Understanding Weather Derivatives and Their Impact

February 29, 2024
An image depicting hops field suffering from frost damageAn image depicting hops field suffering from frost damage
Key Points to Know About Weather Derivatives
They can be used to hedge climate risks. Weather derivatives offer financial protection against a wide array of weather-related perils – e.g. temperature fluctuations, rainfall, etc.
They’re highly customizable. Can be designed to mitigate the risk exposure of businesses like ski resorts and renewable energy companies that rely on specific weather conditions.
They can be traded. Weather derivatives can be traded both over-the-counter (OTC) and on exchanges.
Arbol’s derivatives traders can help businesses of all sizes hedge their weather risks. Arbol structures weather derivatives that cater to both simple and complex risk scenarios for businesses across various industries.

Weather derivatives offer one way for businesses to hedge climate risks. When thoughtfully deployed, they can provide a clear pathway to resilience across different business sectors.

Weather derivatives are designed to hedge against weather-related perils, such as low snowfall or extreme fluctuations in temperature. These financial instruments can prove especially valuable for businesses reliant on specific weather conditions  – like ski resorts, renewable energy developers, agricultural businesses, construction companies, shipping enterprises, etc. 

One of the chief advantages of weather derivatives is that they are highly customizable and allow one to hedge risks tied to a wide range of weather perils. This can be particularly useful for small-to-medium-sized businesses that rely on supply chains. 

For instance, a local brewery that uses hops which are susceptible to early frosts can secure financial protection against a shortfall in hops production by purchasing a weather derivative tied to a low temperature index. In this instance, a contract's value is directly tied to the occurrence of frost, an underlying event capable of affecting a supply chain.Or consider a Louisiana-based agriculture business concerned about potential losses from an upcoming hurricane season. To mitigate financial risk, the company can purchase a weather futures contract — a type of derivative where parties agree to a financial exchange based on future weather events. This contract allows the business to receive a payout if hurricane conditions, like wind speed, reach predefined levels, enabling them to secure their revenue against the unpredictable impact of severe weather.

Such flexibility, a key feature of weather derivatives, allows them to be traded “over-the-counter” (OTC) through a direct agreement with another counterparty. They can also be traded on an exchange. CME Group has listed temperature (HDD, CDD, and CAT) contracts for various cities around the world. Trading on an Exchange provides different benefits tied to margining –i.e. putting up money that will guarantee a trade – and price transparency.

The Arbol Approach to Derivatives 

At Arbol, our derivatives traders help businesses figure out what kind of risks they need to hedge then structure weather derivatives to help them meet their goals. Sometimes, the risks are quite complex. For example, a gas company may be worried that it won’t sell as much gas because of a warm winter. Yet, at the same time, it may be concerned about not being able to meet demand because of an exceptionally cold winter and having to buy gas on the open market at a loss. (Large energy companies have entire teams of people whose job is to figure out the ideal balance for these contingencies so that their companies make a profit either way.)  For medium-sized or smaller  businesses, like a renewable energy firm, the risks might be more straight-forward. A beachside hotel resort might purchase a weather derivative tied to a rain index to hedge against the possibility of an unseasonable downpour that discourages reservations and leads to an uptick in cancellations. A weather derivative can ensure a payout to mitigate business losses tied to unfavorable conditions. 

Our weather derivatives traders relish helping businesses of all sizes, facing different challenges, expand their risk-management options. At Arbol, we’re comfortable structuring weather derivatives for hyperlocal events or for risks covering large geographic areas. 

To learn more, we invite you to contact us here to schedule a meeting with Scott Klemm, Arbol’s Global Head of Derivatives.


Continue reading