The weather derivatives business is still waiting to gain critical mass.

By Theodore J. Kim

For two years, we've been hearing manic marketing types proffer tales of the applicability of weather derivatives to corporate balance sheets. "With 20 percent of U.S. GDP—roughly $1.8 trillion per annum—directly affected by the weather,” they would repeat like a well-worn mantra, "managing weather risk will be the next big thing in finance.”
But is it? Despite the gusty blasts of marketing hot air, there are still only a handful of participants in the market, bid-ask spreads still exceed 20 percent and one could list the total number of monthly deals actually executed on a single sheet of paper.

The jury is still out on when exactly this new market will take off, but the few dozen active participants continue to cheerlead enthusiastically. Meanwhile, personnel movement within the business is beginning to pick up. The entire weather team at one major market-maker left en masse to set up its own independent company. Another trading team with itchy feet, rumored to be on the verge of defecting to a major Wall Street investment bank, was fired and is now being sued by its former employer.

But while there has been much talk about how major Wall Street derivatives houses would staff up and aggressively expand into the weather market, so far it has been mostly that—just talk. Most investment banks are still sitting on the sidelines without a dedicated full-time weather derivatives team and are only occasionally looking at the possibility of doing a few transactions involving the securitization of weather-influenced cash flows.

Because of the small numbers of end-users and traders who have even dipped their feet into the weather derivatives waters, transaction volume is still exceedingly thin, with fewer than 100 deals completed each month—and the exact number is anyone's guess. Thin volumes make it nearly impossible to hedge each and every trade; as soon as a position is opened, it could be days or weeks before a cost-effective counter-trade can be executed. "The lack of liquidity is a real concern,” says Frank Caifa, associate director of structured finance at Swiss Re New Markets. "Everyone is now pushing to get real liquidity in the market by getting a lot more players on board. But if the major investment banks get involved, the liquidity will follow.”

The global insurance industry, by contrast, has already begun to warm up to the benefits of weather derivatives, which can be a natural fit to existing global property books. In terms of risk management, a weather derivative is the perfect vehicle to hedge exposure to ordinary property risk. An unseasonably warm winter in New York may result in a loss on a heating degree day (HDD) option, for instance, but at the same time will mean that the premiums generated from property insurance will probably be safely pocketed, since warm winter weather means no damage from ice and bursting pipes.

"Before we went into this area, it was realized that weather derivatives would prove to be an excellent fit with the natural catastrophe risks we are already exposed to worldwide,” explains Caifa. "For any large global insurance company, there does not necessarily need to be hedging for each and every weather derivative deal. If you get hit on an HDD put contract during one period, then in the same geographic region it is unlikely that you would be exposed to large cold-weather property damage.”

The hurdles

One of the hindrances to the market's development has been the lack of standardized documentation. So far, major market participants such as Swiss Re New Markets, Enron, Koch, Aquila and Southern Co. all have been happy to rely on their preexisting ISDA Master Agreements that govern swap transactions. ISDA's standardized documentation allows any firm to enter into a contract with another firm readily, if both have derivatives market experience—with little fear of documentation glitches.

But the business as a whole will not be content to rely permanently on the ISDA quick fix. A trade group called the Weather Risk Management Association (WRMA) was recently created to harmonize further the use of standardized contracts and to lay down a set of uniform trading rules. The group, led by Peter Gakos, head of structured finance at Swiss Re New Markets, will have its first major conference in Bermuda next month to formulate, among other things, a strategy to see how weather derivatives can best be applied across different sectors of the global economy. Another of the association's aims is to bring in new members. In particular, it's courting people from the commodity and agricultural sectors, where revenues are highly weather-sensitive.

"The lack of liquidity is a real concern...If the major investment banks get involved, the liquidity will follow.” —Frank Caifa Swiss Re New Markets

The WRMA has also initiated lobbying efforts to increase funding for government data collection, and is attempting to establish procedures that will require members to disclose at least some data from all the transactions they complete. In this way, it may be possible to compile and publicize reasonably accurate market statistics. "WRMA will also be instrumental in working on the standardization of the legal documents that govern the transactions themselves—particularly in the area of trade confirmations,” explains Mark Tawney, director of weather risk management at Enron.

Another hindrance to the weather market's development is the lack of reliable, uniform weather data. Much work still needs to be done.

In the United States, the National Oceanic and Atmospheric Administration is thrilled to bits that the financial sector is starting to take notice of its work, and has started a program to upgrade its monitoring equipment. This may cause some short-term problems for people holding existing weather contracts, but in the long run it will mean more reliable measurements. Funding, which is entirely determined by U.S Congressional budget allocations, may also improve, particularly if politicians can be convinced that NOAA data are the basis for a multibillion-dollar insurance industry designed to manage weather-related risk.

In Europe, meanwhile, the U.K. Meteorological Office, which has long been under severe criticism for the difficulties and expense it imposes in distributing U.K. weather data, agreed to review its charges and procedures.

The WRMA, for its part, is dedicated to improving data collection around the world. "The association will help with improving the provision of weather data outside the Unite States,” says Tawney. "There is a lot of potential to do large trades in Japan and Europe, particularly since Europe does not have a lot of the regulatory hurdles we face in the United States.”

"P&G will say it has been in business for a long time and never had a problem with weather risk...The challenge is to convince end-users how they can benefit from weather risk protection.” —Izzy Nelken Supercomputer Consulting

As more and more countries improve the reliability and accessibility of their data collection, weather derivatives usage is expected to increase quickly. It's happening already. Societe Generale recently completed its second weather deal in Japan, according to Diego Wauters, global head of insurance derivatives. The buyer, a Japanese retail chain, is exposed to fluctuations in earnings resulting from changing weather conditions during the month of March. "If the weather is very cold in March, people buy less summer clothing,” Wauters explained. "October is also a significant month for the retail industry—people buy less winter clothing if October is warm.” The weather derivative sold to the retailer will pay out a lump sum of money if the weather in March is particularly cool. The deal, worth roughly $10 million, is the second Japanese weather deal to be written by Societe Generale. Last summer, the bank entered into a deal with a Japanese ski resort in Nagano to protect it against low snowfall last December.

There are signs of life not only in Japan but also in Scandinavia, France and Holland, but the market remains wholly illiquid and far short of the critical mass of deals that quickly catapulted credit derivatives and energy derivatives from the fringes into the mainstream. Some argue, however, that making comparisons with other derivatives markets isn't fair. "You cannot look at trading in gas or oil derivatives and then, on that basis, conclude that weather derivatives are illiquid,” argues Ravi Nathan, weather portfolio manager at Aquila, who reports a doubling of the firm's weather derivatives activity over the last year. "The true comparison is with the insurance market, which barely trades at all except for the rare reinsurance contract being written. What you are seeing with weather derivatives is revolutionary. For the first time ever, there is a convergence between commodity traders, investment banks, the insurance companies and end-users in industry all coming together to develop and trade a new product. This has never happened before.”

Crusading overseas

Nathan, who sits on the Board of Directors of the WRMA, has taken on the role of an evangelist for the product and sees its use spreading to emerging markets, where GDP is heavily dependent on the weather. In India, for instance, because of its agriculture-based economy, more than 20 percent of GDP can be wiped out whenever there is a bad monsoon—which generally happens every five years or so. When such a regular catastrophe occurs, it is the multilaterals, such as the World Bank and the International Finance Corp., that are forced to step in and pick up much of the bill.

At the same time, multilaterals have developed methods to enhance the credit quality of subinvestment-grade debt issued by developing countries. Putting all these factors together, supporters of the weather derivatives market argue that a credit-enhanced weather-linked bond, whose repayment could be linked to the occurrence of monsoons or other weather calamities, would be an ideal instrument for weather-dependent emerging economies. In the event of bad weather causing a drop in agricultural output, the resulting shortfall in national tax collection and budget revenues, as well as the increase in disaster relief spending, could be partially compensated by a slight decrease in the country's debt repayment burden.

Investors, always looking to diversify their portfolios into new. uncorrelated instruments, would presumably be attracted by the fact that there is absolutely no relation between the occurrence of India's monsoons and, for instance, U.S. interest rates. "A completely different view is starting to develop as to how weather risk can be transferred away from emerging economies and laid off in the capital markets,” Nathan adds.

The forecast

Even under the broadest definition, weather derivatives are still a niche product, and players are still scrambling for position. Most expect the market to remain highly fragmented for a while, with transactions taking place through a variety of methods. Any meaningful application of the concept of liquidity may be years away. "Right now, there is not a single market for weather derivatives,” says Steve Goldstein, founder and president of Tradeweather.com, an Internet weather derivatives trading site. "We feel that in order to develop transparency and liquidity, the global market has to be formed around a centralized trading medium.”

He says that for each end-user of a weather derivative—the market segment whose participation will ultimately determine the aggregate demand for the product—there is a different city, a different measurement method and a different hedging strategy involved. Thus it is unlikely industry-wide standardized weather contracts will ever be developed the way comparable contracts have developed for commodities.

"There is a lot of potential to do large trades in Japan and Europe, particularly since Europe does not have a lot of the regulatory hurdles we face in the U.S.” —Mark Tawney Enron

Complicating matters, weather measurement methods continue to develop, and contracts are reflecting these changes. Instead of a measure of aggregate HDDs over a contract's life, for example, some players are now also offering derivatives that will kick in if the minimum temperature falls below a certain level for three days in a row. This type of contract has been especially popular for firms exposed to losses when freezing water causes pipes to burst.

Valuing weather derivatives continues to be a thorny issue as well, but valuation software, such as Supercomputing Consulting's Weatherbox, has already begun to pop up. Weatherbox takes a contract's parameters, such as historic temperature figures downloaded from NOAA, the dates of the contract and strike price, and, with a variety of user-determined methods, including a Monte Carlo simulation, then calculates a contract's price in dollars per HDD or CDD (cooling degree day).

The biggest question that needs to be addressed is also the most basic: How, exactly, are a company's revenues sensitive to weather risk? Derivatives to manage risks related to credit, currency and interest rates have all been successfully sold to the corporate world. But it is still uncertain how effectively weather risk management can be marketed. "If you go to P&G, they will say they have been in business for a long time and never had a problem with weather risk, and have never purchased weather derivatives before,” explains Izzy Nelken, president of Supercomputing Consulting. "The challenge is still to convince end-users how they can benefit from weather risk protection. If the salesmen can meet this challenge, there will be a great future for the product.”

The eternal desire of corporates to appease shareholders and analysts may ultimately be the factor that decides how quickly weather derivatives take off. Weather derivatives optimists predict that the unusually warm temperatures in the United States last winter will shortly lead to depressed earnings announcements by many utility and oil companies. For the handful that entered into a weather derivative contract, the payoff from the contract will partially make up for the shortfall. "When one utility announces better-than-expected earnings—despite the warm winter—then other neighboring utilities will really sit up and take notice,” says Nathan. "Utilities and oil companies that were not hedged will soon start making excuses about low earnings because of the warm winter. But shareholders don't want management punting on the weather.”

Internet Players Target Mother Nature Even in the nascent weather derivatives market, people recognize the importance of the Internet in virtually every facet of weather trading. In the last year, several weather-related sites have popped up, including Tradeweather.com, Rainday.com and Enrononline.com (which covers energy as well). Most recently, the U.K.-based i-wex.com went live, supported by Liffe. The progress of Internet-based markets encourages many. "The development of on-line trading sites has been one of the major factors in the market of the last several months,” observes Mark Tawney, director of weather risk management at Enron. "It provides price transparency to end-users looking to come into the market for the first time. It also provides an anonymous, cost-effective and efficient method for brokers to trade with each other.” Internet sites are targeting the market now occupied by brokers, who act merely as intermediaries by matching buyers and sellers without actually taking on any exposure. While it may seem that brokers have by far the most to lose from the threat of on-line trading, the market may still be too complicated and highly fragmented to make Internet trading a viable option for most potential participants. For instance, a typical spread for one contract posted on a weather site may be as wide as $300,000 to $500,000. Most end-users would reject such a spread at first sight. "There are only a handful of firms that are familiar enough with the market that they can go on-line to execute a trade,” says Frank Caifa, associate director of structured finance at Swiss Re New Markets. "For everyone else, there will be a lot of hand-holding and education required before completing a deal.” So far, Tradeweather.com is the only independent Internet site that is actually executing trades. First launched in January, it now has 35 members who typically monitor activity all day long—including utilities, insurance and re-insurance companies, agricultural and commodity producers and a few banks. Three different membership plans are offered, with the most popular being a zero-upfront fee and a commission of approximately 25 percent of the value of one degree day. By comparison, commissions charged by brokers run anywhere from 50 to 100 percent of the value of one degree day. On average, about two deals are executed per week. Just how much market share on-line trading will capture is difficult to judge. Insurance companies and brokers may feel that the market is so illiquid and complex that it's just as easy to pick up the telephone and ring a few market-makers. Steve Goldstein, the founder and president of Tradeweather, thinks otherwise. "I don't agree that the transactions are all that complicated,” he says. "It's a pretty simple market. It may take a while to understand it, but once you get into it, anyone can easily crunch the numbers and figure out how to price a trade using their own methodology.” The next big launch in terms of real-time on-line trading will be the U.K.-based i-wex.com site. Through free training seminars and a European marketing campaign, i-wex is now trying to focus more attention on developing corporate awareness about managing weather risk outside of the United States, where interest has picked up dramatically over the last several months. The OTC and Internet players may have another source of competition: the Chicago Mercantile Exchange, which entered the weather market last September with a handful of HDD and CDD contracts. Earlier this year, it expanded the number of cities covered by HDD and CDD futures and options to 10: Chicago, Cincinnati, New York, Atlanta, Philadelphia, Dallas, Des Moines, Las Vegas, Tucson and Portland, Oregon. All contracts have one-month durations, and each of the 10 cities has its own HDD and CDD count. For example, on September 1, 2000, there would be 12 consecutive months of both HDD and CDD futures trading with expiration months listed from September 2000 through August 2001. The final settlement price for each monthly contract is based upon the HDD or CDD indices calculated by Earth Satellite Corp., a Maryland-based weather services firm that provides climatic data to many companies in the agriculture and energy sectors. Trading volumes have been quite thin thus far, but the Merc is undaunted; it expects to wait years before substantial trading volumes develop. "The initial development of the market will certainly come from the OTC side,” explains Larry Grannan, director of product marketing at the Merc. "We basically expect the dealers—and perhaps only a few huge energy users—to come here and lay off risk. It is not for us to construct hedge ratios and devise a weather risk-management strategy for corporates.” Since energy deregulation is still happening in the United States, he says, most potential end-users are content to sit things out until the market heats up. "The OTC dealers in the weather market will act much in the same way as OTC dealers in interest rate swaps,” he says. "The dealers will use us to lay off risk they have accumulated from selling customized products directly to the end-users.” —T.K.