Why Should We Care About Weather Risk Management?
Weather Risk in Agriculture
For people who live in developed urban areas, the weather is generally limited to being the basis of outfit choices or a conversation starter. But for billions of people who directly or indirectly depend on raising crops and animals, the weather is a key determinant of their livelihoods. An unsuccessful harvest driven by droughts or floods reverberates across regional and country level economies devastating incomes for farmers producing crops, feeding crops to animals, and a range of industries such as food processing or biofuels that depend on agricultural output to function. As our demand for a wide range of grains, fruits, nuts, and meats has grown rapidly, agriculture has become a complex industry with local and global logistics chains, when these systems are exposed to weather risks the impact does not just hit our grocery bills.
Local Versus Global Pricing
If your local area suffers from bad weather, major futures markets are unlikely to react unless the problem is widespread enough. For the last few years, global grain production has been on the upswing in most major producers leading to declining prices and revenues for agriculture. Coupled with increasing concentration of production, this leaves farmers and agribusinesses in many areas exposed to their local weather. For example, Turkey had a sharp decline in wheat production due to a drought in 2014, but the chief futures price for wheat in Chicago continued to decline in price since global production and inventories were ample that year (see chart below). For a local farmer in Turkey, purchasing wheat futures as a risk hedge before growing season would have offered little respite from the lost production from the weather. Production in the major global producers is mainly what drives prices while local weather can often lead to very different scenarios for farmers in different countries or regions.
Risk Management
The discussion here revolves around wheat, which has a liquid futures market. For many other crops, such futures contracts do not exist leaving farmers and agribusinesses even more exposed to weather-driven losses and no way to offset losses via futures contracts. For example, drought caused a sharp production decline for pistachio producers in 2016 with no liquid price futures market to cushion the loss of income (see chart below). For businesses and farmers in commodities without active futures markets, it is even more imperative to manage local weather risks faced by their crops.
Now in 2018, we are faced with drought reduced production across Australia, Germany, Russia, and Ukraine. For many farmers in these countries crop insurance is not readily available and government relief programs are unclear in their scope and timing. Australian wheat production, in particular, has been volatile and witnessed year-on-year wheat production declines for a number of years since 2012 in sharp contrast to grain production rising globally. This has mainly been caused by recurring droughts as Australia has faced rising temperatures over the past few decades. Waiting for relief programs after a weather event creates a perception of farmers as victims and leaves their planning for the next crop hampered — such a loss of personal control is not an acceptable situation to any businessperson. A backlash against government relief programs in Australia is an example of such sentiments and taking risk management into their own hands is a way for farmers to avoid excessive reliance on impersonal relief programs formulated thousands of miles away from their farms.
As climate change shifts weather patterns and increases weather volatility weather risk for agriculture needs to be managed in a customized manner with an eye on risks specific to a farm or business. The reliance on legacy instruments such as liquid futures contracts is unlikely to be good enough for the increasingly complex global agribusiness landscape going forward.
Old Solutions
Weather and crop insurance are in need of new solutions. Centralized entities such as insurance companies and Governments have not been able to reach the majority of farmers globally and the problem is likely to get worse as budgets shrink and previously generous subsidies pull back. The fact that crop insurance needs extensive subsidies to entice insurers in most places is an indication of the high level of cost and inefficiency inherent in the system. Even more compelling evidence of the inadequacy of the current system is indicated by the large gaps in weather risk protection and crop insurance globally. It is estimated that over $1 trillion of agricultural risk is uninsured and the bulk of risk stems from the weather. Just in 2017 alone, there was a gap of nearly $170 billion between accessible weather risk insurance versus weather risk exposure. These numbers indicate that the current system does not channel enough capital to reduce risk exposure for a very prevalent risk in the global economy.
The shortcomings in the existing system and the rise of new technologies such as smart contracts means the weather protection market is poised for a structural leap.
The Arbol Solution
Solutions to the enormous and growing gaps in weather risk protection need to be addressed by a combination of solutions that tackle challenges across the entire agriculture supply chain from genetic engineering of seeds to reducing waste at the grocery store. At Arbol, we believe a peer-to-peer framework for transferring weather risk at the farm and agribusiness level is an essential part of the solution.
Transfer of risk across a range of risk-taking entities is certainly not a new concept. Prior the start of the mortgage bond market, your ability to get a mortgage was largely dependent on your local bank’s willingness to lend. The mortgage market essentially changed home lending from a locally centralized lending operation to a proto-version of decentralized lending whereby a bank could lend you money for your house but then transfer the risk of you defaulting to a diverse set of investors. Although the abuses of this system get more press especially due to the 2008 market crash, the underlying concept of distributing risk led to a great expansion of available credit to buy houses for many people. Risk transfer has become more widespread since then with car loans, student loans, and later the rise of P2P lenders such as Lending Club in the US and others internationally that have led to accessibility to credit for many who were previously shut out by the banking system.
The advent of new technology around the blockchain ecosystem such as smart contracts provides a unique opportunity for us at Arbol to address the major gaps in weather and crop protection. Instead of relying on Governments or insurance companies, we aim to empower farmers and agribusiness companies to manage their own weather risk by sourcing risk from a diverse set of investors. The Arbol platform is designed to easily create and transfer Weather Immunity Tokens (WITs) which furnish automated payment based on conditions set by the bilateral parties and evaluated using public weather data that both parties trust. The platform will enable users to set up customized WITs for particular locations and times of year to ensure it serves the needs of the agricultural end user.
Without such customization, weather risk markets will not succeed as has been seen by the general failure of weather futures contracts, which cover large areas and offer little customization. For investors, the platform offers a novel investment vehicle to earn income uncorrelated to broader stock and bond markets. The power of Arbol is amplified by the ability for investors to sell baskets of weather risks replicating the diversification benefits utilized by insurance companies to smooth out their return streams.
We hope that this solution will provide much-needed relief to farmers and other agribusinesses the world over, as well as interesting investment opportunities for various classes of investors.
Arbol makes automated payments based on weather outcomes using smart contracts and third-party weather data.
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