Farming, construction, energy and aviation are a few industries whose profits rely on Mother Nature’s mercy. In order to protect themselves from incurring losses due to unfavourable weather conditions, businesses purchase insurance. This is where weather derivatives come into play.
What are Weather Derivatives?
To understand weather derivatives is to understand corporate insurance that covers companies against unfavourable weather conditions. While insurance provides coverage against natural catastrophic disasters like tsunamis, earthquakes and tornados, it doesn’t cover changes in temperature. For instance, during the rainy season, we tend to use less air-conditioning, which means lower profits for energy companies. Before the 1990s, there was no insurance that would cover companies against these kinds of weather-related losses.
Energy companies realised that they could mitigate losses by identifying seasonal temperature changes – creating a temperature index based on historical data. Based on this index, they could attach a monetary value to temperature deviations. If summers were cooler or if winters were warmer than what was indicated on the weather index, energy companies could protect themselves against potential revenue losses with the purchase of weather futures contracts.
How are Weather Derivatives Traded?
Essentially, weather derivatives are financial instruments that organisations or individuals use to hedge against potential weather-related losses. They are futures contracts that state the fixed value of a company’s product or service in the event that temperatures remain consistent. Payouts occur when temperatures fall below or above the stated temperatures.
These contracts generally take on the form of Cooling Degree Days (CDD) or Heating Degree Days (HDD) contracts. For CDD contracts, the purchaser receives payouts when days are hotter than expected while payouts for HDD contracts occur for days that are cooler than expected. The ‘expected’ temperature is generally pegged at 18 degrees Celsius or 65 degrees Fahrenheit. Payouts are calculated on a monthly basis or through seasonal strips, depending on the nature of the contract.
For example, in June, temperatures were at 80 degrees Fahrenheit for every single day. If you are an owner of a CDD for the month of June that placed a $20 premium on CDD point value, you would be very pleased with this result. Here’s a possible payout scenario:
Total CDD value: (80 – 65) X 30 days = 450
Total payout: 450 X $20 = $9,000
This example is a gross simplification of how weather futures payouts are calculated. Analytical distribution, statistical distribution and flexibility accounting are usually taken into account. If you are keen on pursuing a career in trading weather, this is a more accurate example of how weather derivatives are calculated.
These derivatives can be sold at a premium, opening up the seller to the risk of bearing losses. The trick to maximising profits here is to accurately gauge temperatures and to purchase enough derivatives to cover themselves. Pay too much for a contract, and the company would have wasted money. Forgo the contract, and the company will have to bear the full brunt of weather-related losses in revenue.
Weather derivatives are a fairly new form of security. They only started trading these securities over the counter in 1997. The first exchange to introduce the trade of weathers futures contracts was the Chicago Mercantile Exchange (CME) in 1999. The CME is currently the leading platform for the trade of weather futures contracts.
With climate change becoming more apparent in recent years, more businesses are subject to the mercy of unfavourable weather conditions. We can expect more weather futures contracts to be drawn up as more companies seek to protect themselves. The trade of weather derivatives is set to gain even more traction in time to come.