Weather Derivatives

[Guest053011]

This sounds like farmer's insurance on crack.

This is possibly the most absurd financial market I've ever heard of. It reminds me of the betting that goes on in Britain, where almost can bet on almost anything - including weather at shockingly high risks.

It became big on the market thanks to Enron.... Says enough on it's own. No control and can't fully hedge it.

Here's what Wikipedia has to say:
The difference from other derivatives is that the underlying asset (rain/temperature/snow) has no direct value to price the weather derivative.

The first weather derivative deal was in July 1996 when Aquila Energy structured a dual-commodity hedge for Consolidated Edison Co.[1] The transaction involved ConEd's purchase of electric power from Aquila for the month of August. The price of the power was agreed to, but a weather clause was embedded into the contract. This clause stipulated that Aquila would pay ConEd a rebate if August turned out to be cooler than expected. The measurement of this was referenced to Cooling Degree Days measured at New York City's Central Park weather station. If total CDDs were from 0 to 10% below the expected 320, the company received no discount to the power price, but if total CDDs were 11 to 20% below normal, Con Ed would receive a $16,000 discount. Other discounted levels were worked in for even greater departures from normal.

After that humble beginning, weather derivatives slowly began trading over-the-counter in 1997. As the market for these products grew, the Chicago Mercantile Exchange introduced the first exchange-traded weather futures contracts (and corresponding options), in 1999. The CME currently trades weather derivative contracts for 18 cities in the United States, nine in Europe, six in Canada and two in Japan.

Thoughts?

[discreetgent]

Welcome back.

The first use I recall of weather derivatives was a city buying snow insurance (can't remember which one). If the amount of snow was some percent over the average for that city the insurance policy kicked in to cover the additional cleanup costs. So happened that the city was hit by massive storms that winter and made out like a bandit.

Weather derivatives can serve a need similar to the above. For an energy company to hedge their costs makes perfect sense even though the weather in itself does not have a value what does have a value is the costs associated with it.

[Guest083011]

Welcome back both of you (DG and LS)

[Iaintliein]

Right up there with "carbon credits". And to think most places outlaw gambling!

[Guest053011]

Originally Posted by Iaintliein

Right up there with "carbon credits". And to think most places outlaw gambling!

I can't wrap my head around carbon credits... Once energy is spent, and carbon is in the atmosphere...

It seems like empty posturing.

[discreetgent]

Carbon credits are different than hedging against weather. As Lauren points out the carbon is in the air one way or another, although the theory is if it costs to put them in the air then it may cut back on it, not clear that reality will match theory.

Hedging against weather makes some sense. Start with farmers' insurance. The original use of futures contracts was agriculture based. A farmer sold corn or cotton or wheat to a company for a price agreed on in say March. Both the farmer and the company that was going to make bread or cereal or clothing had cost certainty. Sometimes the farmer came out ahead since the price he got in March was better than market prices in August, other times the company that bought the product came out ahead. Now, farmers insurance was rather dependent on what the weather was over the growing season. Too little rain and less product would have meant higher prices, perfect conditions and more farmers planting would mean lower prices. So weather was always a factor just not the one the contract was placed on.

Say I am a commercial property manager with a few million square feet under management in New York. Typically I would lease out space for some set amount/square foot/year and would be responsible for maintenance, heating, cooling, etc. If I am anticipating a particularly cold winter along with some shortage of gas/oil then it is fiscally prudent for me to hedge using a heating day contract.

[Iaintliein]

Originally Posted by Lauren Summerhill

I can't wrap my head around carbon credits... Once energy is spent, and carbon is in the atmosphere...

It seems like empty posturing.

It is, besides CO2 isn't a pollutant to begin with. So, it's actually empty posturing about an empty (imaginary) problem! Posturing squared!

It would really twist some green's fig leaves into knots if they knew how much money the petro-chemical industry would make off "cap and trade" if it actually became law.

[Guest053011]

Originally Posted by Iaintliein

And to think most places outlaw gambling!

Maybe Wallstreet doesn't like the competition

Thanks for the 411 DG

[discreetgent]

Originally Posted by Lauren Summerhill

I can't wrap my head around carbon credits... Once energy is spent, and carbon is in the atmosphere...

True, but the goal is to cut down on the amount of carbon that is getting into the atmosphere in the first place.

[pjorourke]

Originally Posted by discreetgent

Weather derivatives can serve a need similar to the above. For an energy company to hedge their costs makes perfect sense even though the weather in itself does not have a value what does have a value is the costs associated with it.

Word! Conceptually, common stock for a utility IS a weather derivative.

[pjorourke]

Originally Posted by Iaintliein

Right up there with "carbon credits". And to think most places outlaw gambling!

Carbon credits are more like plenary indulgences.

[pjorourke]

Originally Posted by discreetgent

Hedging against weather makes some sense. Start with farmers' insurance. The original use of futures contracts was agriculture based.

...

Say I am a commercial property manager with a few million square feet under management in New York. Typically I would lease out space for some set amount/square foot/year and would be responsible for maintenance, heating, cooling, etc. If I am anticipating a particularly cold winter along with some shortage of gas/oil then it is fiscally prudent for me to hedge using a heating day contract.

two excellent examples of potential counter-parties to the utility.

[Texas Contrarian]

I think weather derivatives make great sense for some individuals and entities, and discreetgent gave a couple of excellent examples. They offer the opportunity to lay off bets you feel you cannot comfortably take.

Many businesses hedge against risks in similar ways, whether with futures or other vehicles. For instance, airlines often hedge against oil price spikes. Those who at least partially hedged against the 2008 oil price spike were sure glad they did!

Carbon credit "markets", on the other hand, at least as have been envisioned by some, tend to be completely phony.

For instance, I could sell you a "carbon credit" with a deal structure sort of like this:

Let's say you want to drive around in big SUVs and motor homes, but want to absolve yourself of the guilt you might feel over possible environmental damage. You can buy a carbon credit from me! For, say, $50,000, I will agree not to charter, or cause to be chartered, a Gulfstream jet for the purpose of transporting me and a girlfriend to and from an international vacation destination at any time during the next 10 years. (The fact that I'm exceedingly unlikely to do that anyway doesn't matter, the point is that I agree not to do it.)

Hardly any market is as rife with potential for scams and frauds as a "carbon credit" market.

[discreetgent]

Now that we have determined why a weather derivative is useful, lets look at where weather derivatives (as with many derivatives) become no more than a roll of the dice.

I am a trader who trades weather derivatives as part of my portfolio. I only care about how cold or hot it is because it affects the price of my contract; I don't have anything tangible that I am hedging, it is a pure financial play basically betting on the temperature.

[pjorourke]

Originally Posted by discreetgent

I am a trader who trades weather derivatives as part of my portfolio. I only care about how cold or hot it is because it affects the price of my contract; I don't have anything tangible that I am hedging, it is a pure financial play basically betting on the temperature.

Why not just go to Vegas?