Weather impacts our daily lives and big businesses alike, posing significant benefits and risks based on the variability of weather factors like temperature, wind, rainfall, snowfall, etc. Germanwatch cites that between 1997 and 2016, a staggering average of around 30% of US GDP was negatively affected by weather. To mitigate the risks emerging out of damaging weather factors, weather derivatives have gained tremendous popularity.
This article discusses the usage of weather derivatives, how they are different from associated commodity derivatives, how various weather derivatives work and who the top players are in the weather derivative sphere.
Usage of weather derivatives
The following scenarios indicate usage of weather derivatives:
- Energy companies can enter into weather derivatives to eliminate risks of varying temperatures leading to uncertain demand and supply for their power, utility, and energy business.
- To eliminate the risk of poor crop production due to bad weather, farming businesses can get into derivatives contracts which includes cases for heavy rains or low rains, adverse temperature conditions, or impacts of high winds or snowfall.
- Hedging by event management organizations – like sports organizing companies, tour and travel companies or open-air theme parks – for mitigating the negative impacts of rain on their event business.
- Insurance companies, hedge funds and even governments trade in weather derivatives, for hedging purposes
- Speculators, arbitrageurs and market makers go for speculative betting or arbitrage opportunities on weather conditions
Utilities, energy, and power companies are the biggest players in the weather derivatives market.
Example of weather derivatives and how they work
- Weather derivatives were introduced around the mid-1990s as OTC products between two individual parties, primarily as conditional clauses (like if temperature exceeded ‘Z’ degrees, one party will offer another a rebate of ‘Y’ dollars on their deal). They soon became popular enough to be included by exchanges as easily tradable futures, options, swaps and options on futures contracts.
- CME today offers weather derivatives specific to locations - US cities like Des Moines or Las Vegas and global cities in Europe and Asia – for temperature specific products.
- Weather derivatives quantify how much the temperature varies from the monthly or seasonal average in a designated city/region. The variations are scaled to dollar-weighted indexes, allowing a quantified dollar value for temperature variations.
- Contracts are linked to index for heating degree days (HDD) and cooling degree days (CDD) based on set temperature threshold of 65° F in the US (18° C in Europe). These values indicate a quantum of available resources needed for heating or cooling. If the temperature goes below this threshold to say 35° F indicating heating requirement, then HDD value is 30 (65-35) and CDD value is zero as no cooling is required. For temperatures above this 65° F threshold, say at 85° F, HDD will be zero as no heating is required, while CDD value will be 20 (85-65).
- Each contract is valued for each day (or month) by multiplying the HDD or CDD value by $20. For the first case (HDD = 30 and CDD = 0), HDD contract value will be $600 and CDD will be zero. For second case (HDD = 0 and CDD = 20), HDD contract value will be zero and CDD contract will be $400.
- Using the above mechanism, one can take appropriate trading positions for mitigating temperature specific risks, as perceived by their respective businesses.
Weather vs. Commodity Derivatives
One important point that differentiates utilities/commodity derivatives (power, electricity, agricultural) and weather derivatives is that the former set allows hedging on price based on a specific volume, while the latter offers to hedge the actual utilization or the yield, independent of the volume. For e.g. one can lock the price of X barrels of crude oil or X bushels of corn by buying oil futures or corn futures, respectively. But getting into weather derivatives allows hedging the overall risk for yield and utilization. Temperature dipping below 10 degrees will result in complete damage to wheat crop; rain on weekends in Las Vegas will impact city tours. Hence, a combination of weather and commodity derivatives is best for overall risk mitigation. (For more, see: Commodities Trading: An Overview.)
The Bottom Line
The weather derivative market has grown globally with big investment coming from a variety of participants. Weather instruments are a useful medium to mitigate risks for weather specific conditions. Depending upon the needs, specific weather derivatives or a balanced combination of weather and traditional commodity derivatives can be utilized for hedging