Hedging Climate Risk: An Investor’s Guide to Weather Derivatives
Ever considered betting on the weather? Just in the first 9 months of 2021, the US was hit by 18 major weather disasters that have cost $1 billion or more each.1 A survey carried out by CDP in 2018 even suggested that climate change could cost the world’s major public companies $1 trillion over the next five years.2 Weather derivatives are just one way companies are taking action to protect themselves from weather-based losses by securing payouts in the event of certain weather conditions.
In this edition of Alt Class we’ll take a look at how weather derivatives work and weigh up their appeal for the average investor.
What Are Weather Derivatives?
Let’s start with a quick refresher on derivatives. They’re financial contracts between two or more parties that get their value from an underlying asset. This asset could be anything from stocks, bonds, and commodities to cryptocurrencies or currencies. Derivatives let investors speculate on whether another market or asset will rise or fall. If the price of the underlying asset goes up, the investor pockets a tidy profit. But if prices fall, the investor can be left with a substantial loss.
Weather derivatives use this basic principle to allow companies to protect themselves against weather-related losses. In return for paying a premium, the buyer is guaranteed to receive a set amount from the seller if certain weather conditions occur.
For example, if temperatures average 10 degrees below normal, risking significant damage to wheat crops, the derivative payout can help offset the buyer’s losses. On the flip side, if temperatures remain in line with historic averages up to the expiry of the contract, the seller pockets the premium. Weather derivatives can be structured to have a sliding scale of payouts depending on how bad the weather gets.
Weather derivatives differ from insurance products since the payout is based on a weather index instead of the losses caused by adverse weather conditions. These indices could be cumulative temperature measured by certain weather stations or total rainfall levels.
This saves companies the hassle and time lag of having to prove their losses in order to get an insurance payout. Derivatives may also cover higher probability bad weather scenarios that might not be covered by conventional insurance products.
Weather derivatives can be a handy tool to hedge for businesses sensitive to weather-related losses like hydroelectric firms, construction firms, sporting events organizers, outdoor attractions, and farmers. Heating degree days (HDD) and cooling degree days (CDD) are two indexes commonly used by energy firms, while hydroelectric plants would monitor cumulative precipitation measured at specific sites.
Key Players
Weather derivatives first started trading in the late 1990s as over-the-counter (OTC) products traded directly between the two individual parties, the buyer and the seller, without being listed on the exchange. Thanks to their surging popularity, they were soon made available to investors as publicly-traded futures, options, and swaps.
Today the Chicago Mercantile Exchange (CME) offers weather derivatives based on HDD and CDDs for certain US cities like New York, Des Moines, Chicago, and Dallas. For Europe there’s the CME CAT Index based on cumulative daily average temperatures over a calendar month for the cities of Amsterdam and London.
What To Know Before You Invest
A niche but growing market: Weather derivatives are still a fairly new asset class, and uptake has been slow but steady amongst institutional and accredited investors. While they’re a handy tool for large firms who are particularly sensitive to adverse weather conditions, weather futures and options can be daunting to smaller investors. According to the CME, trading activity in their weather products has picked up significantly over the last couple of years; as of December 2020, interest in weather contracts was up 175% YoY.3 This uptick in institutional interest may eventually spill over into greater innovation and improved access for smaller investors.
Complexity: Weather derivatives tend to be complex products, especially for investors who aren’t seasoned financial market professionals. Failing to understand exactly how they work can lead to costly investment mistakes.
Risk & volatility: Since they derive their value from the unpredictable nature of the weather, these derivatives do involve considerable risk. An attractive, lower-risk alternative can be catastrophe bonds which cover events like hurricanes or earthquakes. With these bonds investors are paid interest over the life of the bond as long as the catastrophe event doesn’t actually occur. “There is a bit more volatility involved in weather derivatives because of the relative frequency of the types of weather events covered,” Ryan Bisch, senior associate at Mercer in Australia, previously told IPE.4 “In contrast, catastrophe bonds cover events that have a very low probability of taking place and do not carry the same volatility.”
Low correlation: On a positive note, weather derivatives do offer very low correlation to traditional markets since they’re entirely dependent on weather conditions. This could make them an attractive option for portfolio diversification.
Final Thoughts
So, what should the average investor make of weather derivatives? They can be a useful tool for weather-sensitive firms wanting to hedge against poor weather conditions. But for the typical investor, there’s no reason to whip out your checkbook just yet.
Weather derivatives are still a pretty new asset class, and it’ll likely take time for opportunities to emerge that are better suited to smaller investors. And given increasing interest from institutional players and the growing risk of unexpected weather changes due to climate change, it’s worth keeping a close eye on this sector.
Disclosure: All opinions expressed herein constitute the author’s judgment as of the date of this article and are subject to change without notice. Statements made are not facts, including statements regarding trends, market conditions, and the experience or expertise of the author are based on current expectations, estimates, opinions, and/or beliefs. Such statements are not facts and involve known and unknown risks, uncertainties, and other factors. Past events and trends do not predict or guarantee or indicate future events or results.