Weather derivatives boom in public and OTC trade amidst rising extreme weather

As extreme weather events proliferate, energy firms, commodity traders and other financial institutions are diversifying their ways to hedge against poor weather outcomes, creating a boom in weather derivatives.

In an article for the Wall Street Journal, CME Group (which operates the Chicago Mercantile Exchange, Chicago Board of Trade, New York Mercantile Exchange, and The Commodity Exchange) said that the conglomerate was expanding its weather derivatives franchise to include new territories to meet growing demand from rising numbers of market participants.^[1]

In 2023, CME Group saw average trading volumes for its weather derivatives suite surge over 260% compared to 2022, while the number of outstanding contracts was up 48% year-on-year as of May.^[2]

However, a report in Bloomberg pointed out that publicly traded derivatives might represent as little as 10% of all weather derivative activity.^[3] Some industry estimates put the total market at as much as $25 billion, it added.

CME group has recently added contracts tied to weather in Paris, Essen, Burbank, Houston, Philadelphia and Boston to a US and international portfolio that already includes cities like New York, Chicago, London, Amsterdam and Tokyo.^[4] A short history of weather derivatives

According to an explainer from TP ICAP Group, weather derivatives help businesses hedge against the financial impact of weather variability.^[5] Rather than linking to commodities or stocks, the derivatives track weather indices, such as temperature, precipitation, or wind speed and create contracts based on these conditions over a given timeframe.

“For example, an energy company might purchase a weather derivative to protect against the financial losses associated with an unusually warm winter, which would reduce the demand for heating. If the actual weather conditions match those specified in the contract, the buyer receives a payout that offsets the financial impact of the adverse weather,” TP ICAP explains.

Weather derivatives started trading over the counter in the late 1990s and evolved from there into an asset class on the Chicago Mercantile Exchange (CME). While most popular in the US, there are signs that the idea is starting to spread to developing countries. Earlier this year, for example, the National Commodity and Derivatives Exchange (NCDEX) of India reportedly started working on the construction of a suite of weather indices for trading of weather futures, after the Indian central government added weather to its approved derivatives list.^[6]

Weather derivatives can be futures, options, or swaps. In a swap, two parties might agree to exchange cash flows based on actual versus expected weather outcomes. These instruments are becoming crucial for sectors like agriculture, energy, and insurance, providing a vital tool for managing weather-related financial risks. Future market growth

The market is still starting out compared with other commodity futures. Average open interest in CME weather futures and options contracts in September this year was around 170,000 contracts, compared to roughly 10 times that for crude oil, according to Reuters.^[7] However, that doesn’t account for the roughly 90% of the weather derivatives market that takes place in over-the-counter deals.

For now, the primary use of these derivatives is to hedge against changing weather. As the weather warms, energy firms might hedge against falling demand for heating for example. The agricultural sector is another obvious customer. But changing weather can affect almost any commercial endeavour. Alongside heightened risks for insurers of wildfires and floods, there are more prosaic applications such as ski resorts with falling patronage because they don’t get enough snow or festival organisers that get rained out in the summer.

Although they don’t yet lend themselves to speculation because they’re not typically traded like commodities futures, market participants say hedge funds and other institutions are getting more involved.^[8]

"[They] see themselves as a risk warehouse like an insurance or reinsurance company, " Martin Malinow, founder and CEO of Parameter Climate, told Reuters. "It is a sign of a more functional market, having players like Citadel in it that can play different roles."^[9]

According to TP ICAP, weather derivatives “stand at the forefront of financial innovation, transforming how an ever-greater range of businesses manage their exposure to the risks posed by volatile weather patterns”.^[10]