Managing Jakarta's weather risks effectually

Edward McMillan, Jakarta

As a city, Jakarta is unusually vulnerable to weather-related risks. Flooding invariably brings traffic to a juddering halt and paralyses the city. Hot temperatures promote smog, increase the incidence of heat stroke and push up air-conditioning bills.

Mitigating these effects often isn't easy. Planting trees is one answer -- but where, in such a densely built-up city? Clearing river banks is another -- but where would the displaced inhabitants then live? Stricter regulation of vehicle emissions is an obvious step, but faces the twin obstacles of bureaucratic inertia and corruption. And the political will often isn't there to seriously address these problems anyway, especially when the solutions might hinder economic growth and job creation.

What is needed is a means of incentivising the city authorities to do what they reasonably can, but also to financially guard against serious weather-induced damage. Traditional insurance can't do this, and may actually prove counter-productive: A city government that can claim compensation any time it floods might be tempted to do less flood-prevention work, not more.

Help is at hand, however, in the form of weather derivatives. These are a recent financial innovation -- they only appeared on the Chicago Mercantile Exchange in 1999 -- that allow parties to agree pay-outs not on the basis of bad outcomes (flooding or poor air quality, for example) but on the basis of the bad weather that causes them.

For instance, the Jakarta government might choose to purchase a weather derivative relating to rainfall. For every millimeter of rain above an agreed-upon threshold, the government would be able to collect a pay-out. This, in turn, could then be used to pay for the increased costs that flooding -- in the form of road repairs, subsidence, damage to public buildings, public health and so on -- incurs.

Since precipitation can't be influenced by the government, there is no possibility of cheating. And because the pay-out sums relate to rainfall and not to the actual damage done, there is a real incentive for the government to do something about flood control: after all, if it can reduce its flood-related costs while still receiving pay-outs, it could actually make a profit on the deal.

The government might purchase such a weather derivative from a third party, such as an insurance company. But the additional advantage of weather derivatives is that, if a suitable counter- party can be found, they need not cost the city anything at all.

Consider the case of temperature. Higher temperatures impose costs upon the city, in terms of air-conditioning bills and deteriorating air quality. But they spell good news for Jakarta's electricity supplier, PLN: For every one-degree Celsius increase in temperature, PLN can expect the peak electricity load in Jakarta to increase by approximately 3 percent. That not only represents more profit, it also represents the basis of a mutually-beneficial deal between the city government and PLN.

This is how it would work. The city government would not pay up-front for a weather derivative; instead, it would pay PLN if the temperature is cooler than an agreed-upon threshold, and would receive money from PLN if the temperature exceeds the threshold. If, at the end of the deal period, the weather turns out to be cooler than expected, the city's reduced expenditure on air-conditioning and healthcare pays for the derivative; if the weather is hotter than expected, the derivative pay-outs cover the additional costs the city incurs. In effect, the city trades a portion of the potential savings from a cool season for improved cash-flow certainty throughout the year.

If all of this sounds incredibly hypothetical, it isn't. Goldman Sachs, Deutsche Bank, ICICI Lombard and ABN Amro all offer weather derivative products. The International Swaps and Derivatives Association is heavily promoting the sector. And with the World Bank actively supporting the provision of weather derivatives to subsistence farmers in the developing world, it's only a matter of time before metropolitan governments participate.

Successive city governments have failed to remedy Jakarta's pressing environmental problems. Perhaps it is time to leave traditional approaches behind and try something completely new?

The writer is a British freelance writer based in Jakarta.