ENVR 788 - Managing Environmental Financial Risk

Greg Characklis
Rosenau 139
Email: charack@email.unc.edu
Phone: (919) 843-5545

Class Hours: Wednesdays, 9:30a-11:20a

Office Hours: After class or by appointment (I am usually available)

Text: Selected Readings from a number of sources, including:

Briys E. and F. de Varenne (2005). Insurance: From Underwriting to Derivatives, Wiley & Sons (Finance), Hoboken, NJ.

Kunreuther, H.C., Pauly, M.V. and S. McMorrow (2013). Insurance and Behavioral Economics, Cambridge University Press, New York.

Intermediate mathematical and computational skills

Course Motivation:
As society's exposure to environmental risks grows, it has become increasingly important to find innovative tools for mitigating these risks.  While there is a long history of environmentally-related insurance and hedging instruments based on direct correlations between time series data (e.g., temperature and electricity demand), the ability to reliably model more complex environmental systems offers a range of opportunities for expanding risk management.  The financial risks of drought, for example, are often poorly correlated with straightforward metrics such as rainfall.  Many hydrologic factors and human interventions (e.g., reservoirs) mean that simple indices are typically inadequate proxies for financial risk, but a more advanced understanding of these linked environmental-financial systems can be used to develop more sophisticated indices that can serve as the basis for effective insurance and hedging instruments.  Hydropower represents another example in which hydrologic modeling can be used to link water scarcity and financial risk.  In this case, financial impacts on hydropower producers are a function of both water scarcity and the costs of replacement power (often derived from natural gas), so some form of composite metric is required if it is to serve as an effective foundation for an index-based instrument.  Many opportunities exist to develop advanced risk mitigation tools and strategies for other sectors (e.g., thermal energy generators, inland navigation, any water intensive manufacturer) by combining models from both natural and human/economic/financial systems.  This is a unique course developed to meet the growing, and often unmet, demand for more sophisticated approaches to mitigating the increasingly complex array of environmental risks that threaten the financial stability of many societal activities.

Course Objectives:
This course is designed to introduce students to the fundamentals of risk management within an environmental context, with an emphasis on developing coupled environmental-financial systems models.  Students are introduced to methods of assessing financial risk and its impact on factors such as credit rating, cost of capital and firm valuation.  Students begin with a series of stylized examples that involve the development of straightforward weather-related derivative contracts and their use in mitigating various levels of financial risk.  Several forms of contracts (e.g., swaps, collars) are introduced within a power and natural gas setting, with subsequent expansion into environmental applications.  Students are expected to be able to engage in a basic analysis of the reliability of environmental indices as a foundation for hedging risk, including assessments of basis risk, actuarial analyses and contract pricing.  At the end of the course, students are expected to be able to (i) evaluate the utility of instruments currently available for mitigating environmental risk; (ii) develop a strategy for mitigating a desired level of financial risk, and; (iii) identify the potential for more innovative financial risk management instruments and strategies.

Course Format:
The multi-faceted nature of the analytical techniques developed in this course do not lend themselves well to traditional examinations, therefore, grades will be determined on the basis of student performance on several (4-5) "mini-projects".  These will be lengthy and require a substantial amount of forethought regarding problem formulation and solutions, so please do not wait until the last minute to begin work on them.  In addition, there will be group projects that stretch over the entire semester in which the students will have an opportunity to develop a financial risk management strategy for a unique environmental scenario of their choosing.  Student groups then present their analysis and recommendations in both written and oral form (in lieu of a final exam).  Grades will be based on performance in the mini-projects (40%), group project (50%) and participation in class discussions and activities (10%).

A tentative schedule is presented below:

ENVR 890  Managing Environmental Financial Risk

Introduction to Insurance and Hedging  
Financial Risk: Evaluation and Impact  
Risk Pooling vs. Risk Transfer  Project #1
Existing Environmental Risk Mitigation Instruments  
Energy Risk and Mitigation Tools/Strategies  Project #2
Time Series Analysis  
Assessing Basis Risk  Project #3
Innovative Contract Structures  
Actuarial Analysis
Contract Pricing  Project #4
Behavioral and Institutional Considerations  
Linking Environmental and Financial Models  
Linking Environmental and Financial Models
Final Group Project Presentations