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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

people forget where the market came from. There's certainly been an increase in liquidity. Does it still have room to grow? Absolutely, there's no question about that. But I do think a lot of people would like to say there's a problem, rather than looking to see what the positives are."

Smaller is Better?

One of the positives of current market liquidity is, oddly enough, the fact that there were many more small deals in 2000, rather than more of the blockbuster marquee deals. The fact that there were so many more total deals (2,759 in 2000, compared to 2,049 in 1999) points to increasing liquidity. Overall, people are trading significantly higher volumes, but smaller size. Clemmons points out that it is a lot easier to hedge something traded in a smaller size. "It's a lot more palatable for those firms that don't want to take on large amounts of risk, but want to participate in the market. And I think part of it also, when you look at products like ICE and the CME, they're trading in very small lots. If you're interested in those markets, and you want to participate in those markets, you scale your size down to make it appropriate for those [players]," she says.

Sweetnam says the fact of smaller deals, but more of them, is not necessarily a bad thing. "In fact, with these weekly deals, we'll see a lot more smaller deals, and a commensurate increase in the financial size, because these will only be weeklong trades, as opposed to seasonal trades," he says. What is driving more, yet smaller, deals is a drive to create a product that's of value to the customer, which will allow the market to grow. "I think it will also have the side effect of greatly increasing the liquidity and transparency, which will also allow the market to grow," Sweetnam says.

Exit Stage Left

As the weather risk industry was trying to cope with fairly normal business problems, the business problem of the decade came along: the collapse of industry founder Enron. One immediate question was how the precipitous exit of one of the industry's largest players would affect liquidity.

Clemmons says, "With the decline of Enron, we were a little nervous, because they were such a big player in the European market, and they really provided a lot of the liquidity for the trades that were going on in Europe." She noted that Enron had some of the marquee deals, such as signing up the wine bars in London to hedge their weather risk. Initially, Clemmons says, "everyone was in shock ... suddenly, there was no Enron to trade with." But after a short period, she says, people stepped up to the plate and started trading.

Tobben says that there have not been any problems with the market absorbing the risk after Enron's departure. "I think there's adequate risk capital in the market," he says. "I think that's evidenced by the fact that I don't see any end-user deals not being done because of capital constraints." Unlike the