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Market
Origins
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.
Evolution of
the Market
The market has grown rapidly since its inception
in 1997. Expansion has occurred on a number of fronts, including:
Non-energy applications
Beyond the obvious initial applications of
weather derivatives to hedging energy risk, the market has expanded
to address a wide array of weather risks faced by numerous other
industry sectors. A U.S. Department of Commerce estimate indicates
that more than $1 trillion of U.S. economic activity is exposed to
the weather, and transactions over the past several years have
provided weather protection to companies in sectors as diverse as
entertainment, retail, agriculture, and construction. A sampling of
weather risks faced by various industries is presented in the table
below.
Figure 1 - Illustrative Links Between Weather
and Financial Risk
|
Risk Holder |
Weather Type |
Risk |
| |
|
Energy Industry |
Temperature |
Lower sales during warm winters or cool summers |
|
Energy Consumers |
Temperature |
Higher heating/cooling costs during cold winters and hot summers
|
|
Beverage Producers |
Temperature |
Lower sales during cool summers |
|
Building Material Companies |
Temperature/Snowfall |
Lower sales during severe winters (construction sites shut down)
|
|
Construction Companies |
Temperature/Snowfall |
Delays in meeting schedules during periods of poor weather |
| Ski
Resorts |
Snowfall |
Lower revenue during winters with below-average snowfall |
|
Agricultural Industry |
Temperature/Snowfall |
Significant crop losses due to extreme temperatures or rainfall
|
|
Municipal Governments |
Snowfall |
Higher snow removal costs during winters with above-average
snowfall |
|
Road Salt Companies |
Snowfall |
Lower revenues during low snowfall winters |
|
Hydro-electric power generation |
Precipitation |
Lower revenue during periods of drought |
An article in the New York Times (June 27, 1999) reported that
American companies with significant exposure to weather related risk
have more $1 trillion in yearly revenues, suggesting a fertile field
of new risk premium.
New participants
In many ways, the weather market represents a
frontier of convergence between the insurance market and the broader
financial markets. As the market grew, it quickly attracted
involvement not just of other energy traders but also of insurers
and reinsurers, investment banks, and hedge funds. Although the
insurance industry was accustomed to providing coverage for more
catastrophic risks than the seasonal weather variations covered by
the weather market, it found the weather market attractive for two
reasons. First, there was a close similarity between weather
derivatives and traditional “mother nature” insurance products
covering property damage and business interruption, and second there
was a strong overlap between the skills needed to participate in the
weather market and the insurance industry’s core actuarial and risk
management expertise. At the same time, investment banks and
commercial banks saw weather derivatives as a financial risk
management product that they could cross-sell along with other
financial products for hedging interest rate or currency risks.
Finally, some commodity traders and hedge funds saw opportunities to
trade weather on a speculative basis, or to take advantage of
arbitrage opportunities relative to other energy or agricultural
commodities. Today, all three sectors – energy trading, insurance,
and the capital markets – are well represented in both trading and
origination activities.
Broader product offering
To address the needs of non-energy end-users,
and to advance the variety of weather risk management capabilities
available to all market participants, the range of products
available in the market has been greatly expanded via continued
innovation. Weather transactions today can be structured to cover
almost any type of weather variable (temperature, rainfall, snow,
wind speed, humidity, etc.), to have terms from as short as a week
to as long as several years, and to have potential payouts ranging
from a few tens of thousands of dollars for small risks to as much
as $100 million or more for much larger exposures.
Global development
The weather market has quickly expanded beyond
the U.S., both in terms of the types of risks being addressed and
the nationalities of firms involved in the market. Countries in
which weather transactions have been completed include the U.S., the
U.K., Australia, France, Germany, Norway, Sweden, Mexico, and
Japan.
Emergence of exchange traded contracts
Although most trading in the weather market is
still over-the-counter, standardized weather derivative contracts
are now listed on the Chicago Mercantile Exchange (CME), the
Intercontinental Exchange (ICE), and the London International
Financial Futures and Options Exchange (LIFFE). Increasing trading
volumes in these contracts is having positive impacts on market
liquidity and price discovery.
Market
Statistics
In 2002, the Weather Risk Management
Association (WRMA) commissioned PricewaterhouseCoopers (PwC) to
conduct the second annual industry-wide survey of weather market
activity. This survey focused on activity in the weather risk
industry from April 1, 2001 to March 31, 2002, and provided
quantification of transaction volumes and of various breakdowns of
trading activity.
This year’s survey found that more than 3,900
transactions occurred during the year (a growth of 43% over the
previous year) and that these transactions represented more than
$4.3 billion of notional exposure.
The charts below show the progression by year and season in the
number of weather transactions and the total notional limit of these
transactions. Note the convention used here is that Winter 2001
refers to the period from November 2001 to April 2002.
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.
Example
One common form of weather derivative is a put
option providing protection against a warm winter. Such a
transaction might look like this:
Reference weather station: Chicago O’Hare
International Airport (WBAN #94846)
Underlying index:
Heating Degree Days
Term: Nov. 1 –
Mar. 31
Structure: Put option
Strike = 4850 HDDs
Tick size = $5,000
Limit = $1 million
Premium $150,000
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