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climate variability fuels surge in weather derivatives trading a market insight 27

Finance

Climate Variability Fuels Surge in Weather Derivatives Trading – A Market Insight

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Leo Gonzalez

May 4, 2024 - 13:19 pm

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Financial Climate Change: The Surging Demand for Weather Derivatives

(Bloomberg) – Marty Malinow often found himself at a loss to explain his profession to his mother, who would simplify it to acquaintances as the work of “a stockbroker that does something with the weather.” While somewhat inaccurate, Malinow couldn't deny the complexity and relative obscurity of trading financial contracts tied to meteorological variables such as sunlight, precipitation, and wind patterns.

However, the landscape is evolving. Amid escalating climate variability and societal shifts, there has been a profound surge in interest for weather derivatives. Recent data from CME Group reveals that the trading volumes for these listed products soared by over 260% in 2023, with outstanding contracts witnessing a 48% increase from the previous year. Moreover, these publicly traded instruments could represent a mere 10% slice of the entire market, which by some industry estimates, might embody a notional value of up to $25 billion.

"There's a lot more trajectory to our business right now," declares Malinow, founder and CEO of advisory service Parameter Climate. "The heightened fragility from direct weather volatility, supply-chain issues, inflation, geopolitics... It means weather can eat up a bigger part of the bottom line now."

The traditional weather derivatives familiar to Wall Street,like catastrophe bonds, are also enjoying an era of prosperity, fueled by a year of impressive returns. But the current boom is predominantly present in the derivatives market, offering a different breed of hedge – protection from the routine but frequent climatic threats. While catastrophe bonds provide financial relief in the aftermath of catastrophic weather events like a century-scale storm, weather derivatives might compensate businesses for persistently rainy days affecting tourism or the stress of a sweltering summer on crop production.

In response to the burgeoning demand for its listed weather derivatives focused around temperatures, the CME group broadened its selection last year, now covering cities like Philadelphia, Houston, Boston, Burbank, Paris, and Essen, Germany. This expansion complements already established contracts in major cities like Chicago, New York, London, and Tokyo. Furthemore, upon their introduction in August, options linked to the "Heating Degree Day" saw 5,000 trades for Essen alone, illustrating the market's robust growth.

"We're in market version 3.0," states Scott Klemm, chief revenue officer at Arbol Inc., a firm specializing in the development of products for companies managing weather risks. "The growth trajectory where we are now has way more runway, way more upside."

Facing the Weather Threat Head-On

A significant part of the heightened demand is attributed to corporations newly acknowledging their vulnerability to the whims of nature. This realization is often a consequence of direct operational impacts or a reaction to pressure from investors and consumers. Increasingly, regulatory bodies are mandating that companies quantify the potential weather-induced threats to their enterprises.

Large European enterprises are already required to disclose perceived environmental risks and opportunities. In the U.S., the Securities and Exchange Commission unveiled rules in March which assert that companies must disclose climate-related risks that may influence their business operations, including any corresponding mitigation measures taken.

"All of these companies have weather risks that they're not hedging, and now they have to deal with it," says Nicholas Ernst, managing director of climate derivatives at BGC Group. "We're starting to move into this much larger financial market."

Despite intense debate, SEC plans face legal contention from those doubting its regulatory jurisdiction and others who believe the rules are insufficient. Regardless, the mounting pressure from investors and stakeholders is compelling businesses to identify and address potential risks.

Corporations can no longer afford to dismiss the issue, as has been historically common, suggests Arbol’s Klemm. According to him, companies would regularly attribute poor financial performance to adverse weather events, with a simple shrug before moving on.

Malinow, who describes himself as the market's eminence grise, also reminisces his pioneering days on the world’s first weather-derivatives desk at Enron Corp. Throughout his extensive career spanning more than 25 years, he has developed contracts for diverse scenarios including in climate-sensitive sectors such as live cattle (where colder temperatures mean higher caloric burn rates and reduced meat yields), subsea power cables (worsened conductivity due to heat at connection points), and poultry farming (excessive heat leading to increased turkey mortality).

Historically, the primary use of weather derivatives has been for energy companies to soften the blow from temperature-driven demand fluctuations. For instance, power companies can employ temperature index-based options to balance out earnings affected by unexpected seasonal variations.

Star Group LP, an American enterprise specializing in home heating and cooling products, utilizes such hedges to cushion the financial impact of warm weather on its cash flows. The company's financial disclosures reveal that it could receive up to $12.5 million if certain temperature thresholds were met during the heating season between November and March. Notably, after securing payouts in recent fiscal years – including the maximum benefit in 2023 – the potential payout has increased to $15 million for the 2025 contracts. Star Group, however, declined to provide comments.

Beyond traditional risks, the current boom is partly driven by shifts in energy production. Renewable sources like solar, wind, and hydroelectric power are dependent on weather elements – sunlight, wind speeds, and rainfall, respectively. As the industry transitions to renewable energy, new supply-side fluctuations emerge, adding to pre-existing demand-based challenges.

"That intermittency, along with the turbulence of natural gas markets, has revitalized interest in the weather-derivative space," Klemm observes, indicating Arbol's recent $60 million fundraising to support its strategic growth.

Malinow’s Parameter Climate is also actively engaging with corporations, both seasoned practitioners and newcomers to weather hedging, to prepare against such threats. He points out that sectors such as construction, agriculture, and transportation have inherent weather risks that have yet to be fully explored, signaling untapped market potential.

Embracing New Technology

As meteorological science and technology advance, new and more complex products come to light. A classic scenario might resemble Star Group's strategy, but Syngenta, a global player in the seed and pesticide sector, has innovated the application of derivatives to fortify its agricultural offerings.

Under its AgriClime program, Syngenta commits to a cash back guarantee of up to 30% on selected crop purchases should adverse weather conditions arise, thereby securing farmers against natural uncertainties. When excessive rainfall threatened barley yields in the UK last season, Syngenta compensated most of its hybrid barley customers.

The program's backbone is derivative contracts – calls, puts, and swaps being common iterations – usually involving a buyer with weather risks paying a premium to a seller who promises compensation based on specific weather measures being met. Typically, insurance firms, and occasionally hedge funds or investment companies, play the role of the counterparty in these transactions.

Syngenta reports that AgriClime has been immensely successful, now spanning over 17 countries and safeguarding crops across more than 50,000 farms, as endorsed by Peter Steiner, the company’s head of weather and credit risk management. "As the climate grows more volatile, these instruments have proven effective not only for corporate balance sheets but also in protecting individual end users," he asserts.

Navigating Old Challenges

Yet, the expansion of the weather market revives lingering concerns of moral hazard — the notion that providing financial insulation against weather impacts might dampen corporate motivation to address their contributions to climate change. An academic pondered in 2014 that such mitigation could paradoxically exacerbate the actions of beneficiaries, at the expense of the majority and especially those most vulnerable to climate change effects.

Nonetheless, industry professionals defend the market's significance, highlighting its vital role in financing renewable energy projects and shielding communities from climate-related challenges. “We’re not solving the problems, but we're creating situations where governments can fund rebuilding efforts post-disaster,” observes Dave Whitehead, co-CEO of Speedwell Climate, which supplies the essential meteorological data empowering numerous weather trades.

Practical obstacles have previously restrained market growth. The financial crisis notably battered the industry, with studies citing a 50% plunge in the notional value of weather derivatives as players retreated from exotic and challenging-to-hedge positions.

The specificity of weather derivatives – typically customized contracts based on localized risks and their short-term nature – has significantly constrained secondary trading. Moreover, "basis risk," which pertains to the efficiency of a derivative as a hedging mechanism, is a notable challenge. In weather trading, this risk may arise from geographic discordance (if the measurement point doesn't align with the protected site's location), timing discrepancies, and disconnection between payments and actual economic impacts.

Despite these obstacles, the sentiment among market participants is more optimistic than ever.

Maria Rapin, CEO of Nephila Climate, spearheads an investment strategy channeling funds to entities confronting weather volatility. Two decades ago, her discussions on structuring catastrophe bonds and weather risk transfers would bore listeners. Now, she finds people recognizing the centrality of her role. "This has become mainstream," she concludes.

--With assistance from Justina Lee.

©2024 Bloomberg L.P.

Image Source: CME Group

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