Managing Jakarta's weather risks effectually

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.