"Worsening weather is igniting a $25 billion market"

" Worsening weather is igniting a $25 billion market \r\n\r\nMarty Malinow's mom never could get her head around what her son did for a living. To friends, she said he was \u201ca stockbroker that does something with the weather.\u201d\u00a0Malinow couldn\u2019t really object \u2014\u00a0he knew most people had\u00a0no clue about financial contracts based on things like sunshine, rainfall and wind.\r\n\r\nThat\u2019s beginning to change. Against a backdrop of rising climate volatility and social shifts, demand for weather derivatives is surging. Average trading volumes for\u00a0listed products jumped more than 260% in 2023, according to the CME Group, with the number of outstanding contracts currently 48% higher than a year ago. And that publicly traded corner could make up as little as 10% of all activity, according to industry estimates; outstanding derivatives may be worth as much as $25 billion based on notional value.\r\n\r\n\u201cThere\u2019s a lot more trajectory to our business right now,\u201d says Malinow, the founder and chief executive officer\u00a0of advisory firm Parameter Climate. \u201cThe heightened fragility from direct weather volatility, supply-chain issues, inflation, geopolitics. It means weather can eat up a bigger part of the bottom line now.\u201d\r\n\r\nWall Street's better-known weather bets, catastrophe bonds, are also riding high following a year of bumper returns. But this boom is playing out in derivatives, which provide a different kind of hedge: Protection from less severe but more common meteorological threats. While a\u00a0cat bond may pay out if a 100-year storm tears through a community,\u00a0a\u00a0weather derivative can compensate a tourism business if there are too many rainy days, or a farmer if a hot summer stresses her crops.\r\n\r\nIn response to the soaring\u00a0demand for its listed derivatives \u2014 all based around temperatures \u2014 the CME expanded its offerings last year. Now traders and companies can buy options that cover Philadelphia, Houston, Boston, Burbank, Paris\u00a0and Essen, Germany, in addition to\u00a0established contracts covering locations like Chicago, New York, London and Tokyo. In their August debut,\u00a05,000 \u201cHeating Degree Day\u201d options (tied to how cold it gets) traded for Essen alone.\r\n\r\n\u201cWe\u2019re in market version 3.0,\u201d says Scott Klemm, chief revenue officer at Arbol Inc., which structures products for companies looking to hedge their weather risk. \u201cThe growth trajectory where we are now has way more runway, way more upside.\u201d\r\n\r\n Facing the Threat \r\n\r\nPart of the jump in demand is driven by corporations newly confronting\u00a0their exposure to the elements. In some cases, it\u2019s because their operations have already been impacted, in others because they\u2019re responding to investor and consumer pressures.\u00a0In many jurisdictions, regulators are beginning to compel companies to quantify just how much of a threat the weather is to their business.\r\n\r\nMost large and listed European companies are now required to disclose what they see as risks and opportunities from environmental factors. In the US, the Securities and Exchange Commission finalized rules\u00a0in March that would\u00a0make it mandatory for companies to publish information describing the climate-related risks that may impact their business, as well as any mitigation steps they\u2019ve taken.\r\n\r\n\u201cAll of these companies have weather risks that they\u2019re not hedging, and now they have to deal with it,\u201d says Nicholas Ernst, managing director of climate derivatives at BGC Group, a market intermediary. \u201cWe\u2019re starting to move into this much larger financial market.\u201d\r\n\r\nThe SEC plans remain the subject of intense debate, with the watchdog facing lawsuits\u00a0not only from groups challenging\u00a0its\u00a0authority\u00a0to introduce such regulation, but also from those who say\u00a0the rules\u00a0don\u2019t go far enough. Regardless, the expectations of investors and other stakeholders mean there is increasing pressure\u00a0on\u00a0businesses to identify and address their risks.\r\n\r\nIt has simply gotten much harder for corporations to dismiss the issue in a way they have historically, reckons Arbol\u2019s Klemm. \u201cHow many times did we read an earnings report or listen to an earnings call and the officers of the firm said, \u2018You know, it was, it was a really wet, wet spring. It impacted our bottom line.\u2019 Shoulder shrug, move on?\u201d he says.\r\n\r\nMalinow, who describes himself as the\u00a0\u00e9minence grise of the market, was an early recruit to one of the world\u2019s first weather-derivatives desk at Enron Corp. In more than a quarter century helping companies hedge their exposure to Mother Nature, he\u2019s created contracts for everything from cold cattle (shivering burns more calories, which can mean less meat) and subsea power cables (they can\u2019t conduct electricity well when their connection points get warm) to turkey mortality (birds die if it\u2019s too hot).\r\n\r\nBut historically weather derivatives have mostly been used to cushion energy companies from fluctuations in demand caused by shifting temperatures. Power suppliers face clear and predictable risks: If a summer is cooler than expected, people won\u2019t use air conditioners as much, and in a mild winter, heating demand might wane. Options based on temperature indexes can help offset any hit to their income.\r\n\r\nFor example,\u00a0Star Group LP, a US-based supplier of home heating and air conditioning products and distributor of heating oil, uses hedges to help mitigate the impact of warm weather on cash flows. According to its financial statements,\u00a0the contracts meant the company could receive up to $12.5 million if temperatures experienced during the\u00a0coverage period of November through March crossed certain thresholds.\u00a0After receiving payouts in recent financial years \u2014 including the full benefit\u00a0in 2023 \u2014 the maximum payment has risen to\u00a0$15 million\u00a0for the contracts payable in 2025.\u00a0The firm declined to comment.\r\n\r\nEnergy companies are also contributing to\u00a0the current boom, albeit\u00a0for fresh reasons. Solar panels, wind farms and hydropower generation are at the mercy of sunlight, wind speed and rainfall, respectively, meaning as producers shift to renewable sources they face new supply-side fluctuations on top of more traditional swings in consumption.\r\n\r\n\u201cThat intermittency, along with the volatility of the natural gas market, has reinvigorated the weather-derivative space,\u201d says Klemm at Arbol, which recently raised $60 million in a\u00a0funding round to help fuel its expansion.\r\n\r\nMalinow\u2019s firm, Parameter Climate, works with companies keen to insure against these kinds of threats. That includes energy suppliers with\u00a0their increasingly complex needs, as well\u00a0as\u00a0businesses that are considering weather hedges for the first time.\r\n\r\n\u201cThere are other verticals out there with embedded weather risks that have yet to be unpicked, like onshore and offshore construction, agriculture\u00a0and transportation,\u201d he says.\u00a0\u201cThere are a lot of companies that don\u2019t even know how to begin to address their risk, and this will contribute to future market growth as they learn.\u201d\r\n\r\n New Tech\u00a0 \r\n\r\nAdvances in meteorological science and technology are\u00a0giving rise to new and more sophisticated products. A classic weather trade might look like the one used by Star Group, but\u00a0Syngenta, a multinational producer of seeds and pesticides,\u00a0has hit on another way to deploy derivatives to enhance its offering\u00a0to farmers.\r\n\r\nUnder its AgriClime program, Syngenta pledges a cash refund for up to 30% of a farmer\u2019s purchase of certain crops if nature fails to provide the right growing conditions. So when heavy rainfalls threaten a barley harvest, for example, growers won\u2019t be wiped out. That happened in the UK\u2019s last planting season, and Syngenta says it made payouts to 99% of its hybrid barley customers.\r\n\r\nThe program is underpinned by derivatives. The exact structure\u00a0of such contracts can vary\u00a0(calls, puts and swaps are common variants),\u00a0but typically they involve a\u00a0buyer with weather risk \u2014 say,\u00a0Syngenta \u2014 paying a premium to a seller who takes on that risk, promising a payout if certain meteorological measures are met. Insurance companies and sometimes hedge funds or other investment firms usually take the other side of the trades.\r\n\r\nSyngenta says its\u00a0program has proved a wild success. The AgriClime offer now covers a range of crops over\u00a0more than 50,000 farms in 17 countries, according to Peter Steiner, the firm\u2019s global head of weather and credit risk management.\r\n\r\n\u201cIn many countries and areas the climate got more volatile, weather risk became more difficult,\u201d he says. \u201cSyngenta AgriClime has proven that derivatives aren\u2019t only effective for hedging company balance sheets, but that with the right technology and processes, they can protect multiple individual end users.\"\r\n\r\n Old Doubts \r\n\r\nThe growth of the weather market\u00a0risks\u00a0resurrecting\u00a0an unanswered question of moral hazard: Does mitigating the financial impact of weather on corporations reduce\u00a0their incentive to tackle their own contributions to man-made climate change? As one academic wrote\u00a0in 2014, that \u201ccould increase the negative impact of the actions of those benefiting from these markets, at the expense of the majority and particularly those most vulnerable to climate change.\u201d\r\n\r\nIndustry practitioners insist it\u2019s a net positive, pointing to the market\u2019s key role\u00a0in helping fund renewable power projects, as well as protecting communities\u00a0from climate challenges. \u201cWe\u2019re able to ease the pain of some of these massive global problems,\u201d says Dave Whitehead, co-CEO for Speedwell Climate, which provides the detailed meteorological data underpinning many weather trades. \u201cWe\u2019re not solving the problems, but we\u2019re creating situations where governments can fund rebuilding projects in the event of a disaster.\u201d\r\n\r\nIt\u2019s the more practical concerns that have held back the growth of\u00a0weather trading thus far. The industry took a big hit during the financial crisis, with one study\u00a0recording\u00a0a 50% drop in the notional value of the weather-derivatives market as\u00a0risk takers withdrew from more exotic, harder-to-hedge positions.\r\n\r\nWeather derivatives are also highly specific \u2014 often a bespoke contract based on localized risks \u2014\u00a0and\u00a0 frequently short term. That severely curtails secondary trading activity. There\u2019s also \u201cbasis risk,\u201d which refers to a derivative\u2019s effectiveness as\u00a0a hedging tool. In the case of the weather market, basis risk can lie in geography (if the point of measurement deciding a contract isn\u2019t close enough to the location seeking protection), in the timing of when the contract is effective, and in the fact that the payout isn\u2019t tied to the actual economic impact that occurs.\r\n\r\nFor all the challenges, market players now seem as optimistic as they\u2019ve ever been.\r\n\r\nMaria Rapin, the CEO of Nephila Climate, oversees an investment strategy that steers capital to businesses and institutions facing\u00a0increased financial exposure to weather volatility. Rapin says that 20 years ago, eyes would glaze over when she talked about her work at a major insurance firm structuring catastrophe bonds and helping transfer weather risk.\r\n\r\n\u201cNow people are like, \u2018wow, you\u2019re at the center of everything,\u2019\u201d she says. \u201cThis is mainstream.\u201d"

"Worsening weather is igniting a $25 billion market"

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