Derivatives linked to the price of water will be vital to help businesses and investors manage the increasingly dramatic risk of climate change, a top US markets regulator has said.
The comments from Rostin Behnam, a commissioner at the Commodity Futures Trading Commission — which oversees US derivatives markets — underline a growing focus from regulators on the impact of the environment on the stability of the world’s financial system.
CME, which operates the Chicago futures exchange, last week said that it would begin trading the world’s first future contracts for water, tied to prices in California.
The contracts are “a really good thing,” Mr Behnam told the Financial Times. Water derivatives and other investment products linked to environmental, social and governance factors will “help stakeholders manage the risk that is going to continue to present itself to us,” he added.
A committee convened by Mr Behnam earlier this month warned that increasing occurrences of extreme weather events such as large-scale fires, drought and hurricanes posed a risk to US financial stability. The report was the first of its kind from a Wall Street regulator.
“Every time I talk about this, these weather events are just validating the need to take action,” Mr Behnam said, pointing out the fires in Australia and the US, as well as warming in the Arctic.
CME’s contract is based on the Nasdaq Veles California Water Index, which aims to track the spot price of water in the state, based on water rights — entitlements to divert water from natural sources. The group hopes it will become a benchmark for the acuteness of water scarcity both in California and the world. It highlighted the UN’s prediction that two-thirds of the world’s population is likely to face some kind of water shortage by 2025.
Trading in environment-related futures has traditionally been a specialist market. For two decades, the CME has been offering weather derivatives, which allow investors to hedge against a deviation in the air temperature. They are used by utility companies and farmers to protect themselves against unexpected conditions, but there are currently fewer than 4,000 open positions on the exchange.
The CFTC’s report called for further innovation in the derivatives offered by exchanges and clearing houses, “to think about how the products are structured, and to build in sustainability issues,” Mr Behnam said.
As the ESG industry has grown, so has regulatory scrutiny over the claims made by investment managers. Last week, Hester Peirce, a commissioner at the Securities and Exchange Commission, called on asset managers that claim to be sensitive to ESG issues to set out their investment strategies more clearly.
“I am not sure water futures in and of themselves are ESG-friendly or not,” said Gary de Waal, a lawyer for Katten Muchin Rosenman in New York. “However, they will help support the need of farmers to hedge against expected price fluctuations in water resources.”
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