Climate Linkers: Rationale and Pricing

Abstract

This paper makes a case for climate linkers. We define climate linkers as long-dated financial instruments (bonds, swaps, and options) with payoffs indexed to climate-related variables, e.g., temperatures, sea levels, or carbon concentrations. On top of facilitating the sharing of long-term climate risks, another key benefit of these instruments would be informational, as their prices would reveal real-time market expectations regarding future climate. We develop and calibrate a sea-level-augmented integrated assessment model (IAM), and we exploit it to study climate-linked instruments' cost and risk characteristics. We examine, in particular, climate risk premiums: because of the insurance provided by a bond indexed on sea levels (say), investors would demand a lower average return on such a bond than on conventional bonds. Our findings highlight the sensitivity of climate premiums to the assumptions regarding (i) the damages associated with temperature increases and (ii) feedback effects between temperatures and carbon emissions.