Use of weather derivatives surges as extreme climate events rock the globe

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LONDON- Energy companies, hedge funds and commodity traders are stepping up their use of financial products that let them bet on the weather, as they seek to protect themselves against – or profit from – the increasingly extreme global climate.

On the Chicago Mercantile Exchange, average open interest in weather futures and options was four times higher in the January to September period than a year earlier, and 12 times higher versus 2019.

Open interest measures the number of outstanding futures and options contracts that have not been settled. Trading volume has also quadrupled in a year.

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Weather derivatives were born in the late 1990s. Driven in part by US energy company Enron, the market expanded and attracted speculators who were hunting for assets divorced from wider financial markets, before shrinking after the 2007-2008 financial crisis.

This time, market players are hoping its growth will be more sustainable as climate change and concerns over energy supplies push businesses like big utilities to protect themselves using the contracts.

“There is a general belief that extreme (weather) events are both going to become more common and more extreme,” said Peter Keavey, global head of energy and environmental products at CME Group. “That has been the number one driver of this.”

Climate change and the El Nino weather phenomenon combined to make the northern hemisphere summer of 2023 the hottest ever recorded, according to the European Union Climate Change Service. Extreme weather has been a constant this year, causing devastating floods and wildfires around the world.

Weather derivatives let buyers hedge against the risk that the weather will damage their business. Unlike insurance, where companies must prove they have suffered a loss, they pay out based on indexes. These might track the temperature in Paris or rainfall in New York.

A typical transaction would see an energy company buy a temperature-indexed contract to guard against the risk that the weather will be warm over the winter heating season, causing them to sell less natural gas. If it’s hotter than average over the period, the value of the contract will rise and generate a payout upon settlement.

Ski resort operators can hedge against the risk that it does not snow enough, or music festivals protect themselves against rainfall. Typically, it is big reinsurance companies or major hedge funds such as US billionaire investor Kenneth Griffin’s Citadel on the other side of the trade.

“If you can measure it, and you can put a dollar amount on it, we can essentially have a product for you,” said Nick Ernst, an industry veteran who was hired by broker BGC Group in July to launch a weather derivatives desk.

Ernst said the Ukraine war and the ensuing energy crisis, as well as US and European regulations that say companies must understand their exposure to climate change, have kindled interest.

Matthew Hunt, head of the UK power desk at renewable energy company Statkraft, said the Ukraine war highlighted how fragile energy supplies could be. He said he uses the “really useful” derivatives to hedge against the risk that not enough wind power will come on to the grid.

The market remains small compared with its commodity-linked cousins. Average open interest in CME weather futures and options contracts in September was around 170,000 contracts, compared to roughly 10 times that for crude oil – although market participants reckon 90 percent  of the weather derivatives market is in over-the-counter deals.

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