By Robert Hunter

The hype over weather derivatives is being replaced by real deals, and everybody’s scrambling for position.

The viewership of the Weather Channel has always skewed decidedly toward the nerdy. But if the lightning-fast development of the weather derivatives market is any indication, before long the ratings-challenged cable channel could reach a whole new audience—financial players around the world who have suddenly become obsessed with occluded fronts, La Niña and other weather arcana that for years had been the exclusive province of people with backyard barometers.

While derivatives historians may quibble over the precise date of the first weather contract—some say July 1997, while others say August of that year—everyone in the weather business agrees that the market hit the ground running.

“There has been an explosion of deals in the marketplace and a tremendous amount of interest on the client side,” says Richard Turrin of Paribas’ strategic derivatives group. “The industry has seen the birth of a new market in the last year to 18 months, and in the last six months the growth has been exponential.” Houston-based energy giant Enron estimates that between 900 and 1,000 transactions have taken place to date, with the notional value of those deals exceeding $1.5 billion. Kansas City, Mo.-based Aquila, the unregulated marketing and trading arm of Utilicorp, puts that figure closer to 1,200.

Most of the early business consisted of newly deregulated energy firms such as Enron, Aquila, Houston-based Koch and Houston-based Southern Co. hedging against demand spikes resulting from last year’s bout with El Niño, undoubtedly the galvanizing force in the weather derivatives market. But in recent months, the weather business has broadened and deepened to an astonishing degree. Enron has written more than 300 contracts on degree days (see “Weather Derivatives: A Primer,” Page 18) to date, while Aquila has written between 250 and 300. Fast on their heels is New York-based weather broker-dealer Natsource, which passed the 100 mark last year.

The weather derivatives business is now at a critical stage: the initial media-fueled hype has quieted, and marketers are mobilizing to penetrate the most remote reaches of American commerce. A quick glance at attendance numbers in the booming weather derivatives conference circuit indicates that word is spreading like wildfire.

While energy firms are still the most active in the weather business, other industries are getting into the game as well. Enron has already acted as counterparty in deals with manufacturers of snowmobiles and snowblowers, the film industry and the fertilizer industry, and has fielded inquiries from theme parks, golf courses, sports-drink makers, car washes and ski resorts. Aquila boasts transactions with salt producers, ski resorts and other entertainment companies. In addition to the relatively commonplace degree-day deals, says Enron’s Lynda Clemmons, a director at the firm, she has been approached by companies interested in rainfall, snowfall and even barometric pressure contracts.

Spreads are the key

All traders know that the best place to look for evidence of a market’s liquidity is its bid-offer spread, and therein lies the story of the weather business thus far. In degree-day deals, says Turrin, spreads are getting tight—fast. Most players cite spreads as falling somewhere between 10 percent and 30 percent of a contract’s maximum payout, which usually is capped anywhere from $500,000 to $5 million. Some see far narrower gaps. “We’re working on a strangle transaction in which the bid and offer are only $20,000 apart, with a $3 million limit,” says Tripp Dunman, weather portfolio manager at Aquila. Simple degree-day options, he argues, are even tighter—often a mere $5,000 apart.

But in other products, such as precipitation, wind speed and Aquila’s guaranteed forecast products, and in certain geographical regions, spreads have generally hovered from 30 percent to 50 percent—enough to make counterparties think twice about the benefits of hedging. In the recent November–March contract cycle for heating degree-day deals, for instance, the vast majority of transactions were done in the upper Midwest and the East Coast, while the West Coast saw few transactions. But the warmer-than-expected December 1998 was a signal to many that La Niña, the punitive little sister that follows El Niño , might not throw certain areas of the United States into a deep freeze this winter as predicted. The result: a number of companies either unwound completely or altered November–March degree-day option positions by entering into degree-day swaps.

	“There’s a big difference between where companies are willing spend and how much providers are willing to absorb.” Jeff Porter, Koch Industries

Because weather derivatives are so novel, and Mother Nature is so predictable, many potential end-users are content to wait on the sidelines until liquidity improves, spreads narrow and the market deepens further. “Right now, the industry is trying to find where weather derivatives make sense,” says Jack Cogen, president of Natsource. “For example, do they make sense in the agricultural world? Are weather derivatives any different from or better than crop insurance? Those are the kind of issues that have to be dealt with.” Jeff Porter, vice president of origination at Koch Industries, agrees. “The weather derivatives market is somewhat similar to the credit derivatives market,” he says. “There’s a lot of talk and hype, and there’s quite a bit of trading going on in the weather market. Although end-users have increased steadily since the market began, they are certainly not flocking in.” One New York investment banker describes the market as “over-brokered”.

Enter the insurers

The most conspicuous newcomers to the weather derivatives marketplace over the last few months have been insurance and reinsurance companies, which view weather as the latest area of convergence between the insurance industry and the capital markets. As of last October, AIG’s fledgling weather operation had already fielded 50 to 75 inquiries and completed five transactions. “We have primarily written put and call spreads, collars and some strangles on degree days,” says Douglas Oliver, vice president of financial engineering at AIG Risk Finance. The company hasn’t yet written contracts with companies outside the energy industry, but it anticipates at least one municipal snowfall contract and another multiple-trigger transaction for an entertainment facility.

Swiss Re, meanwhile, entered the business last September and, according to Scott Turner, vice president of structured finance, has completed a “significant number” of trades thus far. It focuses primarily on continental United States locations, writing contracts on heating degree days (HDDs), cooling degree days (CDDs) and energy degree days, and is “looking at” rainfall as well.

Insurers are natural players in the weather arena. “Insurance companies are traditionally acceptors of statistically based risks,” says Oliver. “So to the extent there’s an index out there, particularly one that is tracked by a governmental entity such as the National Weather Service, insurance companies have taken the position that a weather index is no different from any other statistically based transaction. The index cannot be influenced by the client, there is a fixed amount of payoff for specific movement in the index, and there is a policy limit or a cap in place.”

The insurance industry, moreover, serves to broaden the market by offering expertise—and structuring ability—in high-risk, low-probability events, filling the void created by the capital markets, which are much more comfortable in the low-risk, high-probability arena. “We are willing to provide capacity further away from the expected mean degree days for a given location,” says Turner. “Also, reinsurance companies, such as ourselves, have diversified risk portfolios. This enables them to assume more of this weather risk on a net (that is, unhedged) basis and can provide more flexibility in structuring programs.”

The success of the nascent catastrophe securitization market, moreover, bodes well for the emergence of a market in weather risk-based securities. Several reinsurers have shown a great deal of interest in securitizing catastrophic risk via cat bonds—to the tune of $5 billion to $7 billion by some estimates. Weather derivatives are intrinsically more attractive because they are based on governmental indices, are readily quantifiable and do not inject what the insurance industry calls moral hazard into the process by linking payouts to insurers’ self-imputed loss figures—the financial equivalent of the honor system.

Weather Derivatives: A Primer

Weather derivatives allow companies to control the effects of the weather on demand for their products. Here are some of the most popular structures. Temperature Contracts A degree day is the deviation of a day’s average temperature from 65 degrees Fahrenheit. In the summertime, the demand for energy increases with every degree above 65; in the winter, the demand for heat increases for every degree day below 65. There are a number of degree-day products available to energy producers. In most, payment is made for every degree day above or below the strike, with a maximum payout that can range from $500,000 to $5 million or more. Degree-day swaps: An energy producer that sells a swap is compensated for a certain amount per degree day whenever degree days settle below or above an agreed strike level. Degree-day options: An energy producer buys a put and is paid a fixed amount per degree day whenever the degree days settle below an agreed strike. Degree-day collars: Producers buy a put on a low strike and sell a call on a high strike to lock in a certain range of degree days. In the cost-free collar variety, the premiums of the call and put cancel each other out, resulting in no cost to the producer. Degree-day straddles: Producers hedging against a massive shift in demand can enter into a straddle, which allows for protection against extreme moves irrespective of the direction of the move. Digital options: Producers hedging against massive demand spikes can also use digital structures, in which a single lump-sum payment is stipulated when the temperature hits a certain strike. Other Weather Derivatives Dual-trigger options: A company can hedge against multiple weather events with dual-trigger options. For instance, a farmer adversely affected by an 85-degree average temperature with 0.5 inches of rainfall can enter into a dual-trigger option to protect against both using a single structure. Compound options: Companies wary of locking into an option can use a compound option, in which they pay only a fraction of the option premium up front, and later—usually after evaluating updated long-range forecasts—have the option of entering fully into the structure. Guaranteed forecast: Aquila, the weather derivatives trading subsidiary of Utilicorp, offers option products based on the National Weather Service’s four- to eight-day forecast. If the actual temperatures fall above or below the forecast, holders receive payments. Precipitation and wind speed contracts: Companies can enter into options, swaps and other structures based on precipitation or wind speed indices provided by the National Weather Service. —R.H.

“Reinsurers like this product because they already have the ability to price a weather option very easily, since they’ve already priced catastrophes,” says Ellen Slote, head of the weather derivatives desk at Eurobrokers. “So it’s a natural extension to what they already have the ability to do. Another reason they’re interested is diversity—it is a new type of product, but to them it still looks, feels and smells the same.”

	Dealers have acted as counterparties with manufacturers of snowmobiles and snowblowers, the film industry, the fertilizer industry, salt producers, and ski resorts.

Peter Gaskos, a director at Swiss Re, agrees. “In a market where there are few natural counterparties to adverse events, Swiss Re is enthusiastic about taking on weather risk because it has limited correlation with our existing risk holdings. In turn, this will help us bring the cost of risk capital down for our clients. Increasingly, we find ourselves in a complementary role to the trading houses, where our participation makes the difference in the completion of large transactions. As reinsurers, this is a role to which we are very accustomed.”

Trouble in paradise?

While companies may be jumping over themselves trying to break into the weather derivatives market, the business is going through its share of growing pains. Basis risk is the most immediate. A counterparty cannot intentionally manipulate weather data, of course, so the market is largely free of moral hazard. But the National Weather Service and its affiliated cooperative weather stations are not infallible—particularly in measuring precipitation. “If you measure how many drops of rain fall in a cup at Chicago O’Hare Airport, that has almost no relevance to how many drops fall 100 yards from there or a mile from there,” says Paul Murray, managing director of Castlebridge Weather Markets, a Chicago-based market-maker. “So the basis risk on precipitation is very large. Whereas with degree days, temperature is ambient—it’s everywhere.” Murray notes that a fairly robust swaps market in the precipitation arena would mitigate basis risk by making option position management easier.

To muddle measurement matters further, the National Weather Service’s automated sensory observation stations (ASOSs) recently began measuring snowfall using a new technique called the snow-water equivalent, injecting a potentially lethal dose of basis risk into preexisting snowfall contracts. And since not every geographical area is adorned with an ASOS, cooperative weather stations staffed by volunteers fill in the data gaps. “The problem here is more than basis risk—you’re dealing with volunteers who are obsessed with the weather,” says a broker. “They’ll go out every single day and measure the temperature. But then, suddenly, five days’ worth of data will be missing, because it’s homecoming weekend.”

Another hurdle to the market’s growth is the lack of a single, universal pricing model that provides transparency. There are many schools of thought on the correct approach. The result: a significant amount of model risk. “How do you model the weather?” asks Lee Branscome, president of Environmental Dynamics Research, a weather and climate consultancy. “How can you be confident that you have accurately represented the probabilities of certain outcomes? If you don’t know that, and are trying to guess at that somehow, you’re probably going to get burned.”

Others agree. “The lack of modeling capabilities is hindering some people from getting into the market,” says Karen Phillips, vice president in Prebon’s weather products group. “Weather is not a standard derivative—it’s different from most other products. Nobody yet has come out with a universal model, and nobody wants to talk about specifics. At conferences, people get up and mention pricing in passing, but they certainly don’t divulge their model’s details.”

One thing is clear about pricing weather contracts—the standard Black-Scholes-Merton model won’t cut it. In a weather derivative, there is no underlying tradable commodity, daily returns are not normally distributed and volatility does not remain constant over time. Because degree days accumulate over time, there is a stair-step pattern that cannot, by definition, revert to a historical mean.

Another suspect approach is expected-loss analysis, in which the historical performance of a weather derivative product is evaluated over some arbitrary period—from 10 years to as long as climate data exist—to determine what the average performance of the product would have been. The problem: previous performance is no guarantee of future returns, says Branscome. “That approach doesn’t incorporate any projection of what might happen in the upcoming season—and there is real value in that.”

The best—and most common—approach, say many, is Monte Carlo analysis. Castlebridge, for instance, simulates weather patterns for 1,000 years. But Branscome is wary of putting all of a client’s eggs in one Monte Carlo basket. “The Monte Carlo simulation can represent what the weather does to some extent,” he says. “But you’ve got to make sure you develop your simulation properly and adjust your parameters so that it reproduces first and foremost the underlying weather index. If you can’t reproduce what the weather does, you don’t have an adequate pricing model. I think people are a little too focused on the financial element of it. The fundamental issue is, how do you model the weather index that the derivative is going to be based on?”

The Rain in Spain

While the U.S. weather market is growing at a healthy clip, the European markets are little more than a gleam in weather brokers’ eyes. Enron completed the first reported transaction in Europe last November, a six-month temperature deal with Scottish Hydro in which Enron will pay SH should temperatures remain below a specified level for more than a set number of days over that period. Some think conditions are ripe for solid growth in Europe. “Deregulation of the electricity markets founded the weather markets in the United States,” says Paribas’ Richard Turrin, “and you’re starting to see that in Europe—deregulation of energy and electricity markets and also privatization of many of the publicly owned utilities. The same conditions that made this a very dynamic market in the United States exist equally in the European marketplace.” But the European market has a major—and until now insurmountable—problem: scarce weather data. The ability to acquire data in other countries is quite cumbersome and expensive. “The biggest single obstacle to growing the international business is data integrity,” says Ronda Schmidt, vice president of origination at Koch Industries. Others agree. “Until other national weather services abroad are able to facilitate our market by supplying inexpensive and complete data, it’s really going to be a hindrance,” says Eurobrokers’ Ellen Slote. “I can’t help my customers if I can’t get the data.” The prime offender, say many, is the United Kingdom. “The weather authorities in London have been extremely capitalistic about the way they’ve supplied records,” says a New Jersey-based broker. “I’ve heard that for six cities it can cost upwards of $21,000. That’s ridiculous. They’re doing their best to thwart the attempts of people to get into this arena.” —R.H.

Castlebridge is careful to separate the financial from the historical. In addition to using 1,000 years of simulations, it uses a relative-value approach as well. “We look at what’s trading in the market right now, and where the forward is trading, because every price implies a forward,” says Murray. “The Monte Carlo simulation gives you a nice theoretical value, but relative-value pricing lets you price things relative to where everyone else is in the market.” Of course, as the market develops, so, too, will the models. “If you ask most people what their model looked like a year or six months ago,” says Prebon’s Phillips, “I bet it looks different today. And probably in a year it’s going to look different again.”

	“Many of the structures we use have marginal additional cost but yield significant benefit to the party purchasing weather risk protection.” Richard Turrin, Paribas

Muddy modeling techniques can lead to difficult price negotiations between counterparties. “There’s a big difference between where companies are willing spend and how much providers are willing to absorb and how they want to be compensated on their absorption of risk,” says Koch Industries’ Porter. “Risk providers want to write contracts to their advantage. For example, market-makers take the position that there has been a definite warming trend in some heating degree-day data, so they’re not going to strike a swap at some historical average, since temperature variations 100 years ago are far less meaningful than those of recent years. But some companies take the position that while there’s been some warmer-than-normal winters recently, temperatures will revert back to a more historical mean. The difference in pricing when you have those two views can be pretty divergent.”

Long-term forecast

Even with such problems, most weather practitioners are bullish about the market’s future. The U.S. Commerce Department estimates that one-seventh of the U.S. gross domestic product has weather-related risk—translating into $1 trillion of potential weather-market business. The fact that primary and secondary markets have developed in weather, with market-makers writing business with end-users and then laying off their exposures to broker-dealers and others, is a clear sign that the market is already solidifying rapidly in the Untied States.

“I see a tremendous amount of application of these products in new and innovative ways,” says Randy Vivona, a tax specialist in Paribas’ strategic derivatives group. “We have just scratched the surface as to how weather products can be used both domestically and on a cross-border basis.” Eurobrokers’ Slote believes transactions will become increasingly structured, with options linked either to a commodity or to another form of weather, such as precipitation, representing the wave of the future, and predicts that precipitation will become a multibillion-dollar business.

AIG’s Oliver sees the market bifurcating into two distinct camps—one dominated by shorter-term, highly liquid deals such as degree-day products transacted by market-makers, and another consisting of more exotic structures transacted by investment banks and the insurance industry. “Derivatives players, by nature, have a tendency to embrace the volume approach—a quick-turnaround, exchange-traded type of transaction,” he says. “The more exotic, esoteric structures are likely going to come from the insurance and reinsurance industries—those firms are going to take a little more time to put deals together.” And Aquila’s Dunman sees the size of deals increasing massively. “Deals of $20 million will not be uncommon, and some of the bigger transactions will be $100 million to $200 million,” he says. There is already evidence that this is occurring. Last year, tick sizes were typically $5,000 per degree day. Lately, they’ve been growing to $10,000 and even $20,000 per degree day, says Castlebridge’s Murray.

	“Reinsurance companies have diversified risk portfolios and can assume more weather risk and provide more flexibility in structuring programs.” Scott Turner, Swiss Re

One area that will likely take off in the future is securitization of weather risk. At press time, United Companies was in the process of brokering for a European client a bond issue with an interest rate tied to weather risk—a seven-year heating degree-day call on a Northeastern U.S. city in the November–March months. One insurer, says Colt Heppe, senior vice president at United, offered a structure that demanded a higher premium than the others but stipulated that if the upper limit on the call is never struck, a majority of the premium would fall back into a quasi escrow account, and after seven years the payer of the option would get back a high percentage of its premium. If the upper limit is struck, the transaction would go into “negative mode,” in which the premium paid each year would go toward netting a zero balance in total premium outlay.

With deals like these already in the works, we may be witnessing the birth of a whole new class of weather fanatics—those with a serious financial stake in the whims of Mother Nature.

End-Users Weigh Their Options

One of the biggest questions these days for end-users thinking about entering the weather market is where to go to do a deal. The business may be in its formative stages, but four main financial groups have already staked out their positions. The first layer consists of the market-makers—primarily energy trading firms such as Enron, Utilicorp, Southern and Koch. These players transact deals primarily with end-users, most commonly in degree-day options and swaps and other minimally structured products. A company looking for a degree-day deal can simply pick up the phone and give a market-maker a call. More often than not it will get a fairly attractive quote. Broker-dealers, by contrast, put counterparties together and make a spread on each deal consummated. As a result, they always have their ears to the ground and know everyone in the business. “If you say, ‘I need X,’ they’ll go out and find it for you at the lowest price,” says an investment banker. “Moreover, they take positions themselves, either with end-users or by accepting risk from market-makers, so end-users might even get a good, cheap price from them. And they can offer slightly more structured products than market-makers.” Most weather derivatives these days are transacted through brokers. Prebon, in fact, obtains one-month quotes from 10 cities—Atlanta, Philadelphia, Cincinnati, Chicago, Portland, Sacramento, Las Vegas, Tucson, Houston and Miami—each morning, offering quasi benchmarks to clients interested in seeing how regions are trading vs. historical averages. “The only group that I see getting rich based on the amount of risk they’re taking is the broker market,” says Jeff Porter of Koch Industries. “They’re thrilled with this business, and while market-makers are happy with our business, we’d all like to trade with more end-users directly.” Investment banks, known for their structuring genius and financial wizardry, occupy the next rung up the weather ladder. Wall Street has been noticeably quiet in the weather business thus far, but some banks have tested the waters. Merrill Lynch, for instance, has been active for about a year. “We are looking at much more structured transactions, potentially much longer-dated transactions, or transactions with features that are able to be structured and fine-tuned to the customer’s risk management needs,” says Eric Tell, vice president of global new derivatives at Merrill. “I have never done two transactions that are the same. The added value we offer our clients is the ability to work with them to figure out what their exposure is and provide them with a structure that precisely fits their needs.” Paribas’ Richard Turrin agrees. “There are two sides to a bank’s role in the business. One is to work with clients so that their weather risk is properly understood. The other is to design products so that weather risk management enters the company in a friendly, amenable way to the accounting process. Banks have a unique role to play in structuring financial products so that the benefits of weather risk management can be transferred in the most efficient way possible.” Additional structuring can come at a higher cost, of course, although investment bank-structured deals need not be much more expensive than those of market-makers or broker-dealers. “The rationale for this is that if we were simply a high-cost provider of structured solutions, we would be out of business immediately based on price competition,” says Turrin. “While some structures can cost more, many of the structures we use have marginal additional cost but yield significant benefit to the party purchasing weather risk protection.” The highest rung on the ladder is insurance, the most structured and expensive of financial products. AIG’s Snow, Temperature or Rain Management (STORM) product and Swiss Re’s Temp Assure product can be structured to embed weather risk into traditional insurance policies. Insurers are generally more likely to structure weather products covering fat-tail risks, and are willing to provide a great deal more capacity than a market-making energy company. Willis Faber, in fact, has already structured a product with a payout of $100 million. Of course, such coverage doesn’t come cheap. In addition to high premiums, “There are more frictional costs associated with insurance policies than standard weather derivatives,” says AIG’s Douglas Oliver. “The premium taxes and guarantee fund assessments that are levied against insurance policies are the biggest.” So where does an end-user go to buy weather protection? A Wall Street banker sums up the choices: “If you’re price conscious and trade-oriented, you go to a market-maker. If you’re out to shop something around, you might want to go to a broker. If you’re more of a typical corporate who’s always hesitant about buying options but you’re allowed to buy bonds, take out loans and do other things, you might want to take a spin at an investment bank. If you’re really looking for a nonfinancial approach and just want the risk management protection, you go to your insurance company.” The lines of demarcation in weather derivatives are already blurring. Last July, Koch Industries and Royal Bank of Canada announced a strategic alliance designed to develop and market weather derivatives worldwide—offering RBC an immediate inroad into the business by tapping into Koch’s 150 traders and marketers in Calgary, Singapore, London and the United States. Some think the collegiality of the market has hastened its development and made such alliances possible. “What’s fostered market growth is the willingness of all the participants to talk to one another about how to price, what the data requirements are and how to propose deals to the market-makers,” says Turrin. “It’s been very positive, and quite extraordinary, that there has been such a free-flow of information in this new marketplace.” —R.H.

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