Weather conditions affect all sorts of things. It impacts what people do, how human beings dress, where we go and what we consume. The weather also impacts the business. It influences the off-take of beer. Furthermore, it impacts the harvest of tea leaves, coffee beans and potatoes, as well as the sales by the hospitality business or amusement parks. Weather conditions also have an impact on oil and gas consumption, and weather elements affect power supply and demand. Rain, heat waves or frost and sun intensity can influence the production of agricultural commodities. Drought can be seen as an extreme and so are floodings. The latter may limit mining for metals. Next, business performances correlate with temperature, precipitation or cloud cover. Moreover, economists estimate that a third of the global economy is exposed to weather risk.
Weather versus climate
Weather and climate are not identical, although the concepts are highly related to each other. Weather is the state of the atmosphere, to the degree that it is hot or cold, wet or dry, calm or stormy, or clear or cloudy. Weather refers to day-to-day temperature and precipitation activity, whereas climate is the term for the average atmospheric conditions over longer periods of time. With climate change (perceived or actual) weather extremes get more attention. The frequency and severity of dry spells, swamping, artic cold outbrakes and torridity may have intensified. This leads to an increased weather risk.
With the introduction of (more) sustainable solutions, attention has been given to renewables, for instance to produce biomass, biogas and biofuels, but also to generate electricity. As a result, the weather-dependency of our society in general, or our economy specifically, has gone up. This brings along more weather risk, unless natural offsets appear.
The so-called ‘weather market’ concerns the market where parties meet to exchange weather risk. This may concern parties with an opposing exposure, or a different view. Alternatively, insurance companies act in the weather markets as risk takers. Quite some insurance companies offer weather-related insurance policies, but these have a few disadvantages. First of all, insurance is a bilateral agreement between two parties. This implies the product is non-tradable and pricing is done by the seller only (the insurance company). Secondly, the payoff of an insurance policy is usually an absolute amount of money, while the economic impact of a certain adverse weather condition may be on a gliding scale, gradually evolving. Thirdly, with an insurance pay-out is usually only effectuated when a certain (extreme) happened or is reached, like a barrier.
As a consequence, one could wonder: Is there an alternative? Indeed, weather derivatives contracts can be considered a substitute. In general, insurances are used in case of relatively ‘high impact-low probability’ events, whereas weather derivatives can be applied for relatively ‘low impact-high probability’ events.
Weather derivatives contracts are being used by companies and industries that have a weather-based performance risk. This includes restaurants at the beach, ski resorts, leisure parks and travel agencies, as well as agricultural firms, farmers, oil and gas companies and electricity producers. They can apply weather agreements to hedge their exposures. On the other side are investors or speculators, like hedge funds, banks and other financial players. They may use the instruments to create exposures and profit from an expected development. In other words, they are keen to capitalise on the volatility of the weather markets.