Over the past couple of years, a new financial option, the weather derivative has emerged. It had been used primarily by the utility and agricultural industries, but now the derivative's uses are almost endless. The simplest and original forms of weather derivatives were flood insurance for homeowners and hail insurance to protect against the financial impact of damaged crops. Recently, they have become more sophisticated. Financial options have been written for a location's cumulative heating (cooling) degree days over the winter (summer), cumulative seasonal precipitation, and the next week's forecast. A weather derivative for cooling degree days (CDD) can be structured such that for a given time period, if the cumulative CDD are less than the predetermined amount, the strike, the buyer of the option will collect $5,000 per CDD from the seller of the option.
The use of various climatological analysis techniques and long-range forecasting tools has proved to be valuable tools in determining the need for a weather derivative. The most recent El Niņo - Southern Oscillation (ENSO) event brought a much warmer than normal winter to the Pacific Northwest and northern Plains. Since warmer than normal temperatures would mean lower revenues to a natural gas distribution company, a weather derivative could have been used to offset lost revenue. An example will be provided to demonstrate how a weather derivative with a premium of $1.1 million could have saved a natural gas company in Bismarck, North Dakota $4.8 million dollars in lost revenues over the winter of 1997-98.