Climate change is becoming a major concern for businesses around the world. At the same time, futures and options tied to managing risk around rising temperatures and extreme weather are seeing a boost in interest.
Last year, for instance, CME Group saw average trading volumes for its weather derivatives suite surge over 260% compared to 2022, while the number of outstanding contracts was up 48% year-on-year as of May.
"We are seeing more extreme weather such as heat waves or deep freezes," says Anne Krema, Commodity Research and Product Development Director at CME Group, explaining the phenomenon fueling demand for the exchange's winter and summer weather contracts, called heating degree days (HDDs) and cooling degree days (CDDs), respectively. The value of each contract is based on the underlying weather index, measured in HDD or CDD – the total number of degrees that the average temperature deviates from 65 degrees Fahrenheit (or 18 degrees Celsius). This temperature is a historical benchmark tracking when people turn on air conditioning or heating units.
"These tools are designed to hedge temperature-related risks," adds Krema. "As these risks increase, more of our customers are using and becoming educated about weather-based contracts."
Volumetric Risks
Fluctuating temperatures can negatively impact firms, especially power utilities that can lose revenue if a particular season turns out to be warmer or cooler than anticipated.
To hedge these events – called volumetric risks – market participants can use the HDD and CDD contracts, which trade primarily as block transactions via ClearPort, CME Group’s clearing service for the OTC market, and usually feature "risk takers" such as hedge funds or insurance companies as counterparties.
Utilities' risk-management drive is currently playing out in full force across the U.S. and around the world. In Texas, for instance, scorching summer temperatures are unnerving utilities.
In 2023, CME Group expanded its weather derivatives franchise to include new territories as a growing number of market participants sought solutions to hedge risks around the world. To meet this need, contracts tied to weather in Paris, Essen, Burbank, Houston, Philadelphia and Boston were added to the suite, boosting a U.S. and international portfolio that already included cities like New York, Chicago, London, Amsterdam and Tokyo.
This demand was clear in the success of their debut – 5,000 Essen HDD contracts traded in August 2023 alone. CME Group also offers an alternative weather contract called Cumulative Average Temperature (CAT), which tracks average daily temperatures over a calendar month in a particular city.
Growth to Double?
As enterprises work to address changing weather patterns, the so-called climate risk transfer (CRT) derivatives market is currently worth well over $25 billion, says Stephen Doherty, founder and chairman of Speedwell Climate, which runs a series of historical weather and climate-data indices to structure trades.
While temperature-based trades still account for most transactions, the global renewable energy market is quickly becoming a huge driver for the market, where swap trading volumes could double in the near-to-medium term, predicts David Whitehead, co-CEO at Speedwell.
Renewable generation is expanding at a faster pace than at any time in the last three decades according to the Renewables 2023 report by the International Energy Agency (IEA), boosting chances that capacity will triple by 2030 – a goal set by governments at the COP28 climate change conference. The IEA also reported that output grew 50% in 2023, reaching almost 510 gigawatts (GW), with solar photovoltaic (PV) power leading the way.
Popularity of Renewables
The U.N. has set ambitious climate targets, including decreasing global emissions by 45% by 2030 and achieving net-zero emissions by 2050 to limit global warming to 1.5 degrees Celsius.
"In the past, people cared about how much oil and gas was coming out of the ground but now the amount of solar and wind that's being produced is what matters most," says Whitehead. Contracts to manage renewables' “volume risks,” which refer to production falling below a historical benchmark, are in high demand.
"These contracts have been extremely active in Europe," says Whitehead. "We see everyone looking at them, from wind farm owners worried about low wind levels to energy participants worrying about too much of it [supply] depressing prices."
Speedwell is receiving a slew of inquiries form current and potential customers in Europe (notably Germany, Netherlands, U.K., France and Belgium), the U.S. (chiefly in Texas and across California), as well as in Asia-Pacific and Australia, asking how they can address weather and climate-change risks in more innovative ways.
Nick Ernst, managing director at BGC Partners, said firms are using Speedwell's historical indices to assess how much wind they would produce for a particular period, structuring long-term agreements.
"Basically, you look at the past 10 years of data to use as a benchmark for what your production could be," he explains, adding that his team is currently using such input to broker a call option tracking Germany's first-quarter wind production.
Extreme Weather
Extreme weather events, such as rising floods and droughts, are also driving demand for climate-based derivatives, and not just from businesses.
Dubai, for instance, is currently looking for ways to stem losses from disruptive weather, such as the intense rains and flooding in April, an unprecedented event in an otherwise dry jurisdiction, according to Ernst.
Meanwhile, Norwegian renewables firm Statkraft is boosting its use of CRT derivatives to offset meteorological risks, says U.K. Power Desk Director Matthew Hunt.
The current attention on CRT derivatives highlights that more companies are thinking about managing overall risks in energy markets.
"The idea that this is a flash in the pan is wrong," says Hunt. "We are having a massive expansion in renewable generation, which the Russia-Ukraine war has intensified because of the need to shift away from natural gas. This is only set to continue."
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