February 13 2001
On October 20 2000 the International Swaps and Derivatives Association (ISDA) announced that it was changing the name of the Energy Committee to the Energy and Developing Products Committee, reflecting the new emphasis on weather derivatives.
The first operation was listed in September 1997 in the United States, developed primarily for the energy market. Since then it has spread to Japan and Western Europe. Weather derivatives are a new type of derivative which are characterized by having wind, snow or sun underlying them, instead of a rate, a price, a value or a credit. Poetic as this sounds, weather derivatives do not constitute less genuine financial instruments. They raise the same kinds of prosaic economic, legal and documentary issues.
In the infancy of any new type of derivative one always finds at least one identifiable risk that can be easily isolated and quantified on a balance sheet, and a reliable database on the historic behaviour of the relevant underlying factor. Weather derivatives are no exception to this rule. However, they do present two particular difficulties: (i) convincing potential end users of the reality of this exposure to climates; and (ii) finding a database and testing its reliability.
With the exception of the two storms of December 1999(1) in France, the effects of climatic phenomena in Europe are generally less violent than on the other side of the Atlantic. However, unlike insurance products or certain financial instruments such as catastrophic bonds, weather derivatives were not devised as protection from these rarer and more violent types of risk. Instead, they are meant to deal with the effects of 'normal' climatic conditions such as rain, sun and wind. The importance of the climatic risk on the economy is still underestimated.
The main elements of trade for many industrial and commercial companies (eg, income, cash flow, margin and cost) are affected by the climate. Weather derivatives offer a simple answer to any company which has identified the perverse effects of a particular climatic risk on its balance sheet. They allow a company to receive one or more payments without having to justify the extent of its losses or to await the results of an expert's report. The frequency and amount of the payments are determined by how far above or below an agreed threshold the climate varies during the protection period.
Access to credit and marketing
Weather derivatives may come to be a condition of credit access for many seasonal or climatically 'risky' activities. Recently, a company that wished to obtain financing for the construction of an auxiliary power station (ie, intended to function only during the demand peaks) was obliged by the American bank it was trying to raise money from to take out a weather derivative which would compensate it for the losses experienced during warm winters, when there was less demand for energy.
Agriculture and the food industry
Agriculture is the industry most obviously affected by the weather. Not only the harvest but also output and prices (eg, overproduction lowers prices) are affected. Further, the 'natural' cover that would provide for the diversification of activities (eg, the sun which scorches cereals, improves the grape of the vine) is in practice extremely rare (eg, wine growers are not cereal growers and agricultural cooperatives are generally very specialized corporate entities).
In these circumstances the food industry will be the first to be affected. In addition to the impact of weather phenomena on the quantities of produce yielded, the annual reports of groups such as ice cream makers or brewers have been reflecting the impact of the average temperatures of the preceding summer. Restauranters who enjoy the beneficial effects of the sun on their sutom can also enter into weather derivatives intended to decrease the volatility of their products in relation to fluctuations in temperature.
Since the introduction of the 1981 decentralization laws French local authorities, and particularly the departments, are liable for the maintenance and development of a large part of the road network. The cost of salting or clearing snow-covered or icy roads in winter is a huge financial burden for these authorities. Provided that current regulations are relaxed the purchase of a weather derivative whose release would be prompted by snow coverage of the roads and which would give enough compensation to cover the hire fee for the clearing machines would allow a department to control these risks by budgeting for the premium for this protection. Any non-commercial entity that works according to a budget or fixed subsidy (eg, state decentralized services, territorial authorities) will find these derivatives invaluable in controlling risks.
Several commercial galleries have already entered into transactions against the detrimental effects of bad weather on their potential turnover during 'golden weeks' (weeks with two public holidays).
The energy sector is also dependent on weather conditions. Around 30% of income is directly affected by rain and temperature. Common costs include:
While a warm winter will cause a fall in the amount of energy used by customers, a colder winter will force companies to use auxiliary power stations (which may involve repairs to damaged machinery) and to purchase the raw materials necessary for their operation (with the associated risks of a price explosion at this time). The cold can also be harmful for energy distributors, leading to pipes freezing, power lines breaking under the weight of ice and snow covering the roads. This also applies to dealers of urban central heating, which only face the fixed costs of the concession in proportion to consumer use. One of the first French transactions was entered into between Société Générale and the Thion Group. There is every indication that an increasing obligation to control costs will result from the increased competition which the liberalization of this sector will lead to.
Tourism and leisure
Tourism and open-air leisure activities are also extremely vulnerable to the weather. The season at a ski or beach resort lasts only for a few weeks of the year. With a weather derivative a tour operator can compensate his customers for disappointing conditions. For example, if the snow coverage at a ski resort is lower than average, he might offer his customers the option of a stay in Mauritius for Ffr1. An open-air amusement park that notes a decline in ticket sales on rainy days may enter into a weather derivative whose payment profile shall compensate for its losses. Last year's bad weather during the French Open tennis tournament is an excellent example of weather derivatives in action. Because of the bad weather the French Federation of Tennis, which organizes the tournament, had to refund tickets for rainy days. Added to these losses were those of the tradesmen installed inside the stadium. The federation (and its insurer) will probably have to make an arbitration between the insurance (or reinsurance) agreement and the weather derivative.
This list is far from complete. Other possible applications include the following:
Subject to finding locally reliable historical databases, weather derivatives could make it possible for whole countries to protect their budgets. This would be of particular relevance to African countries whose incomes depends largely on agricultural production, and thus on the weather conditions.
Insurance and derivatives
Covering climatic risks is nothing new for insurers. This type of risk has been the subject of policies for more than a century. What is new is the involvement of bankers on the market offering different products and operating a more transparent and efficient system.
The objectives of insurers and bankers differ as insurance products are generally intended to cover rarer but more violent risks such as cyclones, hurricanes, tornadoes and tidal waves. Weather derivatives are meant to cover more 'normal' risks. Their respective payment profiles also vary appreciably. Insurance products function according to a principle of indemnification - the policy-holder only collects the amount of his losses once they have been ascertained and estimated by the expert of the insurance company. However, derivatives function on a parametric system. The payments are activated by crossing the agreed parameters of the relevant weather index. It makes no difference to the right to payment if the purchaser of the protection does not actually suffer any loss.
Although there is no absolute rule, insurance agreements tend to cover longer periods of protection (five years and more) than derivatives. But the two techniques are clearly different in the way they can be structured, derivatives being more diverse and felxible and not requiring advance payment. In 1996 France enacted a clear law (2) on bankruptcy, with special advantageous provisions dealing with derivatives.
Sharing the market
Gradually, the market seems to have split into two levels. There is a 'primary' market of acceptance, in which specific weather covers are issued or entered into, and a 'secondary' market of retrocession, in which more standardized products are negotiated. In the first market are the end users and the risks purchasers: insurers, bankers and, in the United States, the market rooms of the big energy groups. This first market, in which insurers are present, is characterized by significant undertakings and multi-annual transactions. It is the market in which the end users' needs are studied and negotiated by derivatives tailor-made for them. In the second market, the risks acquired on the primary market, once dismantled in several standard instruments, are negotiated between the market makers in a more traditional way. Insurers on this second market usually try to pass on the risks taken in the first. This second market is similar to a swap market, where transactions are smaller and generally cover shorter periods.
The deregulation of the energy sector in Europe is still far from complete and the market is still undeveloped. The first listed transaction is from September 1998 and was entered into between Enron and Scottish Hydro. More transactions followed, including one between the Société Générale and the Soccram entered into in March 1999. Today there are probably about 50 transactions in progress. Three main participants now share the market:
There are many prospects and a strong acceleration of the market's development is expected with the coming deregulations.
Barriers to development
One obstacle likely to slow development is the structural imbalance of a market in which there are many more risk sellers than purchasers. However, the correlation of these instruments with the economic or trade crisis turns them into diversification products of a new investment portfolio for potential risk purchasers. The costs of structuring and installing these transactions are still high. The precondition for any transaction is the purchase of weather databases for central organizations and their detailed analysis. However, in Europe such data is often invoiced at exorbitant prices. For example, 30 years of data on a site from the London Meteorological Office costs Ffr35,000. A similar amount of data from Météo France would cost only about Ffr1,200. Problems inherent in weather data processing are added to these cost restraints. In Western Europe, the data provided by the official weather organizations is largely reliable, but is not consistent in the scope and parameters of observation and the recorded periods of observation, which are often too short. Breaks in homogeneity or 'suspect' repetitions of identical values over several days do exist.
The study of the data is also a difficult and important issue. This involves the examination and correction of the impact of:
Weather impact is a complex phenomenon. It is first of all a phenomenon with clear thresholds (eg, barges pass or do not pass under the bridges of a river in spate, ski resorts can only be open with snow coverage of one metre). Linear hypotheses between fluctuations in temperature and fluctuating turnover are thus rare. However, it is also a very localized phenomenon compared to the total market covered. The correlation between a financial risk and a precise weather index, although quantifiable, is still difficult to estimate. The risk is often related to several factors, hence the difficulty in establishing a reliable formula and finding a convincing index for the risk seller and for the purchaser.
In corporations - particularly in the United States - directors are being blamed for exposing the company to fluctuations in interest rates by not entering into a derivative. The unquestionable development of weather derivatives may lead to the same situation where foreseeable losses will have to be covered or explained to analysts and shareholders...
The first generation of weather derivatives will generally take on one of the four following forms:
This typically provides protection for floating rate borrowers on the rate market - a transaction which 'caps' on an agreed threshold (the secured cap) which would otherwise be unlimited. Applied to climatic risk, a cap is a transaction whereby the seller pays the purchaser an amount proportional to the difference (if positive) between the value of a weather index on a certain day (or the average value over a period) and the index level corresponding to the maximum meteorological risk that the purchaser agreed to assume (the secured cap). If a distributor of electricity notes that beyond the average of 20° C during the winter, users do not use their central heating enough for electricity sales to meet the fixed costs, it can buy a cap on temperature with a secured cap of 20° celsius (C). The creditor will then make a payment for each winter day on which the temperature is higher than 20° C (an amount in francs per degree above 20° C shall be agreed on), compensating the distributor for the losses in turnover due to the lower consumption of electricity on these days.
This is a transaction very similar to a cap, but it works in the opposite direction. On the rate market, the floor is the protection of the borrowers at a fixed rate. Each time the floating rate on which their sources of income are indexed is lower than the fixed rate of their debt, this instrument will enable them to receive a sufficient amount to face their debt. The floor shall thus secure a minimum rate of income (the secured floor). Applied to climatic risk, a floor is a transaction whereby the seller pays the purchaser an amount proportional to the difference (if positive) between the secured floor and the index's value on this date, or its average over an agreed period. If a ski resort decides that it cannot operate if there is less than one metre of snow, it may enter into a floor listed on average snow coverage throughout a season, with a one metre secured floor. This transaction will ensure that the creditor makes a payment for each day of the season when the snow coverage in several agreed places of the resort is lower than one metre (an amount in francs per centimetre below one metre shall be agreed on). The floor therefore compensates the resort for the turnover loss due to the lower frequenting of the tracks or of the resort.
A cap or floor permits its purchaser to retain the benefit of its profits when hedging is useless. When temperatures are low and central heating systems work full time, the electricity producer does not share its benefit with the cap's seller. A ski resort does not transfer its profits to the floor's seller when reservations and tracks are full. However, buyers often have to pay premiums which weigh heavily on their margins. One of the possible solutions to these buying costs consists in the entering into of a collar. This offers the same type of protection but with reduced costs, since the purchaser grants in advance, in return for protection, a part of its future profit. The purchaser protects its business by receiving payment when conditions are bad and paying part of the profits to the buyer when things are exceptionally good.
If an electricity producer fixes its climatic risk at 20° C and more during winter, but considers that from 10° C and below its electricity sales will probably be beyond its forecasts, it can enter into a collar. The 'line' will be fixed between 10° C and 20° C. If temperatures rise, it shall receive a payment in order to cover its turnover loss; if temperatures fall significantly, it shall pay the counterpart, thus sharing part of its exceptional benefit. If the average temperature remains inside the agreed line (ie, it complies with the seasonal average), no payment will be made by one party or the other. The direct benefit of this structure is that it costs a lot less.
The ultimate 'free' protection, the swap does not require any advance payment. A first-generation instrument on the rate market, the swap agreement changes when applied to climatic risk. In traditional rate swaps one party regularly pays an amount indexed on a floating reference - for example, the three months Europe Interbank offered rate - while the other pays it fixed amounts (such opposite flows being generally netted among themselves). Climatic swaps on each payment lead only to one gross payment, by one party or the other, according to the level of the weather index compared to an agreed break-even point. On entering into a swap the parties must agree on the level of the index around which their respective payments shall be arranged. Above this level one of the parties is creditor and the other debtor, below it the positions are reversed. A swap thus entitles a party to transform its climatic exposure (financial exposure essentially fluctuating) into a fixed and budgetable cost.
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