Weather Derivatives: The Big Business Side of Climate Change Risk Insurance?

Even though its been freely traded on the Chicago Mercantile Exchange for awhile now, are weather derivatives now represent the big business side of climate change risk insurance?

By: Ringo Bones

Many of us cope with life’s risks in a myriad of ways. Those who are more financially savvy tend to monetize those risks and cash in the name of financial compensation. Given that its been exchange-traded with its corresponding options on the Chicago Mercantile Exchange - or CME – since 1999, are weather derivatives now representative of the big business side of climate change risk insurance?

To many of us not yet part of the richest 1 per cent may be abhorred of such a wealth manipulation scheme being used to monetize the risk posed by climate change, but from an actuarial perspective, such complex derivatives does play such a vital role in making the agricultural industry in the United States and the rest of the industrialized world be able to cope with risk and other catastrophic uncertainties posed by climate change. For the benefit of the uninitiated, here’s a brief discussion on what are weather derivatives.

Weather derivatives are financial instruments that can be used by organizations or individuals as part of their risk management strategy to reduce risks – mainly financial – associated with adverse or unexpected weather conditions. Weather derivatives’ difference from other forms of derivatives is that the underlying asset – namely: rain / temperature / snow – has no direct value to the price of the issued weather derivative. Weather derivatives are more often than not classified under “exotic derivatives”.

Farmers can use weather derivatives to hedge against poor harvests caused by failing rains during the growing period, excessive rains during harvesting, high winds in case of plantations or wild temperature swings in cases of greenhouse-enclosed crops. Theme parks now also use such derivatives to insure against rainy weekends during peak summer seasons and gas and electrical power companies may use heating degree days (HDD) or cooling degree days (CDD) contracts to smooth their earnings. A sports event managing company may wish to hedge their earnings losses by entering into a weather derivative contract because if it rains the day of the sporting event, fewer tickets will be sold.

The first weather derivative deal was in July 1996 when Aquila Energy structured a dual-commodity hedge for the Consolidated Edison, Co. The transaction involved Con Ed’s purchase of electric power from Aquila for the month of August. The price of the power was agreed to, but a weather clause was embedded into the contract. This clause stipulated that Aquila would pay Con Ed a rebate if August turned out to be cooler than expected.

After that humble beginning, weather derivatives slowly began trading over-the-counter in 1997. As the market for these products grew, the Chicago Mercantile Exchange introduced the first exchange-traded weather futures contracts – and their corresponding options – in 1999. The Chicago Mercantile Exchange (CME) currently trades weather derivative contracts for 25 cities in the United States, 9 cities in Europe, 6 cities in Canada and 2 cities in Japan. A major early pioneer in weather derivatives was the Enron Corporation through its Enron Online unit.

There is no standard model for valuing weather derivatives similar to the Black-Scholes formula for pricing European style equity option and similar derivatives. That is due to the fact that underlying asset used in valuating weather derivative contracts is non-tradable which violates a number of key assumptions of the Black-Scholes Model. Typically, weather derivatives are priced in a number of ways: via business pricing, historical pricing or burn analysis, index modeling, physical models of the weather and a more superior approach through a mixture of statistical and physical models.