Weather derivatives: A shield against fickle weather

By: | Published: July 25, 2018 2:23 AM

Farmers are covered under crop insurance schemes—most of them government-sponsored—to hedge against weather risks. But while crop insurance is a useful tool to cover against major calamities, it becomes difficult to cover against, say, drop in yield due to minor weather variations.

weather, weather derivativesThe emergence of weather derivatives has also been ably aided by the advancement of technology, which helped the players to appropriately measure risks.

While the government is striving hard to achieve its goal of doubling farmers’ incomes by 2022, the Economic Survey 2017-18 mentions that climate change could reduce annual agricultural incomes in India in the range of 15% to 18%, on average, and up to 20% to 25% for non-irrigated areas. Significantly, about 52% of India’s total land under agriculture is still non-irrigated or is rain-fed.

Given the direct and indirect dependence of almost all industries on agriculture, climate change or weather uncertainties have a significant and direct economic impact across other segments of the economy, affecting the bottom lines of companies across sectors, including FMCG (especially beverages and ice-cream manufacturers), travel and tourism, sports and event management, housing, etc.

Estimates point out that more than 80% of all business activities in the world are dependent on weather in some way or the other. Hence, it is important to protect the economic interests of all the economic stakeholders from weather-related uncertainties, as much as one does against other risks.

Towards this, financial instruments such as weather derivative instruments can be of immense help.

What are weather derivatives?

Derivatives with weather-based parameters (such as variability in rainfall or temperature) are financial instruments that can be used by organisations or individuals to reduce risks associated with adverse or unexpected weather conditions. These instruments can be traded over exchanges or in over-the-counter (OTC) platforms. Farmers can use rainfall derivatives to hedge against poor harvests caused by drought or excess rainfall—theme parks, multiplexes, malls may insure against rainy weekends during peak seasons.

Globally, variations in temperature are one of the biggest weather risks that are hedged against using weather derivatives, although risks from other weather phenomena such as rainfall variability or snowfall days could also be similarly protected against. In India, the protection is generally sought against the impact caused due to the uncertainty and unreliability of rainfall, hence there is a perceptible demand for rainfall derivatives.

Avenues for risk management against weather vagaries Currently, the Indian farming community is covered under crop insurance schemes, most of them government-sponsored, to hedge against weather risks. However, crop insurance suffers from endemic problems related to inadequate proof of loss for claim, moral hazard, adverse selection, delays in pay-outs, and so on. Again, while crop insurance is a useful tool to cover against major calamities, it becomes difficult to cover against, say, drop in yield due to minor weather variations.

According to media reports, the overall area insured has decreased over the last two years—from 57.2 million hectares in 2016-17 to 47.5 million hectares in 2017-18. This amounts to less than 24% of the gross cropped area (against a target of 40%)—and this is much lesser than 89% in the US and 69% in China. In this context, weather derivatives can complement the existing crop insurance programmes and, unlike crop insurance, cover low risk, high possibility events—as they essentially cover against any variation from normal weather.

Weather derivatives exist in global markets since late 1990s Given the severity of impact of weather conditions on economic activities, risk management tools in the form of weather derivatives have attained popularity in developed economies. The emergence of weather derivatives has also been ably aided by the advancement of technology, which helped the players to appropriately measure risks. The market for weather derivatives (traded OTC) traces its roots to deregulation of the US energy industry in 1992. With deregulation, various participants involved in producing, marketing and delivering energy to US households and businesses were left to confront weather as a new and significant risk to their bottom lines, which previously had been absorbed and managed within a regulated, monopoly environment. Although the insurance industry was accustomed to providing coverage for more catastrophic risks, weather derivatives market grew fast as they cost-effectively covered seasonal weather variations. Trading in exchange-traded weather futures started at the Chicago Mercantile Exchange (CME) Group in 1999, with the launch of two standard temperature contracts—Heating Degree Day (HDD) and Cooling Degree Day (CDD)—for 10 American cities.
From the Indian market perspective, rainfall derivatives can be very useful for the reasons cited above, and have the potential to serve the Indian stakeholders (see box). Apart from farmers, companies whose fortunes are tied to performance of monsoon (such as fertiliser and seed companies, farm equipment manufacturers, etc) could also turn to these rainfall derivatives contracts to manage their business risk. Similarly, retailers and FMCG companies and hydropower-generating companies would be eager to manage risk through such derivatives. Moreover, weather derivatives market can also serve the hedging requirements for insurance providers, in turn helping in bringing down the cost of insurance.

Weather derivatives to complement insurance industry The Economic Survey 2016-17 report mentions that “estimates indicate that currently India incurs losses of about $9-10 billion annually due to extreme weather events. Of these, nearly 80% losses remain uninsured”. Therefore, while subsidised government insurance schemes are serving the stakeholders—mainly covering farming-related losses—derivatives can fill the gaps and boost coverage. Further, such risk management instruments, especially when they are available on exchange platforms, can enable cost-effective sharing of risks across diverse participants—both commercial (from farmers to weather-impacted corporates such as a multiplex with entertainment facility) and non-commercial (willing to take risks based on the information on the underlying weather parameter), while also protecting participants from possible counter-party default risk that may happen in an OTC market scenario.

V Shunmugam & Niteen Jain. V Shunmugam is head, Research, Niteen Jain is senior analyst, MCX. Views are personal

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