Weather covers are traditional financial hedging instruments, except that the index on which the payout is calculated is a weather index. Weather hedges have been around since the late nineties to protect the operating results of weather-sensitive companies. In 2010/2011, the total value of trades in the weather market was 11.8 billion dollars, up 18.4% year on year.
From Antiquity to the 20th Century
Insurances against the consequences of unfavorable weather have in fact existed for a very long time. Roman emperor Claudius (41 to 54 AD) had implemented a financial cover to compensate ship owners carrying grain from Egypt from damages due to bad weather. Similar products were used in Mesopotamia, Egypt and the Byzantine Empire.
In the 17th Century, a rice futures market was created in Dojima to help producers to hedge against the consequences of unfavorable weather. At that time, the Lloyds had also created an insurance product, to offer financial compensation to its customers in case of excessive rain (Pluvius insurance). In fact, many historians consider that the Lloyds created the very first weather derivative instrument in the middle of the 19th Century by using a cumulative rain index to calculate the payout on their Pluvius insurance.
Energy and weather risks
Weather derivatives as we know them today appeared at the end of the nineties with the deregulation of the US energy market. Power distributors used to pass on to their customers the cost of unfavorable temperatures by increasing their price based on a weather normalization adjustment clause. This was no longer possible. An additional trigger was the 1997 El Niño and the related warm winter, which had an important financial impact on the sector.
The first weather derivatives
Energy companies had no choice but to find a way to protect their cost base in order to survive in this business. The impact of warm temperatures in the winter and cool temperatures in the summer had a very significant impact on their profits. Insurers and risk takers and insurers designed a financial instrument based on a temperature index, which worked like a traditional outright. Companies determined what their profits should be on a normal year. This was the baseline. The financial instrument would pay a financial compensation proportional to the difference between the actual unfavorable temperature measured at the end of the cover period, and normal temperature. Weather derivatives were born. The first transaction in modern history to get media cover was the one traded by Koch Industry in 1997, and the first European one was bought by Scottish Hydro Electric. In 1999, the Chicago Mercantile Exchange introduced the first weather contracts in the organized markets. Many transactions have since taken place both on the organized and OTC markets, but hedging weather risk is a strategic decision and many companies are understandably reluctant to disclose the transactions.
Some companies have made their weather cover public : Soccram in Grenoble, France (winter temperatures) and Bombardier in Canada (snowfall) in 1999, Corney & Barrow Wine Bars UK (temperatures) and Rock Garden Restaurant (temperatures) in 2001, Gut Apeldor Golf Club (precipitations) in 2002, Club Med in 2003 (snowfall), or the World Food Program in Ethiopia (drought) in 2006.
The weather market
Today, a weather derivative is a traditional financial instrument with a payout based on the value of a weather index. It can be structured as an insurance product or as a financial instrument. It generates an income proportional to the value of the weather index. A company can use it to offset a potential loss caused by the weather conditions defined by the same weather index. The loss does not have to materialize to trigger the payment of the weather cover. This payment is entirely a function of the final value of the weather index.
For instance, a beverage company which distributes bottled mineral water may decide to cover their exposure to unusually low temperatures in the summer with a weather derivative. The cover is structured so that the company earns an income which is proportional to the difference between the actual average temperature and the normal average temperature over the chosen period. The company may for reasons other than weather not suffer the forecast loss, but the payment of the cover would still take place if weather conditions have been unfavorable.
Weather derivatives are in fact traditional hedging instruments, and as such, they enable companies to manage weather risks just like they manage any other financial risk, to reduce their exposure to weather and protect the bottom line.
Facts and figures
In 2010/2011, the total value of trades in the weather market was 11.8 billion dollars, up 18.4% year on year. Inquiries about weather risk instruments arose from many sectors: energy (46%), construction (23%), agriculture (12%), transportation (5%) and retail (3%). The number of OTC trades in Europe last year was significantly up.