Weather Derivatives

While weather and climate has always had a large impact upon agriculture, and insurance has been an option to guard against losses caused by extreme events, in the past there was little that agribusiness could do about more moderate downturns in income caused by short term environmental impacts, such as variations in the climate.

However businesses can now mitigate the exposure they face from adverse weather conditions by using what are known as weather derivatives.

Weather derivatives are financial products that derive their values from other more basic variables, such as temperature, precipitation, wind, heating degree days and cooling degree days.

They differ from insurance, in that insurance requires a demonstration of loss, whereas weather derivatives require no demonstration of loss, but rather provide protection from the uncertainty in normal weather or climate.

For instance, a weather derivative contract for rainfall at a particular location (say, a town near your farm) would state that for a particular month or season, every decile below decile 4 will pay out a certain agreed amount. To enter into this contract, a producer would pay a particular price, determined on the basis of the historical rainfall record.

Weather derivatives effectively transfer risk from those who are involuntarily exposed to unwanted risk to those who voluntarily trade in risk management.

Stern, H., 2001: The application of weather derivatives to mitigate the financial risk of climate variability and extreme weather events. Aust. Meteor. Mag., Vol 50, September 2001.


Additional Reading

Weather Derivatives

Managing Climate Variability site

This page is produced with the support of Managing Climate Variability - a consortium of primary industry research and development corporations.