THE WEATHER MARKET

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THE WEATHER MARKET

• Rodney R. White
• University of Toronto

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This presentation is based on an unpublished
paperwritten with Sonia Labatt.Weather
derivatives new market instruments for the
transfer of weather risks
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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

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The weather market has evolved to cover the risk
of adverse not catastrophic weather
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Example

• Adverse weather
• for the energy sector includes
• mild summers
• and
• mild winters

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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.

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The weather contract matches

• The business risk,
• such as reduced revenue,
• with the
• weather index
• for an agreed contract season.

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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)

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Example continued ..

• CDDs (and HDDs) are measured in the USA as
  maximum temperature (minimum temperature)
  compared to 65F (18C)
• Thus, a daily maximum temp of 75F produces 10
  CDDs for that day

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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.

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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.

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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

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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.

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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.

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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