Index-Based Insurance for Agricultural Carbon Credits Under Stochastic Drought Risk

Regenerative agriculture generates soil organic carbon (SOC) credits whose delivery is exposed to weather shortfall risk. We study an index-based insurance contract that protects project developers and lenders against under-delivery of SOC credits caused by drought. The contract follows Credit Default Swap (CDS) mechanics: the protection buyer pays a periodic premium and receives an indemnity when realized net additional SOC falls below a contractual target. SOC dynamics under conventional and regenerative practices are generated by a parsimonious three-pool biogeochemical model driven by a stochastic weather process. Drought events arrive according to a homogeneous Poisson process with random duration and severity, altering daily precipitation and hence SOC accumulation. For each simulated weather path we compute the carbon credit shortfall, the associated loss, and the default indicator, and obtain default probabilities, loss given default, and expected loss by Monte Carlo. Risk-neutral fair premiums are derived under an expected value premium principle and expressed either in currency units or in equivalent tons of carbon dioxide (tCO₂e). In a stylized 1,000 hectares project calibrated to a standard soil carbon methodology, annual premiums average about 22% of expected carbon revenue and rise non-linearly with drought frequency, approaching parity with revenue under extreme hazard rates. The framework is modular and can accommodate alternative premium principles, correlated hazards, and portfolio-level applications for insurers.