One of the most unpredictable and influential factors facing economic output is the weather. Natural disasters, abnormal seasonal extremes, and even unexpected precipitation levels can have dramatic consequences on both industry and consumption.
According to the National Center for Environmental Information, the first nine months of 2017 produced 15 weather and climate disaster events in the U.S., each exceeding $1 billion in economic damages. Wildfires, hurricanes, regional freezes, and tornadoes are some of the leading causes of these losses.
So, is there any way producers can limit the impact inclement weather has on business? The answer is yes, through weather derivatives.
What Are Weather Derivatives?
The notion of weather derivatives first gained popularity in the mid 1990s with the deregulation of the U.S. energy industry. Needing a way to manage risks associated with climatic extremes, utility providers began to explore different ways of packaging and exchanging weather-related derivative products.
As pioneers in the field, energy trading companies began to conduct private over-the-counter (OTC) transactions using all sorts of temperature-based assets. Household names such as Enron and Koch Industries were heavily invested in these early OTC markets.
Today, weather derivatives are traded in a standardized format on the CME Globex Exchange. They come primarily in the form of futures and options contracts, specifically designed to account for abnormal fluctuations in temperature.
The CME’s weather product suite consists of several unique temperature-based indexes. Through each of these contracts, temperature is able to be traded with respect to its deviation from a predefined norm at a given locale.
There are two types of U.S.-based temperature indexes available from the CME, each measuring the difference between a given day’s average temperature and a baseline of 65 degrees Fahrenheit:
- Heating degree day (HDD): A HDD occurs when the average temperature for a given day is above the baseline at a specific locale.
- Cooling degree day (CDD): A CDD occurs when the average temperature for a given day is below the baseline at a specific locale.
HDDs and CDDs may be traded on a monthly or seasonal basis as they relate to the climates of various cities located in the U.S. and Europe:
- United States: Atlanta, Chicago, Cincinnati, New York, Dallas, Las Vegas, Minneapolis, Sacramento
- Europe: London, Amsterdam
Hedging Financial Risk with Weather Derivatives
Using weather derivatives to hedge against unforeseen risk is preferred by many business interests over purchasing conventional forms of insurance. Agricultural, tourism and insurance industries, as well as utilities, are a few of the large-scale participants in these markets. In addition, many towns and municipalities implement weather derivatives to offset costs related to abnormal levels of snowfall, rainfall, cold or heat.
Many agricultural producers use temperature index futures as a way of insuring against drought and low-quality yields. Addressing risk through temperature index derivatives has several cost and flexibility advantages over traditional crop insurance.
For instance, if a Midwestern corn farmer wanted to mitigate the damage a drought could have on an upcoming crop, a position in monthly or seasonal Chicago and Cincinnati HDDs may be desirable. In the event that the crop is lost to drought, the gains made in the market will help to offset revenue lost from crop failure.
Putting It All Together
Trading weather-related contracts is different from engaging more popular sectors of the futures market. Volumes and liquidities are limited, so in many ways each participant’s trades are unique. Ultimately, the suitability of weather derivatives greatly depends upon the type of business you’re engaged in.