What it means
Many businesses make or lose money depending on the weather. An energy company sells less gas in a warm winter, a ski resort earns less when snow is scarce, and a farm suffers when rain is poor.
A weather derivative lets these firms transfer that risk to another party that is willing to take it. The contract is based on an index, which is a number calculated from weather data.
A common one is heating degree days, which measures how many degrees the daily average temperature falls below a base level, often 65 degrees Fahrenheit or 18 degrees Celsius. The higher the number, the colder the period, and the more heating customers use.
A typical contract has a strike (the index level at which payment begins), a tick size (the dollars paid for each unit of index movement) and a cap on the maximum payout. The buyer pays a premium at the start, and if the index ends beyond the strike, the seller pays.
Because the payout depends on the index and not on the actual loss, there is no need to prove damage. This feature brings both advantages and a risk.
The payment is quick and clear, which helps cash flow. However, basis risk (the gap between the index payout and the real loss) means the business may still lose money if its local weather differs from the measured weather.
Buyers include energy firms, farmers, construction companies, event organisers and retailers. Sellers include insurers, reinsurers and investment funds, which find weather risk attractive because it has little link to the stock market.
Accounting treatment is complex, so finance teams should check how the contract is recorded.
In practice
Real-world examples.
Example
A gas distributor buys a contract that pays if winter is warmer than average. The winter turns out to be mild and customers use less gas. The payout compensates the company for lost sales.
Example
A ski resort buys a derivative that pays if total snowfall in the season falls below a set level. A dry winter reduces visitor numbers, and the payout covers part of the lost ticket revenue. The resort's lender is comfortable because the cash flow is protected.
Example
A beverage company buys a contract that pays if summer temperatures are cooler than normal. Cold weather reduces sales of soft drinks and ice cream. The contract helps the company stay within its profit forecast.
Formula
Calculation
Payout = (Strike index - Actual index) x Tick size, up to the cap, if the actual index is below the strike
Net benefit = Payout - Premium paid
Suppose a gas utility buys a contract on heating degree days with a strike of 800, a tick size of $1,000 per index point, a cap of $500,000 and a premium of $40,000. A warm winter produces an actual index of 650. The payout is (800 - 650) x 1,000 = 150 x 1,000 = $150,000, which is below the cap. The net benefit is 150,000 - 40,000 = $110,000, which offsets part of the lost sales.Case study
Seen in the real world.
Summit Fields Energy is an illustrative, fictional gas supplier with annual revenue of $80,000,000, most of it earned in winter. A warm winter could cut revenue by $6,000,000 and breach the terms of its bank loan.
The treasurer bought a weather derivative with a $500,000 cap per season for a premium of $40,000. She explained to the board that the aim was to protect the loan covenant (a condition in the loan agreement) rather than to make money.
In this illustrative story the following winter was unusually mild, and the contract paid $350,000. The payment did not cover the full loss but kept the company within its covenant, and the lesson is that weather derivatives protect cash flow against volumes, not against all losses.
Watch out
Common mistakes.
- Treating a weather derivative as identical to insurance, when it pays on an index rather than on proof of actual loss.
- Ignoring basis risk, when the weather measured at the index station may differ from the weather at the business.
- Buying a contract to speculate without understanding the index, the tick size and the cap, and so taking on risk instead of reducing it.
Questions
People also ask.
What is a heating degree day?
It is a measure of how cold a day is, calculated as the number of degrees by which the day's average temperature falls below a base level such as 65 degrees Fahrenheit.
Who sells weather derivatives?
Insurers, reinsurers, banks and investment funds sell them, often because weather risk is not closely linked to the performance of the stock market.
Do weather derivatives cover physical damage?
No, they pay on an index, so damage to buildings from storms is better covered by a conventional insurance policy.
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