New WFE Research Discovers Climate Risk Premium in Commodity Options

The World Federation of Exchanges’ (WFE) new research finds that climate risks are positively priced into commodity options - meaning investors are rewarded for the climate-related risk they bear in holding these assets.

The WFE says the research also highlights a relationship between climate policy uncertainty and climate risk premiums: moderate levels of policy uncertainty increase climate risk premiums by unsettling market expectations, while extreme uncertainty, beyond a certain level, reduces climate risks premiums as traders and producers adopt a 'wait and see' strategy.

The WFE says the paper, Climate Risk Premium: Evidence from Commodity Options, authored by Kaitao Lin, Xin Gao, Bingxin Li, and Rui Liu, is the first to document and quantify the existence of a climate risk premium using commodity options. 

It adds that the 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, says the WFE.

Read the full paper here.