Market Expectations of a Warming Climate
Corporate earnings of several economic sectors are sensitive to temperature fluctuations, and understanding the extent to which financial markets are pricing in climate change risks has implications for financial stability. Given the divergent beliefs about climate change, debate persists about the accuracy of global climate models and the extent to which agents incorporate these projections into their actions. We address these issues by examining how market participants update their expectations about climate over time. The Chicago Mercantile Exchange (CME) offers futures contracts for eight cities on two main weather products: cooling degree days (CDDs), which measure how much cooling is necessary during hot temperatures in summer, and heating degree days (HDDs), which measure how much heating is required during cold temperatures in winter. The payoffs from these contracts depend on observed temperatures over the course of a month. The contracts are traded before the month in which the weather is realized and thus provide a direct measure of the market’s view on the expected climate.
Our paper is the first to use a direct measure of climate change expectations as derived from weather-based futures contracts. The evidence shows that financial markets incorporate warming trends that are consistent with climate model projections. We find the market has been accurately pricing in a warming climate and that this began occurring at least since the early 2000s when the weather futures markets were formed. The market also seems to price in recent scientific findings like the polar vortex that can lead to February cooling over the eastern US, an effect neither present in the CMIP5 archive nor detectable in recent weather station observations.
We compare prices of financial derivatives whose payouts are based on future weather outcomes to CMIP5 climate model predictions as well as observed weather station data across eight cities in the US from 2001 through 2020. Derivative prices respond both to short-term weather forecasts for the next two weeks and longer-term warming trends. We show that the long-term trends in derivative prices are comparable to station-level data and climate model output. The one exception is February in the northeastern US, where financial markets price in a polar vortex-induced cooling effect, a recent scientific finding that was not present in the older CMIP5 climate output. When looking at the spatial and temporal heterogeneity in trends, futures prices are more aligned with climate model out-put than observed weather station trends, suggesting that market participants closely align their expectations with scientific projections rather than recent observations. Since efficient and profit-maximizing behavior requires an accurate assessment of predicted warming, weather markets can provide companies with pertinent information on future weather and climate trends as well as a hedge against potential lost profit. Relatedly, our findings may have relevance to climate adaptation. Adaptation requires that agents form beliefs about the extent to which the climate is changing. This paper suggests that agents, at least those participating in weather markets, have been updating their beliefs that summers are getting hotter and winters colder.