Weather Derivatives: Cashing In On Climate Change?

Even though almost all corporate entities and government institutions now recognize the “financial risk” posed by climate change, are weather derivatives just a way of cashing in on the said risks?

By: Ringo Bones

Back in November 20, 2012, Philippine President Benigno Aquino has just signed into law a one billion peso (24 million US dollar) “Survival Fund” to counteract the effects of climate change. The law often referred to as the “Philippine Climate Change Insurance” by the local press is meant to fund climate change adaptation projects since the Philippines is battered, on average, about 20 typhoons a year that cause large-scale deaths and damage to the nation’s agricultural sector says Climate Change Commission deputy head Mary Anne Lucille Sering. It would also be used to guarantee a kind of climate risk insurance for farmers in case of crop damage, she added.

While underwriters of the bill say it is pegged or indexed with the ebb and flow of the Makati Stock Exchange – at least from an actuarial perspective as a kind of “weather derivatives”. With corporate entities and government institutions now recognize the financial risk posed by climate change – are weather derivates, or related climate change risk insurance policies, a sound fiscal decision to mitigate the risks of climate change – or is this just a way for corporate entities and insurance companies to “cash in” on the risks posed by climate change?

Contrary to popular belief, weather derivates differ from a true-blue climate change risk insurance policy because a typical climate change risk insurance policy generally provide protection against low probability, big catastrophic events like hurricanes and tornadoes while weather derivatives are more often than not used to cover more mundane weather events like a heating oil company hedging against having a warmer-than-expected weather. By definition, a weather derivative is a financial instrument that seems like an insurance policy but is more like an option. Most existing weather derivatives are based on how much the temperature goes above or below 65 degrees Fahrenheit, but also, weather derivatives can be based on anything measurable, like rainfall and snowfall levels.

Given that weather derivatives and its corresponding options had been traded on the Chicago Mercantile Exchange since 1999, many see it as a way for big companies to “cash in” on the weather related vagaries posed by climate change – especially given that one of the early corporate pioneers in trading weather derivatives was the “iffy” Enron Corporation through its Enron Online unit. Whether it is a truly long-term economically viable way to insure one’s assets against the vagaries of climate change risks is often highly debatable at best.

Unlike your “garden-variety derivatives”, weather derivatives don’t have a standard model in valuing it – like the Black-Scholes formula for pricing European-style equity options and similar derivatives. This is primarily due to the fact that the underlying asset of weather derivatives is non-tradable which violates a number of key assumptions frequently associated with the Black-Scholes Model. Typically, weather derivatives are priced in a number of ways: via business pricing, historical pricing or burn analysis, index modeling, physical models of the weather and a more superior approach through a mixture of statistical and physical models.