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Headline: Weather hedging goes online in Europe Source: Euromoney Date: September 2000 Author: Ted Kim more on Risk Management With the recent launch of the London based I-WeX.com internet site, European corporates accustomed to hedging against Financial risk should be able to manage another great uncertainty – weather – just as American corporates have been able to do since 1997 through weather derivatives. I-WeX.com, a collaboration between The London International Financial Futures & Options Exchange (LiVe), Intelligent Financial Systems, and WIRE, is an internet site operated on the basis of open access. This means that I-WeX will allow end-users facing weather risks worldwide to post OTC deals where all the details are specified apart from the price. Any OTC weather desk at a bank, insurance company, reinsurer or broker in Europe or elsewhere can then review the list of open deals and make price oVers. The counterparty that posted the deal can then choose the best price. Weather risk was especially hard felt in the US over the past three winters. In fact, for three consecutive years, meteorological records dating back to the last century were broken. With the US Department of Commerce estimating that nearly $2 trillion of US GDP is weather-dependent, exceptionally high temperatures played havoc with billions of dollars worth of revenues for companies in weather-sensitive sectors such as energy, agriculture, fashion, and tourism. In Europe, with the steady deregulation and privatization of energy producers and distributors, weather traders are betting that risk managers will soon start dealing with unpredictable weather much in the same way that they deal with unpredictable borrowing costs or commodity prices. “The major counterparties in Europe so far have been the big reinsurers who will be selling directly to smaller end-users, such as the European utility sector,” explains Mariann Van Zanten, a weather- derivatives trader at TFS Energy, a US-based risk management consultancy and brokerage Firm. She expects the European market for weather derivatives to become as large as the US market, where perhaps 150 new contracts are written every month, within the next two to three years. Nearly all weather-derivative contracts are written on the basis of temperature or precipitation measurements issued by a public authority, such as the UK Meteorological Office. A key concept is the degree day: the deviation of the average day’s average temperature from 65 degrees Fahrenheit. The average is found by taking the midpoint between the day’s high and the day’s low. In the summer, cooling degree days (CDDs), will be roughly correlated to the demand for energy. The number of CDDs increases with every degree that the average temperature is above 65 degrees. In the winter, the number of heating degree days (HDDs), increases for every degree below 65 degrees and is roughly correlated to the demand for heat. In most temperature contracts, the strike levels of HDDs or CDDs are usually measured over a specified period, such as October to February or June to August. A payment is made by the seller to the end-user for every degree day above or below the strike on the basis of a set number of dollars per CDD or HDD. Nearly always, there is a predetermined maximum payout that can range from $500,000 to $10 million or more. Regulatory obstacles may delay the growth of weather derivatives in Europe. In the case of Germany and the UK, weather derivatives are treated by Financial regulators like any other OTC derivative contract. For these two markets, most trades can be documented through standardized Isda master agreements. In other EU states – notably Italy, France and Spain –weather derivatives are classified as insurance contracts, which fall under a different regulatory regime. And demand may not be as high in Europe as in the US. In the US, about half the country is addicted to power-hungry air conditioners for several months of the year. Electricity consumption in parts of the US, such as New York and Chicago, can be so high during an exceptionally hot summer that electricity shortages occur. Air-conditioning use and the subsequent mid-summer surge in power demand are far less common in Europe. “We [received] some inquiries from major utilities last winter who, in the end, decided against hedging,” explains Frank Caifa, associate director of structured Finance at Swiss Re New Markets in New York. “This worked out pretty well for us because we would have [been] hit for a fairly large pay-out due to the exceptionally warm winter. Those same utilities have now been back planning for this next winter and, again, many have decided against being fully hedged. Hedging is a very long-term strategy. If a company hedges for next season, then in principle, they should be hedged for perhaps a Five-year period.” Such a long-term strategy, which risk-management specialists strongly advise given the short-term volatility of weather, would mean that a corporate would have to lock in an approximate range of expected revenues. If next winter were exceptionally warm, then a massive cash pay-out from a put option on HDDs would be enthusiastically received. On the other hand, if the winter turns out to be arctic-cold, then every penny spent on a weather- derivative premium – perhaps several million dollars – would appear to have been wasted. Van Zanten says: “One of the problems we have seen so far is that some CFOs have gotten back to me months after having bought a weather contract and felt they lost money since the contract did not pay out. They think of the term ‘derivative’ and, like an interest-rate option, assume that sooner or later they will receive a capital gain. “They should really be treating this like ordinary insurance contracts, which all corporates buy. A standard property and casualty insurance contract may never pay out for years and years yet the premiums paid are hardly perceived as loss of money.” Outside the energy and agriculture sectors, it is still not entirely clear how weather is correlated to corporate revenues. Breweries may often point to a cool summer as the cause of depressed beer sales or package tour operators may claim that a hot summer in the UK has led to fewer bookings for foreign holidays. But so far, no one has been able to apply a specific numerical cause-and-effect analysis to weather risk. The arcane world of European meteorological data collection will also have to come under scrutiny and reform. In the US, the National Oceanic and Atmospheric Administration (NOAA) is renowned for the reliability and professionalism of the data it collects. More important, almost all its data and analysis is distributed practically for free as a public service. In Europe, by contrast, the quality and consistency of weather data collection leaves much to be desired. The prices charged by European governmental weather agencies, who see their work as a profit-making business much like running an airport or a telephone system, are also substantially higher than in the US. Nearly all weather-derivative analysts have so far come from a Financial background and the business employs few meteorological professionals. With no widely accepted way of valuing weather-derivative products, as well as occasionally non-existent liquidity in the OTC market, broker prices can vary by as much as 300% for a similar product. At a recent meeting in Bermuda of the newly formed Washington DC-based Weather Risk Management Association (WRMA), the case of Seagram, owner of Universal Studios, was highlighted. Seagram bought a weather derivative covering the the winter of 1997/98 that would pay out if there was exceptionally high rainfall. A wet winter would lead to decreased attendance at the Universal Studios Park, one of the most profitable tourist attractions on the west coast. Meteorological experts all agreed that the El Niño effect meant an exceptionally high probability of substantial rainfall that winter. But the seller of the coverage seemed to have neglected this threat when it priced coverage against rain at approximately one-third of that of most other market makers. Despite such imprecision, the market slowly has been moving online. Outside I-Wex, there are more than a dozen internet sites that provide bulletin-board and brochure-type information as well as several sites where a real-time trade is only a few clicks away: Tradeweather.com; Enrononline.com, launched by US energy concern Enron; Guaranteedweather.com, launched by Aquila; and Swiss Re’s Electronic Risk Exchange system elrix.com are so far the most prominent sites. Given steady growth in online trading, liquidity, price transparency and uniformity are expected to increase and commissions and spreads should decrease. All weather-derivative analysts agree that increasing liquidity and price transparency are crucial if the market is ever to take off in Europe. Yet damning comparisons with other derivatives markets may be misleading. “You cannot look at trading in gas or oil derivatives and then, on that basis, conclude that weather derivatives are illiquid,” says Ravi Nathan, Weather Portfolio Manager at Aquila and a member of the board of directors of WRMA. “The true comparison is with the insurance market, which never trades at all except for perhaps one reinsurance contract being written. “What you are seeing with weather derivatives is revolutionary. For the First time . . . commodity traders, investment banks, the insurance companies and end-users in industry [are] all coming together to develop and trade a new product. This has never happened before.” Competition and the relentless efforts of many corporate managers to appease shareholders and analysts may ultimately be the factor that decides how quickly weather derivatives are embraced in Europe. “When one energy company announces better-than-expected earnings than other competitor companies, the sector as a whole will really sit up and take notice.” says Nathan. “Utilities and oil companies that were not hedged might soon start making excuses about low earnings because of a warm winter. “But these are companies that are not supposed to be in the weather business. Shareholders and analysts do not expect corporate management to be punting on the temperature – which is what they are doing unless they lay off their weather-related risk.” more on Risk Management |
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