Climate Linkers: Rationale and Pricing

We define climate linkers as long-dated financial instruments (bonds, swaps, and options) with payoffs indexed to climate-related variables, e.g. temperatures or carbon concentrations. Such instruments would facilitate the sharing of long-term climate risks. Another key benefit would be informational, as the price of such instruments would reveal real-time market expectations regarding future climate. We develop a tractable climate-risk pricing framework and 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 (positively) indexed on temperature, 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 damages associated with temperature increase and feedback between temperatures and carbon emissions.