Weather derivatives to mitigate weather risk to crops

These new risk-management contracts are finally getting easier to price and evaluate

Agriculture may be the most weather-impacted industry on the planet — by far — but it isn’t the only industry that’s affected by the vagaries of temperature and rain. It’s estimated that a third of the United States’ GDP and 70 per cent of firms in the United Kingdom are also exposed to weather risk.

Recently, Canadian farmers have begun exploring the use of weather derivatives to mitigate weather risk, particularly for higher-value crops like seed. It’s a relatively new tool for farmers, but weather derivatives were first introduced as long ago as the 1990s as a way for the energy sector to hedge against temperature-based usage swings. Soon other industries began using them too, such as retail and tourism, for example ski resorts.

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In the last few years, North American farmers have dabbled in weather derivatives (WD) to hedge against non-catastrophic but yield-impacting weather such as abnormal temperatures or precipitation. “The energy sector has used WD for quite some time, but agriculture is starting to show some interest,” says Sylvain Charlebois, University of Guelph professor and one of the authors of “Weather risk management by Saskatchewan agriculture producers.”

A couple of years ago Charlebois, Saqib Khan and Morina Rennie surveyed Saskatchewan farmers and found about 9.3 per cent of the respondents had used weather derivatives and not surprisingly, most had used crop insurance. Of the sample of 397 respondents, 307 used insurance products, 37 used weather derivatives and 32 had used both within the past three years. “Weather derivatives are not widely used,” concludes Charlebois.

One of the main reasons weather derivatives aren’t used often in agriculture is lack of awareness and understanding, says Charlebois. In their survey, about half of the respondents who did not use weather derivatives weren’t even aware of this tool and another third felt they didn’t have enough skill in derivatives to utilize them.

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Yet compared to most small businesses, North American farmers in general are more involved in using derivatives, mainly through commodity futures contracts for price-risk management. And there’s growing interest in weather protection.

More farmers are looking to mitigate weather risk as they grow higher-value crops and operate on a larger scale. Plus there’s the looming impact of climate change. In the Saskatchewan survey, 78 per cent of the respondents reported their farming business had suffered financial losses within the past three years due to weather-related events.

Basically, a WD treats temperature and precipitation as commodities. A derivative is a contract that derives its value from an underlying point, such as an asset, a set interest rate or an index. Although most derivatives are traded off the exchange, standardized weather derivative contracts are now listed on the Chicago Mercantile Exchange (CME), the Intercontinental Exchange (ICE), and the London International Financial Futures and Options Exchange (LIFFE). As trading volumes in these contracts increase, market liquidity and price discovery are improving.

“The Chicago Mercantile Exchange has WDs listed that you can buy yourself, or get them through your broker,” says Charlebois.

The range of products available today can be structured to cover almost any type of weather variable, including temperature, rainfall, snow, wind speed and humidity, and the terms can be as short as a week to as long as several years. Of the 37 respondents of the Saskatchewan survey who did use weather derivatives, about two-thirds used precipitation-related weather derivatives and half used temperature-related products. In general, temperature-related products are most widely traded.

The settlement value of these weather events is determined from a weather index, expressed as values of a weather variable measured at a stated location. For example, in Western Canada, these derivatives are based on the weather stations in Calgary, Edmonton or Winnipeg.

This means the weather index may be based on a monitoring station quite far away from the fields. So it brings into question the usefulness of derivatives based on information taken from hundreds of miles away.

“Canada has always been behind the U.S. when it comes to data mining. This is something we need to get better at,” says Charlebois. “And because of climate change, we need to get better at collecting data on climate patterns.”

As a result, weather derivatives can have greater exposure to basis risk than insurance. Although yields are highly correlated with weather conditions, it’s simply not possible to exactly link only adverse conditions to lower crop yields. Many variables in addition to rain and temperature are at play in growing a crop, with things like timing or soil structure greatly impacting yields.

Compared to crop insurance

Traditionally, farmers have relied on insurance products to hedge weather-related risks, mostly using government crop insurance programs.

Crop insurance claims are settled on the reduction in quantity and quality produced, with payouts calculated according to a base price set at the time the contract is initiated. Programs vary by province and by commodity, but in general coverage is based on the farm’s production averages with the farmer choosing a coverage level of 50, 60, 70, or 80 per cent of these average yields.

The crop insurance payouts are based on the difference between the actual yield and quality versus the expected production, weighted by the coverage level, but the link between the event and the loss of yield and quality has to be proven.

By contrast, weather derivatives are triggered by a specific weather index rather than whether a specific loss can be attributed to this weather.

There is another big difference too. Unlike crop insurance, WDs cover low-risk, high-probability events. They’re designed to hedge against low-severity but high-probability events, like a cooler- or hotter-than-normal summer, or higher- or lower-than-normal precipitation levels.

Whether it’s too hot or too cold may not be catastrophic but we’ve all seen the impact of such events on yields and the fallout on the income side of the balance sheet.

Although a majority of respondents of the Saskatchewan survey used insurance to hedge against weather-related events, they felt their insurance coverage was not sufficient as a tool to manage weather-related risk. Of the 37 users of WD, 43.2 per cent believed that weather derivatives reduce income volatility and 85 per cent said they were helpful in mitigating weather risk.

So what’s stopping the wider use of WD? Some economists have pointed to pricing issues as causing substantial uncertainty for both the farmers and the institution writing the contract. The Saskatchewan survey confirmed this with 35 per cent of WD users finding it too difficult to price these tools.

Charlebois says only a few years later after they did the survey the amount of information about WD available to farmers has increased substantially. “Brokers, banks, can provide information on WD,” he says

Besides, farmers are always looking for better solutions. It’s our nature. More than double the percentage of respondents of the survey said they’d consider using weather derivatives in the future.

“I do expect WD to become more popular in ag as farmers try to find new ways to mitigate risks,” says Charlebois.

Before you jump…

Before you buy your first weather derivatives, quantify your exposure to weather risk by following these six steps recommended by Alfons Weersink, economist at the University of Guelph.

  1. Identify critical weather variables. What is the limiting factor on your farm?
  2. Identify the potential impact of this weather variable on sales, prices, costs and margins. Crunch the numbers for the worst-case scenario.
  3. Gather a reliable, neutral source of historical data on this weather variable.
  4. Determine the time frame when the variable’s influence is operative. When do you need hedge coverage?
  5. Quantify the relationship between potential changes in this weather variable and your financial parameters. How much damage can a couple of degrees or an inch less rain do to the bottom line?
  6. Estimate the sensitivity of the financial parameter to changes in weather. How much is hedging worth to your farm?

About the author

Senior Business Editor

Maggie Van Camp

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