admin(Bloomberg) — Marty Malinow’s mother could never understand what her son did for a living. To friends, she said she was “a stockbroker who does something with time.” Malinow really couldn’t object: he knew that most people had no idea about financial contracts based on things like sun, rain and wind.
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That is starting to change. In a context of increasing climate volatility and social changes, the demand for weather derivatives is increasing. The average trading volume of listed products increased more than 260% in 2023, according to the CME Group, with the number of outstanding contracts currently 48% higher than a year ago. And that publicly traded corner could represent as little as 10% of all activity, according to industry estimates; outstanding derivatives can be worth up to $25 billion based on notional value.
“There’s a lot more trajectory for our business right now,” says Malinow, the founder and chief executive of consulting firm Parameter Climate. “Increased vulnerability from direct weather volatility, supply chain issues, inflation and geopolitics. It means weather can eat up a bigger part of the bottom line now.”
Wall Street’s best-known weather bets, catastrophe bonds, are also rising after a year of stellar returns. But this boom is happening in derivatives, which provide a different kind of coverage: protection against less severe but more common weather threats. While a cat bond can pay out if a 100-year storm hits a community, a weather derivative can compensate a tourism business if there are too many days of rain, or a farmer if a hot summer stresses his crops.
In response to growing demand for its traded derivatives, all based on temperatures, the CME expanded its offering last year. Traders and firms can now buy options covering Philadelphia, Houston, Boston, Burbank, Paris and Essen, Germany, in addition to established contracts covering locations such as Chicago, New York, London and Tokyo. On its debut in August, 5,000 “heating degree day” options (linked to how cold it is) were traded for Essen alone.
“We’re in version 3.0 of the market,” says Scott Klemm, chief revenue officer at Arbol Inc., which structures products for companies looking to hedge their weather risk. “The growth trajectory where we are now has a lot more track, a lot more upside.”
Confronting the Threat
Part of the jump in demand is being driven by corporations recently grappling with their exposure to the elements. In some cases, it’s because their operations have already been affected, in others it’s because they’re responding to pressure from investors and consumers. In many jurisdictions, regulators are beginning to force companies to quantify the extent to which climate threatens their business.
Most large listed European companies are now required to disclose what they consider risks and opportunities arising from environmental factors. In the United States, the Securities and Exchange Commission finalized rules in March that would make it mandatory for companies to publish information describing the climate-related risks that may affect their business, as well as the mitigation measures they have taken.
“All these companies have weather risk that they’re not hedging, and now they have to manage it,” says Nicholas Ernst, managing director of climate derivatives at BGC Group, a market broker. “We’re starting to move into this much larger financial market.”
The SEC’s plans remain the subject of intense debate, as the watchdog faces lawsuits not only from groups that challenge its authority to introduce such regulation, but also from those who say the rules don’t go far enough. Regardless, the expectations of investors and other stakeholders mean there is increasing pressure on companies to identify and address their risks.
It has simply become much more difficult for corporations to dismiss the issue in a way that historically, Klemm de Arbol believes. “How many times have we read an earnings report or heard an earnings call and company officials have said, ‘You know, it’s been, it’s been a really wet, wet spring.’ It had an impact on our bottom line’. Shrug, move on? he says
Malinow, who describes himself as the market’s gray eminence, was an early recruit to one of the world’s first climate derivatives desks at Enron Corp. In more than a quarter of a century helping companies hedge their exposure to Mother Nature, he’s created contracts for everything from cold cattle (trembling burns more heat, which can mean less meat) to undersea power cables (no they can conduct electricity well when their connection points get hot) to turkey mortality (birds die if it gets too hot).
But historically weather derivatives have been used primarily to protect energy companies from fluctuations in demand caused by changing temperatures. Energy suppliers face clear and predictable risks: if a summer is cooler than expected, people won’t use air conditioning as much, and in a mild winter, demand for heating may decrease. Options based on temperature indices can help offset any impact on your income.
For example, Star Group LP, a US supplier of home heating and air conditioning products and distributor of heating oil, uses hedges to help mitigate the impact of warm weather on cash flows. According to its financial statements, the contracts meant the company could receive up to $12.5 million if temperatures experienced during the November to March coverage period crossed certain thresholds. After receiving payments in recent years, including the full benefit in 2023, the maximum payment has increased to $15 million for contracts payable in 2025. The company declined to comment.
Energy companies are also contributing to the current boom, albeit for new reasons. Solar panels, wind farms and hydroelectric power generation are at the mercy of sunlight, wind speed and rainfall respectively, meaning that as producers switch to renewable sources, they face further fluctuations in the of supply in addition to the more traditional changes in consumption.
“That intermittency, along with the volatility of the natural gas market, has energized the climate derivatives space,” says Klemm at Arbol, which recently raised $60 million in a funding round to help fuel its expansion.
Malinow’s company, Parameter Climate, works with companies that want to insure against these types of threats. That includes energy providers with their increasingly complex needs, as well as businesses that are considering weather coverage for the first time.
“There are other verticals with embedded weather risks that have not yet been chosen, such as construction on land and at sea, agriculture and transport,” he says. “There are a lot of companies that don’t even know how to begin to address their risk, and this will contribute to the future growth of the market as they learn.”
New technology
Advances in weather science and technology lead to new and more sophisticated products. A classic climate trade might look like the one used by Star Group, but Syngenta, a multinational producer of seeds and pesticides, has found another way to deploy derivatives to improve its offering to farmers.
Under its AgriClime program, Syngenta promises a cash refund of up to 30% of the purchase of certain crops by farmers if nature does not provide the right growing conditions. So when heavy rains threaten the barley harvest, for example, growers won’t be wiped out. That happened in the last UK planting season, and Syngenta says it has made payments to 99% of its hybrid barley customers.
The program is supported by derivatives. The exact structure of these contracts can vary (puts, calls and swaps are common variants), but they usually involve a buyer of weather risk, eg Syngenta, paying a premium to a seller who assumes that risk, promising a payment if it is true, the meteorological measures are met. Insurance companies and sometimes hedge funds or other investment firms often take the other side of the business.
Syngenta says its program has been a wild success. AgriClime’s offering now covers a variety of crops on more than 50,000 farms in 17 countries, according to Peter Steiner, the company’s global head of time and credit risk management.
“In many countries and areas the climate has become more volatile, weather risk has become more difficult,” he says. “Syngenta AgriClime has shown that derivatives are not only effective for covering companies’ balance sheets, but with the right technology and processes, they can protect multiple individual end users.”
Old doubts
The growth of the weather market risks resurrecting an unanswered question of moral hazard: Does mitigating the financial impact of climate on companies reduce their incentive to address their own contributions to human-caused climate change? As one academic wrote in 2014, that “could increase the negative impact of the actions of those who benefit from these markets, at the expense of the majority and, in particular, of those most vulnerable to climate change.”
Industry professionals insist it’s a net positive, pointing to the market’s key role in helping finance renewable energy projects as well as protecting communities from climate challenges. “We’re able to ease the pain of some of these huge global problems,” says Dave Whitehead, co-CEO of Speedwell Climate, which provides the detailed weather data that underpins many weather exchanges. “We’re not solving the problems, but we’re creating situations where governments can fund disaster reconstruction projects.”
It is more practical concerns that have held back the growth of the weather trade until now. The industry took a big hit during the financial crisis, with one study recording a 50% drop in the notional value of the weather derivatives market as risk takers pulled out of more exotic and harder-to-hedge positions.
Weather derivatives are also very specific, often a customized contract based on localized risks, and often short-term. That severely reduces secondary trading activity. There is also “basis risk”, which refers to the effectiveness of a derivative as a hedging tool. In the case of the weather market, the base risk may lie in geography (if the point of measurement that decides a contract is not close enough to the place seeking protection), when the contract comes into force, and the fact that the payment is not linked to the actual economic impact that occurs.
Despite all the challenges, market players now seem as optimistic as ever.
Maria Rapin, CEO of Nephila Climate, oversees an investment strategy that directs capital to companies and institutions facing increased financial exposure to climate volatility. Rapin says that 20 years ago, his eyes lit up when he talked about his work at a major insurance firm that structured catastrophe bonds and helped transfer weather risk.
“Now people are like, ‘Wow, you’re at the center of everything,'” she says. “This is mainstream.”
–With the assistance of Justina Lee.
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