MANAGING THE FINANCIAL RISK OF VARIABLE WATER LEVELS IN THE GREAT LAKES

Understanding environmental financial risk, more specifically how revenues or costs are impacted by environmental events (e.g., drought), requires knowledge of natural systems, an understanding of financial principles that drive decision making, and knowledge of the relationships that link the two. Weather-related environmental risks result in losses of approximately $500 billion annually, and are projected to grow with increasing population, economic development, and a more uncertain climate. This dissertation is focused on evaluating and mitigating the financial risks associated with water level variability in the Great Lakes, which leads to substantial variation in revenues for commercial shippers (low water levels limit cargo capacity) and hydropower producers (low water levels decrease generation). Current approaches to managing these risks involve physical acts (dredging) and simple financial measures (``self-insurance''), but they are inadequate by themselves. By combining hydrologic modeling of the Great Lakes with financial models of the impacted activities, and developing a quantitative understanding of linkages between the two, innovative risk management strategies for limiting revenue variability are developed. The first stage of this research involves developing strategies based on portfolios of novel index-based binary contracts and their application to the shipping industry. This research details contract development, pricing, portfolio assembly and assessment of performance. In the second stage, portfolios of index-based contracts are applied to hydropower facilities that operate on inter-lake flows, and the potential impacts of climate change on the pricing performance of these portfolios are evaluated. Potential climate change impacts on water level behavior can vary widely, but results suggest that portfolios that protect against the most extreme events (those most likely to be insured against), remain relatively attractive financially despite variations in behavior. In the third stage, financial (index insurance) and physical (dredging) risk management strategies are integrated to develop joint strategies, an approach that departs from the traditional path of employing financial instruments only after physical forms of mitigation. The Net Option Value (NOV) is used to incorporate risk aversion into an evaluation of each integrated risk management strategy to determine which yields the highest level of risk-adjusted value. Combining index insurance contracts with dredging leads to improvements in utility (expressed using NOV) that exceed those of dredging alone by 22%.Doctor of Philosoph