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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 strategy to reduce risk associated with adverse or unexpected weather conditions. Weather derivatives are derivative securities in which an investor hedges against the future state of the weather. Derivatives are commonly used as a market-based instrument to transfer risk from one party that is exposed to risk, to another that is considered able or willing to bear it. In other words it is a contract between two parties. One party (the investor) promises to make a financial commitment to another (the purchaser or contract owner) if pre-defined conditions associated with the underlying asset eventuate. In return for this promise and the financial risk it entails, the writer receives an up-front 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 but different from insurance. 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 as effective instruments for hedging against the risk associated with weather variability under today's climate and may become even more attractive under projected future climates characterized by increased variability and increased frequencies of extreme weather.

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Reference information

Adaptation Details

Category

Soft

IPCC categories

Institutional: Economic options

Stakeholder participation

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

Success and Limiting Factors

Weather derivatives are unique to each participant’s trades. So ultimately, the suitability of weather derivatives greatly depends upon the type of business a person is engaged in. Up to now, there is little use in the EU of weather derivatives, an assessment is consequently limited. Available information, also on success and limiting factors, is partially available and less detailed.

Costs and Benefits

In general, weather derivatives cover low-risk, high-probability events, while weather insurance typically covers high-risk, low-probability events, as defined in a highly customized policy. Weather derivatives are stated as a low cost tool, but are also seen as a high risk tool.

The EU Solvency II Directive (2009/138/EC) codifies and harmonises the EU insurance regulation, also addressing the issue of derivatives. Primarily this concerns the amount of capital that EU insurance companies must hold to reduce the risk of insolvency. EIOPA, in its opinion on sustainability in Solvency II, suggest that climate-change considerations deserve more attention from the sector when it comes to the valuation of assets and liabilities, investment and underwriting practices, capital requirements and the insurance sector’s internal models and that the Solvency II Directive does not prevent to do so. At the same time, EIOPA acknowledges that the medium to long-term impacts of climate change cannot fully be captured in the Solvency II capital requirements which are designed to reflect the risks that undertakings are exposed to over a one-year time horizon.

Further the European Market Infrastructure Regulation (EMIR) is a body of European legislation for the regulation of over-the-counter derivatives. The regulations include requirements for reporting of derivative contracts and implementation of risk management standards. It established common rules for central counterparties and trade repositories. The objective of the legislation is to reduce systemic counterparty and operational risk, and help prevent future financial system collapses. Climate change is not a particular aspect of the regulation.

Implementation Time

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

Life Time

As a new class of financial instruments, weather derivatives are still in the development stage. Weather derivatives when taken up last normally as long as contract is agreed between the insurer and the insured item.

Reference information

References:

Buckley et. al., (2002). European weather derivatives. Working paper

Published in Climate-ADAPT Jun 18 2020   -   Last Modified in Climate-ADAPT Mar 18 2021

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