacity requirements and long-term costs can be reduced by Conservation measures (reduces revenues) Acquiring additional water (increases costs)

11 Research Triangle of North Carolina, USA Rapidly growing population of ~1.5M 4 major utilities, each independently run - 9 reservoirs - 5 treatment plants - interconnections Serious droughts in 2002 and 2008

12 Research Triangle of North Carolina, USA Utilities have 3 options to deal with growing demands: New sources Conservation Transfers But, there are many financial concerns Unless managed, these concerns will limit implementation

13 Conservation Reduces Revenues

14 Comparison of Transfers vs. New Supplies (Costs for OWASA ) ( ) = Supply Increase *Based on annualized costs over 20 years at 6% interest Risk-based contracts are substantially less expensive than infrastructure Transfers lower average costs, but cost variability remains a challenge Caldwell, C. and G. W. Characklis (2014). Impact of Contract Structure and Risk Aversion on Inter-utility Water Transfer Agreements, Journal of Water Resources Planning and Management, 140(1), pp

15 Cost/Revenue swings can affect utility credit ratings We have observed that one of the most common reasons for a utility to miss its financial targets is weather Standard & Poors [Commenting on new evaluation criteria related to hydrologic variability]: We estimate that about 25% of total ratings [of water utilities] will change as a result of these criteria Standard & Poors

16 Water Business is capital intensive (interest rates matter a lot) ~2.5% spread Source: Moody s Debt service payments often make up 25- A significant rating downgrade can increase utility costs significantly

17 Financial Risk Mitigation Managing Financial Risk Mitigation Self Insurance Financial Hedging Risk Pooling Risk Shifting

18 Financial Risk Mitigation Managing Financial Risk Mitigation Self Insurance Financial Hedging Risk Pooling Risk Shifting

19 Index-based Financial Instruments Premium Buyer $ Seller Covered Losses $ Payout Index products have some advantages over traditional insurance o o o Lower transaction costs (less subjectivity, no adjustors) Fewer moral hazard concerns Quick resolution of claims/payouts But, developing an effective index is often difficult

20 Index/Payouts Financial Index Insurance Financial Damages ($MM) Financial Damages ($MM) Index must correlate well with financial losses Transparent, reliable and free from moral hazard concerns

21 Payout ($) 160 Contract Structure (standard index insurance) Sample Call Strike (S L ) Slope (A) Index Value (L) Single contract scaled to increase payout as index value declines Similar to a call option Contracts can be structured to protect against high or low index values

22 Financial Risk Mitigation Managing Financial Risk Mitigation Self Insurance Financial Hedging Risk Pooling Risk Shifting

23 Weather risks are spatially correlated

24 Weather risks are spatially correlated

25 Energy Risks

26 Peaking resources are critically important Hydropower and natural gas are the typical choices, but hydro is cheaper On demand sources will become more important with increased use of renewables (e.g., wind, solar)

27 Annual Reservoir Inflows (km3) Hydropower Generation (GWh) 14 Generation Inflows 12 A nearly 1:1 match Year

28 Annual Reservoir Inflows (km3) Hydropower Revenues ($M) 14 Revenues Inflows Not a 1:1 match because prices fluctuate Year

29 Seasonal Revenues ($M) Seasonal Revenues ($M) Identifying the right index R 2 = 0.48 R 2 = Seasonal Inflows (km 3 ) Inflows-Natural Gas Price Kern, J. D., Characklis, G. W. and B. F. Foster (2015) "Natural Gas Price Uncertainty and the Cost Effectiveness of Hedging Against Low Hydropower Revenues Caused by Drought," Water Resources Research, 51, doi: /2014wr

30 Revenues (Millions $) without Hedging Mean Annual Revenues without Hedging: $4.91M Revenue Floor without Hedging: $0.83M Year

31 Revenues (Millions $) without Hedging with Hedging Mean Annual Revenues without Hedging: $4.91M with Hedging: - $4.70M Average annual cost: $0.21M Revenue Floor without Hedging: $0.83M Year Revenue Floor with Hedging: $2.4M 1 65

32 Hot water: River temperature so high that Duke Energy curtails work at 2 coal plants Aug 12, 2007 Drought Could Force Nuclear Plants to Shut Down January 23, 2008

33 Impacts of Water Scarcity on Inland Navigation

34 Effect of Low Water Levels on Ships Max Cargo Capacity Water Level Lower Water Level Decreased Cargo Capacity Water Level Max Draft Ship Hull Smaller Draft Ship Hull Minimum Underkeel Clearance Minimum Underkeel Clearance Low water levels translate to less cargo carrying capacity Translates to higher shipping costs for products Imposes financial impacts on both shipping firms and their clients

35 Lake Michigan-Huron Level (feet) Great Lake Level Variability Yearly Avg. with High & Low Period of Record Average Source:

36 Final Thoughts Financial instruments can provide an effective and adaptable means of managing environmental financial risk These instruments require an understanding of both the natural and financial systems, as well as their linkages Financial instruments will be one part of a coordinated risk management strategy Insurers will need to balance climate uncertainty and price when offering risk management products 36

37 Thanks to our funding agencies

38 Thanks for attending! Want to talk more? I can be reached at charack@ .unc.edu 38