The Free Market Makes Decision on Climate Change
Article from Reason by Ronald Bailey.
Markets are superb at turning what participants believe to be facts into prices. An intriguing new National Bureau of Economic Research study on market expectations about climate change looks at the price trends of Chicago Mercantile Exchange (CME) weather futures contracts.
“The evidence shows that financial markets fully incorporate climate model projections,” conclude Columbia University’s agricultural and resource economist Wolfram Schlenker and sustainable development researcher Charles Taylor. “We find that the market has been accurately pricing in climate change, largely in line with global climate models, and that this began occurring at least since the early 2000s when the weather futures markets were formed.”
In 2001, the CME created a weather futures market enabling traders to hedge against losses stemming from fluctuations in the weather. As the researchers explain, the predominant contracts are based on heating and cooling degree days, which are indexed to 65 degrees Fahrenheit and encompass eight cities scattered across the United States. Cooling degree days (CDD) measure by how much and for how long temperatures exceed 65 degrees and thus require cooling. Conversely, heating degree days (HDD) measure by how much and for how long temperature fall below 65 degrees and thus require heating. The CDDs are traded for the months of May, June, July, August, and September, and the HDDs are traded for the months of November, December, January, February, and March. The payoff of these contracts is based on the cumulative difference between the daily temperature and 65 degrees Fahrenheit during a certain period of time, usually one month.
The notional value of weather futures and options traded on the CME in the last year adds up to more than $360 million, according to the Wall Street Journal. Over the counter trading values are much larger.
Read the entire article at Reason.
Image Credit: By Photo: Andreas Praefcke (Self-published work by AndreasPraefcke) [CC BY 3.0 (https://creativecommons.org/licenses/by/3.0) or GFDL (http://www.gnu.org/copyleft/fdl.html)], via Wikimedia Commons