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.