Integrating Physical and Financial Approaches to Manage Environmental Financial Risk on the Great Lakes

Physical and financial approaches each provide different benefits for managing environmental financial risks. Index insurance contracts, a financial approach, have been proposed for managing numerous environmental financial risks. A method for testing when and how physical (dredging) and financial risk management strategies (index insurance) could be deployed in tandem to maximize improvements in utility for commercial shippers on the Great Lakes is developed using principles from the benefit-cost analysis and expected utility theory. Using a utility function with a decreasing marginal utility of income explicitly models the risk aversion of commercial shippers. The probabilistic nature of future revenue and costs is modeled and combined with the utility function to determine a Net Option Value. This value represents the maximum amount commercial shippers would pay more than the cost for reduced variability in net revenues. Results indicate that while the Net Option Value for dredging exceeds the potential benefits of using insurance contracts alone, the combination of dredging and insurance can improve overall utility with less cost than dredging alone. The strong autocorrelation in lake levels over long periods reduces the value of index insurance, such that the results show a potential lower bound of the value of combining physical and financial approaches in highly variable systems.