Weather Derivatives: Merely Making Money From Climate Change?

Even though they’ve been traded for over a decade now on the Chicago Mercantile Exchange, are weather derivatives nothing more than a way to merely make money off climate change?

By: Ringo Bones

As many of us already know, weather derivatives are nothing more than financial instruments that can be used by organizations / business groups or individuals as part of a risk management strategy to reduce risks associated with adverse or unexpected weather conditions. The difference from other forms of tradable derivatives is that the underlying asset – rain / temperature / snow as in weather phenomena – has no direct value to price the weather derivative. Thus make it to be classified under “exotic derivatives”.

Weather derivatives differ from bona fide insurance policies which generally provide protection for low possibility big catastrophic events like hurricanes and tornadoes, weather derivatives can cover more mundane weather events like a heating oil company hedging against having a warmer-than-expected weather. For all intents and purposes, a weather derivative is a financial instrument that seems like an insurance policy for climate change risk insurance but is more like an option. Most weather derivatives are based on how much the temperature goes above or below 65 degrees Fahrenheit, but weather derivatives can also be based on any measurable meteorological phenomena.

Even though the Chicago Mercantile Exchange has been trading the first exchange-traded weather futures contracts – and their corresponding options – since 1999, I might not be the only one who is skeptical about the long-term economic viability of weather derivatives and related financial instruments. Unlike fire insurance companies that – since their establishment - has been supporting the Underwriters’ Laboratories or similar research and development organizations actually doing something to reduce fire losses and spur fire prevention, business groups involved in weather derivatives trading or climate change risk insurance underwriters seems to have little or no involvement in supporting research and development organizations developing ways to make the industrialized world to move away from intensive carbon burning activities and preventable greenhouse gas dumping into the Earth’s atmosphere. Would weather derivative underwriters still willing to cough up the money if their heating degree days (HDD) and cooling degree days (CDD) payouts will become unsustainable due to the wild temperature swings brought about by climate change?