How Weather Derivatives Help Prepare For Financial Storms

It’s estimated that the impact of weather accounts for $5.3 billion of the $16 trillion U.S. gross domestic product. Extrapolate potential figures to the scale of the entire world, and you have a stunning picture. Indeed, one-third of businesses worldwide are directly affected by weather conditions. Beyond utilities seeking weather protection, market participants utilizing the weather markets include dedicated brokers and market makers, investment banks, insurance and re-insurance firms, and hedge funds.

The trading of weather derivatives has changed how the world views managing cash flow and earnings fluctuations associated with weather volatility. In the past, circumstances such as extreme temperature swings or a lack or overabundance of precipitation could have significant effects on vast sectors of the global economy.  Now there is a way to manage and hedge against weather uncertainty.

In 1996, energy trading firm Aquila Energy and utility company Consolidated Edison transacted the first weather trade. This transaction started something big. It began the ball rolling with an over-the-counter (OTC) market. Then, in late 1999, CME launched an exchange-traded market.  Each is a multi-billion dollar market in notional value today.

A broad range of weather derivative futures, options and swap products is available – including those based on temperature, rain, snowfall, wind and frost. These products enable market participants to manage global weather-related risk such as catastrophic hurricanes, heat waves and coldbreaks, while also offering opportunities to speculate – absorbing that risk in exchange for possible profit on weather variations.

Indeed, energy companies are the main users of weather derivatives, as demand for their products can vary drastically due to extreme weather conditions. In fact, within the last decade, the Weather Risk Management Association has reported that nearly 70 percent of the end users of weather derivatives were from the energy sector. The agricultural industry is the second main user of such instruments.

CME weather locations

CME’s Exchange-Traded Weather Futures and Options

CME Group launched the first weather derivative contracts in 1999 to help businesses manage their exposure to temperature-based risk. To help manage that impact on consumers and corporations, CME Group’s product slate has grown to meet customer needs by offering multiple risk management opportunities related to temperature, snowfall, frost, rainfall and hurricanes in more than 50 cities in the United States, Europe, Asia, Australia and Canada. Weather futures and options are available for block trading, which are privately negotiated futures, options, or combination transactions. Futures contracts are also available to be traded on CME Globex, and options contracts are available via open outcry on the CME trading floor.

Utilities and energy companies were the main users of weather futures and options when CME Group first introduced weather derivatives, but the expanded product slate has captured the interest of a diverse set of market participants across several sectors, including construction, hedge funds, retailing, manufacturing, agriculture, insurance and reinsurance.

CME Group Hurricane contract regions

Trading these products on an exchange offers these participants price transparency, financial safeguards and capital efficiencies.

On the other hand, while OTC trades in the weather market allow firms to tailor contracts to their individual needs, these transactions can be illiquid, are subject to credit risk exposures and have high transaction costs.

Nicholas Ernst, director of weather markets for Choice Natural Gas, says that temperature-based derivatives have been a game changer for utilities that don’t pass through their weather risk to their rate base: “Our customers have been able to effectively transfer their weather risk,” he says.

Users of the market say main areas of growth for this product outside of the United States are Europe, specifically London, Amsterdam and Paris.

Evolution in Use of Weather Derivatives

The use of weather derivatives leads to higher market valuations, investments and leverage, according to a scholarly paper distributed in 2010 by Francisco Perez-Gonzalez, an assistant professor of Finance from Stanford University and faculty research fellow of the National Bureau of Economic Research (NBER), and Hayong Yun, an assistant professor of Finance at the Eli Broad College of Business at Michigan State University.

In their paper, “Risk Management and Firm Value: Evidence from Weather Derivatives, September 2010,” which studied data from U.S. energy firms, Perez-Gonzalez and Yun found that firms whose cash flows have historically fluctuated with changing weather conditions are, relative to other firms, more likely to use weather derivatives once they become available, irrespective of their investment opportunities.

Both company decision makers and shareholders of companies are more educated about available instruments. Users of the market say energy firms, retail and other entities often impacted by weather conditions are simply becoming more adept with taking risk management positions.

“Unfavorable weather is no longer an excuse for a company’s bad earnings announcement,” says Peter Rosen, a weather derivatives broker with Tullett Prebon.

Market participants have also become more sophisticated and the use of weather derivatives has become more international in scope. Some of the newest participants in the market have included end users in the retail, construction and beverage industries. And no doubt, a heightening intensity in global weather events is likely to draw an even larger focus on these products going forward.

 

Heidi Centola and Charles Piszczor of CME Group contributed to this article. It first appeared in Swiss Derivatives Review

Christine Marie Nielsen is a journalist based in Chicago. In the course of her career, she's served as a reporter for Dow Jones & Company as well as for Knight-Riudder Financial. She currently runs her own media effort, Geodialog Media LLC, and has a patent pending on technology that aims to improve the news delivery process. She is a member of the TechNexas community, which was named one of the top 10 tech incubators in the U.S. by Forbes in 2012.

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