Weather Derivatives
Weather derivatives are risk management tools, that work like an ‘option’, that potentially hedge volume-related risks caused specifically by variations in environmental extremes over defined future time periods.
Insurance is useful for weather-related disasters, whereas weather derivatives can be used not only for disasters but also for more moderate events.
Weather derivatives can be used by larger businesses, cooperatives or collectives to manage risk due to changes in weather. They are most commonly used by the energy sector to reduce exposure to weather events such as cold snaps and heat waves that drastically alter energy demand. Recently, mainly in the United States, weather derivatives have been used by larger companies in the agribusiness sector.
They can be Heating Degree Day Contracts, Cooling Degree Day Contracts, and other contracts such as non-standard temperature measures, rainfall, snowfall, and wind. For example, if yield from a certain crop can be directly related to temperature (eg. frost damage, or increased pest activity due to high temperatures), compensation will be paid based on the duration and degree of temperature extreme relative to an agreed level.
The earnings of the grower are then stabilised and minimum levels of financial income guaranteed before the crop is sold. Overall, profit forecasting will be more predictable and accurate, and the strengthened risk management portfolio, combined with more transparent accounts, will result in a lower cost of debt from financial institutions. With profit levels stabilised, business management decisions can be made with greater confidence.
Currently in Australia the agricultural weather derivatives market is quite limited, and is more applicable to large corporate grain and cotton growers and suppliers of agrochemicals. Over time it may be worthwhile for smaller farmers to form co-operatives to achieve economies of scale to make weather derivatives worthwhile for them and also for insurance agencies.
More information is available from Australian operators (Element Re, Aquila Energy, Entegy Koch, AXA, Soc Gen, CreditLyonnais and Swiss Re), and from the Weather Risk Management Association (http://www.wrma.org).
