Can a Bengaluru startup hedge against a flash flood? Maybe soon

Weather derivatives are already trading in some global exchanges such as the one run by Chicago-based CME Group, but each country needs products specific to their climate risks. (Photo by Thirumalai Rajan P/Pexels)

Can you trade the heatwave that shrunk a wheat harvest or the flash flood that took down the IT capital of India? It may soon be possible through weather derivatives.

These derivatives have been in discussion for a while and now they can be launched because the Ministry of Finance has added weather to the list of goods under clause (bc) of Section 2 of Securities Contracts (Regulation) Act (SCRA), 1956.

Also read: Derivatives trade now allowed in weather, cement and 11 commodities

Weather is one of the additional 13 goods, along with alloys of five metals, that have been added to the list. A circular dated March 5 from the Securities and Exchange Board of India (Sebi) stated that now derivatives can be launched for 104 goods. Earlier, there were only 91 .

Arun Raste, MD&CEO of NCDEX, the country’s leading agricultural commodity exchange, said that “for a country where half the population is dependent on agriculture and allied activities, weather futures would be a big boon”.

What is a weather derivative?

It is like any other derivative, getting its value from an underlying good, which, in this case, is weather.

“Weather derivatives are risk management tools against inclement weather conditions that enable companies involved in weather-dependent businesses like farm inputs or equipment or food trade, or  farmers and people involved in allied industries to manage the impact of unfavourable weather conditions on their livelihoods/business,” NCDEX’s Rasteexplained.

“The worry at the moment, for example, is that if temperatures spurt this month, will wheat in Punjab and Haryana be adversely affected? For energy companies in Himachal Pradesh and Kashmir, power requirement in north India for heating will be dependent on short snowfall days ," he said.

"Farmers can use weather derivatives to hedge against poor harvests caused by failing rains during the growing period, excessive rain during harvesting, high winds in case of plantations or temperature variabilities in case of greenhouse crops. Theme parks such as Esselworld  may want to insure against rainy weekends,” he said.

How does it work?

If a farmer anticipates a bad weather condition, like poor rainfall, he/she could buy a hedge against it.

Here’s an example to give a rough idea of how one such product might look like, based on a paper by two researchers at the University of Mysore. If a farmer believes that deficit rainfall could affect paddy crop, he could buy a deficit rainfall day (DRD) index futures that goes up in value with higher deficit. Similarly, if a software company believes that excess rainfall could eat into its revenues, it could buy an excess rainfall day (ERD) index, the units of which increase in value with surplus from the average precipitation.

In the event of an adverse event—deficit in the first case and surplus in the next—the units in the futures contract will increase in value and compensate for the loss.

The losses would be borne by sellers of the respective contracts, and these sellers would be those who stand to gain with the weather event. For example, a soft-drink maker which profits if there is deficit rainfall, or a cement business, if there is rebuilding to be done after the floods.

NCDEX already has two rainfall-based indices—Indian Monsoon Index and Indian Rainfall Index--that tells you surplus or deficit deviations from a 30-year average. While the first tracks surplus or deficit during the monsoon season, which is from June 1 to September 30 every year, the second tracks the same for the whole year. As of now, they cannot be traded and people only use it as an information source.

Also read: Four national highways among 350 roads closed as snow, rain lash Himachal Pradesh

Are there other products globally?

Yes.

Weather derivatives are already trading in some global exchanges such as the one run by Chicago-based CME Group, but each country needs products specific to their climate risks. In his book Derivatives Demystified, derivatives expert Andrew Chisholm has explained how futures based on two weather indices—Heating Degree Day (HDD) for the winter months and Cooling Degree Day (CDD) for summer months--work. If winter is cooler than expected, HDD rises since more heating would be needed; and if summer is hotter than expected, CDD rises, going by a similar logic.