A localised flood

Weather derivatives

For Japan’s Imaoka Corporation, a manufacturer of sore throat lozenges, sales often drop during the country’s hot summer months – the soaring humidity levels lessening incidences of dry raspy coughs among the Japanese population. Conversely, as the air becomes cooler and drier, more people are struck with irritating tickly throats, prompting a spike in throat lozenge purchases.

Imaoka’s dependence on climate in terms of profits has prompted it to join the growing number of small end-users active in Japan’s burgeoning weather derivatives market. In fact, Imaoka was one of the first companies to purchase a weather derivative referenced to humidity, aimed at protecting revenues in case of an unusually humid winter. The deal, transacted with Japanese insurance company Mitsui Sumitomo Insurance between December 2001 and February 2002, paid out once a proprietary humidity index rose above a predetermined level in Tokyo. The nominal value, or maximum payout, was only ¥9 million ($72,000) – a massive difference between the $1.5 million average nominal value of a weather derivatives transaction in the US. But the deal illustrates the main characteristics of a market that has evolved into the most creative and diverse in the world.

While the US, the largest market for weather derivatives globally, is dominated by the country’s titanic energy companies, hedging predominantly temperature-related spikes or slumps in electricity demand, Japan’s weather market is centred around a broad range of small end-users – from retailers to theme parks – hedging a wide array of weather conditions. According to the most recent survey of the weather derivatives market, released by the Weather Risk Management Association (WRMA) and consultants PricewaterhouseCoopers (PWC) last June, the total notional value of weather derivatives contracts transacted in Asia in the 12 months to April 2002 grew by more than 100% to $90 million, the overwhelming majority of which originated from Japan.

This is still a mere pinprick in global volumes, estimated at $4.3 billion, but while temperature-related contracts continue to account for the vast majority of transactions worldwide (82% were heating degree day or cooling degree day contracts), Japan’s market is far more diverse, with contracts regularly referenced to rainfall, wind and snow. “Precipitation deals make up around a 50% share of our portfolio,” says Shuichi Okuda, manager in the derivatives and structured products division, and head of weather derivatives at Bank of Tokyo-Mitsubishi, in Tokyo. Another head of weather derivatives at one European bank in Tokyo estimates that 60% of the Japanese market comprises temperature-related contracts (predominantly critical temperature day options), 30% of deals are related to rainfall, and a sizeable 10% of the market relates to other weather types, including snow and wind. In comparison, only 6.9% of the global weather market relates to rainfall, 2.2% to wind and 0.4% to snow, according to the WRMA/PWC report.

But other, more idiosyncratic weather derivatives contracts have also emerged in Japan, such as those referenced to humidity, wind speed, wind direction, and ‘bad weather’, which combines wind and precipitation. Japanese insurance company Tokio Marine and Fire Insurance, for example, introduced typhoon derivatives in May 2002. Payout is dependent on whether the number of typhoons passing through a particular 150-kilometre circular observation area (cal-led the area method) or between two pre-agreed geographical points (called the gate method) exceeds an agreed strike during a particular observation period. “Typhoon derivatives have become popular in the Japanese market, and we are expecting them to become more widespread next year,” says Toshihiko Aizawa, manager, product development group, commercial lines underwriting department at Tokio Marine and Fire Insurance, in Tokyo, adding that the company has transacted between 30–40 typhoon derivatives contracts in Japan so far.

Structured deals that use weather derivatives in combination with other asset classes, are also emerging. In October 2002, Tokyo-headquartered kerosene wholesale company Sinanen entered into a dual weather and fuel derivatives contract with trading company Sumitomo Corporation to hedge its kerosene sales during the winter months. The wholesaler entered into a fuel derivatives contract to fix the domestic kerosene premium over the imported crude oil price, while also entering into a weather derivatives contract, whereby Sinanen receives payment from Sumitomo Corporation if the temperature exceeds an agreed strike price. The wholesaler therefore hedged the cost of imported oil in case of yen depreciation or a rise in oil prices, but also protected itself against lower kerosene consumption in case of a mild winter.

The emergence of such deals could lend a further hand to the weather derivatives market in Japan, say observers. “This kind of deal will hopefully spread the use of weather derivatives in Japan even further,” says Hiroshi Matsui, Tokyo-based senior vice-president, head of the derivatives business development team at Mizuho Corporate Bank, and member of the WRMA board of directors.

Nonetheless, while the weather types underlying derivatives contracts are much broader in Japan, the average notional value of around ¥10–20 million ($83,000–$166,000) is significantly lower than the global average of around $1 million, reflecting the absence of large energy companies. The market is almost exclusively made up of small, retail-based end-users, and many weather derivatives contracts are actually distributed through regional banks to retail end-users in a ‘ready-made’ format. “We have standardised some of the small [weather derivatives] options,” says Takashi Morita, an official at Sumitomo Mitsui Banking Corporation (SMBC) in Tokyo. “These products are designed to be sold by the bank staff through our branch network, without requiring individual attention from the bank’s weather derivatives experts.” SMBC acts as an intermediary, matching the counterparties on either side of a deal and taking on credit risk on both parties, says Morita, adding that the bank – not a member of WRMA – transacted nearly 400 weather deals in 2001 using this template.

However, there is nascent interest from a handful of energy companies in Japan, sparking hopes that there could be growing participation from this sector in 2003. “We are expecting many electric power companies will get into the market this year, and the amount of volume in the Japanese market could increase very quickly,” says Tokio Marine and Fire’s Aizawa.

In August 2001, Tokyo Electric Power Company (Tepco) entered into a ¥700 million weather swap with Tokyo Gas. The transaction was arranged directly between the two counterparties, without the involvement of an intermediary bank. As part of the deal, Tokyo Gas compensated Tepco if the temperature fell below an agreed strike of 25.5 degrees Celsius, under the assumption that fewer people would be using air conditioning. If the temperature rose above 26.5 degrees Celsius, Tepco compensated Tokyo Gas on the assumption that fewer people would be using gas heating.

Following that deal, a number of companies followed suit in 2002, including Tepco, which repeated its deal with Tokyo Gas, as well as another ¥770 million swap with Osaka Gas. The latter transaction incorporated a double trigger feature, where the temperature in both Osaka and Tokyo must reach a certain level before either party pays out. Kansai Electric Power Corporation also transacted a ¥770 transaction with Osaka Gas. But all were costless collar transactions directly between the two counterparties, and energy companies have so far been reluctant to purchase derivatives contracts from financial institutions due to the costly premiums required, says Mizuho’s Matsui. “[Energy companies] have not shown any interest in paying some premium to hedge their exposures, so they have predominantly used collar-type transactions,” he says.

Nonetheless, there have been a couple of deals completed between energy companies and financial institutions. Last summer, Kyushu Electric Power transacted a ¥100 million deal with Mitsui Sumitomo Insurance to protect itself against a fall in temperature between August 1 and September 30. The contract was based on the average temperature of the daily average temperatures at seven pre-determined locations in Kyushu where the company operates. Mitsui Sumitomo Insurance also transacted a similar ¥100 million deal with Saibu Gas between December 1, 2002 and February 28, 2003, although the average temperature was based on readings at one location in Kyushu.

A number of other electricity and gas companies are also known to have looked at transacting with financial institutions over the winter. In summer, there are natural counterparties with which a utility company can offset its risks – an electricity company benefits from hot weather, while a gas company benefits from cooler weather. In winter, however, the risks for both companies are the same. “[Gas companies and electricity companies] both like to avoid mild winters, so they are not in a position to exchange their risks,” says Yuji Ito, deputy general manager and alternative risk transfer manager in the financial solutions department at Mitsui Sumitomo Insurance, in Tokyo.

Market observers hope that, as deregulation of the energy sector in Japan picks up, the energy companies will have no choice but to use the banks as counterparties. “It is very hard for the utility companies to find other companies that can take the totally opposite side of a deal for a very long time,” says Mizuho’s Matsui. “So, they will have to look at the financial institutions.”

Elsewhere in Asia-Pacific, however, the weather derivatives market is almost non-existent. With the exception of Australia, where the market increased by 72% to reach $4.3 billion in the year to April 2002, most Asian countries either have too small a deviation in climate to make weather derivatives worthwhile (eg, Singapore) or are faced with unreliable weather data (eg, China). “China is the biggest potential market, but the most difficult in terms of accurate and timely data. A history of weather data is also required and this too is missing in China,” says Matsui.

One possible exception is South Korea. Like Japan, the Korean energy market is undergoing deregulation, with full retail competition expected in 2009. Former government-owned power monopoly, Korea Electric Power Corporation, has already been split up into six generating companies – five thermal and one hydro- nuclear – and there are plans to privatise the five thermal companies as early as this year. Bankers believe the deregulation process may prompt the newly privatised companies to look to weather derivatives to hedge their risks.

A number of insurance companies, including Samsung Fire & Marine Insurance and LG Insurance, already offer weather insurance products in South Korea. But there is a lack of financial institutions and brokers willing to participate in a weather derivatives market. “The weather derivatives market in Korea is very slow at the moment,” says In-Suk Kang, director of Weather Trade, a Korean weather brokerage and data firm, based in Seoul. “Some participants have considered it, but it has been difficult for them to demonstrate the benefits to customers.”

Korea Development Bank, for example, was contemplating launching a weather derivatives desk early last year, but decided to hold off due to a lack of interest from end-users. “We tried to attract some clients at the beginning of last year, but we felt the customers were not ready for this product,” says one official at KDB in Seoul who asked not to be named. But there are hopes that South Korea may eventually become a viable market for weather derivatives products once customers become familiar with the concept. “Maybe [customers] will be ready in the near future,” the KDB official adds.

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