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Weather Market Overview
 

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

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. 


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

 

Related Information

Weather Data
"Sunny Outlook for Weather Investors"
 

 

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