Our paper studies whether climate-related risks are priced in commodity derivatives markets, using a novel setting based on iron ore options traded on the Singapore Exchange (SGX). We focus on whether otherwise similar “brown” and “green” commodity option contracts embed different climate risk premiums because of their different climate exposures. We employ a dual-differencing approach that enable us to cleanly identify climate risk premiums. Another advantage of using options is that they contain market expectations about future volatility and tail risk, allowing us to study climate risk pricing in a forward-looking manner.
We use two SGX iron ore option contracts: options on 62 percent Fe Fines iron ore and options on 65 percent Fe Fines iron ore. We classify the 62 percent Fe contract as relatively “brown” because lower-grade iron ore requires more carbon-intensive processing to produce steel. We classify the 65 percent Fe contract as relatively “green” because higher-grade iron ore requires less material, less energy and less coke input for the same steel output. Crucially, the two option contracts have nearly identical contract specifications: both are options on iron ore futures, are denominated in US dollars, have the same contract size and follow similar expiration conventions. This empirical setting allows us to compare two contracts that differ mainly in the climate-related attributes of the underlying commodity.
Our main methodological contribution is a dual-differencing approach to isolate climate-specific risk premiums. In the first step, we follow the options literature and define the overall variance or skewness risk premium as the difference between the risk-neutral measure implied by option prices and the corresponding physical measure from the underlying return distribution. In the second step, we difference the brown contract’s risk premium against the green contract’s risk premium. The intuition is that because the two contracts are otherwise highly similar, common risk factors and shared physical-measure components should largely cancel out. The remaining difference can therefore be interpreted as the climate-specific variance risk premium or climate-specific skewness risk premium.
This approach helps address a central identification problem in climate finance. In equity markets, green-versus-brown classifications are often subjective and potentially confounded by firm characteristics unrelated to climate risk. In our setting, however, the comparison is cleaner because the two iron ore contracts are standardised and differ primarily in the environmental implications of the underlying iron ore grade. We also support this identifying assumption empirically by showing that the underlying 62 percent and 65 percent Fe iron ore indexes have statistically similar physical return distributions in terms of standard deviation and skewness.
Our data consist of daily SGX iron ore option observations from January 1 to December 31, 2022. We apply standard option filters, excluding deep out-of-the-money contracts, contracts with maturities outside 30 to 500 days and observations that violate no-arbitrage bounds. We then match 62 percent and 65 percent Fe options by trading date, option type, maturity and nearest strike price, producing 3,662 matched option-day observations. We compute implied variance from Black-Scholes implied volatility and model-free implied skewness following Bakshi, Kapadia and Madan (2003).
Our first result is that brown iron ore options command higher climate-related risk premiums than green iron ore options. The average implied variance is higher for 62 percent Fe options than for 65 percent Fe options, producing a positive and statistically significant climate variance risk premium. We also find a positve and statistically significant climate skewness risk premium. These results suggest that market participants perceive the brown iron ore contract as carrying greater climate-related volatility and tail-risk exposure and, therefore, require higher compensation for bearing those risks.
We then examine what drives these premiums, focusing on China Climate Policy Uncertainty. This focus is natural because China is the dominant destination market for iron ore, and the underlying indexes track Chinese iron ore prices. We find that China-specific climate policy uncertainty is a significant driver of climate risk premiums, while broader global physical and transition climate risk indices are generally insignificant. This suggests that market participants in this setting respond more strongly to regional policy uncertainty that directly affects the underlying commodity market than to broad global climate risk sentiment.
A central finding of the paper is that the relationship between climate policy uncertainty and climate risk premiums is nonlinear. For both the climate variance and skewness risk premium, we document an inverted U-shaped pattern. At low-to-moderate levels of policy uncertainty, climate risk premiums rise because uncertainty destabilises market expectations and increases the demand for compensation or hedging. However, when uncertainty becomes extreme, the premiums decline. We interpret this as a real-options or “wait-and-see” effect: when policy uncertainty becomes very high, investors may delay decisions, reduce trading activity, or use alternative hedging strategies, which lowers observed demand for option-based protection.
We also find that the effect of climate policy uncertainty is asymmetric and maturity-dependent. Sustained levels of policy uncertainty have a stronger effect than daily changes in uncertainty, suggesting that investors respond more to persistent uncertainty than to temporary policy news shocks. In addition, increases in uncertainty matter more than comparable decreases, indicating asymmetric market responses to worsening versus improving policy conditions. These effects are concentrated in short-maturity options, consistent with the interpretation that policy-driven climate risks are primarily transition risks and are therefore especially relevant over shorter horizons.
Overall, our paper provides direct evidence that climate risk is priced in commodity options. By exploiting a clean green-versus-brown comparison, using forward-looking option-implied measures, and applying a dual-differencing identification strategy, we show that climate-related risks affect both volatility and tail-risk pricing in an economically important commodity market. Our findings extend climate finance research into the commodity markets and show that climate risk pricing is also present in commodity derivatives linked to carbon-intensive production chains. The policy implication is that clearer and more predictable climate policy may reduce uncertainty, stabilise market expectations and support more efficient climate risk pricing.