Weather derivatives: A new dawn in risk management

With the increasing unpredictability of weather patterns due to climate change, the demand for financial instruments to manage weather-related risks is only likely to grow.
Weather derivatives: A new dawn in risk management
Picture credits: PTI

The allure of weather derivatives—financial instruments that allow businesses to hedge against the whims of Mother Nature—is undeniable. They are tradable instruments that usually employ observed weather data to create an index on which a pay-out is based. Weather phenomenons such as precipitation, tempests, cyclones and tsunamis pose significant risks to businesses, with one estimate suggesting more than 80 percent of business activities in the world are weather-dependent. These instruments offer a way to manage uncertainties. With the increasing unpredictability of weather patterns due to climate change, the demand for financial instruments to manage weather-related risks is only likely to grow.

With the Indian economy being largely agrarian, the agricultural sector and industries such as tourism, travel and energy have always been at the mercy of weather. The recent notification of the finance ministry allowing derivatives trading in weather marks a significant milestone in India’s financial landscape. But the success of this initiative hinges on effective regulation of weather derivatives trading.

Derivatives are contracts between parties that hold a monetary value based upon the value of an underlying asset like equities, currency and other financial assets, or commodities. In India, a derivative contract that has a commodity or good notified by the central government as its underlying asset is known as a ‘commodity  derivatives’ contract. These commodities, notified from time to time by the central government under the Securities Contracts (Regulation) Act, 1956, may include goods such as cereals and pulses, oil, spices, fruits and vegetables. These may also include certain notified activities, services, rights, interests and events, including weather derivatives.

The underlying asset in weather derivatives is meteorological parameters such as temperature, rainfall and drought. The value is defined by a predetermined weather index that varies according to the location and source of data. Unlike traditional financial derivatives, the underlying asset in weather derivatives does not possess any inherent value or marketability. Weather derivatives are considered an ‘incomplete market’ for this reason, which may lead to confusion when using the term ‘derivative’ to refer to them. The execution of the transaction is limited to cash settlements between the involved parties, which entails one party remitting the difference between the ‘strike’ value, which represents the agreed level of the weather parameter or index, and the ‘spot’ price, which represents the registered index throughout the duration of the contract.

Over-the-counter trading in weather derivatives commenced in 1997. In a relatively short span, these assets attained the status of being tradable on an exchange and were regarded as an investment class by many hedge funds. The introduction of exchange-traded weather futures contracts by the Chicago Mercantile Exchange in 1999 was a response to the expanding market.

According to the recent notification, the central government announced the broadening of the range of commodities in consultation with the Securities and Exchange Board of India. In another notification issued the same day, the government notified certain items, including weather derivatives, as being permitted. These notifications will have a transformative impact on derivatives and commodity trading in India. These modifications will signify a substantial change in the regulatory structure that governs financial markets in the areas of derivatives and commodity trading. The government aims to improve market liquidity, expand hedging alternatives, and encourage involvement of the agricultural and industrial sectors in commodity markets by expanding the definition of tradable commodities and derivatives.

Weather derivatives will be of utmost significance to an agrarian economy like ours. They can be employed by farmers as a means of mitigating the risks associated with suboptimal harvests resulting from inadequate or excessive rainfall, strong winds or fluctuations in temperature. A study conducted between 1998 and 2006 on the use of weather derivatives in the wine industry in Italy showed the average payoff for the period with hedge is above the average of the payoff with no hedge. Even non-agricultural industries would benefit from this. For instance, a software company that has had to face hassles from yearly flooding may opt to purchase a rainfall day index, the value of which would appreciate in case of excessive rainfall.

The successful implementation of allowing trading in weather derivatives requires a robust regulatory framework, adequate market infrastructure and increased awareness among potential users, especially at grassroot levels. The SEBI, which is yet to come out with regulations for the trading of weather derivatives, has a crucial role to play in ensuring the smooth functioning of this new market. It needs to put in place stringent regulations to prevent market manipulation and ensure transparency. Potential users of weather derivatives need to be educated about the benefits and risks associated with these instruments. This could be achieved through workshops, seminars and training programmes. Nonetheless, the decision to allow trading in weather derivatives is a step in the right direction.

(Views are personal)

(saaisudharsans@gmail.com)

Sriram Venkatavaradan & Saai Sudharsan Sathiyamoorthy | Advocates, Madras High Court

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