Financial markets

Weather derivatives are financial market products that were developed in the US energy industry by Enron, Koch Industries and Aquila in the mid-1990s. They are popular in the energy industry and agriculture.

We tried to speak to various firms and individuals engaged in the weather derivative markets, however they were not interested in participating in the study.

We plan to continue our research into weather derivatives markets using documentary sources, and will continue to try and find market participants to speak to us about their work.

Data journey

Agreeing a contract

Weather derivative contracts are traded across all forms of weather event, although the most popular contracts are based on temperature and the divergence of the average daily temperature from 18⁰C.

Weather derivatives are dependent upon vast indexes of weather and climate data. Weather derivative contracts pay out if the index of observed weather indicates that certain weather conditions – for example a warm winter or cool summer – were met. Unlike traditional indemnity insurance, whether a firm sustains any actual loss from a particular weather event is not taken into consideration.

The weather market data supply firm that we spoke to has many clients who are buyers and sellers of weather derivative products in the over the counter market.

When a firm decides to hedge against weather risk using a weather derivative product, the terms of the contract must be established between the buyer and seller. The terms of the contract are laid out in what is known as a term sheet. They include the price, the conditions under which the contract will pay out, and the amount to be paid out if these conditions are met.

“A term sheet defines the parameters of an over the counter transaction, yeah. And in that term sheet it will say we’re using these sites, and this is the form that defines the payout. And if the temperature is above X I get X million. Yeah? And what happens if there’s no data needs to be thought of in the term sheet? And what they may do is to say, if this site has failed use that site. And that’s called a fallback method.”

Prior to agreeing and purchasing a weather derivative contract, one option for an organisation is to source data about the weather and climate within the geographic area of concern from the data supply firm we spoke to.

Some of these organisations subscribe to the full weather database of the data supply firm, whereas others only purchase access to parts of the database that are relevant to a specific contract.

The dataset provided by the firm includes all of the observed and forecast data – raw and cleaned – for relevant stations over a specified historical period. An audit trail of any changes made during the data cleaning process is also included, and in some cases data will be supplied with specific parameters and analysis requested by the client.

The organisation then uses this data to calculate the price it is willing to pay for a derivative product and approaches potential providers. On occasion the data supply firm has acted as a settlement agent between the buyer and seller of a weather derivatives contract. The data supply firm then delivers the same data to all the potential providers on behalf of its client:

“Now this client will then use that data to come up with the price that they think they should be paying to hedge that transaction. We will then deliver that data to all of the guys that they’re asking to price that transaction. So all the reinsurance companies, the weather risk funds.”

Once a provider is selected, a contract is agreed. Sometimes this means further work for the data supply firm:

“Where we have a lot of financial contracts this will be, this process will be modified to take into account any definitions that are within a term sheet or a structure. So we take account of that. It may include more inspection [of stations]. It may mean we have to insert a client’s prescribed checking methodology, or infill methodology, as per the terms of their contract that they’ve agreed with their counter parties.”

Secondary markets

There is also a secondary market in weather derivatives. In this market the sellers of weather risk contracts in the over the counter market trade these contracts in order to manage their risk. Whilst this secondary market was slow to develop it now provides important liquidity for the weather derivatives market.

Market strength

The weather derivatives market saw massive growth in the mid-2000s, experiencing both the hedge fund boom of 2005–06 and the pre-crash boom of 2007–08. As with other forms of financial product, the vulnerability of the weather derivatives market was highlighted when the market crashed during 2008–09 and 2009–10, with only slow signs of growth by 2011.

However, the Weather Risk Management Association is hopeful for weather derivatives, pointing to continued growth outside the US markets throughout the downturn, growing interest in non-temperature-related weather derivatives, and increasing interest from outside the energy industry.

Weather derivatives and climate change

In research we published in 2013, we argue that the model of paying out based upon observed weather means, in effect, placing bets on future weather conditions – rather than a business insuring itself against a specific loss. Clearly, during a time of instability in global weather systems, there is a lot of potential profit to be generated from such financial products.

The emergence of this developing data-driven weather derivatives and risk market needs thorough investigation. The market exploits common threats in order to generate private wealth, favours those in a financial position to protect their interests in these markets at the expense of those most vulnerable to climate instabilities, and ultimately could reduce the incentive for those profiting in these markets to engage in action to mitigate climate change.

Definitions of terms

Settlement agent

A settlement agent works with both the buyer and seller to complete a transaction. The settlement agent can help to set up the transaction, and any contracts, cash and other compensation are transferred between buyer and seller via the settlement agent.

See Investopedia for further details on settlement agents

Hedge

In the financial markets, to hedge means to offset a risk to your business or investment by purchasing a related security such as a futures contract. In the case of weather derivatives, a firm will offset the risk to its profits due to adverse seasonal weather by investing in a weather derivatives contract that will pay out if the adverse conditions occur.

More about hedging on Investopedia

Over the counter

Over the counter (OTC) contracts are financial trades that are not made through a stock exchange. Instead they are traded directly between two parties, potentially with a broker acting as an intermediary. OTC trades tend to lack transparency and the prices are rarely made public, unlike at a public stock exchange.

Liquidity

If an asset has a high liquidity it means that it can be bought and sold quickly without having a significant impact upon its price.

Weather derivative

A weather derivative is a financial product that allows firms to hedge against future weather conditions. For example, an energy company can buy a weather derivative contract that protects it against a warm winter. If the average winter temperature goes above a pre-agreed figure then the firm will receive a pay out from the derivative supplier.

More about weather derivates on the Financial Times website

Climate change

Climate change is a long term alteration in global weather patterns and average temperatures.

See the Met Office section for further explanation

Archival sources

Due to reasons of confidentiality, no archival materials are available for this station.

Reflection

We’d like you to take a minute to reflect on some of the things you have read in this section.

Some questions to get you started:

• How do you feel about weather derivative markets? Do you think they are a good way of addressing issues around adapting to climate change?

• What do you think are the advantages and disadvantages of weather derivative markets?

• Do you think the government should be investigating the weather derivative markets more closely?

• Why do you think we found it difficult as researchers to find market participants to talk to?