3/21/25, 7:44 PM How Weather Derivatives Hedge Against Nature’s Unpredictability
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A RT I C L E
How Weather Derivatives Hedge
Against Nature’s Unpredictability
February 20, 2025 | 7 minutes reading time | By Tim Boyce
Discover how businesses are using weather derivatives to mitigate risks associated with
adverse weather conditions.
Picture wheat farmers in Kansas, where the amount and timing of rainfall determines the health
and productivity of their vast crops. Now imagine a wind farm on the coasts of Denmark,
counting on Nordic winds to power thousands of homes and maintain company revenues. Both
enterprises face the same daunting challenge. The capricious changes in global weather
patterns leave both at the mercy of mother nature’s unpredictability. Too much rain or one year
of weak winds could mean financial hardship. But what if they could turn the uncertainties of
wind and rain into a predictable part of their financial planning?
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Welcome to the revolutionary world of weather derivatives. These financial instruments allow
businesses to hedge against the risks posed by volatile weather patterns, transforming nature’s
unpredictability into a strategic advantage.
What Are Weather Derivatives?
Weather derivatives are financial instruments that pay out based on specific weather-related
parameters such as temperature, wind, sunshine, or rainfall levels. Unlike traditional indemnity
insurance, which compensates for actual losses incurred, weather derivatives provide payouts
based on the occurrence and magnitude of predefined weather conditions. This makes them a
powerful tool for businesses whose revenues are significantly impacted by weather variability.
The Growth of the Weather
Derivatives Market
The market for weather derivatives has seen substantial growth over the past decade. What
was initially a niche market with limited participants and liquidity has more recently been driven
by the impacts of climate change.
Climate-related risk becoming more pronounced has created a
paradigm shift in the way people view and model their weather risk,
and the demand for these instruments has consequently surged. This
added interest has naturally improved the depth of liquidity as the
cycle of expansion has organically moved through phases of growth.
While most trades are still executed on an over the counter (OTC)
Tim Boyce
basis, the listed market is an area of particular interest as traditional
financial players — such as investment banks, hedge funds, and commodity trade houses —
look to increase the diversification of their portfolios by trading new types of derivatives such as
weather. The fact that weather derivatives are typically not correlated to traditional asset
classes like stocks or bonds further adds to the appeal.
Currently CME group’s temperature contracts are the only cleared offering and trading volumes
have increased substantially. In 2021 and 2022, the monthly average was around 11,500
contracts, which jumped to 42,052 in 2023, before reverting to 20,660 last year, as can be seen
in Figure 1. The 2023 spike was a result of six new contracts being launched in the U.S. along
with several hedging programs coming to market.
Figure 1: Historical Temperature Contracts Traded at CME
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Source: CME Group internal data 2025
This growth is driven by the need for companies like utilities and commodity producers to
manage the risks associated with unexpected anomalous weather events. In response to this
increasing demand, another two major exchanges are expected to start trading weather
derivatives in 2025.
How Weather Derivatives Work
Weather derivatives are typically structured as futures or options with daily weather indices
used to financially settle those contracts. The indices are calculated based on daily data of an
atmospheric or oceanic parameter, such as maximum temperature or precipitation, from the area
covered by the derivative (the so called surface and gridded observations).
As the indices are a fundamental part of the contract, it is important that the index providers
offer robust, independent data to ensure user trust and confidence. Currently there are only two
globally recognized providers — Speedwell Climate and Enwex — that provide high quality
data.
These indices are used to settle every weather peril imaginable such as heating degree days
(HDDs) for winter or cooling degree days (CDDs) for summer. The following is an example of
how a contract works for HDDs:
Heating degree days are the number of degrees that a day’s average temperature is below
65°F (18°C).
For example, if a day’s average temperature was 55°F, that day’s HDD would be 10.
If every day in a 30-day month was 55°F that month’s HDD index points would be 30x10
= 300.
CME’s value — the tick value — per point is USD 20.
So that month’s settlement value would be USD 6,000 (300 x USD 20).
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A utility company, for example, might purchase a weather derivative to hedge against the risk of
a mild winter, which would reduce the demand for heating and consequently impact their
revenues.
If the weather is warmer, the average daily temperature will be closer to or above the base
temperature of 65°F (18°C), indicating less need for heating. As a result, the HDD value on such
days will be lower or even zero. Consequently, a warmer month’s final settlement will be lower.
Typically, a utility company wanting to protect itself from a milder winter would do so by
transacting a contract that would result in a payout if the winter was warmer than a pre-agreed
temperature. That is, if the predetermined period’s index settled lower than the agreed value
(the strike price).
For example, Utility Company A sells 500 contracts of New York LaGuardia Airport January
HDD Swap at 350, to protect themselves from a mild winter in New York. This gives them a
short index position at 350 in a notional amount of USD 10,000 (500 contracts x USD 20).
Therefore, if January’s average temperature was 55°F for all 31 days, its settlement for the
month would be 10 x 31 = 310, and the payout received would be (350 – 310) x USD 10,000 =
USD 400,000.
Another example relates to wind energy and its ever-increasing amount of power generation, as
seen in Figure 2. In 2024, wind energy once again had the largest share of German electricity
production with around 33% (net).
Figure 2: Make Up of Power Generation in Germany
Source: Fraunhofer ISE 2025
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While this shift to renewable energy sources helps to reduce climate change-related risks, it
doesn’t come without risks to producers and the millions of customers reliant on consistent
energies supplies. Low wind (wind drought) during periods of high demand can see power
markets exposed to extremely volatile short-term pricing swings. Conversely periods of high
wind and low demand lead to periods where producers can’t sell their power and/or
curtailments where wind turbines are switched off.
These risks are extremely unwelcome, but weather derivatives can provide those exposed with
viable hedging possibilities. For example, if a wind farm wanted to hedge against the risk of low
wind, which can lead to reduced electricity generation and revenue, they might buy a put option
with a strike price of 35,000 MWh. This means that the wind farm is protected, if their electricity
generation falls below 35,000 MWh, by exercising the put option (selling at the pre-determined
strike price).
A tick size of EUR 0.25 represents the smallest price movement for the option. This means that
for every MWh below the strike price, the wind farm receives EUR 0.25. So, if 30,000 MWh
were produced in a given period, the wind farm would receive EUR1,250 (5,000 x EUR 0.25).
Differences Between Insurance
and Weather Derivatives
While both indemnity insurance and weather derivatives aim to mitigate financial risks, they
operate differently. Traditional insurance compensates for actual losses incurred, often requiring
a lengthy claims process. In contrast, weather derivatives and parametric insurance provide
payouts based on predefined weather conditions, offering quicker and more predictable
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financial settlements. This can be particularly advantageous for businesses needing immediate
liquidity to manage cash flows.
Real-World Applications and Benefits
Weather derivatives are used across various industries. For instance, agricultural businesses use
them to hedge against the risk of poor crop yields due to adverse weather. Energy companies
use them to manage the risks associated with fluctuating demand for heating or cooling, and
fluctuating supply, as shown in the examples above. Events companies use them to protect
against potential losses that may occur as a result of inclement weather.
The flexibility of OTC weather derivatives allows for tailored contracts that directly reflect a
company's specific risk needs.
The growth in liquidity and adoption of weather derivatives has led to more competitive pricing
and cheaper hedging tools. This has spurred interest in trading weather derivatives, particularly
in the energy and commodities sectors. As renewable energy markets have grown, activity in
temperature and wind segments has increased, creating a virtuous cycle of development.
The Future of Weather Derivatives
As the market for weather derivatives continues to expand, there is potential for more
innovative use cases. These contracts can be as bespoke or as vanilla as a client needs them to
be. Furthermore, many users find the effective and predictable financial settlements attractive,
often within 72 hours of a risk period ending, based on robust parametric data triggers.
The suppliers, customers, and users of weather derivatives are constantly evolving, and the
diverse nature of the industries that are accessing them is driving the next wave of growth.
Parting Thoughts
After years of being viewed as an esoteric market, weather derivatives are gaining mainstream
acceptance.
They are a robust risk transference tool that help to protect businesses against unexpected
financial losses and improve management strategies.
There isn’t a company on the planet that doesn’t have weather-related risk, and every company,
no matter the industry, should be taking a proactive approach to support its operational
resilience, foster investor confidence, and ensure stability and predictability of its revenue
streams.
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Tim Boyce has 25 years of experience at TP ICAP, including 14 years in interest rate swaps. He
spent a decade in Singapore managing thermal coal and iron ore businesses. Currently, Tim is
the European Head of TP ICAP's Global Weather Team.
Topics: Physical Risk, Climate Risk Management, Financial Markets
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