Market Futures: Introduction to Weather Derivatives

Even in our advanced, technology-based society, we still live largely at the mercy of the weather. It influences our daily lives and has an enormous impact on corporate revenues and earnings. Until recently, there were very few financial tools offering companies protection against weather-related risks. However, the inception of the weather derivative—making weather a tradeable commodity—has changed all this. Here we look at how the weather derivative was created, how it differs from insurance and how it works as a financial instrument.

It is estimated that nearly 20% of the U.S. economy is directly affected by the weather, and the profitability and revenues of virtually every industry—agriculture, energy, entertainment, construction, travel and others—depend to a great extent on the vagaries of temperature. In a 1998 testimony to Congress, former commerce secretary William Daley stated, "Weather is not just an environmental issue, it is a major economic factor. At least $1 trillion of our economy is weather-sensitive."

The risks businesses face due to weather are somewhat unique. Weather conditions tend to affect volume and usage more than they directly affect price. An exceptionally warm winter, for example, can leave utility and energy companies with excess supplies of oil or natural gas (because people need less to heat their homes). Or an exceptionally cold summer can leave hotel and airline seats empty. Although the prices may change somewhat as a consequence of unusually high or low demand, price adjustments don't necessarily compensate for lost revenues resulting from unseasonable temperatures. (For related reading, see: What impact does weather have on my investment in the weather industry?)

Finally, weather risk is also unique in that it is highly localized, cannot be controlled and, despite great advances in meteorological science, still cannot be predicted precisely and consistently.

Until recently, insurance has been the main tool used by companies for protection against unexpected weather conditions. But insurance provides protection only against catastrophic damage. Insurance does nothing to protect against the reduced demand businesses experience as a result of weather that is warmer or colder than expected.

In the late 1990s, people began to realize if they quantified and indexed weather in terms of monthly or seasonal average temperatures and attached a dollar amount to each index value, they could in a sense "package" and trade weather. In fact, this sort of trading would be comparable to trading the varying values of stock indices, currencies, interest rates and agricultural commodities. The concept of weather as a tradeable commodity, therefore, began to take shape. (For related reading, see: How Do You Trade the Weather?)

"In contrast to the various outlooks provided by government and independent forecasts, weather derivatives trading gave market participants a quantifiable view of those outlooks," noted Agbeli Ameko, managing partner of energy and forecasting firm EnerCast.

In 1997, the first over-the-counter (OTC) weather derivative trade took place, and the field of weather risk management was born. According to Valerie Cooper, former executive director of the Weather Risk Management Association, an $8 billion weather derivatives industry developed within a few years of its inception.

In general, weather derivatives cover low-risk, high-probability events. Weather insurance, on the other hand, typically covers high-risk, low-probability events, as defined in a highly customized policy. For example, a company might use a weather derivative to hedge against a winter forecasters think will be 5° F warmer than the historical average (a low-risk, high-probability event). In this case, the company knows its revenues would be affected by that kind of weather. The same company would also most likely purchase an insurance policy for protection against damage caused by a flood or hurricane (high-risk, low-probability events).

In 1999, the Chicago Mercantile Exchange (CME) took weather derivatives a step further and introduced exchange-traded weather futures and options on futures—the first products of their kind. OTC weather derivatives are privately negotiated, individualized agreements made between two parties. But CME weather futures and options on futures are standardized contracts traded publicly on the open market in an electronic auction type of environment, with continuous negotiation of prices and complete price transparency.

Broadly speaking, CME weather futures and options on futures are exchange-traded derivatives that, by means of specific indexes, reflect monthly and seasonal average temperatures of 15 U.S. and five European cities. These derivatives are legally binding agreements made between two parties and settled in cash. Each contract is based on the final monthly or seasonal index value determined by Earth Satellite (EarthSat) Corp, an international firm specializing in geographic information technologies. Other European weather firms determine values for the European contracts. EarthSat works with temperature data provided by the National Climate Data Center (NCDC), and the data it provides is used widely throughout the over-the-counter weather derivatives industry as well as by CME.

Figure 1 - A weather derivative table quoting prices of May 2005 contracts. Source: Chicago Mercantile Exchange Weather-i™

Weather contracts on U.S. cities for the winter months are tied to an index of heating degree day (HDD) values. These values represent temperatures for days when energy is used for heating. The contracts for U.S. cities in the summer months are geared to an index of cooling degree day (CDD) values, which represent temperatures for days on which energy is used for air conditioning. Both HDD and CDD values are calculated according to how many degrees a day's average temperature varies from a baseline of 65° Fahrenheit (The day's average temperature is based on the maximum and minimum temperature from midnight to midnight).

An HDD value equals the number of degrees the day's average temperature is lower than 65° F. For example, a day's average temperature of 40° F would give you an HDD value of 25 (65 - 40). If the temperature exceeded 65° F, the value of the HDD would be zero. This is because in theory there would be no need for heating on a day warmer than 65°.

Figure 2 - Table summarizing daily average temperatures and the corresponding HDD and its impact on the relevant contract

A CDD value equals the number of degrees an average daily temperature exceeds 65° F. For example, a day's average temperature of 80° F would give you a daily CDD value of 15 (80 - 65). If the temperature were lower than 65° F, the value of the CDD would be zero. Again, remember that in theory there would be no need for air conditioning if the temperature were less than 65°F.

For European cities, CME's weather futures for the HDD months are calculated according to how much the day's average temperature is lower than 18° Celsius. However CME weather futures for the summer months in European cities are based not on the CDD index but on an index of accumulated temperatures, the cumulative average temperature (CAT).

A monthly HDD or CDD index value is simply the sum of all daily HDD or CDD values recorded that month. And seasonal HDD and CDD values are the accumulated values for the winter or summer months. For example, if there were 10 HDD daily values recorded in Novemer 2004 in Chicago, the Nov 2004 HDD index would be the sum of the 10 daily values. Thus, if the HDD values for the month were 25, 15, 20, 25, 18, 22, 20, 19, 21 and 23, the monthly HDD index value would be 208.

The value of a CME weather futures contract is determined by multiplying the monthly HDD or CDD value by $20. In the example above, the CME November weather contract would settle at $4,160 ($20 x 208 = $4,160).

Current users of weather futures are primarily companies in energy-related businesses. However, there is growing awareness and signs of potential growth in the trading of weather futures among agricultural firms, restaurants and companies involved in tourism and travel. Many OTC weather derivative traders also trade CME Weather futures for purposes of hedging their OTC transactions.

The advantages of these products are becoming increasingly known: The trading volume of CME weather futures in 2003 more than quadrupled from the previous year, totaling roughly $1.6 billion in notional value, and the momentum of this volume continues to increase.

(For additional reading, see: Does Weather Affect the Stock Market?)