What is a climate derivative?
A climate derivative is a financial instrument, similar to a stock, bond or option, whose purpose is to protect companies and individuals from losses caused by weather events.
How does it work?
This type of contract is exchanged outside the stock exchange system, or more commonly called Over the Counter. The seller undertakes to bear the underlying climate risk, in exchange for a premium, paid by the buyer. A simple analogy is to compare them with insurance. The seller (the insurer) undertakes to pay the agreed amount to the buyer (the insured) if the specified event occurs or if the insured suffers losses related to the weather event.
The use of weather derivatives is mostly part of a company’s risk management strategy. Here are some examples of industries in which players could benefit from these products:
- The agriculture sector
Farmers can use this type of product to protect themselves from various weather risks. They can use it to compensate for losses related to a poor harvest season caused by drought, an intense rainy season, drastic temperature changes or destructive winds.
- Tourism and transportation
Hoteliers can use weather derivatives to compensate for losses caused by unfavourable weather conditions for tourists. In this way, hoteliers could generate revenue from these products even if there is a decrease in tourist volume.
- The energy sector
A renewable energy company that owns wind farms in several geographic areas of the world can benefit greatly from the use of these products. The company could purchase contracts that would protect it if the wind needed to break even on a certain farm does not occur.
Why would companies and individuals use these products when insurance exists?
Climate derivatives have similarities with insurance, but it is important to emphasize the main element that differentiates them. Insurance covers risks related to extreme events, that is with low probability, while weather derivatives cover risks related to high probability events. For example, insurance will not cover a hotelier’s losses following a colder than usual summer, but it is possible to use weather derivatives to protect against such an event.
Indices, the basis of weather derivatives
In the context of weather derivatives, examples of relevant indices can be:
- The total amount of rainfall for a specific period and geographical area
- The number of times the temperature has dropped below 0 for a specific period and geographical area
- The total amount of snowfall for a specific period and geographical area
A concrete example: the calculation of the HDD (Heating Degree Day) index
Below, we will proceed step by step to calculate the nominal value of a derivative product (contract) based on the temperature covering a period of 10 days. HDD is very useful for calculating/forecasting the energy demand needed to heat buildings. Let us pose the following equation:
- x: Face value of the contract ($USD)
- 20: Standard multiplication factor for calculating the nominal value of a temperature-based derivative
- K: Base temperature for the calculation of the HDD*.
- zi: Average temperature of day i
- yi: Difference between the base temperature and the average temperature of day i
- n: The number of days for the period studied
*For our example, we will use the standard base temperature used in the United States, which is 65 degrees Fahrenheit.
So, in our case, n = 10 and K = 65.
Assume the following data series:
For this 10-day period, we obtain the face value of the HDD contract:
𝑥 = 20 ∗ 88 = 1760$
It is therefore easy to understand that the value of an HDD contract increases with colder temperatures. There is also the opposite of HDD, the CDD (Cooling Degree Day) which reflects the amount of energy needed to cool buildings.
The relevance of this type of product in the financial markets is becoming increasingly apparent. Admittedly, the use of these tools is still a relatively marginal practice for most companies. However, with the advent of climate change causing droughts, extreme precipitation and rising water levels, it would not be surprising to see the popularity of this financial instrument rising in the coming years.
ESG And Climate Derivatives in Equity Exposure Management, MSCI, Lien web: https://www.msci.com/www/research-paper/esg-and-climate-derivatives-in/02631033346
Heating Degree Days, Climate Atlas. Lien web: https://climateatlas.ca/map/canada/hdd_2060_85#lat=54.52&lng=-81.37
Units And Calculator Explained – Degree Days, U.S. Energy Information Administration. Lien web: https://www.eia.gov/energyexplained/units-and-calculators/degree-days.php