Weather Derivatives

Anatomy of a Weather Derivative

In what way is a weather derivative useful?

Cost of a Weather Derivative

Weather agency Skymet plans to launch derivative indices

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US Monthly Weather Cooling Degree Day (CDD) Futures

Weather Derivatives

Weather derivatives are one of the fastest growing segments of the commodities market. These financial instruments are used by companies to hedge against the risk of weather-related losses.

The weather market traces its roots to deregulation of the U.S. energy industry. Variability in weather conditions had always been recognized as one of the most significant factors affecting energy consumption, however the effects of unpredictable seasonal weather patterns had previously been absorbed and managed within a regulated, monopoly environment. With deregulation, the various participants in the process of producing, marketing, and delivering energy to U.S. households and businesses were left to confront weather as a new and significant risk to their bottom line.

Early pioneers in the market – energy traders Aquila, Enron, and Koch Industries – conceived of and executed the first weather derivative transactions in 1997. The first deals were all arranged as privately-negotiated over-the-counter transactions and were structured as protection against warmer or cooler than average weather in specific regions for the winter or summer seasons. The early market participants saw weather derivatives as both a mechanism to hedge inherent weather exposure in their core energy assets and other energy commodity trading operations as well as a new risk management product to offer to regional utilities and other energy concerns alongside the array of structured products they were already providing.

Investors, who sell weather derivatives, agree to take on the risk for a premium. Investors will profit from these transactions if nothing extraordinary weather-wise occurs. If the weather goes bad, the company that bought the derivative collects an agreed-upon amount.

Weather derivatives differ from insurance, which generally provide protection for low-probability, highly catastrophic events like hurricanes and tornadoes. Weather derivatives can cover more mundane weather-events like a heating oil company hedging against having a warmer-than-expected winter.

Worldwide, about 730,000 weather derivative contracts were traded last year, according to the Weather Risk Management Association in Washington, D.C.

The total value of contracts traded on the Chicago Mercantile Exchange was $19.2 billion last year, down from 2006’s record of $45.2 billion, but significantly higher than the $8.4 billion traded in 2005 and the $4.6 billion traded in 2004, according to the WRMA.

A weather derivative it’s a financial instrument that seems like an insurance policy but is more like an option. Most weather derivatives are based on how much the temperature goes above or below 65 degrees. But weather derivatives can be based on anything measurable.

An example

A ski area could pay a $250,000 premium to collect, say, $100,000 for every inch of snow this winter under the “strike” amount of 100 inches. This is like a “put” option. The ski area is out the premium whether or not snowfall is inadequate. Or, it could enter into a “swap” with another party, paying no premium and getting $100,000 for every inch under 100 and paying $100,000 for every inch over. Increased ticket sales in good winters would cover the cost.

There is also a “call” option where the ski area receives a premium of $250,000 and pays $100,000 for every inch over the strike 100 inches, again assuming higher revenue with heavy snowfall.

Why would anyone assume financial risk by taking the other side?

Some are speculators. It seems that forecasting the weather can be a lot like trying to read an opponents face in a poker game. You may think you’ve got it right but you won’t know either way until that time comes. They believe they understand the probabilities of weather and are willing to wager just as a football fan might bet against a football team because he believes the quarterback is injured. But most parties take the other side of a weather derivative because they also are hedging. Cities, for example, might want to hedge against heavy snowfall because of the cost to clear the streets.

What makes a weather derivative different than other derivatives?

All derivatives are used to hedge against bad news. Airlines use derivatives to protect against soaring jet fuel prices. Derivatives are commonly used to avoid fluctuations in interest rates or foreign currencies. What makes weather derivatives unique: They are not derived from anything with an underlying value.

Anatomy of a Weather Derivative

A weather derivative is defined by several elements, explained below:

Reference Weather Station

All weather contracts are based on the actual observations of weather at one or more specific weather stations. Most transactions are based on a single station, although some contracts are based on a weighted combination of readings from multiple stations and others on the difference in observations at two stations.

Index

The underlying index of a weather derivative defines the measure of weather which governs when and how payouts on the contract will occur. The most common indexes in the market are Heating Degree Days (HDDs) and Cooling Degree Days (CDDs) – these measure the cumulative variation of average daily temperature from 65oF or 18oC over a season and are standard indexes in the energy industry that correlate well with energy consumption. A wide range of other indexes are also used to structure transactions that provide the most appropriate hedging mechanisms for end-users in various industries. Average temperature is another common index for non-energy applications, and some transactions are based on so-called event indexes which count the number of times that temperature exceeds or falls below a defined threshold over the contract period. Similar indexes are also used for other variables; for example cumulative rainfall or the number of days on which snowfall exceeds a defined level.

Term

All contracts have a defined start date and end date that constrain the period over which the underlying index is calculated. The most common terms in the market are November 1 through March 31 for winter season contracts and May 1 through September 30 for summer contracts, however there have been an increasing volume of trading in one month and one week contracts as the market has grown. Some contracts also specify variable index calculation procedures within the overall term – such as exclusion of weekends or double weighting on specific days – to address individual end-user business exposures.

Structure

Weather derivatives are based on standard derivative structures such as puts, calls, swaps, collars, straddles, and strangles. Key attributes of these structures are the strike (the value of the underlying index at which the contract starts to pay out), the tick size (the payout amount per unit increment in the index beyond the strike), and the limit (the maximum financial payout of the contract).

Premium

The buyer of a weather option pays a premium to the seller that is typically between 10 and 20% of the notional amount of the contract, however this can vary significantly depending on the risk profile of the contract. There is typically no upfront premium associated with swaps.

Early Pioneers of Energy Derivatives

Enron Corp along with few other companies were the first to conceive and execute weather derivatives transactions in 1997.The first transactions in energy derivatives were organized as privately negotiated over the counter deals aimed as a protection against unusual weather . Those engaged in the process sought to use such opportunity to hedge against unusual weather exposure to their core energy assets and operations.

The collapse of Enron, the biggest name in energy arena created much panic and uncertainty regarding energy trades particularly trades involving Enron itself. About 36 of the Enron’s trading desks of the 48 existing at the time had been short down following Enron’s’ problems.

However the weather derivatives markets took off from the collapse of Enron, Linda Clemons, President of Element Re, the Connecticut based weather trading arm of Reinsurance firm XL Capital said there are now about 30 companies looking at weather derivatives prices in the U.S alone on a daily basis.

According to data from the U.S Department of Commerce more than $1 trillion of the U.S economic aspects are directly exposed to weather. A. New York Times article of June 27, 1999 shows that American companies with significant exposure to weather related risk earn about $1 trillion in annual revenues. Today more actors and participants have joined the energy derivatives sector, which has also attracted actors from other groups including Insurance and Reinsurance industry, Banks, and Hedge fund industry participants.

Energy and weather transactions can be structured to cover other types of variables including temperature, rainfall, snow, wind speed, humidity and others. Payouts for risk range from a few thousand dollars to tens of millions.

Global Implications

The weather derivatives market has grown internationally. Weather transactions have been completed in Countries such as the United States, United Kingdom, Australia France, Germany, Norway, Sweden, Mexico and Japan. Exchange traded contracts in weather derivatives markets are currently listed on the Chicago Mercantile Exchange {CME}, the Inter Continental Exchange {ICE} the London International Financial Future and Options Exchange {LIFFE}, and may soon become available in Japan as well. According to weather Risk Management Association data from survey conducted between April 1 2001 and March 31, 2002, there were more than 3,900 weather derivatives transactions representing a growth rate of 43 percent over the previous year. Such transaction added up to a total of about $4.3 billion in exposure.

All weather derivative contracts generally define the measure of weather which relates to when and how payouts may occur. Weather heating degrees {HDG’s} and Cooling Degree Days {CDG’s} are the most common indexes used in weather derivatives markets. Today growing numbers of hedge fund operators are becoming active in the energy trading markets and analysts believe that the energy derivative markets will continue to grow over the years.

Temperature

Another type of derivative based on weather-related phenomena those that derive their values from temperature conditions in different cities. While it is easy to understand the link between temperature and returns in the agriculture, utilities, and tourism industries, the CME Group estimates that a whopping thirty percent of economic activity is related to weather and temperature. Launched in 1999, temperature represents the first weather-related derivative group offered by the CME Group.

Much like how damage from hurricanes can cause financial setbacks to businesses, the possibility of abnormally high or low temperatures represents risk for businesses whose revenue predictions are tied to expected weather conditions. For example, a farmer can hedge against the risk that the temperature will not be suited for his crops by investing in a position that will pay out if his needed temperature does not happen and his crops fail. That way, even if he does not make profit from his crops, he will make profit from his contracts.

These derivatives are offered on the temperatures in 46 major worldwide cities, of which 24 are in the U.S. They are categorized on a weekly, monthly, or seasonal basis. Using 65oF as a base level, days in the ‘summer season’ occur when the average daily temperature is above 65F, while days in the ‘winter season’ occur when the average daily temperature is below 65F. Used in the summer, the value of the so-called Cooling Degree Day is indexed as the distance between the average temperature of the day and the 65F base level. Inversely, the Heating Degree Day is used in the winter and calculated in the same way as the CDD. Thus, for temperature futures, your contract will pay out if either the cumulative value of the HDD or the CDD (depending on the season) surpasses the strike level, or the number of degree days, depending on your contract. Your payout would then be the sum of all CDD/HDD values multiplied by $20. Options on the HDD and CDD are also tradable.

weather derivatives

In what way is a weather derivative useful?

Weather derivatives serve as a tool for hedging the economic loss arising from variations in weather conditions.

These derivatives focus on day-to-day variations in weather conditions and not on one-off disasters such as hurricanes or cyclones that are taken care of by insurance.

Day-to-day variations happen frequently and have a more subtle effect on the profitability of many businesses. For instance, a rise or fall in temperature may have an effect on the sale of ice creams. Similarly, the amount of rainfall decides the fate of our crops and wind speed may affect the viability of a wind power project.

Weather derivatives bring together those who want to hedge their risk and those who want to assume the risk. It makes trading of weather risk possible in the form of a financial instrument. A party willing to protect himself from the vagaries of nature transfers his risk to someone who is willing to play the role of an adventurous risk-taker by taking a fee. In case nature remains within its expected limits, the risk-taker earns a profit; however, in case of greater fluctuations, the risk-taker has to take a loss.

The remarkable thing is that the profit or loss arising out of a weather derivative is not correlated at all with the trends in the financial market. Stock or bond markets may rise or fall together.

But a rise or fall in the city temperature has nothing to do with the rise or fall in the stock market indices. A weather derivative remains unaffected by the general mood of the financial market. Investments that aren’t correlated have their own charm for some investors.

Cost of a Weather Derivative

Weather traders price transactions on the basis of reliable, historical weather data, taking into account recent trends and volatility. They then derive a statistical price based upon these parameters. The buyer of the protection, on the other hand, usually compares the expense of buying a weather option with the risk of letting the weather affect its revenues, profits and in the end, possibly its share price.

Weather derivatives usually cover one or two successive seasons. Prices will depend on the volatility of, and underlying trends in the weather and the riskiness of the product. A number of energy groups, insurance companies and banks are capable of designing, securitising and trading weather products. Transparency is growing while liquidity in core weather products (especially linked to temperature) is growing.

Most transactions have a maximum payout of between US$1 million and US$20 million; but the market is growing rapidly and larger transactions are appearing. The majority of deals are concluded ahead of the season to be covered. The negotiation process between the risk takers and the buyer of protection can take from two hours to two months.

Weather agency Skymet plans to launch derivative indices. May 6 2012

Private sector weather forecaster Skymet Weather Services plans to launch weather derivative indices on commodity exchanges like the MCX and NCDEX as and when approvals are received, a top company official said.

“Our chief scientific officer Samal Basant is heading the modelling part of the weather derivatives index products. He has worked with the IITM as well as C-DAC earlier,” Skymet chief of instrumentation Yogesh Patil said on the sidelines of an event organised by the company here over the weekend.

Incidentally, in 2011, Omnivore Capital, whose anchor investor is Godrej Agrovet, had picked up 33% interest in the private sector weather forecaster Skymet for a consideration of Rs 4.5 crore.

The rest of Skymet is owned by a former Aaj Tak journalist Jatin Singh, who is also its founder along with his father B K Singh, who was a vendor-contractor to the Pune-based Indian Meteorological Department.

The India Today Group news channel Aaj Tak also happens to be one of the clients of Skymet along with other leading media houses like Reuters Market Light, Times Now, Dainik Jagran, Telegraph, Mint, Hindustan Times, Sakshi TV, Zee News and Zee TV.

Skyment has four statisticians and two weather forecasting modellers who are part of its weather derivatives Indices design team, based in its Noida office, where it has its computing facilities, he said.

“Our eventual goal is to tie up with an institution like Goldman Sachs to launch weather forecasting derivatives. Otherwise it will not take off. The domestic commodity exchanges like MCX and NCDEX have also evinced interest,” Patil said.

He further said the company will be applying for permission to all commodity exchanges, including companies like Indian Energy Exchange and PTC India. Work on these products should be over by next year.

The development comes despite the fact the Forward Contract (Regulation) Act Amendment Bill, which will enable introduction new products like weather derivatives, has been stuck in Parliament for the past 13 years.

This February, Assocham president RN Dhoot had written to Prime Minister Manmohan Singh pointing out that the implementation of the Forward Contracts (Regulation) Amendment (FCRA) Bill 2010 would strengthen commodity market regulator.

“The new FCRA Bill will enable the regulator to coordinate globally under mandate of G-20 and will also enable the market to introduce new and innovative hedging products like options and weather derivatives which can be tailored to the risk appetite of farmers to hedge risks,” Dhoot said in his letter to the Prime Minister.

However, on May 1 this year, Union Food & Consumer Affairs minister K V Thomas had said the proposed amendment Bill was unlikely to be passed in the current Parliament session.

The company also provides data to power companies like Reliance Energy, CESC Kolkata, Torrent Power and North Delhi Power.

“We provide weather forecast for the next 48 hrs to Reliance Energy. This enables them to predict demand for electricity at particular times. For example, when the temperature reaches a certain point, using past data, they can predict what will be the power consumption in the city at that temperature. This also enables them to do energy hedging,” the official said.

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