Planning for a rainy day—understanding weather derivatives

How can businesses utilise weather derivatives to protect themselves from adverse weather events? Joanna Perkins of South Square Chambers looks at the development of weather derivatives and their role in managing risk.

What exactly are weather derivatives?

Fluctuations in seasonal weather can pose a challenge to a wide spectrum of businesses whose performance is sensitive to the prevailing patterns. The weather risk market is designed to assist users in managing the adverse financial impact of weather through risk transfer instruments based on weather variables (temperature, rain, snow, wind, etc). To enter into a weather derivative, an enterprise pays a premium to a risk taker who assumes the risk of adverse weather. In exchange for the premium, the risk taker will promise to pay the buyer an amount of money corresponding to the anticipated loss occasioned by the adverse weather. Standardised derivatives, such as futures, will reference published risk indices calculated from contemporary weather data (such as temperature or precipitation). The purchase price, or premium, will correlate broadly to the perceived chance of the risk materialising and the relevant probabilities will be calculated from historic data. In this respect, weather derivatives are analogous to other ‘adverse event’ derivatives, such as credit default swaps. They also share features with more traditional forms of protection, such as insurance.

How have weather derivatives developed since they were first used?

The first over-the-counter (OTC) weather derivatives trades took place in 1997, involving Willis, Koch Industries, and Enron. Two years later, the Chicago Mercantile Exchange (CME) introduced exchange-traded weather futures and options. At the launch of these standardised products, two temperature contracts—Heating Degree Days (HDDs) and Cooling Degree Days (CDDs)—were listed for trading. These contracts were monthly futures and options reflecting the accumulated differences between the average daily temperature and a base temperature of 65°F for each day in a calendar month. Given that exposure to weather risks is normally localised, the products referenced individual US cities—ten in all.

In the first four years of trading, the market consolidated around these early contracts but thereafter it rapidly gained traction and, in 2003, the number of US cities for which weather derivatives could be listed was expanded and seasonal strip combinations (which allow users to string together two consecutive calendar months or more) were sold for the first time. In 2005, new products were introduced, including frost and precipitation derivatives. By 2011, weather derivative contracts were listed by CME for nearly 50 locations worldwide.

Unfortunately, the era of market expansion did not last and the recent years represent a period of contraction for exchange-traded derivatives in the US. In the first few months of 2016, CME slashed its listings by half, delisting products for several US cities and for Paris. Listings remain for products referencing weather indices in eight US cities, London and Amsterdam. Of these, 13 CME weather products are currently active. Ten are either futures or options on HDD or CDD at various US locations. The remaining three are for Amsterdam HDD, CDD, and seasonal strip combinations.

Aggregate trading volume in CME products from January to April 2016 amounts to 33,000 contracts, around 393 contracts per day, or roughly 30 contracts per day per active product. Today, ‘open interest’ (ie the number of contracts entered into that have not yet settled) is just short of 30,000 contracts.

Although the market for weather derivatives was born in the US, its centre of gravity may be shifting eastwards. Derivatives are now being transacted on risks from a much wider array of countries, with the most significant non-US markets being found in Europe and Japan. A leading provider in Europe is European Energy Exchange AG (EEX).

Who is using this sort of derivative?

Energy companies are the dominant users of weather derivatives but several other industries are now involved. Agriculture, in particular, has been a growth area. A derivative linked to precipitation levels can, for example, help farmers manage the risks of low rainfall.

The market also encompasses mining, construction, transportation, travel, tourism and entertainment, all of which may be adversely affected by the weather. For example, a major ice cream manufacturer might use a weather derivative to hedge against the commercial risks of a summer that forecasters think will be 5°F cooler than the historical average. The Weather Risk Management Association is an industry association based in Washington DC which has had some success in popularising weather derivatives with smaller businesses outside the traditionally-dominant energy sector.

What are the challenges in designing these derivatives?

For an end-user, the weather risk management process involves weighing multiple variables:

  • the weather type in question
  • historical and expected weather pattern
  • the potential impact of weather fluctuations on commercial outcomes and the degree of correlation between the two
  • the sensitivity of the business to the risk of historical and anticipated weather patterns, and
  • the seasonal (or other) period of risk

The user will have to assess all these factors before it can enter into a suitable OTC derivative or purchase a portfolio of exchange-traded weather derivatives. The process, however, is not always straightforward. In particular, data quality and availability may be patchy. Furthermore, the business will have its own structural and commercial idiosyncrasies and, if it is new to the market, lessons learned by previous businesses coming to the market may not be particularly pertinent.

To what extent have/can such derivatives operate instead/alongside insurance?

For commercial enterprises wishing to manage risks associated with extreme weather events, such as droughts, hurricanes and flooding, insurance offers an established means of doing so. Weather derivatives, in contrast, generally offer a means of dealing with the consequences of less perilous weather conditions. Another way of saying this is that, while weather derivatives cover low-risk, high-probability events, weather insurance typically covers high-risk, low-probability events (and is known accordingly as ‘catastrophe insurance’).

Weather derivatives also differ from insurance in that they are linked to indices which measure weather variables. Weather-related insurance, on the other hand, typically links both the trigger for payment and the size of the pay-out to the loss incurred by the policyholder.

These differences mean that users can combine the two products to hedge different risks. That said, complex OTC derivatives which reference a combination of weather variables and price indices—for example, simultaneously measuring both the probability of elevated demand for energy and the cost of supply—will behave more like traditional insurance products.

With weather becoming more extreme (and more difficult to predict), has this helped or hindered the market for weather derivatives?

Weather derivatives have traditionally been offered to cover the impact of foreseeable ‘adverse days’ such as rainy days, which can affect energy businesses, agriculture, transportation, construction, tourism and leisure businesses—in fact, all businesses typically at risk from the weather. The hedging strategy of the business usually involves making reasonable allowance for the occurrence of a tolerable number of ‘adverse days’ and then purchasing protection—in the form of a derivative—from an unusually high number of occurrences.

Some derivatives, however, are structured to manage risks which are wholly adverse to the business of the user and which cannot be commercially tolerated. An example would be the risk of an unseasonable rain storm which prevents play at a major, one-off sporting event or the risk of high winds preventing an airshow from going ahead.

The popularity of derivatives offering this kind of ‘adverse event’ cover has encouraged some providers in the weather risk market to offer additional products covering extreme weather events—traditionally the purview of catastrophe insurance. Although these products do not reflect the core business of weather derivatives, they may represent a growth area for providers as weather becomes more extreme and difficult to predict.

What does the future hold for weather derivatives?

One area to watch is probably the use of weather derivatives in the renewable energy sector. Hydropower, solar power and wind power all depend to a greater or lesser on weather conditions for their means of production and therefore carry the risk of weather pattern fluctuations. As renewables gain traction in the energy markets, derivatives could offer a useful way for businesses to manage the risks of adverse weather patterns. EEX has said it will launch wind power futures in Europe this year.

Joanna Perkins specialises in advising on legal issues relating to structured finance, derivatives and financial regulation. In 2011 Joanna was appointed as a finance expert to the panel of recognised international markets experts in finance and in 2012 was listed as one of the most influential women in the European financial markets by Financial News FN100 Women.

Interviewed by Barbara Bergin.

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.

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