An energy retailer may want to hedge the risk of lost revenue if summer turns out to be cooler than normal. These variables can be plotted with precision using models that combine historical data with short and long-term weather predictions to create a product suited to the client.
Unpredictable and intense weather events are putting upward pressure on insurance premiums.Credit: Getty
Demand for weather derivatives is soaring, with average trading volumes for listed products jumping more than 260 per cent in 2023, according to the CME Group. The number of listed weather derivative contracts that year was 48 per cent higher than the previous May.
Those publicly traded derivatives may represent just 10 per cent of all activity. According to some industry estimates, there may be as much as $US25 billion ($40.2 billion) of weather derivatives overall.
Weather derivatives started trading over the counter in 1997 and evolved into an investment class listed on the CME, initially in the US alone and later in Europe and Australia. In 2004, the CME expanded its portfolio to Japan, adding Tokyo and Osaka as its first Asian markets.
They took off more recently as weather became more unpredictable and businesses were forced to find new ways to track related risks. Part of the impulse for this has come from their own investors, who leaned on companies to disclose their climate-related risk exposure and make plans to address it.
A growing body of literature suggests the impacts of climate change on the global economy may be much greater than previously thought. A study found that a 1°C rise in temperature may lead to a permanent decline in global economic output of as much as 12 per cent, a situation comparable to the 1929 Great Depression.
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Erratic weather is already changing energy demand patterns around the world, increasing the appetite for financial instruments designed to offset that risk. According to one United Nations study, the cities of Toronto and Vancouver may see a reduction in annual energy demand in their office buildings of as much as 10 per cent between 2056 and 2075. In Sweden, heating demand is forecast to drop by 30 per cent by 2100.
Technology is also playing a part: Satellites and other weather monitoring technologies are providing big data sets to track the most complex, localised weather patterns, allowing the finance industry to design derivative products that are tailored to each buyer’s situation.
Weather derivatives first emerged in the US and are now expanding rapidly across the developed world, especially in energy and agriculture. Other industries are also getting involved. For example, the New York City Metropolitan Transportation Authority has reportedly used them to hedge the risk of colder winters that could disrupt mass transit services.
Yet, they’ve not yet taken off in developing countries that still rely heavily on agriculture and therefore have potentially the most to gain.
India is making some initial moves. The government recently made it possible to trade the weather, a first step toward the creation of home-grown weather derivatives. But there’s scant awareness of the products among local businesses, and a mass of red tape required to get involved.
Various studies have highlighted the potential for weather derivatives to help manage climate risks in African countries too, but beyond a few limited experiments the market remains underdeveloped.
Bloomberg L.P.
