MALAWI: Derivatives used to hedge against bad weather

LILONGWE, 18 July 2008 (IRIN) - Malawi, riding high on recent cereal surpluses, is hedging its bets against inclement weather disrupting its good fortune by using a financial derivative to offset agricultural risk.

Unlike insurance, weather derivatives are financial contracts based on an underlying weather index; in the case of Malawi the index will use a model that estimates maize production based on rainfall data.

The thresholds underlying the rainfall index are based on a national maize yield assessment model used by the Malawi Meteorological Office since 1992 for forecasting maize production in the country.

David Rohrbach, a senior economist at World Bank's Malawi office, told IRIN the goal was to reduce vulnerability to weather shocks in the context of strengthening food security.

"First, it is important to note that this is not a formal insurance policy, as might be transacted through an insurance company, with a payout when a problem is judged by the company to have occurred; this is a contract on the international weather derivatives market," he said, because the contract was based on rainfall levels.

Rohrbach said the index captured the impact of the timing, amount and distribution of rainfall during the growing season. This allowed the model to determine the impact of early-, mid- or late-season drought on the maize harvest. Daily rainfall data is collected from about 20 rainfall stations used to supply data for the model.

"In simple terms, if the rainfall level is above a given threshold there is no payout. If rainfall drops below the threshold, a payout occurs. The payout grows as the severity of drought increases up to a maximum level. In effect, there is no need to confirm that the country or any particular farmer actually suffered a loss," Rohrbach said.

In June the World Bank agreed to create a new weather derivatives product, allowing Malawi to use the financial markets to offset risks from drought. The weather derivative market began in the US in 1997 and has rapidly grown into a multibillion-dollar industry used by investors ranging from agricultural industries to sporting events organisers.

Malawi introduced a fertiliser subsidy programme in the aftermath of the 2005 drought, which left nearly five million people in need of food aid, and has since become increasingly food secure.

The government estimated the 2007 maize crop at 73 percent higher than the average for the past five years. Around two million tonnes of maize are required annually to feed the population of about 12 million, but the country has harvested a surplus of about 1.5 million tonnes.

Pilot project

According to the World Bank, Malawi's weather derivatives transaction will test the market with a small contract that is expected to pay out a maximum of about US$3 million if severe weather conditions prevail. The premium for the initiative will be paid by the United Kingdom's Department for International Development (DFID).

A similar transaction was completed in Ethiopia in 2006 under the auspices of the World Food Programme. "In that case no payout was made because Ethiopia experienced favourable rainfall," Rohrbach said.

The World Bank Treasury will act as an intermediary on behalf of Malawi to facilitate the country's access to the international weather derivatives market, thereby reducing transaction costs. Malawi will pay the World Bank Treasury for the costs of the transaction and receive any payout generated.

As the international weather derivatives market becomes accustomed to these transactions, the World Bank expects the Malawian government - and other governments - to begin pursuing such transactions independently.

"In sum, if there is significant drought in the country, the government will get a payout whose level is determined by the size of the premium paid and the severity of the drought. This payout may be used to help purchase grain to resolve supply shortfalls or to distribute grain from national strategic grain stocks," Rohrbach said.

"One caveat: payouts are most likely if drought is severe. If drought is restricted to a small part of the country, or is not severe, there may only be a partial payout or none at all."