Weather derivatives

Serious Information

Even investors who lack the capacity to realize the sorts of sophisticated meteorological data analyses upon which actuarial pricing models are based can generate profits in the weather market, if given the correct advice.

It is estimated that nearly 30 percent of the U.S. economy is directly affected by the weather. As a result, the earnings of businesses can be adversely impacted by summers that are hotter than normal or winters that are much colder than anticipated.

Weather derivatives are financial instruments to be used by organisations or individuals as part of a risk management strategy to counter the negative economic affect of weather conditions that harm the financial prospect of a company. Hedge funds, insurance companies, and other asset managers are active weather market participants, seeking out risks they are willing to accept in return for potential profits. The difference from other derivatives is the underlying asset rain / temperature / snow has no direct value to price the weather derivatives. Farmers can use weather derivatives to hedge on poor harvests caused by drought or frost, theme parks may want to insure against rainy weekends during peak summer seasons, and power companies may use heating degree days (HDD) contracts to smooth earnings. A shipping company may insure against storms that prevent a ferry crossing the Irish sea.

The derivatives markets are financial markets for derivatives. The market is often divided into two, for exchange traded derivatives and that for over-the-counter derivatives. The legal nature of these products is very different as well as the way they are traded, though many market participants are active in both.

In 1997, weather became another commodity, much like soybeans or heating oil, quantifiable in dollar amounts and tradable on a public exchange. That economic agents have expanded the scope of markets to include natural phenomena may seem incredible, but reflection on the problem posed by weather suggests the inevitability of this expansion.. As the market for these products grew, the Chicago Mercantile Exchange introduced the first exchange traded weather futures contracts in 1999. The CME currently trades weather derivative contracts for 18 U.S. cities, 9 European cities, and 2 cities in Japan. Most of these contracts track cooling degree days or heating degree days, but recent additions track frost days in the Netherlands and monthly/seasonal snowfall in Boston and New York.

Heating degree days are one of the most common types of weather derivative. Typical terms for an HDD contract would be like: for the November to March period, for each day where the temperature falls below 18 degrees Celsius keep a cumulative count. Depending upon whether the option is a put option or a call option, pay out a set amount per heating degree day that the actual count differs from the strike.

A derivative is a generic term for specific types of investments from which payoffs over time are derived from the performance of assets (such as commodities, shares or bonds), interest rates, exchange rates, or indices (such as a stock market index, consumer price index (CPI) or an index of weather conditions). This performance can determine both the amount and the timing of the payoffs. The diverse range of potential underlying assets and payoff alternatives leads to a huge range of derivatives contracts available to be traded in the market. The main types of derivatives are futures, forwards, options and swaps. It is possible for companies to use derivatives to outlay risks in their business. For instance oil companies can buy derivatives to guard against the risk of prices lowering. These would be put under the classification of Energy & Energy Derivatives & Energy Risk Management

The weather derivative industry can be risky

In 2006 The Met Office lost £4.5m in what was stated the the house of commons a "naive and amateurish" attempt to sell weather forecasts to the international money markets. Chief executive Mark Hutchinson told MPs that civil servants the agency lacked hard private sector experience. And they had been unable to properly assess WeatherXchange risks, which collapsed earlier in 2006. But he insisted lessons had been learned from the experience and it had not made the Met Office "risk averse". WeatherXchange was set up in 2001 with commercial partners including Australian mining giant BHP Billiton. The idea was to create an online market in Europe for weather derivatives - complicated financial instruments which allow companies to insure against - and profit from - bad weather.

But a wave of negative publicity following the collapse of US energy giant Enron, which was also in the weather derivative business, hit confidence in the market.Mr Hutchinson told the Commons defence select committee WeatherXchange had never made money and in order to stay afloat had wanted to start selling data previously provided free of charge by the Met Office. But he said the Met Office, which is part of the Ministry of Defence (MoD), could not do this because it had to provide "generic" weather forecasts to "a wide range of users" by law. He denied there had been a deliberate Met Office "conspiracy" to "drive WeatherXchange out of business". He said the Met Office now had non-executive directors on its board to help it "manage future commercial risks". It had also appointed a marketing director with a "commercial private sector background" and was looking for a new chairman with commercial experience. The Met Office lost £1.5m in direct investment in weatherXchange and a further £3m for services provided and legal costs associated with the project since 2001.

But Mr Hutchinson stressed the experience had not made the organisation "risk averse", adding it wanted to seek out more commercial partnerships to help boost its annual profits from £20m a year to £29m by 2010.

Enron tried to trade in numerous Commodities on offer at Enron Online Argentine Natural Gas Japanese weather
On 29 November 1999, Enron Online was born, as "an internet-based global transaction system which allows Enron's customers to view real-time prices from Enron's traders and transact instantly online". Two years after its launch, the platform was averaging 6,000 transactions a day worth an average $2.5bn. 2,100 different financial products were on offer to traders, across four continents in 15 different currencies. The site was offering products as varied as Dutch aluminium, Japanese weather derivatives, US lumber, European plastics and Argentine natural gas.

In 2001 London's Liffe became the first European futures exchange to offer derivatives designed to help businesses protect themselves against unforeseen weather changes.

In 2001 in the US, the weather futures market was worth $9bn (£6.4bn) a year.

According to the UK's Meteorological Office, up to 70% of all businesses, especially farms, clothing retailers and pubs, have some degree of exposure to weather risk.

In 1999 years ago, the London pub chain Corney and Barrow bought specialised futures to hedge against colder than expected summer weather, which had sharply reduced profits the year before.

Quotes

"In no circumstances enter the derivatives trading market without first agreeing it in writing with me ... at some time in the future it could bring the world's financial system to its knees." Julian Hodge a Banker once said

We view them as time bombs both for the parties that deal in them and the economic system ... In our view ... derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." clamied Warren Buffett The world's greatest stock market investor, known as "the Sage of Omaha", in his Chairman's Letter in the Berkshire Hathaway 2002 Annual Report.

Former Federal Reserve Board chairman Alan Greenspan commented in 2003 that he believed that the use of derivatives has softened the impact of the economic downturn at the beginning of the 21st century.

In 2005 WFP was preparing to protect farmers, not just against the risk of starvation, but against the risk of chronic poverty. To do so, it needs to provide aid when the rain fails, not - as it currently does - when the harvest fails. It plans to use weather derivatives, a sophisticated financial instrument, pioneered on Wall Street, and their use represents a shift in the thinking behind emergency aid.

In 1999 BG said its third-quarter results had been held back from further growth by warmer-than-normal weather, which had cut some £11m off operating profits at its main unit, Transco.

http://www.metoffice.co.uk/

Links on websites on subject

http://www.federalreserve.gov/Boarddocs/testimony/2000/20000621.htm Testimony of Chairman Alan Greenspan on Federal Reserve Board's views on the Commodity Futures Modernization Act of 2000

http://www.federalreserve.gov/pubs/feds/2005/200539/200539pap.pdf A paper which claims that

http://www.ise.ie/index.asp The home page of Irish stock exchange

http://www.nasdaq.com/ The homepage of the stock exchange

http://www.cityequities.com/
http://www.moneyweek.com

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