Putting financial tools to use against climate change

A tool commonly used by financial strategists to determine what shares to purchase to create a diversified stock portfolio was used to develop a diversified portfolio of another kind — land to be set aside for conservation purposes given the uncertainty about climate change.

Instead of plugging into the formula the data for the history of a stock, University of Illinois environmental economist Amy Ando and agricultural economist Mindy Mallory used the historical climate data of the Prairie Pothole Region of the northern Great Plains to develop a new application of the financial tool called the Modern Portfolio Theory.

“It’s a very well-known tool in finance,” said agricultural economist Mindy Mallory. “There are many tools that are widely available to solve a portfolio problem. So it was really just a new marriage of the tool with a different kind of portfolio problem.”

Mallory and Ando used the Modern Portfolio Theory to develop a diversified land portfolio for conservation in the Prairie Pothole Region. The region contains thousands of shallow wetlands created by glaciers and serves as breeding grounds for almost 200 species of migratory birds. The region is about 276,000 square miles and includes portions of Saskatchewan, Manitoba, and Alberta in Canada and Minnesota, Iowa, North and South Dakota, and Montana in the United States.

Ando said the U.S. Fish and Wildlife Service has already protected over 3 million acres in the region and seeks to quadruple that investment. The techniques incorporated in this study could help them make decisions based on the cost, risks, and benefits of the land.

Mallory explained that in the stock analogy, simple diversification would be like someone buying one of every kind of stock in the entire market. Ando seconded that simple land diversification, such as buying one acre in every county, would be just as farfetched a plan.

“For a long time, uncertainty due to climate change wasn’t a problem so conservationists weren’t even looking at diversifying,” Ando said. “More recently, people have been thinking like that old phrase ‘don’t put all of your eggs in one basket’ so simple diversification would be the first natural step to take — and you wouldn’t need a mathematical model. But buying some land in each area doesn’t work very well.”

The researchers modeled different future regional climate scenarios using historic conditions, warming of 2 and 4 degrees Celsius and a 10 percent increase in precipitation in the Prairie Pothole Region.

“What we found was that when we looked at benefits only, the area in the east was best,” Mallory said. “But when we considered both benefits and costs, the less expensive land in the central area achieved the highest expected benefit.” Ando said there are major cost factors for buying the land or putting land under conservation easement. The eastern portion of the region includes Minnesota and Iowa, which are high land-cost states, became a big driver of their results.

“Setting aside land in that area for conservation is pretty expensive,” Ando said. “In our study, we didn’t include restoration of the land, which would result in additional costs.”

Ando said their results showed that if climate change wasn’t likely, “the current Fish and Wildlife holdings were pretty close to being on the efficient frontier. And while simple diversification schemes may be appealing, they did not perform well. Before we began the research, we didn’t realize just how important it would be to think carefully about the diversification and not just divide the investment between the regions.”

Mallory said that one of the biggest challenges of implementing this approach in planning is that to truly use this method it’s important to know the probability distribution of the climate change outcomes.

“It’s a really hard question, even for climate scientists who study the topic,” Mallory said.

Another challenge is that the results are dependent upon policies as well as physical processes.

“There’s uncertainty about whether countries will agree on climate change policy,” Ando said. “If they do agree, you get one trajectory of carbon emissions with an associated set of probabilities of climate change. If they don’t agree on policies, you get a different trajectory of carbon emissions with a different probability distribution over climate outcomes. So there’s that uncertainty, on top of all of the physical uncertainties,” she said.

Optimal portfolio design to reduce climate-related conservation uncertainty in the Prairie Pothole Region was published in the Proceedings of the National Academy of Sciences of the United States of America and funded by the University of Illinois.