Managing Seasonal Weather Risk using Financial Instruments

Weather dependant production makes Australian grain farmers one of the most vulnerable businesses to revenue volatility. Traditionally, farmers have managed this by ensuring the business had enough cash and unleveraged assets on hand to cope with successive poor seasons. However, as profit margins come under pressure from increasing investment in agriculture from external sources, the opportunity cost of having unleveraged assets may impede the ability for family farm businesses to compete with larger, diversified, and corporate businesses.

Previous attempts at managing farm production volatility using multi-peril crop insurance products (MPCI) have become victim of moral hazard, adverse selection, and a lack of government support with additional taxes, and no mandate to collect and report farm production data. Programs which have been successful in other countries have not been able to replicate their success in Australia, with many critics highlighting the large subsidies in foreign countries as the obvious point of difference.

In the last 20 years, other global industries such as renewable energy supply, energy distribution and agricultural supply chain companies have developed financial instruments to manage the revenue volatility caused by seasonal weather. All without government subsidy or assistance. These over the counter weather derivatives are now making their way into agriculture, with developing countries including Ukraine, Uzbekistan, India and Brazil all developing weather derivative programs for agricultural producers, rather than using the traditional crop production insurance model implemented in the United States, Canada and European Union.

This report investigates how farmers and the greater agricultural industry in other countries manage seasonal weather risk, and what potential benefits are available for industries which use such instruments. Investment confidence, lending behaviour, land values and profitability are all investigated in several case studies of businesses utilising financial risk management products.

It also looks at how the reinsurance industry is utilising new technology and data to provide solutions for farmers to manage volatility. It provides recommendations for the Australian agricultural industry to best position itself to benefit from these products.

There is an enormous opportunity for growth in the Australian agriculture industry by utilising these products. However, it will require participation from both the Australian farmers and lenders to ensure the products can sustainably meet the needs of the industry and its investors.