By James Scarrow

Weather derivatives are starting to make an appearance in the project finance market. Energy finance professionals need to be familiar with these risk mitigation tools and the creative ways that they can be used. A large “monetization” transaction moving currently to market — and a debate about whether weather derivatives should be regulated as insurance — will determine the extent to which they will become a standard tool in the future financing of energy projects.

What is a Weather Derivative?

A weather derivative is a transaction through which payments from one party to the other are made based on weather-related measurements, such as temperature, rain, snow or wind speed.  Businesses that bear weather-related risks can use weather derivatives to transfer, share or otherwise hedge against such risks.

Take the hypothetical example of a beer vendor and a cocoa vendor at the baseball stadium used by the New York Yankees.  Each is concerned about how the unpredictable April weather in the Bronx could affect his respective beverage sales.  In order to hedge against the risk that sales will be lower than anticipated due to unseasonably warm weather (in the case of the cocoa vendor) or unseasonably cold weather (in the case of the beer vendor), they agree that for each game during April, the cocoa vendor will pay to the beer vendor $10 for each degree Fahrenheit by which the temperature at game time is below 55 degrees and, conversely, the beer vendor will pay to the cocoa vendor $10 for each degree by which the temperature is above 55.  They further agree that the maximum amount per game that either party would owe the other is $100, and that they will settle up on May 1.

As is the case with derivative contracts for more commonly-traded commodities like gold, platinum and pork bellies, weather derivative contracts can be structured in a variety of ways including swaps (as in the example above), futures, options on futures, collars, and so on.

Although weather derivatives share many of the attributes of traditional commodity-based derivative contracts, there are several important distinctions.  First, derivatives contracts for physical commodities are used to hedge price-related risks (for example, the risk that gas prices will rise in the future) while weather, derivatives are typically used to hedge against volume risks (for example, the risk that because of cold weather, additional volumes of gas will have to be purchased).  Second, derivatives contracts for physical commodities can require the actual delivery of the underlying commodity (gas, oil, etc.) at a pre-determined time, price and date.  In contrast, weather derivatives never involve the physical delivery of the weather “commodity” (ambient temperature, rain, wind, etc.), and they are always settled financially.  Finally, while there are speculators who bet on the future prices of physical commodities, industry sources indicate that, to date, weather derivatives have been used principally for hedging and not for speculation.

Temperature-Based Weather Derivatives

Weather derivatives based on temperature are by far the most common type of weather derivative, accounting for approximately 85% of all weather derivative transactions.  Such contracts are typically based on the number of heating degree days — called “HDD” — or cooling degree days — called “CDD” — over the contract period (typically a month or a winter or summer season) at a specified location.

The number of HDD or CDD in any period is a measure of the amount by which each day’s average temperature during the period deviates from 65 degrees Fahrenheit.  For this purpose, the “average” is 50% of the sum of the highest and lowest temperature for the day.  For example, during January 2004, Chicago had 1,385 HDD.  Houston had 335 HDD and 16 CDD during that same period.

A business that would expect to suffer reduced revenue during an unusually cold December could mitigate its risk by entering into an agreement with a counterparty (such as Entergy-Koch Trading, Goldman Sachs, Deutsche Bank or XL Weather and Energy) under which the business would receive a payment if the number of HDD during that month exceeded the historic average of 800 but would not be required to make any payment to the counterparty if there were fewer than 800 HDD.  The premium that the business would have to pay to the counterparty for this form of option agreement would depend on the perceived risks and the maximum payment that the business could receive under the contract.  Typical premium amounts range from 10% to 30% of the contract payment limit.

In 1999, the Chicago Mercantile Exchange launched the first public exchange-traded weather derivatives, based on the number of HDD and CDD over monthly or seasonal periods for certain population centers.  Futures and options on futures can be purchased on the Chicago Mercantile Exchange.  Exchange-treaded weather derivatives based on temperature are now also offered on the London International Financial Futures Exchange and the Helsinki Exchange.  There are no exchange-traded derivatives available for wind- or precipitation-based derivatives.

Wind-Based Weather Derivatives

Weather derivatives linked to wind have recently become available, allowing wind farm owners to hedge against the risk of sporadic winds.

These contracts (of which, to date, fewer than a handful have been executed in the US) are negotiated bilateral contracts in which both the wind speed and turbine power-production characteristics are taken into account.  Entergy-Koch Trading has developed proprietary wind power indices for selected locations in the US and Europe.  The index for each location is designed to reflect the amount of power that could be generated at that location, based on both wind speed data and a power generation curve that reflects a basket of typical turbines. (Because the amount of power produced by a wind turbine is not linearly proportional to wind velocity, the wind power indices are not simply the wind velocity.) The wind power index for each location is calibrated such that the index for each location will be 100 during a normal year.  Thus, a wind farm with certain debt service obligations might enter an agreement that would generate sufficient funds to pay debt service during any contract period during which the wind index drops below 90.

Precipitation-Based Weather Derivatives

Rain-related contracts account for approximately 10% of weather-derivatives transactions.  Typically, these contracts are based on the number of critical precipitation days — called “CPD” — that occur during the contract period — that is to say, the number of days during which precipitation exceeded a specified reference level.

Derivatives transactions based on precipitation can be used to hedge energy-related risks associated with reservoir levels at hydropower facilities.  For example, the Sacramento Municipal Utility District, which relies on hydropower for approximately 60% of its generating capacity, entered an agreement under which it would be paid up to $20 million if the local precipitation was below the 30-year average.  In wet years, when SMUD enjoys more revenue from power sales, it would be required to pay up to $20 million to the counterparty.

Documentation of Transactions

Privately-negotiated weather derivatives contracts typically are based on the standard International Swaps and Derivatives Association, or “ISDA,” Master Agreement, which is the same form agreement used for derivative agreements involving physical commodities.

In October 2003, in response to the growing volume of weather derivatives transactions, ISDA published a series of new template confirmations and appendices, including form confirmations for weather index swaps, put options and call options, as well as form appendices for CDD, HDD and CPD index transactions.  The new ISDA forms will help bring uniformity to the structure of privately-negotiated weather derivative transactions and presumably reduce the costs of negotiating such agreements.

The ISDA forms now include weather index appendices for heating degree days, cooling degree days and critical precipitation days.  ISDA has not published standardized forms for wind transactions.

Monetizing Weather Derivatives

The holders of large positions in weather derivatives can hedge their exposure in a number of ways, including covering their positions by entering transactions with other parties or, in the case of temperature-based derivatives, through exchange-traded transactions.  Another way the risk can be transferred is through weather bonds.

A weather bond is conceptually similar to “catastrophe bonds,” which have been used periodically since 1997 by reinsurers to transfer risks associated with catastrophic events such as earthquakes and hurricanes.  When catastrophe bonds are issued, the sales proceeds are deposited into the account of a special purpose entity.  Bondholders receive interest and principal payments from the premiums owed to the reinsurer.  Depending on how the bond is structured, the bondholders lose all or a portion of interest and principal payments if a covered catastrophic event occurs.  For example, in January 2004 a 5-year catastrophe bond was issued by a special purpose entity to transfer to bondholders the risk of windstorm damage to the electricity transmission and distribution system of Electricité de France.  The bond uses a specially structured index that not only takes into account recorded windspeeds in the area of the covered transmission and distribution system, but also reflects the vulnerabilities of that system to wind-related damage.  When the measured index exceeds the trigger point, payouts are made to EDF regardless of whether there was actual physical damage.

As with catastrophe bonds, weather derivative bonds can be used to transfer to bondholders weather risks associated with a basket of weather derivative positions.  The first, and thus far only, weather bond was issued in 1999 when Koch Energy Trading worked with underwriter Goldman Sachs to structure a $50 million, 3-year 144A offering that transferred to investors the risks associated with a portfolio of 28 weather derivative contracts based on temperatures in 19 different US cities.  The securities were offered by a special purpose Cayman company, Kelvin Ltd.  The portfolio’s aggregate temperature risk was modeled by a consulting firm, with such modeling presumably showing to the satisfaction of would-be bond purchasers that the portfolio of derivative contracts would support payment of interest and principal.  If the aggregate position of the derivative contracts became out-of-the-money, the special purpose issuer would be required to make payments to Koch Energy Trading under the terms of a swap agreement.  Although the Kelvin transaction eventually closed, it was not without difficulty and the $50 million offering was considerably less than had originally been contemplated.

Despite the challenges of closing the Kelvin bond issuance, within the last few weeks it has been reported that the Inter-American Development Bank is preparing to launch a $300 million weather-linked bond offering that would transfer to the capital markets a portfolio of derivative weather exposures believed to be held by Entergy-Koch Trading.  Reportedly, the coupons will be linked to the performance of a wide array of global weather risks, ranging from wind speed in Spain to snow depth in Fukushima, Japan.  The bond issue will be split into three tranches and offer a guaranteed coupon in the first year.  Thereafter, the coupons are linked to the weather index and may fluctuate, but the principal is guaranteed by the IADB.  The appetite of investors for these complex securities may be a good indicator of whether weather bonds will enjoy a robust future.

Are Weather Derivatives Insurance?

Weather derivatives are considered financial derivatives and in many cases regulated as such by the US Commodity Futures Exchange Commission.  However, with the continued growth in volume and variety of weather derivatives, the line between capital market products and insurance products is becoming blurred.

In a September 2003 draft white paper circulated by a working group of the National Association of Insurance Commissioners, or “NAIC,” it was argued that weather derivatives are insurance products and should be regulated as such: “businesses that are involved in accepting risk transfers for a fee are known as insurers and the fee paid by the entity seeking to transfer its risk is known as premium.” Regulation of weather derivatives, the white paper argued, would protect consumers from unfair contractual terms, provide assurance that adequate reserves are being maintained and also provide a safeguard against the gaming of indices like those that allegedly have occurred in the natural gas market.

In a forceful February 23, 2004 response, ISDA urged NAIC to reject the draft white paper.  Arguing that weather derivatives are not insurance, ISDA stressed that unlike insurance, weather derivatives do not require a party to have suffered a loss in order to receive payment; instead, weather derivatives are “simply contracts with contingent payment obligations.”

As the weather derivatives market grows and matures in the coming years, the proper classification of weather derivatives will be a subject of continued discussion and debate.  The resolution of this debate will have significant regulatory, tax and accounting implications that will probably determine the extent to which weather derivatives become standard tools used in the financing of energy projects.