India is About to Trade Rain. Yes, Literally

SYNOPSIS

Synopsis India's NCDEX is launching RAINMUMBAI, a derivative contract that lets businesses hedge against monsoon rainfall the same way traders hedge against oil prices, and the fact that we are now putting rain on an exchange tells you everything about how seriously financial markets are taking climate risk today.

For centuries, we prayed for good rain. Now Indian Markets wants to trade it. When markets run out of things to price, even the weather becomes an asset class.

Picture this. You are a farmer in Maharashtra and the monsoon this year was absolutely terrible and your entire crop is destroyed and you have no way to recover that loss. Now imagine if someone had told you before the monsoon that you could actually take a financial position against bad rainfall the same way a trader hedges against falling oil prices. Sounds completely insane right. Well India is actually about to do exactly that.

The NCDEX, which is India's National Commodity and Derivatives Exchange, is preparing to launch something called RAINMUMBAI which is basically a derivative contract linked to Mumbai's actual rainfall during the monsoon season keeping the underlying asset for the derivative as the Rain Water. The idea is that businesses, farmers and traders can hedge against bad weather the same way they already hedge against currencies or commodity prices and over the last 30 years India has lost around $180 billion due to extreme weather alone so the need for something like this is very real. This product will be traded on standard deviation difference (IPA Methodology).

Now the concept of weather derivatives is not new at all and the biggest pillar of this was actually Enron. He thought that if weather affects revenue then weather uncertainty can also be bought, sold,  hedged and so traders started creating contracts linked to temperature and snowfall and wind patterns and the idea slowly spread across global markets.

The way RAINMUMBAI works is actually pretty simple. Mumbai's historical average rainfall is around 2206.7 millimetres and so during the monsoon every single day the actual rainfall is compared against that historical average. If Mumbai gets more rain than usual the number is positive and if it gets less rain the number turns negative and the financial contract settles based on that difference. So a business that loses money when it rains too much one can basically take a position that pays them when rainfall crosses a certain level and that offsets their actual loss on the ground.

And when one thinks about it in the Indian context it actually makes a lot of sense because 46% of India's workforce is in agriculture. A weak monsoon destroys crops and excessive rainfall floods supply chains and heatwaves spike electricity demand and so weather is not just a background variable for Indian businesses, it is literally one of the biggest risks they face every single year.

But here is where it gets complicated. Rainfall is so hyperlocal that even a city wide number like Mumbai's average does not really capture what is happening on the ground. This is because anyone who has lived in Mumbai knows that Bandra can be flooded while Andheri is barely wet and so the payout from the contract may not actually match the real loss a business suffered and this problem is called basis risk and it is a genuinely serious limitation of weather derivatives.

Then there is the speculation problem because the moment any financial market becomes liquid enough people who have absolutely no exposure to the underlying risk start coming in just to make money off price movements. And one could very easily end up with a situation where traders in air-conditioned offices are betting on Mumbai's rainfall without any real connection to the actual damage happening on the ground and that makes a lot of people uncomfortable.

Also again that is also how every insurance market has ever worked and life insurance does not prevent death, it just makes sure your family does not suffer financially because of it and maybe rainfall derivatives are doing exactly the same thing.

Because at the end of the day markets do what they have always done when uncertainty starts costing people real money. They find a way to price it. And the fact that India is now trying to price rainfall is not really about trading rain. It is about the fact that climate change is no longer just an environmental problem. It is a financial one too.

Parth Ajmera