Climate risks are positively priced in commodity options, according to new research from the World Federation of Exchanges (WFE), which says the work proves that transparent and predictable climate policies can stabilise markets and reduce uncertainty.
The study, Climate risk premium: Evidence from commodity options, investigated how climate-related risks may affect the pricing of commodity options by focusing on two types of iron ore options traded on the Singapore Exchange: a “brown” version with lower iron content and a higher environmental impact, and a “green” version with higher iron content and lower environmental impact.
The authors say there is clear evidence that the market charges higher risk premiums for the “brown” iron ore options, something they believe reflects investors’ expectations of greater price volatility and downside risks due to climate-related factors.
“‘Brown’ assets are more vulnerable to climate-related risks, while ‘green’ assets are viewed as hedges against such risks,” the paper stated. “Consequently, ‘green’ assets attract strong demand from climate-conscious investors, resulting in lower expected returns.”
This means that investors demand more compensation for holding options tied to less sustainable commodities, confirming the existence of a climate risk premium in commodity derivatives markets.
The report goes on to say that climate policy uncertainty, particularly in China, the largest importer of iron ore, plays a significant role in driving these climate risk premiums.
The study found that the relationship between policy uncertainty and risk premiums is nonlinear, meaning that moderate uncertainty increases premiums by making market outcomes less predictable, while extreme uncertainty reduces premiums because investors become more cautious and hesitant to make decisions.
Additionally, the study says that sustained levels of uncertainty have a greater impact on risk premiums than daily fluctuations, with markets responding more to increases in uncertainty than decreases.
“By demonstrating that climate policy uncertainty affects risk premiums in a nonlinear and asymmetric fashion, our findings imply that clearer and more predictable policy guidelines can help stabilise market expectations,” the paper concluded.
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