Research conducted by the World Federation of Exchanges’ (WFE) has shown climate risks are positively priced into commodity options – meaning investors are rewarded for the climate-related risk they bear in holding these assets.
The paper, Climate Risk Premium: Evidence from Commodity Options, quantifies the existence of a climate risk premium using commodity options, highlighting a relationship between that and climate policy uncertainty.
Moderate levels of policy uncertainty increase climate risk premiums by unsettling market expectations, the paper suggests, while extreme uncertainty, beyond a certain level, reduces climate risk premiums as traders and producers adopt a ‘wait and see’ strategy.
Also read: Can you be a responsible investor in commodities?
The WFE’s research analysed a proprietary dataset featuring two iron ore option contracts: one classified as ‘brown’ and the other as ‘green’, but both traded on the Singapore Exchange (SGX). Using a two-stage differencing methodology to isolate the climate risk premium without relying on subjective ESG ratings or event studies, the research was able to compare risk premiums between two nearly identical option contracts, which differed only in their environmental impact.
Dr Pedro Gurrola-Perez, head of research at the WFE, added: “Looking at commodity derivatives is particularly interesting as some of these financial instruments are directly tied to products with diverse environmental impact. WFE Research looks forward to studying key areas in market design and infrastructure as the world seeks to limit, mitigate and reverse the impact of climate change.”
By demonstrating climate-focused commodity option derivatives as a useful tool for managing exposure to climate risk, the research proposes that transparent and predictable climate policies can stabilise markets and reduce uncertainty – crucial for investors, government, climate professionals and policymakers.
Nandini Sukumar, CEO of the WFE, added: “Climate policy uncertainty affects risk premiums. Our findings show that clearer and more predictable policy guidelines can help stabilise markets. Such transparency and consistency in environmental regulations can reduce uncertainty, facilitate more efficient climate risk pricing and encourage greater investment in sustainable assets, thereby contributing to broader climate-change mitigation objectives.”
