In Investopedia, Felix Carabello, Associate Director, Environmental Products, Chicago Mercantile Exchange, gives an introduction to weather derivatives.

“Even in our advanced, technology-based society, we still live largely at the mercy of the weather. It influences our daily lives and choices, and has an enormous impact on corporate revenues and earnings. Until recently, there were very few financial tools offering companies’ protection against weather-related risks. However, the inception of the weather derivative – by making weather a tradeable commodity – has changed all this. Here we look at how the weather derivative was created, how it differs from insurance and how it works as a financial instrument.

Weather: Risky Business. It is estimated that nearly 20% of the U.S. economy is directly affected by the weather, and that the profitability and revenues of virtually every industry – agriculture, energy, entertainment, construction, travel and others – depend to a great extent on the vagaries of temperature. In a 1998 testimony to Congress, former commerce secretary William Daley stated, “Weather is not just an environmental issue; it is a major economic factor. At least $1 trillion of our economy is weather-sensitive.”

The risks businesses face due to weather are somewhat unique. Weather conditions tend to affect volume and usage more than they directly affect price. An exceptionally warm winter, for example, can leave utility and energy companies with excess supplies of oil or natural gas (because people need less to heat their homes). Or, an exceptionally cold summer can leave hotel and airline seats empty. Although the prices may change somewhat as a consequence of unusually high or low demand, price adjustments don’t necessarily compensate for lost revenues resulting from unseasonable temperatures.
Finally, weather risk is also unique in that it is highly localized, cannot be controlled and despite great advances in meteorological science, still cannot be predicted precisely and consistently.
Temperature as a Commodity Until recently, insurance has been the main tool used by companies’ for protection against unexpected weather conditions. But insurance provides protection only against catastrophic damage. Insurance does nothing to protect against the reduced demand that businesses experience as a result of weather that is warmer or colder than expected.

In the late 1990s, people began to realize that if they quantified and indexed weather in terms of monthly or seasonal average temperatures, and attached a dollar amount to each index value, they could in a sense “package” and trade weather. In fact, this sort of trading would be comparable to trading the varying values of stock indices, currencies, interest rates and agricultural commodities. The concept of weather as a tradeable commodity, therefore, began to take shape.”

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Photo from China Economic Net.