Democratizing weather derivatives through tokenization could be crypto's most important real-world use case

“Since the 1980s the number of registered weather-related loss events tripled, and the inflation-adjusted losses have increased fivefold. These trends are set to continue and could threaten assets worth 20 per cent of global GDP."

That's Canada's Prime Minister Mark Carney talking about climate risks in his 2021 book Value(s): Building a Better World for All.

I recently finished reading this 600-page book and it has been an eye opener on many levels, especially on weather, a space I last tracked at my gig on a currencies and commodities research desk in Mumbai from 2012 to 2014. Part of my job involved tracking natural gas prices, which take cues from weather forecasts and sometimes weather derivatives, more specifically options on heating degree days (HDD) and cooling degree days (CDD).

Back then, it struck me how broken, fragmented and little known these weather options were, leaving the bulk of the world’s population exposed to the financial devastation of weather and climate risks (not to mention the physical risks).

Omkar Godbole is a co-managing editor on CoinDesk’s Markets team.

Now, after spending a decade in crypto, I believe the most important real-world use case of tokenization, blockchain and smart contracts could be tokenizing weather derivatives and not merely creating a digital warehouse of traditional yield-generating assets such as bonds.

Weather derivatives are financial instruments that pay out when specific climate conditions cross predetermined thresholds. For example, a utility company might buy a contract that pays if winter temperatures stay unusually warm, cutting heating demand and revenue. An airline might hedge against the cost of flight cancellations caused by storms. A farmer in India might protect against a failed monsoon.

These instruments exist precisely because weather is one of the largest unhedged financial risks in the global economy. According to estimates by the World Meteorological Organization, weather-related disasters have caused a global economic loss of over $2 trillion in the past decade alone.

The problem is that the market built to manage this risk is itself broken.

Weather derivatives are highly specific, mostly bespoke contracts based on localized risks and are frequently short term, which severely curtails secondary trading activity. The entire market has a notional value of roughly $25 billion, a rounding error compared to interest rate or credit derivatives markets, and an equally striking rounding error relative to the $2 trillion in weather-related losses recorded over the past decade — let alone the scale of potential disasters ahead.

It is also worth noting that weather-related financial risk is not limited to the destruction caused by extreme events. Carney calls these physical risks.

There are equally significant transition risks. As the global economy moves toward a lower-carbon economy, Carney argues, changes in policies and technologies could trigger billions in losses from stranded assets — those that no longer comply with new regulatory frameworks or emerging technologies, and therefore no longer hold the value they once did.