| Hedging against the weather |
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| Scientists put a man on the moon over thirty years ago, but we still cannot produce a reliable weather forecast beyond five days. Robert McGlynn explains weather derivatives and details how they allow you to manage risk. |
The insurance and re-insurance, agriculture, construction, tourism and leisure industries all have one thing in common. To a greater or lesser extent their earnings are dependent on weather, or to put it another way their fortunes are vulnerable to climatic variance.
In recent years the commodity markets have undergone a period of vast innovation. We buy and sell power in the market the same way stockbrokers do equities. We trade both the physical and forward markets out to 2005. Based in Dublin, EnergyPlus have a team trading power, natural gas, jet-fuel and weather derivatives. They are expanding into environmental finance, green energy and CO2 emissions.
In the late 1990’s, energy markets across Europe went through a process of de-regulation, and because energy companies have a natural exposure to weather variance an oil distributor loses revenue in a milder than expected winter - it was only a matter of time before someone came up with a weather hedge, hence the birth of weather derivatives.
The weather market was established in 1997 in the United States where contracts are available on temperature, rainfall, wind-speed, snowfall and sunlight hours. There is currently $7.5 billion of exposure in the market, and last year saw the first weather contract traded in Europe. Weather derivatives allow you to manage risk. Till now, weather has held business to ransom. Industries such as agriculture are totally dependent on weather and the presumption that past patterns are an indication of future patterns just does not hold true anymore. We cannot manipulate the weather but we can control the effects of it on revenues. Weather derivatives hedge against low-risk events that have a higher probability of occurrence. This means a company can smooth out the financial effect of climatic variance.
So how do they work? Weather risks cannot be eliminated, but there is recourse to protect against their adverse financial impact. The basic structure is similar to any derivative contract that you find in equity, currency or money markets. The range of risk hedging and transfer options available is substantial and can be designed to meet the most difficult exposures, underwritten at a price that is commensurate with the probability of future loss, and not just a reflection of historical events. An upfront formula is agreed to calculate a cash payout based on the value of a weather variable over a pre-specified period of time. An array of market tools including calls and puts, floors, caps, collars and swaps are used in the construction of individual contracts. There is a difference however, in that the payout is calculated on the average value over the life of the contract, rather than solely on where the underlying is at expiry. For example, insurance companies can reduce their exposure to weather-related claims by hedging with risk products tied to rainfall that can provide funds to offset flooding claims.
Data collated and published by independent meteorological stations is used to calculate the make-up of the payout. This makes the market totally transparent and free from manipulation. The market is a level playing field since nobody can control weather.
My view is that power or energy will become an asset class in itself. In recent years, players in the energy markets were participants in the energy industry, but now we are seeing new entrants; investment banks attracted by high margins and hedge funds investing in power and weather derivatives as a means to achieving portfolio diversification due to their low correlation with other asset classes.
Weather derivatives can be used in numerous ways. A wind-farm will use a wind contract as a means to secure project finance on the basis of guaranteed revenues during adverse weather conditions.
Businesses interpret bad weather in different ways. Rainfall can present problems for the construction industry. If work is stopped on site due to rain, labour and plant hire costs still have to be met. Large civil engineering projects such as Dublin Port Tunnel where the movement of earth constitutes a major part of the construction process can be hampered due to excessive rainfall. However a hydro-electric station depends on rainfall to fill its reservoirs and turn turbines. When you have two counter-parties with opposing views or requirements, you have the basic structure of a market.
Weather derivatives emerged as a direct result of utility deregulation. Under regulation, utilities used a cost-based pricing method to guarantee a return for their investors. The utility did not have to take into account the weather’s effect on earnings as they could ask regulators to adjust the rates according to their losses or profits. In the unregulated market, the company and its shareholders bear the financial impact by being at risk to all the fundamentals, including weather. A characteristic common to all financial markets prevailed. The industry needed to financially engineer a hedge, hence the emergence of weather derivatives.
By removing the unknown weather factor from the equation, a financial controller is able to ensure a smooth consistency in revenue and earnings. This rationale and hedge can be applied to any business that may be vulnerable to weather. Since their introduction to financial services in 1997, the market for weather derivatives has grown exponentially. They should be viewed by the end-user as an insurance policy against bad weather. The future is bright and every cloud has a silver lining. With an estimated 70 per cent of the European economy directly exposed to weather, the future does look bright for the weather market. |
Robert McGlynn is a director of EnergyPlus Ltd.
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| Article appeared in the February 2002 issue.
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