Is your Revenue Weather Dependent?
A weather derivative is a financial instrument that some (weather dependent companies) buy, to hedge against the risk of weather-related losses. The profitability and revenues of virtually every industry—agriculture, energy, entertainment, construction, travel, and others—depend on the vagaries of temperature, wind, rainfall, and storms. Unexpected weather rarely leads to price adjustments that fully compensate for lost revenue, making weather derivatives a valuable tool for companies to hedge against the possibility of adverse weather conditions affecting their business.
Companies whose business depends on the weather, such as hydroelectric businesses, solar and windfarms, or those who manage sporting events, might use weather derivatives as part of a risk-management strategy. Farmers, meanwhile, may use weather derivatives to hedge against a poor harvest caused by too much or too little rain, sudden temperature swings, or destructive winds.
Weather derivatives can also be related to adverse weather conditions, such as droughts, cyclones/ hurricanes, and monsoons. Insurance weather derivatives, also known as climate derivatives, work in a similar fashion to financial derivatives. The buyer of a climate derivative will receive a monetary payment (as stipulated by the derivative contract) by the seller/ insurance company of the derivative in the event a certain climate-related event occurs, or if the buyer suffers any financial loss due to a climate event.
How Do Weather Derivatives Work?
Weather derivatives work as a contract between a buyer and an insurer. The insurer of a weather derivative receives a premium from a business with the understanding that the insurer will provide a monetary amount in case the business suffers an economic loss due to adverse weather or if any adverse weather occurs. Weather/ climate derivative products are normally taken out, to protect revenue from such things as: long term drought (for Hydroelectric production), or too many cool & cloudy days (in the case of solar); and/ or lack of wind for onshore & offshore windfarms.