A financial market for weather

Source: the National Oceanic and Atmospheric Administration (NOAA)

People suffer from bad weather. In particular, extreme weather events increase cost of doing business and cause in turn financial losses. In order to decrease economic and financial impact of volatile weather, people have started to protect their assets initially by means of insurance. With the development of financial and energy markets, other types of financial instruments appeared. The market of weather derivatives, for instance, has been experiencing a rapid growth since 1997.

It is not clear who made the first deal related to weather risk mitigation or what was the bargain about or when was the contract signed. Nevertheless, there will be no mistake to claim that the first transactions on financial markets that involved weather risk abatement were insurance contracts. Insurance for weather were widespread in 20th century all over the world. For example, it is acknowledged that ICICI Lombard, a private sector general insurance company in India, offered weather insurance for Indian farmers in the early 20th century. The product referred to the risks related to temperature and precipitation turmoil. The integration of capital and insurance markets in 20th century gave birth to new financial instruments that allowed to hedge against extreme weather events. Catastrophe bonds and weather derivatives are cases in point.

Industry experts agree on the fact that financial market for weather developed in 1990s after the deregulation of US electricity market. New market conditions of the second half of 20th century forced American government to modify energy legislation in favor of market competition. The reform focused on utility industry and presumed the switch from the government regulation of utility rates to the price formation by means of market mechanism.

The cornerstone of new institutional environment of American power market was Energy Policy Act of 1992. The bill enabled electricity producers to sell their power to utilities. This increased competition on the market and was supposed to push the prices for end consumers down.

Another key element of the electricity deregulation reform was Order #888 issued by the Federal Energy Regulatory Commission (FERC) in 1996. According to this directive, electric utilities had to provide all of players with free access to transmission lines. This shortened in turn the supply chain network of electric power.

Free access to American transmission capacity along with new approach to pricing based on the laws of demand and supply created new opportunities for weather risk mitigation. Such financial instruments as weather derivatives appeared. Targeting on weather forecasts, these became soon an efficient tool for hedging against extreme weather events.

In 1996, for instance, Consolidated Edison Company of New York (Con Edison) signed the contract on power supply with Aquila. The deal included weather risk abatement and prevented Con Edison from financial losses in case the August would be cold and people’s demand on electricity for air conditioning would decline. Companies relied on the weather forecast supplied by New York City’s Central Park weather station. According to the deal, Aquila had to provide Con Edison with the predetermined discount to the electricity price in case the number of cooling degree days prevailed the expectation by more than 10 percent.

Another example dates back to 1997, when Willis Group Holdings, Koch Industries and Enron Corporation incorporated weather data to risk indices and conducted one of the first transactions that the one may describe as weather risk management by means of derivatives.

The El Niño oscillation in winter of 1997–1998 became a crucial driver of the development of the weather derivatives market. According to National Climatic Data Center, the event brought the second warmest winter since 1895. As a result, many companies suffered from serious financial losses owing to an uncharacteristic mild winter. At the same time, this was a trigger for investors who subsequently started to look for opportunities to hedge against the risk associated with the weather.

The deal between Con Edison and Aquila along with Willis-Koch-Enron contract referred to the weather risk management on over-the-counter market (OTC). The rapid growth of OTC market for weather derivatives in 1990th was due to its unique features. Specifically, OTC contracts allow an investor to hedge weather-related risks for almost any location. The so-called Master Agreement of International Securities and Derivatives Association (ISDA), however, decelerated the further growth of the OTC market because of the credit risk issues that OTC contracts include.

Organized market subsequently became major driver in trade of weather-related financial instruments. The boom refers to 1999 when Chicago Mercantile Exchange (CME) introduced standardized futures and options on weather indices. Initially, CME listed only temperature contracts. These were standard contracts of HDD and CDD. Both of them represented hedging opportunities in only ten cities in the US at the initial lunch. Nowadays, there is more weather related contracts traded on exchange than on OTC.

To sum up, the liberalization of commodity markets, which took place in the second half of the last century, resulted in new opportunities on financial markets. Hedging weather risk with the help of derivatives is a case in point. Since 1997, when El Niño increased the demand for the derivatives written on weather indices, both OTC and organized market for weather has grown remarkably. Nevertheless, the latter one has a greater potential for further development given the market legislation and credit risk constraints imposed on OTC market.