Climate change boosts bets on weather derivatives

Weather derivatives were born in the late 1990s. Driven in part by US energy company Enron, the market expanded and attracted speculators who were hunting for assets divorced from wider financial markets, before shrinking after the 2007-2008 financial crisis.

This time, market players are hoping its growth will be more sustainable as climate change and concerns over energy supplies push businesses like big utilities to protect themselves using the contracts.

“There is a general belief that extreme [weather] events are both going to become more common and more extreme,” said Peter Keavey, global head of energy and environmental products at CME Group. “That has been the number one driver of this.”

Climate change and the El Nino weather phenomenon combined to make the northern hemisphere summer of 2023 the hottest ever recorded, according to the EU Climate Change Service (C3S). Extreme weather has been a constant this year, causing devastating floods and wildfires around the world.

Weather derivatives let buyers hedge against the risk that the weather will damage their business. Unlike insurance, where companies must prove they have suffered a loss, they pay out based on indices. These might track the temperature in Paris or rainfall in New York.

A typical transaction would see an energy company buy a temperature-indexed contract to guard against the risk that the weather will be warm over the winter heating season, causing them to sell less natural gas. If it’s hotter than average over the period, the value of the contract will rise and generate a payout upon settlement.

Ski resort operators can hedge against the risk that it does not snow enough, or music festivals protect themselves against rainfall. Typically, it is big reinsurance companies or major hedge funds such as US billionaire investor Kenneth Griffin’s Citadel on the other side of the trade.

“If you can measure it, and you can put a dollar amount on it, we can essentially have a product for you,” said Nick Ernst, an industry veteran who was hired by broker BGC Group in July to launch a weather derivatives desk.

Ernst said the Ukraine war and the ensuing energy crisis, as well as US and European regulations that say companies must understand their exposure to climate change, have kindled interest.

Matthew Hunt, head of the UK power desk at renewable energy company Statkraft, said the Ukraine war highlighted how fragile energy supplies could be. He said he uses the “really useful” derivatives to hedge against the risk that not enough wind power will come on to the grid.

Growing pains

The market remains small compared with its commodity-linked cousins. Average open interest in CME weather futures and options contracts in September was around 170,000 contracts, compared to roughly 10 times that for crude oil — though market participants believe 90% of the weather derivatives market is in over-the-counter deals.

“Extreme weather events tend to make good marketing for weather futures,” said Samuel Randalls, a professor at University College London (UCL) who focuses on weather and climate. But he said they were only of limited use in defending against climate change, as they did not mitigate long-term changes that would make many businesses non-viable.

Education is a challenge, said David Whitehead, co-CEO of Speedwell Climate, which produces many of the weather indices that underpin the market. Many people do not know these products exist, so the growing renewable-energy market has been a boon.

“Everyone was worried about how much oil is coming out of the ground. Now people care about how much wind, how much solar,” Whitehead said.

UCL’s Randalls is, however, sceptical about the potential for growth.

“Unless businesses are convinced that this is a necessary activity — and that may be hard — the futures market will struggle to grow beyond a select group of companies and traders.”

Another possible limitation is the fact that investors cannot trade weather indices, like they would the oil or bonds that underlie other futures markets. This means the market does not lend itself to pure speculation, BGC’s Ernst said.

Yet market participants say hedge funds and other institutions are getting more involved again. Citadel is an increasingly important player.

Such firms “see themselves as a risk warehouse like an insurance or reinsurance company”, Martin Malinow, founder and CEO of Parameter Climate, said. “It is a sign of a more functional market, having players like Citadel in it that can play different roles.”

Reuters