When it rains it pours: Financial instruments against a volatile climate

Long-term business planning for ski resorts does sound a little comical in the context of climate change. Is artificial snow the only future? Nobody knows. However, investors and businesses did not wait around to find out. Enterprises and financial markets have constructed so-called weather derivatives to ensure firms have something to rely upon in case unfavourable weather conditions reduce expected revenues.

What are weather derivatives?

They are financial instruments, which involve a contract between two parties: a buyer and a seller. The seller is paid a premium to bear the risk of weather-related losses and will have to pay compensation if they are incurred. Otherwise, the seller makes a profit. The buyer is the one paying a premium to hedge against the risk of losing revenue due to “bad” weather. For instance, a farmer could buy a weather derivative, and if say, there was not enough rain in a given period, the farmer would get compensation. In practice, unfavourable conditions could be too much (too little) precipitation, too high (low) temperatures etc.

Risks of weather derivatives:

Risks associated with the weather could be separated into two categories, catastrophic and non-catastrophic. Catastrophic risks, which are unlikely to happen but can result in major losses e.g. earthquakes, can be managed properly with direct insurance contracts (Cui & Swishchuk, 2015).

Weather derivatives were created to address non-catastrophic weather risks and are relatively new. The emergence of weather derivatives arose from the energy sector, which was deregulated in the US in the mid-1990s where monopolies were crumbled making way for new competition. These firms later realised they had no instruments to insure against weather risks as higher temperatures could lead to a sharp decrease in demand for energy (Brockett et al., 2005). In 1999, Chicago Mercantile Group launched the first exchange of weather derivatives. But these instruments can be purchased by firms operating in many different sectors e.g. agriculture, construction, and transportation. For example, it is estimated that trucking companies face costs of $2.2-3.5 billion due to weather-related delays (Berlage, 2013).

Weather derivatives in practise:

Weather contracts may offer a few advantages over traditional insurance. Firstly, since the payoff is completely determined by weather, there is no information asymmetry. Both parties have complete access to weather data, and neither will have inside information. Furthermore, there is no adverse selection and moral hazard. An insurance company cannot know if a particular firm will take good care of its equipment or even damage it on purpose to receive compensation. Consequently, some firms may be unable to receive insurance. However, no firm can influence the weather to their favour.

It is argued that companies are taking more risk by not engaging in weather contracts. Jeff Hodgson, the President of the Chicago Weather Brokerage said "If your business is dependent upon the weather you are gambling by not participating in this marketplace, because your revenue is driven off of something you cannot control." The effectiveness of different types of weather derivatives can be measured by how much it reduces the volatility of revenues. Many different studies have estimated the effect on various industries across the world (shown in Table 1):

Table 1: Summary of studies on the effectiveness of the weather derivatives application in agriculture (Source: (Stulec et al., 2018)).

For the aforementioned skiing industry, a study of Serbia’s ski business (Đorđević, 2018) has shown the effectiveness (reduction in volatility) to be over 40%.

So, hedging strategies could be effective for businesses to ensure that any weather-related losses are covered. The problem for firms is to figure out whether they are worth the price. And for many companies, the answer seems to be yes. At its peak in 2005-2006, the market for weather derivative was estimated to be $45 billion. Many financial institutions exited the market during 2008-2009 crisis. “ [The] market has functioned sporadically ever since” (Thind, 2014).

Even though the market size is past its peak, these financial instruments are still relevant. The problem with centralised exchanges is that the products are standardised. On the contrary, the demand for these products is very differentiated and is said to be custom. Companies can hedge on heating/cooling degree days, rainfall, snowfall etc. Therefore, most companies choose to engage in over-the-counter deals, which are done through dealer networks and are not a part of the exchange market. That is why the numbers appear disappointing, even though weather contracts are still being used. (Kimbarovsky, 2014, as cited in Till, 2015).

Weather derivatives are solution created by the financial markets with no government intervention, which can be used for companies to fight the effects of climate change. Importantly, the market for weather derivatives was only made possible due to improved measurement of weather conditions and improved weather databases (Berlage, 2013). Overall, this suggests that financial markets could use the improvements in climate research to come up with new solutions in adapting to climate change.

By Jokūbas Paičius

References:

Alexandridis, A. (2015, June 31). Weather Derivatives: Answers to 10 most popular questions – Part B | Dr. Antonis Alexandridis’ Research Webpage. https://blogs.kent.ac.uk/antonis/2015/07/31/weather-derivatives-answers-to-10-most-popular-questions-part-b/

Antonis Alexandridis. (2015, June 28). Weather Derivatives: Answers to 10 most popular questions – Part A | Dr. Antonis Alexandridis’ Research Webpage. https://blogs.kent.ac.uk/antonis/2015/07/28/weather-derivatives-answers-to-10-most-popular-questions-part-a/

Berlage, K. (2013). The weather business: How companies can protect against increasing weather volatility. https://www.agcs.allianz.om/content/dam/onemarketing/agcs/agcs/reports/AGCS-Weather-Risk-Report.pdf

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Cui, K., & Swishchuk, A. (2015). Applications of weather derivatives in the energy market. In Journal of Energy Markets (Vol. 8, Issue 1). www.risk.net/journal

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Thind, S. (2014, January 23). As Temperatures Tumble in North America, Weather Derivatives Warm Up | Institutional Investor. https://www.institutionalinvestor.com/article/b14zbksjmn4504/as-temperatures-tumble-in-north-america-weather-derivatives-warm-up

Stulec I., Petljak K., Bakovic T. (2016): Effectiveness of weather derivatives as a hedge against the weather risk in agriculture. Agric. Econ. – Czech, 62: 356-362.

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