Weather derivatives as risk management tool

Weather derivatives are financial instruments that can be used by organizations or individuals as part of a risk management strategies to protect themselves from risks caused by unexpected weather changes. These tools work like contracts where one party (the investor) agrees to pay another party (the buyer) if certain weather conditions happen, like a pre-defined amount of rain or temperature. In exchange for this promise, the investor gets an upfront payment. Weather derivatives are based on a specific “weather” trigger (e.g. heating degree days) rather than proof of loss (for instance temperature over a specified threshold and period) and therefore are simpler (and cheaper) to administer than other alternative options.

For example, farmers can use weather derivatives to hedge against poor harvests caused by e.g. lack of rain during the growing period or excessive rain during harvesting. A farmer who grows peaches in Central Europe relies on the temperature never to fall below a certain temperature (5 °C) during the flowering of frost-sensitive trees. The longer the temperature is below 5 °C, the lower is its harvest. This farmer can transfer his business risk to a bank by concluding an appropriate weather derivative with the bank. The contract could be designed so that for each day of the months of April and May (the months in which the frost-sensitive peach trees are blooming) at which the temperature measured by the nearest weather station falls below 5 °C, the farmer will be compensated by a specific amount. Whether he pays an option premium for this contract or has a payment obligation to the bank when the temperature is above five degrees Celsius, depends on which specific hedging instrument is chosen.

Weather derivatives are similar to insurance, but they function differently. Insurance covers low-probability, catastrophic weather events such as hurricanes, earthquakes, and tornadoes. In contrast, derivatives cover higher-probability events such as a dryer-than-expected summer. Weather derivatives are currently by far less used than insurance schemes in the EU. However, they are considered effective instruments for managing the risk associated with weather variability under today's climate. They may become even more attractive in the future, as climate change is expected to increase both weather variability and the frequency of extreme weather events.

Business management practices naturally involve risk diversification strategies and weather derivatives are already in use in the agricultural sector. Giving the growing importance of climate-related risks, businesses should consider using weather derivatives tailored to their specific industry. This is important because these risks can cause damage to physical assets and disrupt business operations. At the same time, the variety of available weather derivatives should be expanded to cover a broader range of economic activities that are increasingly exposed to climate-related risks.

Stakeholder involvement normally does not play particular roles in the formulation and use of weather derivatives.

Weather derivatives are unique to each participant’s trades, meaning that their suitability largely depends on the type of business involved. Currently, the use of weather derivatives in the EU is limited and there is little available data on their effectiveness. While some information exists regarding their success and challenges, it is often incomplete and lacks detailed analysis.

In general, weather derivatives are used to cover low-risk, high-probability events, whereas weather insurance typically addresses high-risk, low-probability events through highly customized policies. While weather derivatives are often considered a low-cost tool, they are also viewed as a high-risk option.

The EU Solvency II Directive (2009/138/EC) sets the rules for the EU insurance industry. It also includes how insurance companies should use derivatives and the amount of capital they must hold to minimize the risk of bankruptcy. The European Insurance and Occupational Pensions Authority (EIOPA), in its opinion on sustainability in Solvency II, suggested that the insurance industry should pay more attention to the impact of climate change when evaluating assets, liabilities, investments, underwriting practices, and capital requirements. EIOPA also notes that the Solvency II Directive does not prevent insurers from considering climate risks, but it acknowledges that the long-term effects of climate change cannot be fully captured within the one-year time frame used by Solvency II capital requirements. In addition, the European Market Infrastructure Regulation (EMIR) regulates the of over-the-counter derivatives in Europe. It includes requirements for reporting derivative contracts and for the implementation of risk management standards. It includes rules for reporting derivative contracts and managing risks, aiming to reduce the potential for financial system collapses by setting common standards for central counterparties and trade repositories. It should be noted that the EMIR does not specifically address climate change.

The development of a derivative product normally takes several months. Once a contract is signed, it becomes effective immediately.

As a new class of financial instruments, weather derivatives are still in the development stage. When utilized, they typically remain in effect for the duration specified in the contract between the insurer and the insured party.