An NYPD Highway Patrol officer observes motorists driving through a flooded road after heavy rains as the remnants of Tropical Storm Ophelia bring flooding across the Mid-Atlantic and Northeast on FDR Drive in Manhattan near the Williamsburg Bridge in New York City, U.S., September 29, 2023. REUTERS/Andrew…Purchase LICENSE RIGHTS
- Trading in weather derivatives is booming on the major stock exchange
- Climate change and energy supply concern companies
- Weather derivatives pay off when bad weather occurs
- Hedge funds like Ken Griffin’s Citadel are involved
LONDON, Oct 11 (Reuters) – Energy companies, hedge funds and commodities traders are increasingly using financial products that allow them to bet on the weather to protect themselves from or profit from the increasingly extreme global climate.
On the Chicago Mercantile Exchange, average open interest in weather futures and options in the January-September period was four times higher than a year earlier and 12 times higher than in 2019.
Open interest measures the number of outstanding futures and options contracts that have not been settled. The trading volume has also quadrupled within a year.
Weather derivatives were born in the late 1990s. Driven in part by U.S. energy company Enron, the market expanded, attracting speculators looking for assets separate from broader financial markets, before contracting after the 2007-2008 financial crisis.
This time, market participants are hoping for more sustainable growth as climate change and energy supply concerns force companies such as major utilities to protect themselves through the contracts.
“There is a general belief that extreme (weather) events are becoming both more frequent and more extreme,” said Peter Keavey, global head of energy and environmental products at CME Group. “That was the main reason for it.”
According to the European Union Climate Change Service, climate change and the El Niño weather phenomenon have combined to make the summer of 2023 the hottest summer ever recorded in the Northern Hemisphere. Extreme weather events have been a constant this year, causing devastating floods and wildfires around the world.
Weather derivatives allow buyers to hedge against the risk of weather harming their business. Unlike insurance, which requires companies to prove they have suffered a loss, they pay out based on indices. These could track the temperature in Paris or the precipitation in New York.
In a typical transaction, an energy company buys a temperature-indexed contract to hedge against the risk that the weather will turn warm during the winter heating season and sell less natural gas. If it is hotter than average over the period, the value of the contract will increase and result in a payout at settlement.
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Ski resort operators can protect themselves against the risk of insufficient snowfall, or music festivals can protect themselves against precipitation. Typically it is large reinsurance companies or large hedge funds such as US billionaire Kenneth Griffin’s Citadel on the other side of the trade.
“If you can measure it and put a dollar amount on it, we can essentially have a product for you,” said Nick Ernst, an industry veteran who was hired by broker BGC Group in July to open a weather derivatives division.
Ernst said the Ukraine war and subsequent energy crisis, as well as U.S. and European regulations requiring companies to understand their exposure to climate change, have sparked interest.
Matthew Hunt, head of UK energy at renewable energy company Statkraft, said the Ukraine war had shown how fragile energy supplies can be. He said he was using the “really useful” derivatives to hedge against the risk of not enough wind power coming online.
GROWING PAIN
The market remains small compared to its commodity-linked cousins. Average open interest in CME weather futures and options contracts was about 170,000 contracts in September, compared with about 10 times that of crude oil – although market participants estimate that 90% of the weather derivatives market consists of over-the-counter trades.
“Extreme weather events tend to be good marketing for weather futures,” said Samuel Randalls, a professor at University College London who focuses on weather and climate. But he said they were of limited use in mitigating climate change because they could not mitigate long-term changes that would make many businesses unviable.
Education is a challenge, said David Whitehead, co-chief executive of Speedwell Climate, which produces many of the weather indices that underlie the market. Many people don’t know these products exist, so the growing renewable energy market is a blessing.
“Everyone was concerned about how much oil was coming out of the ground. Now people care about how much wind and how much sun,” Whitehead said.
However, UCL’s Randalls is skeptical about the growth potential.
“Unless companies are convinced that this is a necessary activity – and that can be difficult – the futures market will have a hard time growing beyond a select group of companies and traders.”
Another possible limitation is the fact that investors cannot trade weather indices like they would the oil or bonds underlying other futures markets. This means that the market is not suitable for pure speculation, said Ernst from BGC.
Still, market participants say hedge funds and other institutions are becoming more involved again. Citadel is an increasingly important player.
Such companies “see themselves as risk warehouses like an insurance or reinsurance company,” said Martin Malinow, founder and CEO of Parameter Climate. “It’s a sign of a more functional market where there are players like Citadel who can play different roles.”
Reporting by Harry Robertson; Editing by Emelia Sithole-Matarise
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