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

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

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

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

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

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Annual Reservoir Inflows (km 3 ) Hydropower Generation (GWh) Hydrologic Variability = Financial Risk (ex. Hydropower) 14 12 10 Generation Inflows 1100 900 8 6 4 700 500 300 2 100 Year

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

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

New Reservoirs* Pace of US reservoir construction has declined * Capacity > 0.1 km 3 Source: GRanD database, at http://atlas.gwsp.org/

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)

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

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

Conservation Reduces Revenues

Comparison of Transfers vs. New Supplies (Costs for OWASA 2010-2025) ( ) = 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. 100-111.

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 - 2012 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 - 2016 Standard & Poors

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

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

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

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

Payout ($) 160 Contract Structure (standard index insurance) Sample Call 140 120 100 80 60 Strike (S L ) 40 20 0 Slope (A) 0 1000 2000 3000 4000 5000 6000 7000 8000 9000 10000 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

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

Weather risks are spatially correlated

Energy Risks

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)

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Annual Reservoir Inflows (km3) Hydropower Generation (GWh) 14 Generation Inflows 12 A nearly 1:1 match 1100 10 900 8 700 6 500 4 300 2 100 Year

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Annual Reservoir Inflows (km3) Hydropower Revenues ($M) 14 Revenues Inflows 70 12 10 Not a 1:1 match because prices fluctuate 60 50 8 40 30 6 20 4 10 2 0 Year

Seasonal Revenues ($M) Seasonal Revenues ($M) Identifying the right index 25 20 R 2 = 0.48 R 2 = 0.94 25 20 15 15 10 10 5 5 0 0 2 4 6 Seasonal Inflows (km 3 ) 0 0 10 20 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:10.1002/2014wr016533.

Revenues (Millions $) 14 12 without Hedging Mean Annual Revenues without Hedging: $4.91M 10 8 6 4 2 0 1 65 Revenue Floor without Hedging: $0.83M Year

Revenues (Millions $) without Hedging with Hedging 14 12 10 Mean Annual Revenues without Hedging: $4.91M with Hedging: - $4.70M Average annual cost: $0.21M 8 6 4 2 0 Revenue Floor without Hedging: $0.83M Year Revenue Floor with Hedging: $2.4M 1 65

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

Impacts of Water Scarcity on Inland Navigation

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

Lake Michigan-Huron Level (feet) Great Lake Level Variability 584 582 Yearly Avg. with High & Low Period of Record Average 580 578 576 574 1915 1930 1945 1960 1975 1990 2005 Source: http://www.glerl.noaa.gov/data/now/wlevels/dbd/

Final Thoughts 1 2 3 4 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

Thanks to our funding agencies

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