Weather derivatives — also known as climate derivatives — were launched in 1999 as a way to hedge against financial losses related to climate risks.
Weather derivatives work similarly to insurance. In return for a premium, the seller of a weather derivative (the insurer) agrees to a pay a certain amount to the buyer (the insured) if a weather-related event occurs or the buyer experiences a weather-related financial loss before the contract expires. The seller’s profit is the premium (or the price of the derivative at its initiation) if no damages occur before the expiration of the contract.
Climate-related losses have the potential to disrupt many businesses. About one-third of world GDP is affected by climate, according to Pierre Saint-Laurent, full-time finance lecturer at HEC Montréal and associate of the Canadian Derivatives Institute. Some of the business sectors most affected are agriculture, tourism and transportation.
Given the abundance of market participants that could be interested in using weather derivatives, why are there relatively few markets — organized or otherwise — offering these financial hedges?
Most weather derivative trades are completed over the counter (OTC). However, weather derivatives are also actively traded on the Chicago Mercantile Exchange (CME). These products are now offered in more than 30 cities on three continents by the CME.
To better understand the complex world of weather derivatives, we met with Alain Brisebois, CEO of CWP Energy, an electricity trading firm. In his own words, Brisebois manages “the trading of physical and financial electricity in unregulated North American markets.”
Electricity trading is “strongly impacted by weather variations” including variations in temperature, sunshine, wind, storm activity and other factors that impact electricity generation, Brisebois said. Hence, CWP Energy faces “extreme price jumps, whether positive or negative” while aligning supply with demand — one of the main objectives of weather derivatives trading.
As a direct player in financial markets, CWP understands weather derivatives well. Despite this, the company has not established a specific use for these derivatives since current contracts, which are focused only on daily temperature, do not correspond to its range of needs.
According to Brisebois, “The reality of the professionals needing [weather derivatives] goes beyond the standardization of products offered in markets such as the CME.” The OTC market could provide the required customization of trades, but OTC trades require higher premiums and generate counterparty risk. Given this vicious circle of risk, few accept OTC trades. OTC trades also face asset valuation challenges, require special audit treatment and trigger additional regulatory requirements, Brisebois noted.
Yet another potential barrier to entry into the weather derivatives market, according to Brisebois, is the complexity of these products. Weather derivatives are often explained poorly to those who are not experienced financial market professionals. Investing in weather derivatives may prove to be a costly and ill-informed decision for these participants.
So, how do companies face their climate risk, given their lack of knowledge regarding these hedges? Brisebois said they tend to use insurance to hedge against climate risk. CWP Energy, meanwhile, adopts a risk reduction strategy, actively limiting the impacts of weather by controlling the magnitude and frequency of potential losses. Trades are limited to the short term to maximize the predictability of ambient weather and to tightly bracket purchase prices for certain products.
The weather derivatives market has low liquidity and several barriers to participation, even if the underlying weather risk is globally recognized. Professionals thus need a high “level of sophistication” to operate in this industry, as even companies as innovative and knowledgeable as CWP Energy do not fully participate in the weather derivatives market, Brisebois said.
Weather derivatives taking off in Canada will require “ease of access and improvements in the understanding of these products, which would foster greater interest,” Brisebois said. If the market attains good levels of depth and liquidity, insurers could also recognize an opportunity for them to hedge the risk they themselves take to insure companies facing climate risk.
Current weather derivatives contracts often reference only the largest American cities, such as New York or Chicago. It could be interesting to see the TMX consider the weather derivatives market, as the TMX already trades agriculture and energy futures contracts. Could the Canadian exchange be motivated to give weather derivatives a chance?
Brisebois said he would like to see this market grow in Canada. This would make Canadian weather derivatives options available and lead to more professionals proficient in Canadian and American pricing points.
“This would allow us to better match our electricity portfolio to weather risks in certain environments, and to do so with liquidity, which would trump our competitors,” Brisebois said. “It’s true, though, that liquidity will be provided by competitors.”