The suspension of operations at two of the six wells used for Hépar water by Nestlé Waters in the Vosges region due to a prolonged drought is a concrete example of how climate-related risks affect businesses. This decision has impacted Hépar water production and forced Nestlé Waters to reduce output, which will affect the entity’s financial results. This underscores the need for companies to manage climate risks. Climate derivatives can be a solution to help companies protect themselves against risks associated with climate hazards.
Climate derivatives are financial products that provide protection against risks associated with weather events, such as storms, droughts, or floods. Unlike weather insurance, climate derivatives are financial products that can be bought or sold on specialized markets. Climate derivatives are designed to transfer risks associated with climate events from stakeholders seeking protection to stakeholders willing to assume them.
These derivatives are based on indices that serve as the underlying assets for the contracts; here are the main indices:
- CME Group Heating Degree Days (HDD) and Cooling Degree Days (CDD): These indices measure the energy demand for heating or cooling buildings based on temperature.
- National Oceanic and Atmospheric Administration (NOAA) Hurricane Index: This index measures the probability of a hurricane forming in a given geographic area.
- Chicago Mercantile Exchange (CME) Snowfall Index: This index measures the amount of snowfall in a given geographic region.
- European Climate Assessment and Dataset (ECA&D) Precipitation Index: This index measures precipitation in a given geographic region.
- Natural Disaster Index (NDI): This index measures the economic losses associated with natural disasters such as hurricanes, floods, earthquakes, etc.
However, the use of climate derivatives faces several obstacles to its expansion.
1. Lack of liquidity
Climate derivatives markets are relatively new, and there is not yet enough liquidity for market participants to trade large volumes. In fact, the first climate derivative was a futures contract traded in 1997 on the Chicago Mercantile Exchange, which was based on the average temperatures of seven cities in the United States.
2. Complexity
Climate derivatives are often complex and require technical expertise to understand and evaluate. This can deter some investors and companies from using them.
3. Lack of data
Climate derivatives are based on historical and predictive data, but there may be a lack of reliable and accurate data on weather events, particularly in regions where meteorological infrastructure is limited.
4. Price volatility
Prices of climate derivatives can be highly volatile depending on current weather conditions and short-term forecasts, which can make them difficult for some investors to use.
5. Regulations
The market for climate derivatives is relatively new, and regulations can vary from country to country, which can make trading these contracts more complex.
6. Perception of risk
Some investors may not be aware of the risks associated with climate-related events or may not be convinced that these risks justify the use of climate derivatives.
7. Costs
Climate derivatives can be expensive to trade and maintain, which can be a barrier for investors and companies with low profit margins.
In conclusion…
Climate derivatives can be a solution for companies seeking to protect themselves against risks associated with climate-related events. They allow stakeholders who wish to protect themselves to transfer risks associated with climate events to stakeholders who are willing to assume them. However, their use faces several barriers to expansion, including lack of liquidity, complexity, lack of reliable data, price volatility, regulation, risk perception, and costs. Despite these obstacles, climate derivatives can be a useful tool to help businesses manage risks associated with climate hazards and thereby ensure their economic resilience in the face of the effects of climate change.
an article written by…
Ghislain KOKOYE,
Co-Director of the Risk, Compliance, and Regulatory Practice at Quanteam
