Listed Weather Derivatives Grow in Popularity But Have Limitations

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KEY TAKEAWAYS

  • Interest in weather derivatives at the Chicago Mercantile Exchange has reached an all-time high amid concerns about climate change and short-term weather uncertainty.
  • Despite the spike in attention, trading remains far lighter than other CME futures and options contracts.
  • Market-specific challenges and competition from privately structured contracts may continue limiting the appeal of listed weather derivatives.

Rising uncertainty about short-term weather volatility and the effects of climate change have driven trading in listed weather derivatives at the Chicago Mercantile Exchange to an all-time high.

Open interest in CME weather derivatives, which measures the number of outstanding contracts in play, was five times higher in the third quarter of this year compared with the year-ago period and more than 20 times higher than the third quarter of 2019.

Nonetheless, interest in using such products to hedge or speculate on risks tied to weather remains low—far lower than for other exchange-listed futures contracts and customized weather derivatives traded in private markets. Certain market vagaries and limitations may keep it that way, representing an ongoing challenge for an exchange that has had trouble getting listed weather derivatives off the ground.

“The reality of professionals needing (weather derivatives) goes beyond the standardization of products offered in markets such as the CME,” said Alain Brisebois, CEO of CWP Energy, a Montreal-based energy trading firm told Investment Executive in 2021.

Heavier Interest—But Still Light

Peter Keavey, the CME’s global head of energy and environmental products, says that “growth is coming from multiple customer segments, including buy-side and commercial customers.” Keavey noted that year-to-date average trading volume has risen almost four-fold from the same period last year, with open interest reaching a record 230,000 contracts Aug. 30.

Even so, the use of CME weather derivatives remains relatively low compared with more traditional futures markets. Open interest in crude oil futures contracts, for example, was 10 times as high at the end of September.

Colin Carter, professor of agricultural and resource economics at University of California-Davis, said several factors work against greater interest in the CME’s weather derivative offerings, which began trading in 1999.

Perhaps the biggest: competition from privately traded, customized products, many designed by reinsurers and other insurance industry participants. Such products account for a bulk of the U.S. weather derivatives market.

“Weather ‘insurance’ products have a long history of trading over-the-counter,” Carter said. “This includes both swaps and outright insurance-type products. Many commercial firms have used this approach to manage weather risk.”

Commodity futures contracts designed to hedge raw material supply risks date back to the mid-1800s and the early days of the Chicago Board of Trade, which merged with the CME in 2007.

Commercial firms (such as grain processors and refineries) and commodity producers (think oil drillers and farmers) have bought and sold futures contracts as means of guarding against price uncertainty tied to commodity production.

But they’re not the only market participants. Specialized trading firms speculate on futures contracts, and in the process, provide added liquidity that help futures markets function smoothly.

Hurdles for Speculators

A 2015 paper appearing in the Journal of Governance and Regulation, entitled “Why Haven’t Weather Derivatives Been More Successful as Futures Contracts? A Case Study,” says that the structure of CME weather derivatives limits the ability of speculators to manage risk within that market.

That’s because CME’s existing products, focusing solely on seasonal temperature changes, don’t easily allow speculators to spread trades and positions across different geographic markets.

The CME recently addressed this criticism by adding six new cities to its weather derivatives lineup, expanding the global list to 18.

Still, the highly localized nature of many weather events means that contracts based on weather events within a broader region may not fit the needs of some traders.

“Even though the potential size of the weather derivatives market is large, it is likely that the specialized institutions, which are most equipped for managing weather risk, are outside the futures markets,” the paper stated. “Instead, it may be that the reinsurance companies and funds, using customized OTC derivatives, may be the best suited for taking on and managing weather risk,”

Carter agrees.

“Swaps or insurance can be tailored to a specific region or specific event, whereas futures are usually based on more general weather events occurring in a broader region that may not be precise enough for hedgers,” he said. “The futures-defined weather outcome may not be well correlated with local weather.”

Struggling to Gain Traction

Though commodity futures contracts have allowed commercial firms to hedge the supply impacts of either favorable or unfavorable weather for decades, it wasn’t until the mid-1990s that derivatives tied directly to weather changes surfaced.

The now-defunct Aquila Energy created the first OTC weather derivative in July 1996 when it structured a hedge for New York’s Consolidated Edison for its electricity needs the following month.

The CME soon followed with the first listed weather derivatives, based on deviations from average temperatures. It later added derivatives tied to rain, snowfall and frost, and it launched listed hurricane contracts in 2007.

However, the exchange delisted 12 hurricane and 12 snow, rain and frost derivatives in October 2014 because of lack of open interest and trading volume. Its remaining temperature-based derivatives attracted only marginal interest until recently.

The traditionally low trading volume in the CME’s weather products, Carter said, constitutes a “bit of chicken-and-egg problem.”

“A lack of interest in trading futures may exist due to low liquidity and large bid/ask spreads,” he said, adding that using swaps or insurance avoids the basis risk associated with futures positions. “This could be a significant reason for the relatively low level of interest in these futures products.”



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