(Bloomberg) -- As the world’s climate becomes increasingly volatile, businesses that depend on predictable weather are turning to financial products that compensate them when there’s a heat wave, a drought or an unusually persistent bout of rain.
Unlike better-known catastrophe bonds, which help to shield insurers against rare natural disasters, so-called weather derivatives offer protection from less severe but more common meteorological events. These contracts help companies to manage risks that may go barely noticed, such as a warmer winter or a rainier summer.
Here’s how weather derivatives work, and who is starting to use them:
What are weather derivatives?
Traditionally, companies involved in agriculture, hydropower and tourism tended to buy insurance against rarer types of disruptive weather event, such as cyclones. Those policies will only pay out if it can be proved that their finances had been materially affected.
Buyers of weather derivatives get a payment when indexes tracking different aspects of the weather deviate from an agreed norm. A solar power plant operator could get paid when there’s an unusually high number of cloudy days. A farmer could get a payout if unseasonably hot weather wilts their crops.
Many businesses that purchase weather derivatives use them to stabilize revenue streams that would otherwise be more erratic due to fluctuating weather.
Where are weather derivatives bought and sold?
Some contracts focused on temperature are listed on the Chicago Mercantile Exchange (CME). Using so-called heating degree days (HDD) and cooling degree days (CDD) as parameters, they pay out when temperatures deviate from daily averages against an 18C baseline. Other indexes simply calculate the contract’s value by adding up the daily average temperatures through the contract period.
The highest volume of weather derivative contracts is currently traded “over the counter” — that is, off the public markets. This is because buyers often prefer to work directly with sellers to customize the contracts so they include several payout triggers.
For example, a gas distribution company may want to hedge against various weather conditions that would lead a consumer to use less gas.
A power utility may want to hedge the risk of lost revenue if summer turns out to be cooler than normal. These variables can be plotted with precision using models that combine historical data with short and long-term weather predictions to create a product suited to the client.
How popular are weather derivatives?
Demand for weather derivatives is soaring, with average trading volumes for listed products jumping more than 260% in 2023, according to the CME Group. The number of listed weather derivative contracts that year was 48% higher than the previous May.
Those publicly traded derivatives may represent just 10% of all activity. According to some industry estimates, there may be as much as $25 billion of weather derivatives overall.
Why are weather derivatives becoming so popular?
Weather derivatives started trading over the counter in 1997 and evolved into an investment class listed on the CME, initially in the US alone and later in Europe and Australia. In 2004, CME expanded its portfolio to Japan, adding Tokyo and Osaka as its first Asian markets.
They took off more recently as weather became more unpredictable and businesses were forced to find new ways to track related risks. Part of the impulse for this has come from their own investors, who leaned on companies to disclose their climate-related risk exposure and make plans to address it.
A growing body of literature suggests the impacts of climate change on the global economy may be much greater than previously thought. A study found that a 1°C rise in temperature may lead to a permanent decline in global economic output of as much as 12%, a situation comparable to the 1929 Great Depression.
Erratic weather is already changing energy demand patterns around the world, increasing the appetite for financial instruments designed to offset that risk. According to one United Nations study, the cities of Toronto and Vancouver may see a reduction in annual energy demand in their office buildings of as much as 10% between 2056 and 2075. In Sweden, heating demand is forecast to drop by 30% by 2100.
Technology is also playing a part: Satellites and other weather monitoring technologies are providing big data sets to track the most complex, localized weather patterns, allowing the finance industry to design derivative products that are tailored to each buyer’s situation.
Who else is getting into weather derivatives?
Weather derivatives first emerged in the US and are now expanding rapidly across the developed world, especially in energy and agriculture. Other industries are also getting involved. For example, the New York City Metropolitan Transportation Authority has reportedly used them to hedge the risk of colder winters that could disrupt mass transit services.
Yet they’ve not yet taken off in developing countries that still rely heavily on agriculture and therefore have potentially the most to gain.
India is making some initial moves. The government recently made it possible to trade the weather, a first step toward the creation of home-grown weather derivatives. But there’s scant awareness of the products among local businesses, and a mass of red tape required to get involved.
Various studies have highlighted the potential for weather derivatives to help manage climate risks in African countries too, but beyond a few limited experiments the market remains underdeveloped.
©2024 Bloomberg L.P.