Weather Derivatives
Financial contracts that pay out based on measured temperature, rainfall, or snowfall, letting energy companies and farms hedge weather risk directly instead of through a commodity proxy.
A utility's biggest business risk isn't always the price of gas or power — it's the weather itself, since a mild winter cuts heating demand regardless of what fuel costs. Weather derivatives let a company hedge that risk directly by paying off based on an actual measured weather outcome rather than a price. The most common structure uses heating degree days (HDD) and cooling degree days (CDD), each day's deviation of average temperature from 65°F, summed over a season, as the underlying "price" the contract settles against.
A buyer might purchase a contract that pays out if a winter's cumulative HDD count falls below a threshold — protecting against the mild-winter, low-heating-demand scenario that would otherwise hurt a gas utility's revenue — while an energy trading desk on the other side takes the opposite view as a bet, not a hedge.
Worked example. A utility buys an HDD floor at 4,000 degree-days, paying $20 per degree-day below the floor. If the season sums to only 3,700 HDDs, the contract pays (4000 - 3700) \times 20 = \6,000$, offsetting the shortfall in heating-driven gas sales.
Weather derivatives settle on measured temperature (via heating or cooling degree days) rather than any commodity price, letting a business hedge the weather exposure directly instead of relying on an imperfect price-based proxy.
Further reading
- CME Group, Weather Products Overview