Climate Risk in Ancient Mesopotamia: a Farmer and a Merchant Seal a Clay Pot

What is a Derivative, and how do they work?

A derivative is a financial contract whose value is dependent on an underlying asset, a group of assets, or a condition.^[1]The most familiar example of a derivative would be a futures contract, in which two parties agree to buy or sell a specific commodity at a set future date for a set price. The price of the contract is determined by what the parties to the contract predict the price of the commodity to be in the future, hence why this form of derivative contract is often called a futures contract. The benefits of such a contract include up-front payment, market security, and – most important for our discussion – transferring, or hedging, risk from one party to another.

To demonstrate these three benefits – up-front payment, market security, and hedging risk – let’s imagine a time and place where financial markets were just beginning to take form – Mesopotamia in the Fourth Millennium BCE.

Sumer, as civilization was known in this time and place, had the first recorded instances of human beings developing the fundamental ingredients for what we would think of as a contract – uniform written language, agriculture, a system of currency, markets, and a semi-organized system of labor and governance. Sumerians, like us, also faced climate risks – albeit more localized. Living along the valleys of the Tigris and Euphrates rivers, farmers in Sumer grew an abundance of grains and other crops – wheat, barley, lentils and peas.^[2] The Tigris and Euphrates, however, were temperamental rivers – it was hard to predict when they would flood and wipe out farmers’ crops.^[3] If that were the case, why plant wheat at all? Why not herd cattle, and herd them away from the rising waters when the floods came? The short answer is contract.

Gilgamesh, a farmer living on the bank of the Tigris River, wants to grow wheat on his land. He thinks he can make a decent profit from selling wheat, but he faces a few uncertainties: he doesn’t know for sure where he’s going to get the money for seeds, he doesn’t know for sure who will want to buy his wheat when it grows, and he doesn’t know for sure whether the Tigris is going to flood this year, potentially destroying everything he’d worked so hard for. To solve this problem, Gilgamesh hops on his mule and rides to Uruk, the nearest city in Sumer.^[4] There, he meets Enkidu, a wealthy merchant in wheat, and after sharing a few barley-wheat beers, they reach the following understanding:

Enkidu, being familiar with the wheat market in Uruk, thinks the price of wheat in the next harvest season will be worth 30 shekels per bushel. Gilgamesh, being familiar with growing wheat, thinks he’ll need at least 500 shekels to grow 100 bushels of wheat, of which he has 0. He also knows of the risks associated with being unable to find a buyer for his wheat, and the Tigris flooding.

Enkidu and Gilgamesh, then, agree to seal 1,500 of Enikidu’s shekels in a clay pot,^[5] which is marked with cuneiform symbols representing the terms of their agreement:

Enkidu agrees to give Gilgamesh the 500 shekels he needs to plant wheat this season, and in return Gilgamesh agrees to sell his wheat come harvest season to Enkidu for the 1,500 shekels sealed in the clay pot. If the Tigris floods and destroys all of Gilgamesh’s wheat, Gilgamesh keeps the 500 shekels tendered and Enkidu keeps the 1,500 sealed in the clay pot. Gilgamesh and Enkidu will trust the clay pot with the local priest in Uruk, who they both trust to keep it safe and give to the rightful claimant in the harvest season.

Enkidu is therefore out a total of 500 shekels – the price of the agreement – plus 1,500 shekels – the price he agreed to pay for Gilgamesh’s wheat when the harvest season comes – totaling 2,000 shekels. That’s okay with Enkidu, however, because he feels confident that the Tigris won’t flood this year and he can sell the 100 bushels of wheat for 30 shekels a bushel next harvest season, totaling 3,000 shekels and netting a profit of 1,000 shekels – not bad!

Gilgamesh is also happy with this agreement because he solved his three problems: he has the 500 shekels for seeds, he has a predetermined buyer and price of 1,500 shekels for his wheat that will also net him a profit of 1,000 shekels, and whether or not the Tigris floods he knows he won’t be at a net loss, since he doesn’t have to pay Enkidu back for the 500 shekels. Gilgamesh has solved his three problems by tapping into the three benefits of a futures contract that we identified earlier: up-front payment, market security, and hedging risk – all by making not one, but two predictions: a prediction about the price of wheat, an asset, and a prediction about whether or not the Tigris will flood, a condition.

Climate Risk in Modern-Day Long Island Sound: an Oyster Farmer Visits an Investment Bank

How can a Derivative be used to hedge against Climate Change?

Much like Gilgamesh, farmers today have similar uncertainties about whether or not they’ll be able to turn a profit on their crops – including where they’ll get money to plant seeds and who they’ll sell their crops to in the harvest season. Unlike a seasonal flooding of the Tigris and Euphrates, however, these farmers face a more long-term, existential threat that could imperil not only their harvest for the next season, but for all future seasons: climate change.

This existential uncertainty requires farmers to hedge their existential risks – farmers need to have certainty, like Gilgamesh, that whether or not climate change gets drastically worse in the next 10, 15, or 30 years, that they won’t be at a net loss on the investments that they put into their farms today. To hedge these risks, they’ll have to hop on their mule, ride to Uruk, sit down with an Enkidu and seal a clay pot.

Without tiring out our analogy to ancient Mesopotamia, let’s proceed with a financial arrangement that looks more like a modern-day derivative contract. This time it can be between a farmer, let’s call him Greg, who grows oysters in the Long Island Sound, and a banker in New York City, who for the sake of consistency we can call Ernest.

Greg inherited his place on Long Island from his great-great uncle, Gillian, who has farmed oysters for his entire life and left to his great-great nephew the land, a boat, a pair of waterproof overalls, just enough money to purchase oyster spat – tiny, nascent oysters that are used to grow new oyster beds on reefs in the Sound.^[6] Unlike his great-great-uncle Gillian, however, Greg is worried about climate change – he’s been watching CNN and believes that rising ocean temperatures will lead to the destruction of Long Island Sound’s ability to sustain reefs, imperiling his oyster farm.^[7] That’s why he hops on the Long Island Railroad and rides into New York City, where he meets Ernest in a conference room at a large investment bank in Manhattan.

Greg pitches to Ernest the following agreement – a derivative contract – inspired by a story he read about ancient Mesopotamians sealing shekels in a clay pot:

Greg needs $100,000 to purchase a floating cage system – a series of cages that hold multiple bags of oysters buoyed by floats. The cages are typically attached by lateral lines to a main line that is anchored at either end, and function like an artificial reef where Greg can farm oysters, potentially even more oysters than he could on a natural reef, whether or not climate change destroys the natural reefs in Long Island Sound in the next 30 years.

Ernest, and his investment bank, will give Greg the $100,000 he needs for the floating cage system – but here’s the catch: instead of purchasing Greg’s oysters every year for the next 30 years, which Ernest’s investment bank has no interest in trying to sell themselves, Greg can sell the cage-raised oysters himself, and will pay the bank $1,000,000 if the surface temperature of Long Island Sound warms more than 2 degrees centigrade in the next 30 years. If it doesn’t warm more than 2 degrees centigrade, Greg can keep the $100,000.

At first glance, this agreement between Greg and Ernest may seem a lot less intuitive than the agreement between Gilgamesh and Enkidu – for starters, where the hell is Greg supposed to get a million dollars? When we look to the future, however, Greg and Ernest’s agreement starts to make more sense.

Greg is confronted with two possible futures, a future in which Long Island Sound warms by more than 2 degrees centigrade and natural reef farming becomes impossible, or a future in which Long Island Sound doesn’t warm by more than 2 degrees centigrade. He thinks that either way, he would be better protected from the risk of climate change destroying the reefs if he had a floating cage system where he could potentially grow even more oysters than he would otherwise be able to grow on a natural reef, even if Long Island Sound only warmed 1 or 1.5 degrees centigrade, or didn’t warm at all. Like the flooding of the Tigris, this is the condition that Greg is worried about, and unlike Gilgamesh he can’t hedge that risk by finding a buyer for his oysters for the next 30 years – he has to hedge it another way.

Ernest, like Greg, is also thinking about these two possible futures, a future in which Long Island Sound warms by more than 2 degrees centigrade and natural reef farming becomes impossible, or a future in which Long Island Sound doesn’t warm by more than 2 degrees centigrade. Unlike Greg, however, Ernest and his investment bank are able to hire the most expert team of climate scientists, who have developed a model that predicts – like climate scientists often do – that the oceans will almost certainly be warmer – by 1.5 to 2 degrees centigrade within the next 20 to 40 years.

In a future where Long Island Sound is 2 degrees centigrade warmer in 30 years, Ernest gets $1,000,000 from Greg, who will likely have the most profitable oyster farm on the northern shore of Long Island after implementing his floating cage system and avoiding the risk of reef destruction – a return of 1,000% on his initial investment – not bad! He’s certainly getting promoted to Senior Vice President of Coastal and Maritime Investments. In a future where Long Island Sound isn’t 2 degrees warmer in 30 years, Ernest is only out $100,000 on a contract he made 30 years ago, which – with the help of inflation – would be much easier to keep under wraps from his Managing Director.

Whether or not Long Island Sound is 2 degrees warmer in 30 years, Greg still has an oyster farm.

Like Gilgamesh’s agreement with Enkidu, Greg’s agreement with Ernest has solved his three problems by tapping into two benefits of a futures contract without the benefit of market security: up-front payment and hedging risk. Instead of making two predictions – about an asset, like the price of wheat, and a condition, like whether or not the Tigris will flood – Greg and Ernest’s agreement required only one prediction about a condition: climate change.

This agreement is a climate derivative.

Climate Risk in the Future: Billions of Farmers Survive in a Warming World

Are climate derivatives a solution to climate change?

The short answer to this question is yes – see above – and the long answer to this is no – see below. While climate derivatives offer short-term solutions that allow people like Greg to hedge against the risk of climate change for their oyster farms, their success is dependent on three factors that you may have already picked up from our discussion of Greg and Ernest’s agreement:

First, for Greg to be able to succeed in the future where Long Island Sound gets 2 degrees warmer, the other oyster farmers on the north shore of Long Island must fail. This is the only way that Greg will be able to net enough profit to pay Ernest back his $1,000,000. Greg would have to implement his floating cage system, and in the warmer future sell his oysters for higher prices on a market with less competition from oyster farmers who can no longer farm on the natural reefs. Prices for oysters would be higher for oyster-enjoyers, and more oyster farmers will be without their livelihoods and homes as oceans warm and rise, either flooding them out or pricing them out of their homes as land and living on Long Island becomes more scarce.

Second, for many of the same reasons Ernest and his investment bank can’t make this agreement with all of the oyster farmers. If the investment bank purchased 100 derivative contracts for a total of $10,000,000, they would be in a much more leveraged position – meaning they would risk a greater loss in a less-warm future and would be less likely to receive their payout from each oyster farmer in a more-warm future. Ernest would instead be incentivized to give these other oyster farmers more short-term conventional loans from season to season until the reefs become too warm for them to farm in the season ahead, at which point the predictive models developed by the investment bank’s team of expert climate scientists would be useless – warmer oceans are already here, and the bank should turn its attention to investing in avocado farms on the tropical coasts of Maine.

Third, the climate derivative doesn’t solve climate change. Any derivative, being a financial contract whose value is dependent on an underlying asset or condition, must be separated from the underlying asset or condition for it to work properly. In this case, Ernest and his investment bank are actually rewarded with a payout from Greg if Long Island Sound warms more than 2 degrees celsius – what if the investment bank also held investments in offshore oil-drilling companies, possibly millions or billions of dollars more than their contract with Greg? The investment bank would then be incentivized to keep investing in those oil-drilling operations, which their team of expert climate scientists told them would accelerate the warming of the oceans. For the investment bank, this isn’t an existential threat, it’s profit.

What this all means is that climate derivatives, while having some potential to protect and finance resilience to the existential risks forthcoming from climate change, are not the solution to actually creating a sustainable future. Farmers like Greg can contract to receive thousands to build floating cage systems to hedge their risk of warming oceans, but Long Island Sound will still be warmer. Real estate developers can contract to receive millions to build housing developments with better shutters, roofs and stormwater systems, but hurricanes will still become worse and worse. Cities like New York, Boston, and New Orleans could contract to receive billions to build levees and dams, but the waters will still rise. To actually solve climate change, financial instruments like the derivative contract will need to not only hedge climate risk, but eliminate climate risk. Whether or not that goal is compatible with the financial system and the tools we currently have remains to be seen.

^[1] P.J. Hunt and J. E. Kennedy, Financial derivatives in theory and practice, rev.ed., (2004), ISBN: 0470863587

^[2] H.E. Crawford, Sumer and the Sumerians, 2d ed., Cambridge University Press, (2004), ISBN: 0521533384

^[3] Al-Ansari, N., Adamo, N., & Sissakian, V. (2019). Hydrological characteristics of the Tigris and Euphrates Rivers. Journal of Earth Sciences and Geotechnical Engineering, 9(4), 1-26.

^[4] See generally, George, A., Sandars, N. K., & Pasco, R. (2003). The Epic of Gilgamesh (A. George, Trans.). Penguin Classics.

^[5] Chris Trant, “The Origin and Evolution of the Commodity Futures Market,” StoneX, May 31, 2012. (observing that Sumerians in the 5th Millenium BCE used jugs filled with clay tokens in the shape of the animals or crops they had in their possession to represent future promise of delivery, not unlike modern day futures contracts).

^[6] Brennessel, Barbara. Good tidings: The history and ecology of shellfish farming in the Northeast. Upne, 2008.

^[7] Field, C., Elphick, C., Correll, M., Huang, M. and Olsen, B., “Sentinels of climate change: coastal indicators of wildlife and ecosystem change in Long Island Sound.” Final Report submitted to the Connecticut Department of Environmental Protection (http://www. tidalmarshbirds. org/wp-content/uploads/downloads/2015/01/Field_ et_al_Sentinels_final_report. pdf). 2004.