Download the weather market - University of Toronto

THE WEATHER MARKET
Rodney R. White
University of Toronto
This presentation is based on
an unpublished paper
written with Sonia Labatt.
“Weather derivatives: new
market instruments for the
transfer of weather risks”
Definition:
‘A derivative is a financial contract
whose value derives from the value
of some underlying asset, such as
a stock, bond, currency or
commodity.’
Swiss Re, 2001. Capital market
innovation in the insurance industry
The weather market has
evolved to cover the risk of
adverse – not catastrophic –
weather
Example:
• ‘Adverse weather’
for the energy sector includes
mild summers
and
mild winters
Other examples:
• Low precipitation for hydro-electric
power generators
• Low precipitation for agriculture
• Rainfall and frost for the
construction industry
• Cool, damp weather for outdoor
entertainment, beverage sales etc.
The weather contract matches …
• The business risk,
such as reduced revenue,
with the
weather index
for an agreed contract season.
Example: the energy sector
• Business risk = reduced revenues
associated with mild summer and
mild winters.
• Weather index = cooling degree
days (CDD) and heating degree
days (HDD)
Example continued …..
• CDDs (and HDDs) are measured in
the USA as maximum temperature
(minimum temperature) compared
to 65°F (18°C)
• Thus, a daily maximum temp of
75°F produces 10 CDDs for that
day
Example continued …..
• The cumulative ‘cooling degrees days’
are then totaled over an agreed period,
e.g. a 3-month,
or 6-month, ‘cooling season’.
The energy company receives payment
on the contract if the cumulative CDDs
fail to reach an agreed total.
The growth of the weather market
• First traded derivative 1997, based on a
temp index (HDDs) for Milwaukee for
the 1997-98 winter.
• All trading was OTC until the CME
began listing derivatives based on
10 US cities in 1999.
$4,578
$4,339
$5,000
$4,188
$4,500
$4,000
$3,500
$3,000
$2,517
CME
Winter
Summer
$2,500
$2,000
$1,500
$1,000
$500
$0
2000/1
2001/2
2002/3
2003/4
100%
Other
Wind
Snow
Rain
Oth Temp
CDD
HDD
80%
60%
40%
20%
0%
2001/2
2002/3
2003/4
100%
90%
80%
Other
Europe
Asia
NA East
NA Mwest
NA South
NA West
70%
60%
50%
40%
30%
20%
10%
0%
2000/1
2001/2
2002/3
2003/4
Emerging products:
• For wind farms, risk found both in too
little wind and too much wind
• For the construction industry, risk may
be transferred for wind, frost and rain
in a hybrid contract
Emerging products cont. ….
• In developing countries agricultural
protection from adverse weather based
on an index would be much cheaper
than conventional crop insurance.
• Critical day insurance can protect
retailers, tourism, ski resorts etc.
Climate change.
• Climate change will increase
uncertainty about the weather.
• Uncertainty means that the historical
weather record becomes a less reliable
guide to the future.
• Uncertainty will increase the premium
for weather risk transfer.
Richard Sandor
“It took almost three years for the
first trade to occur in the Acid Rain
Program, and now that market is
worth $4 billion. History has taught
us that environmental markets
need time to mature.”
In Environmental Finance, 2004