Climate change and climate-linked finance

PurposeThis paper investigates the relationship between climate finance and climate ergodicity. More specifically the paper examines how climate ergodicity as measured by a mean-reverting Ornstein-Uhlenbeck process affects the value of climate-linked bonds.Design/methodology/approachBond valuation is evaluated using Monte Carlo methods of the Ornstein-Uhlenbeck process. The paper describes climate risk in terms of the Hurst coefficient and derives a direct linkage between the Ornstein-Uhlenbeck process and the Hurst measure.FindingsWe use the Ornstein-Uhlenbeck mean reversion relationship in its OLS form to estimate Hurst coefficients for 5 x 5 degrees grids across the US for monthly temperature and precipitation. We find that the ergodic property holds with Hurst coefficients between 0.025 and 0.01 which implies increases in climate standard deviation in the range of 25%-50%.Practical implicationsThe approach provides a means to stress-test the bond prices to uncover the probability distribution about the issue value of bonds. The methods can be used to price or stress-test bonds issued by firms in climate sensitive industries. This will be of particular interest to the Farm Credit System and the Farm Credit Funding Corporation with agricultural loan portfolios subject to spatial climate risks.Originality/valueThis paper examines bond issues under conditions of rising climate risks using Hurst coefficients derived from an Ornstein-Uhlenbeck process.