The suspension of use of two of the six wells designated for Heber water by Nestlé Waters in Foggs due to a prolonged drought is a concrete example of the effects of climate risks on business. This decision had an impact on the production of Hibar water and forced Nestlé Waters to reduce its production, which will have an impact on the financial results of this entity. This highlights the need for companies to manage climate risks. Weather derivatives could be a solution to help companies protect themselves from risks related to climate risks.
Weather derivatives are financial products that provide protection against risks related to weather events, such as storms, droughts, and floods. Unlike weather insurance, weather derivatives are financial products that can be bought or sold in specialized markets. Weather derivatives are designed to transfer the risks associated with weather events from stakeholders who want to protect themselves to stakeholders who are willing to assume it.
These derivatives are based on indices that serve as the basis for the contracts, here are the main ones:
- CME group temperature days (HDD) f cooling degree days CDD: These indicators measure the energy demand for heating or cooling buildings as a function of temperature.
- National Oceanic and Atmospheric Administration (NOAA) Hurricane indicator : This indicator measures the probability of hurricane formation in a specific geographical area.
- Chicago Mercantile Exchange (CME) snowfall indicator This indicator measures the amount of snow that falls in a particular geographical area.
- European Climate Assessment and Dataset (ECA&D) Precipitation index : This indicator measures the precipitation in a specific geographical area.
- natural disaster index (National Democratic Institute): This indicator measures economic losses related to natural disasters such as hurricanes, floods, earthquakes, and others.
However, the use of weather derivatives faces several obstacles to its expansion.
1/ Lack of liquidity
Weather derivatives markets are relatively new and there is not yet enough liquidity for players to trade in large volumes. In fact, the first weather derivative was a futures contract in which it was traded 1997 in Chicago Mercantile Exchange which was based on the average temperatures of seven cities in the United States.
Weather derivatives are often complex and require technical expertise to understand and evaluate. This may deter some investors and companies from using them.
3/ Lack of data
Climate derivatives rely on historical and predictive data, but there may be a lack of reliable and accurate data about climatic events, especially in regions with limited weather infrastructure.
4/ Price volatility
Weather derivatives prices can be very volatile depending on current weather events and short-term forecasts, which can make them difficult for some investors to use.
The weather derivatives market is relatively new and regulations may vary from country to country, which can make trading in these contracts more complicated.
6/ Risk perception
Some investors may not be aware of the risks associated with weather events or may not be convinced that these risks justify the use of weather derivatives.
Weather derivatives can be expensive to trade and maintain, which can be a barrier for investors and companies with lower profit margins.
In conclusion, weather derivatives can be a solution for companies seeking to protect themselves from risks associated with climate risks. They make it possible to transfer risks associated with climate events from stakeholders who want to protect themselves to stakeholders who are willing to take it. However, their use faces many barriers to their expansion, including lack of liquidity, complexity, lack of reliable data, price volatility, regulation, risk perception, and costs. Despite these obstacles, weather derivatives can be a useful tool to help companies manage risks related to climate risks and thus ensure their economic resilience to the effects of climate change.
The Tribune is written by Ghislain Cocuy, Practice Manager – Risk, Compliance and Regulation – Rainbow Partners Group
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