What is a Weather Derivative

Weather derivatives are an unusual class of investment in which investors sign contracts to mitigate weather risk. All derivatives, essentially, are intended as forms of risk insurance, in which two parties bet on the future fluctuations in the value of an uncertain and unpredictable asset. In the case of weather derivatives, the investment is used by weather-dependent industries as a form of hedging against severe losses due to poor weather. What makes weather derivative trading more exotic than other derivatives is that the quantity being bet on – future weather – normally has no monetary value, fluctuating or otherwise.

The easiest example to understand the purpose of a weather derivative is a farm. Farmers face serious risks due to weather. Early frost can ruin crops. Drought can kill the crops, too. Even excess rain can be a problem – as some farmers discovered in 2010. If conditions are good, the farm will perform very well (barring other problems, like a large wave of pests) and the farmer will end the year with a profit. However, if conditions turn out very poor, the crops may fail and the farmer will face bankruptcy. (In most places around the world, this sort of perennial financial instability is a constant feature of the small farm sector.) A farmer with access to weather derivative trading could essentially place a bet against his own performance by finding an investor who believes weather will be well, and betting that instead the weather will be poor. If the weather is good, the farmer pockets his profits minus the cost of investing in the derivatives contract. If the weather fails him, however, he still has the payout from the derivative to fall back on.

In practice, small farmers generally use another, more traditional financial investment to both hedge against risk (to an extent) and bring in capital at the beginning of the year: the futures contract. However, other industries now do trade in weather derivatives on a more regular basis, and are also weather-dependent. Electric utility companies, for instance, may wish to hedge against the substantial changes in demand they may experience as a result of unusually hot or cold weather. Outdoor music and sports venues, and theme parks, also have an interest in securing some sort of derivative income in the event that a particularly terrible season of weather wipes out their usual earnings.

Modern weather derivative trading was essentially invented in the mid-1990s by Aquila Energy, now a subsidiary of Great Plains Energy (GXP), and Consolidated Edison (ED). However, it was the heavy investment in weather derivative trading by now-defunct Enron several years later which brought the exotic new market to public attention. Weather trading was one of the increasingly exotic activities Enron invested in during its last years as the fraudulent management of the company attempted to keep the stock price high as it cooked its books behind the scenes. Today a considerable number of corporations are involved in weather derivatives trading, including many hedge funds.