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November-December 2010

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Hedging Your Weather Bets: The Science of “Weather Futures” Trading

For hundreds of years, people have come up with ways to overcome weather disasters before they occur. Although the concept of weather insurance is a fairly old—in the United States, Benjamin Franklin first proposed crop insurance against storm, blight, and insects in 1788—its implementation took a bit longer. The first tornado insurance apparently first appeared around 1865 where

(from H.E. Simpson, 1905 Monthly Weather Review, 33:534–539) there were as many as seventeen companies organized under the laws of a single State writing this kind [tornado] of insurance in connection with that of fire and lightning. In this period, however, the business was without a proper basis and as been aptly described as “the betting of stockholders' money on opinions.”

Caption: Benjamin Franklin first proposed crop insurance against storm, blight, and insects in 1788.

Hail insurance took a bit longer. The first hail insurance was written for tobacco crops back in 1880 by the Tobacco Growers' Mutual Insurance Company of North Canaan, Connecticut. Interestingly, that company went out of business in 1887.

But recently, within the last decade or so, an entirely new, but related, type of coverage for weather has begun—weather derivatives. In contrast to weather insurance, weather derivatives, in general, cover a fundamentally different kind of weather event: one that involves low-risk but high-probability weather.

In general, a financial derivative is simply an agreement or formal contract between two or more people (or companies) involving the price of a given asset. So, the value of the derivative is determined by the periodic fluctuations in the price of that asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates, and market indexes. Derivatives are generally used as contractual means to hedge risk—and so, similar to insurance, but they can also be used for speculative purposes. For example, an American investor purchasing shares of a European company from a European exchange (and therefore using Euros to do so) would be exposed to exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase currency derivatives to lock in a specified exchange rate for the future stock sale and the currency conversion back into U.S. dollars.

That concept can be applied to weather situations—and consequently, we can have weather derivatives. For example, a snowboard manufacturing company might purchase weather derivatives to hedge against a winter that seasonal weather forecasters think will be perhaps warmer (so less snow) than the historical average, which is usually defined as a 30-year time period that climatologists call a “climate normal.” In such a case, the snowboard company could purchase the weather derivatives as a hedge against the possibility that its revenues would be seriously affected by the warmer weather.

Such “low-risk event hedging” practices have been around since the mid-1990s. One of the first occurred in 1996 when a company named Aquila entered into a transaction with New York–based power company Consolidated Edison, which combined weather and energy risk, that protected the power company against a cool August, which would reduce its power sales.

Another more publicized deal took place between the infamous Enron energy corporation and a Kansas-based company, Koch Industries, in 1997. Koch Insustries subsidiary Koch Energy and Enron completed a deal that allowed the utility to protect its profits by creating payout situations when the temperature exceeded certain parameters (in this case, using the index of heating-degree days, discussed in a bit more detail later on) for the winter of 1997 in Milwaukee, Wisconsin. Energy companies, of course, are keenly aware of the financial implications of short-term changes in hot or cold weather, since their stock-in-trade is the power used to counter those very changes. Hedging their risk by purchasing weather derivatives is one means that energy companies such an Enron developed to protect their assets.

Following the determination of the usefulness of such derivatives, Enron and a number of other U.S. energy companies quickly proceeded to set about establishing markets specializing in weather risk. Since Enron was the innovator and leading trader of weather derivatives, the market suffered dramatically when the company collapsed. However, the Chicago Mercantile Exchange (CME) quickly stepped into the void to become a leader in weather futures trading. A major difference between the prior dealings with Enron and the CME's management of weather derivatives is that the CME guarantees that trades will be honored in the event of counterparty default. That promise reinvigorated the market.

In general, over-the-counter (OTC) weather derivatives, such as those traded in a means other than on a formal exchange such as the NYSE, AMEX, etc., are privately negotiated, and so they are individualized agreements made between two trading partners. But another primary difference of the CME model with the earlier weather derivatives model is in the degree to which the general public is able to view and participate in the trade. Weather futures and futures options are standardized contracts that are bought and sold publicly on the open market in an electronic, auction-like environment, with continuous negotiation of prices and complete price transparency.

In 1999, the CME began exchange-trading of weather futures and also the the ability to buy and sell options on those futures. Options are contracts sold by one party to another that offers the buyer the right (however, not the obligation) to buy or sell the commodity at an agreed-upon price during a certain period of time or on a specific date. By September 2005, the notional value of weather contracts stood at $22 billion with over 630,000 contracts being traded on the CME. By 2007, the CME Group weather-trading volume reached nearly 1 million contracts. In addition to CME, the London International Financial Futures and Options Exchange (LIFFE) offers trading of standardized weather contracts as well as a number of electronic weather marketplaces (for example, Intercontinental Exchange and Swiss Re's ELRiX).

In contrast to other financial and commodity markets, weather features don't offer a tangible, sellable product—there is no weather equivalent to the real commodities of frozen orange juice or pork bellies, for instance. Instead, weather futures work with operational weather indexes—typically of temperature, but potentially of any weather variable, for any location. As of July 2010, CME offers weather futures and options for 47 cities throughout the world for which weather derivatives are available: 24 in the U.S., six in Canada, 11 in Europe, and six in the Asian-Pacific.

Weather derivatives operate using standard weather indices. The index of choice generally involves the calculation of either a winter-time meteorological quantity called a “heating degree day,” (HDD), or the warm weather equivalent, a “cooling degree day” (CDD). Both HDD and CDD values are calculated for specific cities, as the difference in degrees between that day's actual average (its maximum minus its minimum) temperature from a set baseline of 65°F. Obviously, the higher the HDD (meaning colder temperatures than the baseline) and CDD (representing warmer temperatures than the baseline) values, the more likely people in those cities will need (and use) energy for heating or cooling.

Say, for example, that on a winter day in New York City, the official high and low temperatures were, respectively, 50°F and 30°F. The average temperature for New York City on that day would 40°F (or 50 + 30 divided by 2). The HDD value would be 25 (the baseline value of 65 minus the average temperature of 40). The higher the HDD, the more likely that heating in the city would be necessary. There would, of course, be no CDD value for that day since the average temperature was below the 65°F baseline—typically there would be no need for air conditioning on a day cooler than 65°F. And, conversely, if the day's average temperature doesn't fall below 65°F, there is no HDD value for that day. For their HDD measurements, European cities typically use a baseline of 18°C.

A month's worth of daily HDD or CDD values is then simply summed. For instance, if there were 10 non-zero HDD daily values recorded in March in Chicago, the March HDD index would be the sum of the 10 non-zero daily values. Consequently, if the HDD values for the month were 25, 15, 20, 25, 18, 22, 20, 19, 21, and 23, the monthly HDD index value would be 208.

That value helps to establish the price of the contract. The problem is that, compared to other commodities, weather risk is slightly more complicated regarding price, since there is no actual product. The Associate Director of Environmental Products for the Chicago Mercantile Exchange, Felix Carabello, says that the actual value of a weather futures contract on the CME is determined by multiplying the monthly HDD or CDD value by a dollar value. In the example above, with the monthly HDD index of 208, if the commodity value were $20 per HDD unit, the CME March weather contract would settle at $4,160 ($20 × 208).

In practice, this works as follows (using an example provided by Professor of Economics at Pamona College, Ludwig Chincarini): On February 28, 2005, the monthly HDD contract for March 2005 for Atlanta closed at 305. This indicated that the market's fair value for the sum of HDD daily values in Atlanta was 305. As daily average temperatures for Atlanta were recorded for the month of March (and their HDD values computed), the final HDD value of weather turned out to be 349. So the final settlement of the contract was equal to 349 on the first business day of April. Therefore, someone who purchased the HDD contract on February 28, 2008, would have paid $6,100 for their weather derivatives contract and—if they held that contract until expiration—it would have made $880 ($6980 – $6100).

The weather derivatives market stands apart from many commodity markets in that there is no possibility for direct inside information—such as in the comic movie Trading Places, in which the end of the movie hinges on the availability of a U.S. agricultural citrus crop report before it is officially announced. But there are now a number of financial meteorologists to give “quasi-insider” knowledge of weather. According to Alice Gomstyn and her colleagues at ABC News (Feb. 8, 2010), there are perhaps currently a dozen or more meteorologists, such as Corey Lefkof of Deutsche Bank, who directly work in the commodity trading business, and others work in related fields.

According to Gomstyn and her colleagues, some universities, such as Cornell University's Department of Earth and Atmospheric Sciences, have even developed business minors for their meteorology programs to accommodate the growing number of students headed into the private sector, including utility companies, insurance companies, consulting firms, and, most recently, banks.

So, perhaps given the growing interest in the financial markets in weather prediction, we might even one day see Al Roker and The Weather Channel giving the latest weather derivative prices as well as the day's high and low temperatures.

Weatherwise Contributing Editor RANDY CERVENY is a President's Professor of Geographical Science at Arizona State University.

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