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The Perils of Ignoring Mother Nature

Experts say utilities' inconsistent approach to weather risk is costing them dearly.
Fortnightly Magazine - May 15 2002

may not have significant liquidity is a highly structured transaction that is over $20-30 million, that kind of transaction takes a little more care." Having a bigger mix of players, she says, is certainly going to help liquidity. "It's going to attract an even different kind of service provider to the marketplace."

Sweetnam agrees that liquidity remains a barrier to growth. "Our real challenge is to get liquidity up, to have the market be more liquid and more transparent, so that companies that aren't currently using weather instruments become comfortable doing that," he says. Sweetnam sees the lack of a single benchmark for weather products as the chief obstacle to liquidity and transparency. In other words, he explains, weather is very localized, so you don't have a standard like a Henry Hub gas price. That localization means that weather exposure varies significantly.

Whereas energy companies may be primarily concerned about temperature over a broad area, agricultural companies may be primarily concerned about precipitation-and even that concern may vary, either over a wide or fairly specific area. Construction may be concerned about precipitation in a very specific area. As a result, "everything gets very customized," Sweetnam says. "It's all very do-able, so it's not a fundamental problem, but it's definitely a problem to increasing liquidity and transparency. The deals that get crafted, many are one-offs."

To improve that situation, Sweetnam says Reliant's approach is to design products that will be used by gas and power traders, to optimize their trading activities. He says Reliant, along with several other market players, began to make markets in six U.S. cities for weekly average temperature swaps, on the Intercontinental Exchange (ICE). They are weeklong swaps, Monday through Friday, average temperature, traded for the current week and the next week. Sweetnam says that these derivatives are traded and designed to match up with exactly how power traders trade power.

"For example, if you had access to the ICE, which power traders do, you could get on and look at what power is trading forward in PJM, then click over to the weather page, then look what weather is trading for in Philadelphia. Then you can buy your power, and sell your weather, and hedge your bets. It's very slick," Sweetnam says. He fully expects that such trading activities will give the industry the liquidity it is looking for.

Others, like Clemmons, are more optimistic about the current level of liquidity in the market. "U.S. liquidity is fairly strong on smaller transactions that are within a season. I think we have very strong liquidity within that arena." She acknowledges that liquidity is a hurdle that the industry faces, but is not terribly worried about it. "I've been in the market longer than almost anyone else, so I remember when there really was no liquidity. Maybe it's just a relative sense of how many trades we're able to see, how many deals we see, now versus two to three years ago, and the numbers are just so much larger," she points out. "At least to my mind, I think