Worsening weather is igniting a $25B market
Marty Malinow’s mom never could get her head around what her son did for a living. To friends, she said he was “a stockbroker that does something with the weather.” Malinow couldn’t really object – he knew most people had no clue about financial contracts based on things like sunshine, rainfall and wind.
That’s beginning to change. Against a backdrop of rising climate volatility and social shifts, demand for weather derivatives is surging. Average trading volumes for listed products jumped more than 260% in 2023, according to the CME Group, with the number of outstanding contracts currently 48% higher than a year ago. And that publicly traded corner could make up as little as 10% of all activity, according to industry estimates; outstanding derivatives may be worth as much as $25 billion based on notional value.
“There’s a lot more trajectory to our business right now,” says Malinow, the founder and chief executive officer of advisory firm Parameter Climate. “The heightened fragility from direct weather volatility, supplychain issues, inflation, geopolitics. It means weather can eat up a bigger part of the bottom line now.”
Wall Street’s betterknown weather bets, catastrophe bonds, are also riding high following a year of bumper returns. But this boom is playing out in derivatives, which provide a different kind of hedge: Protection from less severe but more common meteorological threats. While a cat bond may pay out if a 100-year storm tears through a community, a weather derivative can compensate a tourism business if there are too many rainy days, or a farmer if a hot summer stresses her crops.
In response to the soaring demand for its listed derivatives – all based around temperatures – the CME expanded its offerings last year. Now traders and companies can buy options that cover Philadelphia, Houston, Boston, Burbank, Paris and Essen, Germany, in addition to established contracts covering locations like Chicago, New York, London and Tokyo. In their August debut, 5,000 “Heating Degree Day” options (tied to how cold it gets) traded for Essen alone.
“We’re in market version 3.0,” says Scott Klemm, chief revenue officer at Arbol Inc., which structures products for companies looking to hedge their weather risk. “The growth trajectory where we are now has way more runway, way more upside.”
Part of the jump in demand is driven by corporations newly confronting their exposure to the elements. In some cases, it’s because their operations have already been impacted, in others because they’re responding to investor and consumer pressures. In many jurisdictions, regulators are beginning to compel companies to quantify just how much of a threat the weather is to their business.
Most large and listed European companies are now required to disclose what they see as risks and opportunities from environmental factors. In the U.S., the Securities and Exchange Commission finalized rules in March that would make it mandatory for companies to publish information describing the climate-related risks that may impact their business, as well as any mitigation steps they’ve taken.
“All of these companies have weather risks that they’re not hedging, and now they have to deal with it,” says Nicholas Ernst, managing director of climate derivatives at BGC Group, a market intermediary. “We’re starting to move into this much larger financial market.”
The SEC plans remain the subject of intense debate, with the watchdog facing lawsuits not only from groups challenging its authority to introduce such regulation, but also from those who say the rules don’t go far enough. Regardless, the expectations of investors and other stakeholders mean there is increasing pressure on businesses to identify and address their risks.
It has simply gotten much harder for corporations to dismiss the issue in a way they have historically, reckons Arbol’s Klemm. “How many times did we read an earnings report or listen to an earnings call and the officers of the firm said, ‘You know, it was, it was a really wet, wet spring. It impacted our bottom line.’ Shoulder shrug, move on?” he says.
Malinow was an early recruit to one of the world’s first weatherderivatives desk at Enron Corp. In more than a quarter century helping companies hedge their exposure to Mother Nature, he’s created contracts for everything from cold cattle (shivering burns more calories, which can mean less meat) and subsea power cables (they can’t conduct electricity well when their connection points get warm) to turkey mortality (birds die if it’s too hot).
But historically weather derivatives have mostly been used to cushion energy companies from fluctuations in demand caused by shifting temperatures. Power suppliers face clear and predictable risks: If a summer is cooler than expected, people won’t use air conditioners as much, and in a mild winter, heating demand might wane. Options based on temperature indexes can help offset any hit to their income.
Energy companies are also contributing to the current boom, albeit for fresh reasons. Solar panels, wind farms and hydropower generation are at the mercy of sunlight, wind speed and rainfall, respectively, meaning as producers shift to renewable sources they face new supply-side fluctuations on top of more traditional swings in consumption.
With assistance from Justina Lee.