Marty Malinow's mother could never understand what her son was doing for a living. To friends, she said he was "a weather-related stockbroker." Malinow can't be completely against it – he knows that most people don't know anything about financial contracts based on sun, rain and wind.
This is starting to change. Against the backdrop of heightened climate volatility and social change, the demand for weather derivatives is soaring. According to CME Group, the average trading volume of listed products jumped by more than 260% in 2023, and the number of outstanding contracts is now 48% higher than a year ago. According to industry estimates, this publicly traded corner could account for only 10% of all trading activity, and the notional value of outstanding derivatives could be as high as $25 billion.
Marino, founder and CEO of consulting firm Parameter Climate, said: "Now we have more trajectories for our business. "Direct weather fluctuations, supply chain issues, inflation, and geopolitics exacerbate vulnerabilities. This means that now the weather is likely to eat into a larger portion of profits. ”
Wall Street's better known weather bet – catastrophe bonds, has also been on the rise after a year of strong returns. But this boom is playing out in derivatives, which offer a different kind of hedge: protecting people from the threat of less serious but more common meteorological phenomena. If a once-in-a-century storm hits a community, a cat bond may pay out, while weather derivatives can compensate tourism if there is too much rain or farmers when a hot summer causes crops to suffer.
In response to the surge in demand for its listed derivatives, all temperature-based, the Chicago Mercantile Exchange expanded its product offering last year. Traders and firms can now purchase options covering Philadelphia, Houston, Boston, Burbank, Paris, and Essen, Germany, in addition to established contracts covering Chicago, New York, London, and Tokyo, among others. In its August debut, 5,000 "daily heat" options (tied to how cold the weather is) were traded in Essen alone.
Scott Klemm, chief revenue officer at Arbol Inc., said, "We are in the market version 3.0. The company designs products for companies that want to hedge against weather risk. "We have more room for growth now, there's more room for upside. ”
Hedging risk
Part of the reason for the surge in demand is that businesses are just beginning to face the weather. In some cases, this is because their business has already been affected, and in others, because they are dealing with pressure from investors and consumers. In many jurisdictions, regulators are beginning to force companies to quantify the extent to which weather threatens their business.
Currently, most large European listed companies are required to disclose what they believe to be risks and opportunities arising from environmental factors. In the United States, the Securities and Exchange Commission finalized a rule in March that required companies to disclose information about climate-related risks that could affect their operations, as well as the mitigation measures they have taken.
Nicholas Ernst, managing director for climate derivatives at market intermediary BGC Group, said: "All of these companies have weather risks, and once they didn't hedge, now they have to deal with that risk. "We're starting to get into this much bigger financial market. ”
The SEC's plans remain the subject of heated debate, and the regulator faces lawsuits not only from groups challenging its regulatory powers to introduce such products, but also from those who believe the rules are not strict enough. Regardless, the expectations of investors and other stakeholders mean that there is increasing pressure on businesses to identify and address risks.
Albor's Clem believes that it has become more difficult for companies to solve this problem in the same way as before. "How many times have we read earnings reports or listened to earnings calls where company executives say, 'You know, it's been a very wet spring. It impacts our bottom line. Then shrug your shoulders and continue?he said.
Mr. Marinnow, who describes himself as a "dispenser" in the market, was an early employee at Enron Corp., one of the world's first weather derivatives divisions. For more than a quarter of a century, he helped companies hedge against nature's risks, creating contracts ranging from cold cattle (shivering burns more calories), which can mean less meat) and submarine power cables (they don't conduct electricity well when their connection points warm) to turkey mortality (birds die if they get too hot).
But historically, weather derivatives have been used primarily to mitigate demand fluctuations caused by temperature changes in energy companies. Electricity providers face a clear and foreseeable risk: if the summer is colder than expected, people will not use air conditioning as often, and in mild winters, heating demand may weaken. Options based on the temperature index can help offset any impact on their income.
For example, Star Group LP, a U.S.-based supplier of household heating and air conditioning products and distributor of heating oil, uses hedging tools to help mitigate the impact of warm weather on cash flow. According to the company's financial statements, the contracts mean that the company will earn up to $12.5 million if the temperature between November and March exceeds a certain threshold. The maximum payment, including full benefits for 2023 and contracts payable for 2025, has risen to $15 million after payments are received in the most recent fiscal year. The company declined to comment.
Energy companies are also contributing to the current boom, albeit for new reasons. Solar panels, wind farms, and hydropower are governed by sunlight, wind speed, and rainfall, respectively, which means that as producers switch to renewable energy, they face new supply-side fluctuations in addition to traditional consumption fluctuations.
Arbol's Klemm said: "This intermittency, combined with the volatility of the natural gas market, has reactivated the weather derivatives space. "Arbol recently raised $60 million in a funding round to help it expand.
Malinow's company, Parameter Climate, works with companies that are passionate about protecting against these kinds of threats. This includes energy suppliers with increasingly complex needs, as well as companies considering weather hedging for the first time.
"There are other verticals that also have potential weather risks, such as onshore and offshore construction, agriculture and transportation," he said. "There are a lot of companies that don't even know how to start dealing with the risks, and as they gradually realize all of this, it will help the market grow in the future. ”
The product of scientific and technological progress
Advances in meteorological science and technology are producing new, more sophisticated products. A classic weather deal may look like one used by Star Group, but multinational seed and pesticide producer Syngenta has found another way to deploy derivatives to enhance the appeal of its products to farmers.
Under the AgriClime program, Syngenta has pledged to receive cash refunds of up to 30% for certain crops purchased by farmers if the natural environment does not provide suitable growing conditions. For example, when heavy rains threaten the barley harvest, growers are not wiped out. This happened during the last planting season in the UK, where Syngenta said: "It paid 99% of its hybrid barley customers. ”
The program is actually underpinned by derivatives. The structure of these contracts varies (calls, puts, and swaps are common variations), but typically a buyer who bears the weather risk (such as Syngenta) pays a premium to the seller who bears the risk, with the promise of paying if certain weather indicators are met. Insurance companies, and sometimes hedge funds or other investment firms, are usually the other party to the transaction.
Syngenta says the project has been a great success. According to Peter Steiner, the company's head of global weather and credit risk management, the services currently provided by AgriClime cover a range of crops on more than 50,000 farms in 17 countries.
"In many countries and regions, the climate has become more unstable and weather risks have become more difficult," he said. "Syngenta Agribusiness has proven that derivatives can not only effectively hedge a company's balance sheet, but with the right technology and processes, they can protect multiple individual end-users. ”
Doubts that continue to this day
The growth of weather markets could re-raise an unanswered question of moral hazard: Will mitigating the financial impact of weather on businesses reduce their incentive to address man-made climate change?, as one scholar wrote in 2014, "could increase the negative impact of the actions of those who benefit from these markets at the expense of the majority, especially those most vulnerable to climate change." ”
On the contrary, industry insiders insist that this is a positive, noting that the market plays a key role in helping to fund renewable energy projects and protect communities from climate challenges. Dave Whitehead, co-CEO of Speedwell Climate, said: "We were able to alleviate the pain of these large-scale global issues. "The company provides detailed meteorological data for many weather transactions. "We're not solving problems, we're creating a situation where the government can fund reconstruction projects in the event of a disaster. ”
So far, more tangible concerns have hampered the growth of weather trading, with the industry battered during the financial crisis. One study showed that the notional value of the weather derivatives market fell by 50% as risk bearers withdrew from more exotic and hard-to-hedge positions.
Weather derivatives are also very specific – often bespoke contracts based on local risk – and tend to be short-term. This severely limits trading activity in the secondary market. There is also "basis risk", which refers to the effectiveness of derivatives as a hedging tool. In the case of weather markets, basis risk may exist in geographical location (if the point of measurement that determines the contract is not close enough to the place where protection is sought), the timing of the contract in force, and the fact that the content of the compensation is not related to the actual economic impact that occurred.
Despite the challenges, market participants remain optimistic.
Maria Rapin is the CEO of Nephila Climate, where she oversees an investment strategy that directs capital to businesses and institutions that are at greater financial risk due to weather fluctuations. Rapin said that 20 years ago, when she talked about working for a major insurance company, people's eyes would have been glazed because her job was to build catastrophe bonds to help transfer weather risk.
"Now people will say, 'Wow, you're at the center of it all. She said.