Location: University of Victoria and University of Alberta
Reserach Team: Cornelis van Kooten, Scott Jeffrey, Jim Unterschultz
Duration: March 2011 – March 2012
Background
In this research proposal, we wish to look at adaptation to climate change by considering weather derivatives. Weather derivatives are financial instruments that can be bought and sold in markets, or used to insure a party against potentially large losses from adverse weather events, such as drought or early frost. However, weather derivatives need not be solely financial. They might be simple indexes that decision makers can use to allocate budgets (such as budgets related to snow removal, wildfire suppression, avalanche precaution, flooding and protection of wetlands) in advance of possible weather events. That is, whether sold in markets or simply used for policy purposes, weather indexes/derivatives can help mitigate the cost of adjusting to weather-related risks. In this sense, such ‘instruments’ can reveal something about the potential to adapt to climate change. The intention in this research is to examine potential weather indexes to use in western Canada as these affect agriculture, and more specifically planting of winter wheat and protection of migratory waterfowl habitat.
As part of the proposed research, we intend to construct weather indexes using historical precipitation and temperature data from weather stations throughout the study region, and link these indexes to the relevant outcome (crop yield, wetlands area, planting of winter wheat). Then, using financial models, we will construct financial derivatives associated with each weather index; that is, we will determine the premium that a private insurance company would charge to ensure that the insurance scheme will be actuarially sound, and conduct cost-benefit analysis to determine which weather index (if any) is appropriate for guiding decisions regarding wetlands protection. Both the financial information and correlation between the weather index and outcome of interest will be used to compare various weather indexes and determine if they might be useful for insurance purposes, or to guide policy.
Finally, recent research has shown that crop yields are affected by climate events, such as the Pacific Decadal Oscillation and El Niño. Then weather indexes based only on historical precipitation and temperature may not be adequate, as it may then be possible to game a scheme such as crop insurance. Whether to include these climate events in a weather index also needs to be investigated.
Research Objectives
• To study the ability of the agricultural sector in western Canada to adapt to drought.
• To determine how one might construct weather indexes that could be used to guide decision makers in adapting to weather related events, including drought and potentially climate change.
• To investigate if, in Canada’s grain belt, weather index insurance can be used as an alternative or supplement to government-sponsored crop insurance, and whether this would lead to an increase in economic efficiency.
• To analyze the potential for ‘gaming’ a weather index insurance instrument using information on climate events such as the Pacific Decadal Oscillation and El Niño Southern Oscillation (ENSO).
• To analyze the effect of variations in weather on wetlands and waterfowl production in the Prairie Pothole region, and on the success of winter wheat.
• To examine the potential use of weather indexes as an incentive for guiding landowners’ decisions regarding protection of wetlands.
• To design economic institutions and financial incentives that promote wetlands conservation and facilitate adaptation to climate change within and across the agricultural sector of western Canada.
Methodology
There are four tasks of importance to the research: (1) data collection; (2) development of appropriate theory regarding weather derivatives and the relevant economic outcomes to be investigated; (3) statistical analysis; and (4) development of financial tools to determine the ‘premiums’ required to make a weather index insurance scheme actuarially sound. With regard to data collection, it is necessary to identify an appropriate study region within the Prairie Pothole Region (PPR) of western Canada and then collect historical temperature and precipitation data for weather stations throughout the study region; crop yield data for the relevant crop production regions in Alberta, Saskatchewan and/or Manitoba; and data on climate events such as the PDO and ENSO.
Development of theory is required to guide the construction of appropriate statistical relationships and weather indexes. While a more encompassing literature review is required, Turvey (2001, 2005), Vedenov & Barnett (2004), Skees (2008), Woodward & Garcia (2008), Xu et al. (2008), Turvey et al. (2006, 2009) have explored the potential use of weather derivatives in an agricultural context. However, their use in practice has been limited to the trading of cooling degree days and heating degree days on the Chicago Mercantile Exchange; these derivatives are available for a limited number of cities in the United States and can be used by energy supply companies, for example, to protect against the risk of too cold or too warm weather. The use of weather derivatives in land use decisions and agricultural policy, including wetlands policy, has not yet been examined.
To warrant its use as a financial insurance instrument or ‘trigger’ that results in expenditure of public funds, a weather index would need to be correlated with a relevant economic outcome – crop loss, reduced yields, wetlands area, winter wheat success, etc. If the weather index is to be used for insurance purposes, the premium to be charged needs to be based on a weather index that uses the best available historic data. Usually sufficient historical data are available from one or more nearby weather stations. In the case of agriculture, data should ideally come from the farm.
Basis risk is a problem because a payout might be indicated using the weather index when in fact the farmer’s crops have been unaffected because precipitation at the farm was greater than that at the monitoring stations; or the farm may experience less than the threshold precipitation (i.e., reduced crop yield and loss of income), while the weather index suggests otherwise. Is it possible to reduce the basis risk in constructing weather indexes for the agricultural sectors of Alberta and Saskatchewan?
Statistical analysis is needed to determine if there a link between the climate indexes (e.g., PDO, El Niño/La Niña, PNA) and futures prices of grains. Is it possible to develop weather indexes that can be used as an insurance instrument to mitigate farmers’ weather-related production risks? Is it possible to construct weather indexes that can be used by decision makers to guide the allocation of funds to protect wetlands given weather related risks?
Financial analyses are necessary to determine whether the benefits of using a weather derivative exceed costs. We intend to use historic weather and climate event data to determine possible premiums for different weather derivatives (whether used by private insurers, public decision makers or environmental NGOs). Finally, we use statistical and financial analysis to determine if our indexes can be gamed, whether information on climate events, for example, might enable someone to take advantage of a precipitation based weather index.
References
Skees, J.R., 2008. Innovations in Index Insurance for the Poor in Lower Income Countries, Agricultural and Resource Economics Review 37(1): 1-15.
Turvey, C.G., 2005. The Pricing of Degree-Day Weather Options, Agricultural Finance Review 65(1): 59-85.
Turvey, C.G., 2001. Weather Derivatives for Specific Event Risks in Agriculture, Review of Agricultural Economics23(2): 333-351.
Turvey, C.G., R. Kong and B.C. Belltawn, 2009. Weather Risk and the Viability of Weather Insurance In Western China. Selected paper for the annual conference of the AAEA, Milwaukee, 26-28 July, 2009.
Turvey, C.G., A. Weersink and S.-H.C. Chiang, 2006. Pricing Weather Insurance with a Random Strike Price: The Ontario Ice-Wine Harvest, American Journal of Agricultural Economics 88(3): 696-709.
Vedenov, D.V. and B.J. Barnett, 2004. Efficiency of Weather Derivatives as Primary Crop Insurance Instruments,Journal of Agricultural and Resource Economics 29(3): 387-403.
Woodward, J.D. and P. Garcia, 2008. Basis Risk and Weather Hedging Effectiveness, Agricultural Finance Review68(1): 99-118.
Xu, Wei, Martin Odening and Oliver Mußhoff, 2008. Indifference Pricing of Weather Derivatives, American Journal of Agricultural Economics 90(4): 979-993.
Research Team:
The research team will consist of the following individuals:
G. Cornelis van Kooten, principal investigator
Dr. Scott Jeffrey, collaborator, University of Alberta, and potential student PhD committee member
Dr. Jim Unterschultz, collaborator, University of Alberta, and potential student PhD committee member
PhD student in Economics (The student currently identified is Ms. Grace Lee)
Dr. van Kooten is the Canada Research Chair in Environmental Studies and Climate in the Department of Economics at the University of Victoria. He is also an adjunct professor in the Department of Geography. The proposed research project will enable him to embark on a line of research involving climate, weather indexes for use in agriculture and policy, and adaptation to climate change in agricultural land use.
Dr. Scott Jeffrey is an agricultural economist and farm management specialist in the Department of Rural Economy at the University of Alberta. He has written extensively on prairie agriculture, wetlands conservation, crop production and farm management.
Dr. Jim Unterschultz is a finance economist with expertise in agriculture finance, farm management and crop expert farm management specialist in the Department of Rural Economy at the University of Alberta. He has written extensively on farm finance, wetlands protection and prairie agricultural policy.
Ms. Grace Lee recently completed an MA in Economics and is currently enrolled in the Department’s PhD program. She will complete her PhD comprehensive exams in Spring, 2011.
Partnership
After trying to get responses from Ducks Unlimited, we were unable to coordinate with them to obtain their involvement. However, the Pacific Institute for Climate Solutions (PICS), which is an endowed institute of the Universities of Victoria, British Columbia and Northern British Columbia, and Simon Fraser University, is interested in this type of research. It will help facilitate data gathering and provide an outlet for publication. The contact person is Dr. Lawrence Pitt (lpitt@uvic.ca), who is the research director of PICS.
Student Training
The requeste d budget will be primary used is to support a PhD graduate student and provide him/her the opportunity to present one or more papers at one or more conferences. The budget is aimed at funding the research component of a PhD student’s research. The PI will contribute funds from his Canada Research Chair for administrative support and additional expenses.
Deliverables:
The PI will consult with the collaborators throughout the project. It is anticipated that, by January 31, 2012, the student and PI will have prepared a working paper that describes the choice of study region, methodology, data sources, summaries of the data, estimation results and weather indexes. In addition, we anticipate to provide an excel file with the underlying data.
From this larger working paper, we intend to develop two research papers for presentation at professional meetings and potential submission to journals. The dates for completion of papers for conferences will depend on conference deadlines. However, drafts of both papers, one focused on the agricultural insurance aspect of weather derivatives and the other on policy aspects of the weather indexes, will be available by March 31, 2012. Work will be required after this time to develop a third paper that focuses particularly on the needs of environmental NGOs.
A presentation will also be made at one of the monthly PICS meetings, which receive widespread publicity. A white paper will also be written for PICS sometime in the second year of the project.