Baiting the hook

End-users such as utilities and industrial companies are not showing the same keenness as hedge funds for trading weather derivatives, despite the efforts of banks, dealers and brokers to lure them in. By Joe Marsh

There are huge untapped potential volumes in the weather derivatives market, but what will it take to get more energy companies and industrial groups hedging their weather exposure? Brokers, banks and other weather derivatives dealers are trying various methods to lure such businesses in.

Some feel an active spot market might help. But others believe the weather will have to have a clear effect on the bottom line before many firms will become active in the weather market.
“The big changes will happen when utilities present their financial results, and an analyst responds by asking why they have not used the weather hedging tools at their disposal to mitigate losses or make savings,” says one hedge fund executive who asked not to be named. “Weather risk is not currently priced into equity prices, but that time is coming.”

A reason to hedge
Certainly, Felix Carabello, associate director of environmental products at the Chicago Mercantile Exchange, which lists weather contracts, feels that companies will need to be ‘shocked’ into hedging weather. “Until some extreme weather event happens, people won’t be inspired to hedge,” he says.

For example, in an unusually hot summer – such as the US is experiencing now – companies such as utilities or building operators not only feel the effects physically, but also financially, as they have to buy more electricity than expected to supply air conditioners, says Carabello.

Hence, while the secondary weather market – comprising plain-vanilla futures and options – is booming thanks to hedge funds, primary market volumes – comprising more complex, structured insurance and derivatives deals – are relatively flat, say market observers.

Nevertheless, weather risk management providers and brokers are doing their best to change this. In June, Fimat, the brokerage arm of French bank Société Générale, hired Dan Parker, founder of former exchange the Weather Board of Trade, to build up a weather and emissions desk. Parker is brokering trades mainly for end-users, such as utilities and corporates, based on the index he created in 2000, Nordix (normal departure index).

The temperature-based market has achieved strong participation already, says Parker, and he intends to build on its success via other weather measures and locations.
Nordix represents the variance of the most recent actual weather data offset against the historical average, and is flexible, covering all types of temperature, wind and precipitation deals, or even combining them. For example, says Parker, you could create an index based on wind and precipitation – in effect, a hurricane index – and do a swap based on the average variance between them; alternatively, you could create a tradable regional index.

Although Nordix is posted on Bloomberg, Parker has not done many deals yet, so there is not yet much market transparency. Still, he says, “I’m committed to solving problems for end-users, rather than just looking to trade with the status quo.”

For example, he is working on a new product – a financial streamflow index for the Pacific northwest, which relies on hydropower for at least 80% of its electricity generation. (The region comprises California, Idaho, Montana, Oregon, Washington and southern British Columbia.) Streamflow is the rate at which water passes a given point in a stream or river, and the index would measure variance from the norm.

Hydropower generators such as Pacificorp and Portland Gas & Electric, which use streamflow to measure business risk, agree such a product would be valuable, says Parker. He plans to launch the index before the end of the year and believes it could ultimately be listed and cleared on a futures exchange.

Spot advantage
There are certainly some in the market who feel Nordix has its advantages over standard degree-day data. Nordix can capture the daily volatility in weather better than degree-day data, for example, says Steve Mitchell, vice-president of business development at weather data provider Weather Insights.

Degree-day contracts may not work as effectively as Nordix for, say, a month’s hedge, he says. There may be well-above-average heat at the start of month, followed by well-below-average temperatures at the end, and these extremes may cancel each other out, resulting in an average degree-day month, explains Mitchell. This extreme weather volatility may have resulted in adverse financial conditions for a hedger, yet the degree-day contract would have represented an average month payout.

Yet Nordix would offer an active spot market that would provide greater transparency to these daily weather fluctuations, says Mitchell. An active spot market should also allow more intra-month trading, which would leverage weather forecasts, which typically only forecast weather 16 days into the future.

In addition, adds Mitchell, the Nordix spot market would also provide a historical dataset that would be easier to correlate with a hedger’s specific business needs, as opposed to monthly or seasonal heating or cooling degree-day contracts.

Industry vulnerability
Other weather market players, too, have made specific attempts to attract more energy companies and industrials, among others. Dutch bank ABN Amro, one of the biggest providers of weather risk protection, is using ‘shock’ tactics, by pointing out how weather can harm production. In June, the bank launched the first ever study to quantify how adverse weather conditions affect industry production in western Europe, Scandinavia and North America. ABN has traditionally been strong in structuring weather derivatives and insurance deals, and obviously has ambitions to attract more business in this area.

The bank’s recent addition to the insurance and weather derivatives team is further evidence of this. Merijn Nederveen moved in June from the bank’s corporate finance business to focus on structuring and sales of weather derivatives and related hedging strategies.

Global reinsurance firm Swiss Re has also had a lot of success in the past year structuring contracts for end-users. One type of deal it says it has been selling a good deal of are contracts with commodity – rather than cash – payouts. For example, building operators in the US – such as universities and hospitals – are increasingly using products based on temperature that pay out in volumes of heating oil, says the company.

Yet Swiss Re’s two main weather risk specialists, Mark Tawney and Bill Windle, and weather risk trader Bill MacLauchlan, left the company in early July, so whether it will continue in a similar vein is yet to be seen.

The consensus certainly seems to be that take-up of weather derivatives will increase due to increased liquidity in the market, more attractive contracts and increased risk management sophistication among potential users. The weather market is already more well balanced than it used to be, given the influx of hedge funds and slow trickle of new end-users making their presence felt, says Scott Mathews, president of New York-based commodity trading adviser WeatherEx.

“The balance among the types of players is crucial to the health of the market,” he says. “But we have already come a long way since the earlier years, when the field was 75% energy companies and 25% reinsurers.” It is hard to say with any certainty what the current mix is, since the annual US Weather Risk Management Association survey from PricewaterhouseCoopers has not been released yet, says Mathews.

But in the capital market space, an even mix of players from all quarters is a healthy sign, he says, adding: “Our information tells us that the weather futures market is attaining that state of equilibrium where no single group has unfair influence.”