Marty Malinow's mother never understood what her son did for a living. To friends, she said he was “a weather-related stock broker.” Malinow can't completely object — he knows most people are ignorant of financial contracts based on sunshine, rain, and wind.

That is beginning to change. Demand for weather derivatives is soaring against the backdrop of increased climate variability and social change. According to data from the Chicago Mercantile Exchange Group (CME Group), the average trading volume of listed products jumped by more than 260% in 2023, and the number of unpaid contracts is currently 48% higher than a year ago. According to industry insiders, this public trading corner may account for only 10% of all trading activity; the nominal value of outstanding derivatives may be as high as $25 billion.

Marino, founder and CEO of consulting firm Parameter Climate, said, “Our business now has a much larger development trajectory. “Direct weather fluctuations, supply chain issues, inflation, and geopolitics have increased vulnerability. That means the weather is likely to eat away at a larger portion of profits now.”

Wall Street's better known weather bet — Catastrophe Bonds — also went up after a year of lucrative returns. But this boom is playing a role in derivatives, which provide a different kind of hedging: protecting people from less severe but more common weather phenomena. If a once-in-a-century storm hits a community, a cat bond may pay out, while weather derivatives can compensate tourism if there are too many rainy days, or farmers when a hot summer causes damage to crops.

In response to surging market demand for its listed derivatives (all temperature-based), the Chicago Mercantile Exchange expanded its product range last year. Traders and companies can now buy options covering Philadelphia, Houston, Boston, Burbank, Paris, and Essen, Germany, in addition to established contracts covering places such as Chicago, New York, London, and Tokyo. At its debut in August, 5,000 “Daily Heat” options (linked to how cold the weather is) were traded in Essen alone.

Scott Klemm (Scott Klemm), chief revenue officer of Arbol Inc., said, “We are in the market version 3.0.” The company designs products for companies looking to hedge against weather risks. “Our current growth trajectory has more room and more room for improvement.”

Hedging risks

Part of the reason for the surge in demand is that businesses are just beginning to face severe weather. In some cases, this is because their business has been affected, and in others because they are dealing with pressure from investors and consumers. In many jurisdictions, regulators are beginning to force companies to quantify the extent to which the weather threatens their business.

Currently, most large European listed companies are required to disclose what they believe are risks and opportunities stemming from environmental factors. In the US, the Securities and Exchange Commission (Securities and Exchange Commission) finalized a regulation in March this year requiring companies to disclose information on climate-related risks that may affect their business and the mitigation measures they have taken.

Nicholas Ernst (Nicholas Ernst), managing director of the climate derivatives business at BGC Group (BGC Group), a market intermediary, said: “All of these companies have weather risks. Once, they didn't hedge, and now they have to deal with this risk.” “We are starting to enter this much larger financial market.”

The SEC's plan remains the subject of intense debate, and the regulator faces lawsuits not only from groups challenging its ability to introduce regulatory powers over such products, but also from those who think these rules aren't strict enough. In any case, the expectations of investors and other stakeholders mean that companies are under increasing pressure to identify and address risk.

Arbor's Clem believes that it has become more difficult for companies to solve this problem in the past. “How many times have we read earnings reports or listened to earnings calls, and company executives said, 'You know, it's been a very humid spring. It affected our bottom line of earnings. Then shrug your shoulders and continue? he said.

Marlino calls himself the “dispensator” in the market; he is Enron Corp. (Enron Corp.) — An early employee in one of the world's first weather derivatives divisions. For over a quarter of a century, he helped the company hedge against nature's risks, creating contracts ranging from cold cows (shaking burns more calories), which could mean less meat, and undersea power cables (which don't conduct electricity well when their connections warm) to turkey mortality (birds die if they get too hot).

Historically, however, weather derivatives have mainly been used to mitigate fluctuations in demand caused by changes in temperature in energy companies. Electricity suppliers face a clear and foreseeable risk: if summers are colder than expected, people will use air conditioning less frequently, and demand for heating may weaken during mild winters. Options based on the temperature index can help offset any impact on their earnings.

For example, Star Group LP, a US-based supplier of home heating and air conditioning products and heating oil distributor, uses hedging tools to help mitigate the impact of warm weather on cash flow. According to the company's financial statements, these contracts mean that if the temperature between November and March exceeds a certain threshold, the company will earn up to $12.5 million in revenue. Following receipt of payments in the most recent fiscal year, the maximum payment, including full benefits in 2023 and contracts payable in 2025, has risen to $15 million. The company declined to comment.

Energy companies have also contributed to the current boom, albeit for new reasons. Solar panels, wind farms, and hydropower are each dominated by sunshine, wind speed, and rainfall, which means that as producers switch to renewable energy, they face new supply-side fluctuations in addition to traditional consumption fluctuations.

“This intermittent nature, combined with the volatility of the gas market, has reinvigorated the weather derivatives sector,” Arbol's Klemm said. Arbol recently raised $60 million in a funding round to help it expand.

Malinow's company Parameter Climate collaborates with companies that are passionate about preventing such threats. This includes energy suppliers with increasingly complex needs, and companies considering weather hedging for the first time.

“There are also potential weather risks in other vertical industries, such as onshore and offshore construction, agriculture, and transportation,” he said. “There are a lot of companies that don't even know how to start dealing with risk, and as they gradually become aware of it all, this will help the market grow in the future.”

A product of scientific and technological progress

Advances in meteorological science and technology are producing new, more sophisticated products. A classic weather deal might look like the one used by Star Group, but multinational seed and pesticide producer Syngenta (Syngenta) has found another way to deploy derivatives to make its products more appealing to farmers.

Under the AgriLime program, Syngenta promises that farmers will receive up to 30% cash refunds on certain crops purchased if the natural environment does not provide suitable growing conditions. For example, when heavy rain threatens barley harvests, growers aren't wiped out. This happened during the last growing season in the UK, and Syngenta said, “It paid 99% of its hybrid barley customers.”

The plan is actually backed by derivatives. The specific structure of such contracts varies (call options, put options, and swap options are common variants), but usually the buyer that bears the weather risk (such as Syngenta) pays a premium to the seller that bears that risk and promises to pay if certain weather indicators are met. An insurance company, and sometimes a hedge fund or other investment company, is usually the other party to the transaction.

Syngenta said the project was a huge success. According to Peter Steiner (Peter Steiner), the company's head of global weather and credit risk management, the services currently provided by AgriLime cover a range of crops from more than 50,000 farms in 17 countries.

“In many countries and regions, the climate has become more unstable and weather risks have become more difficult,” he said. “Syngenta Agriculture has proven that derivatives can not only effectively hedge a company's balance sheet, but with the right technology and processes, they can protect multiple individual end users.”

Questions that continue to this day

The growth of the weather market may once again raise an unanswered question of moral risk: Will mitigating the financial impact of weather on businesses reduce their motivation to address human-induced climate change? As one scholar wrote in 2014, this “could increase the negative impact of the actions of those who benefit from these markets at the expense of most people, particularly those most vulnerable to climate change.”

In contrast, industry insiders insist that this is a positive factor and point out that the market plays a key role in helping fund renewable energy projects and protecting communities from climate challenges. Dave Whitehead (Dave Whitehead), co-CEO of Speedwell Climate, said, “We are able to ease the pain caused by these large-scale global issues.” The company provides detailed weather data for many weather transactions. “We're not solving a problem; we're creating a situation where the government can fund reconstruction projects in the event of a disaster.”

More realistic concerns have so far hampered the growth of weather trading, and the industry was hit hard during the financial crisis. A study showed that the nominal value of the weather derivatives market declined by 50% as risk takers pulled out of more exotic and harder to hedge positions.

Weather derivatives are also very specific — usually custom contracts based on local risk — and are often short-term. This has severely limited secondary market trading activity. There is also “base difference risk”, which refers to the effectiveness of derivatives as hedging tools. In the case of a weather market, the risk of base difference may exist in geographical location (if the measurement point of the determination contract is not close enough to the place where protection is sought), the time the contract takes effect, and the fact that the content of compensation is unrelated to the actual economic impact.

Despite all the challenges, market participants remain optimistic.

Maria Rapin is the CEO of Nephila Climate and is responsible for overseeing an investment strategy to direct capital to businesses and institutions that face greater financial risk due to weather fluctuations. Rapin said that 20 years ago, when she talked about her work for a major insurance company, people's eyes would be sluggish because her job was to construct catastrophe bonds to help transfer weather risks.

“Now people say, 'Wow, you're the center of everything. '” she said.