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Nevertheless, even if we will soon be able to accurately forecast climate change, we are nowhere close to actually developing the technology to control the climate itself. We may, however, be able to better prepare for the financial risks. One instrument for doing so that has recently attracted much attention is the weather derivatives.
Weather derivatives were born in 1997 as a means of hedging the business risks in the energy sector associated with climate fluctuations. The first such trade was a swap of the risks of a mild winter against the risks of a cold winter between a natural gas wholesaler and a natural gas retailer in the United States. In Japan, discussions of using such instruments started the following year, and the first Japanese company to sell them was Mitsui Sumitomo Insurance Company Limited.
“Weather derivatives are really part financial product and part insurance product,” says Yuji Ito, Manager of the Alternative Risk Transfer (ART) Section within Mitsui Sumitomo Insurance’s Financial Solutions Dept. “Losses from major events such as abnormal weather patterns and earthquakes can be so large that the insurance industry has not been willing to fully cover the risks. The idea of using derivatives, a financial product, was based on the realization that if part of such risks could be traded in the markets to hedge a wide variety of risks, the markets would be capable of absorbing even such large potential losses.”
When designing a weather-derivative product, time, place, and specific weather conditions must be defined. A weather derivative for a kerosene sales company might specify conditions such as: “from December through the following February,” within the company’s sales area, and if an average temperature for the month is as high as equal to or above five degrees. The kerosene company would then pay an option premium based on these conditions, and if all of the conditions were met, receive a specified payment. Although this resembles the function of insurance, with insurance, benefits are paid out based on assessment of the actual damages incurred. Payouts from weather derivatives, however, are based on an agreed, pre-determined amount, which means the products can be designed more flexibly than insurance policies.
In addition to temperature, other weather conditions sometimes specified in weather derivatives include rainfall, snowfall, and wind. In 2002, Mitsui Sumitomo Insurance issued a weather-derivative contract to a soft drink wholesaler based on the number of hours of sunshine. If the number of sunshine hours recorded in the July–September quarter fell below a certain predetermined threshold, Mitsui Sumitomo Insurance would pay the company a pre-determined amount. Mitsui Sumitomo Insurance has also developed, small-payout weather-derivative products in fixed forms for smaller businesses, and partnered with some 50 regional banks to sell them. Sales are on the rise.
But the risks assumed by weather derivatives also have to be balanced, explains Ito: “If we restricted ourselves to selling weather derivatives for Japan, we would be taking on a great deal of cumulative risk. Let’s take warm-winter risk for example. Tokyo and Osaka follow virtually the same temperature trends in any given season. That’s why we have to look for other regions of the world that would tend to move in a different direction in order to better distribute and balance the risks. Recognizing this, we are partnering with European and American companies to pool the risks taken through weather derivatives, thus setting up more stable revenue streams. The fact is that just about every business feels the impact of the weather at some level. We have no doubt that as recognition of weather derivatives grows, the market for them will expand strongly.”
A look at weather derivatives tells us that the forecast for the future of Alternative Risk Transfer is very positive. By making global climate change its ally, this business looks like it has a sunny future ahead.
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According to an analysis of surface-temperature data collected over the 122 years from 1880 to 2001 at observation points all over the world, the earth’s average atmospheric temperature is trending upward over the long term at the rate of 0.7°C per hundred years while going through overlapping average temperature fluctuations that can last for several years to several dozens of years. The possibility is very high that artificial influences such as the increased atmospheric density of greenhouse gases are manifesting themselves in the upward temperature trend that has been continuing since the latter half of the 19th century. |
| (Data collected September 2002) |
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