Getting a grip on the market

Weather Risk

Tony West, director of trading and marketing at Innogy, an energy company based in Swindon, UK, recently made an intriguing discovery. “We always knew we had some sort of weather risk,” he says. “But we did some work to find out just how much risk we had. We came to the conclusion that it was the fourth biggest risk after power, gas and coal. Weather risk came out ahead of oil.”

Innogy – one of the UK’s main weather derivatives traders – is the country’s largest supplier of electricity and second-largest supplier of gas by volume. Being both generator and retailer puts it in a good position to neutralise those risks associated with higher or lower demand for electric power. “We started trading in Nordpool four years ago to get an understanding of how to trade in markets where we didn’t have assets,” says West. “We noticed that – not surprisingly – there were weather-related correlations between the gas we traded in the UK and the power we traded in Scandinavia. You can’t arbitrage gas to power between Scandinavia and Scotland, but when the spot price on Nordpool was higher than expected, the next day the gas price in the UK went up.”

Power station managers know a one degree Celsius rise in winter temperature for a day can cause a decrease in power demand of almost 2%, together with a 5% change in gas demand. But generating electricity is more efficient in cold weather, so when temperatures fall, the power producer gains a bigger margin. As temperatures continue to fall, however, demand may outstrip capacity, so the generator will have to go to the market to buy more supplies at a higher cost.

“It’s not a simple straight line,” says West. “It’s more complex, and we still haven’t got all the details. But we have gained a lot of understanding over the last few years.”

Innogy weather trader Nancy Williams was taken on in order to teach the trading team about the weather. With a masters degree in earth and atmospheric science, Williams has specialised in meteorology and produces weather forecasts based on several models that she then uses in conjunction with information on prices in the weather market to make trading decisions. “We use swaps, mainly, but the market also trades options,” she says.

“I talk to the other traders – particularly the gas traders – about the next week or two, and that’s really as far as you can go in terms of the weather,” she explains. “People are moving towards the idea of ‘ensemble’ forecasting. This method of forecasting gives you an idea of the most likely temperature for tomorrow – that is, it gives you a probability forecast.”

West explains: “From a risk management perspective, it’s always more about volatility than certainty. What I want to know is not the exact temperature, but the likelihood of it veering away – and how far away – from the probable temperature. That brings it into almost the same language a trader thinks in. The trader thinks about price and the volatility of price. Volatility is just [an expression of] probability.”

In fact, the European market is seeing a trend towards contracts based average temperature swaps. These make more sense for Europe because the summers aren’t as hot as those in the US, and air conditioning isn’t as common, says Williams.

The key to successful weather risk hedging is, first, quantifying it. “To manage your risk you’ve got to know what it is,” West continues. “To know what it is, you’ve got to be able to measure it, and to measure it, you’ve got to know the markets – the volatility of the market and the underlying price. But you can’t know that unless you’re in the market, and you can’t be in the market unless you trade.”

As more customers enter the European market, so new centres of liquidity will open. “The main ones are London, Paris and Berlin,” says Williams. “But other locations, such as Amsterdam and Essen, are becoming more liquid, and there is also more interest in Spain and Scandinavia.”

West and Williams also say that non-financial deals will soon figure more prominently – deals where the payout is in oil or gas fuel rather than money. Current developments promise a more end-user-friendly market, but also one in which ignorance of weather risk is less tolerated. The message for corporate decision-makers is getting louder: don’t blame the weather; hedge against it.
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