Evaluating financial risk management strategies under climate change for hydropower producers on the Great Lakes

Abstract

AbstractHydropower on the Great Lakes makes up a substantial fraction of regional electricity generation capacity. Hydropower producers on the Niagara River (flowing between lakes Erie and Ontario) operate as run‐of‐river, and changing lake levels alter interlake flows reducing both generation and revenues. Index‐based insurance contracts, wherein contract payouts are linked to lake levels, offer a tool for mitigating this risk. As a potentially useful tool, pricing of financial insurance is typically based on historical behavior of the index. However, uncertainty with respect to the impacts of climate change on lake level behavior and how this might translate to increased (or decreased) risk for those selling or buying the insurance remains unexplored. Portfolios of binary index‐insurance contracts are developed for hydropower producers on the Niagara River, and their performance is evaluated under a range of climate scenarios. Climate Informed Decision Analysis is used to inform the sensitivity of these portfolios to potential shifts in long‐term, climatological variations in water level behavior. Under historical conditions, hydropower producers can use portfolios costing 0.5% of mean revenues to increase their minimum revenue threshold by approximately 18%. However, a one standard deviation decrease in the 50 year mean water level potentially doubles the frequency with which these portfolios would underperform from the perspective of a potential insurer. Trade‐offs between portfolio cost and the frequency of underperformance are investigated over a range of climate futures.