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Taking the Weather Option

Weather-contingent options are cheaper than other weather risk products and can be crafted to suit emissions allowance markets.
Fortnightly Magazine - July 15 2003

Weather-contingent options are cheaper than other weather risk products and can be crafted to suit emissions allowance markets.

Weather is a pivotal demand factor in energy consumption, but one that is difficult to predict and impossible to control. With weather-hedging tools available in the over-the-counter (OTC) markets for several years, the market has grown to $4.2 billion, with approximately 4,000 contracts traded in 2001, according to Pricewaterhouse-Coopers.

The utility sector is particularly exposed to weather risk. Most companies have identified their financial exposure to weather events and trends, but now, with a firm understanding of the dollars at risk, companies are more likely to turn to weather markets to buy derivatives.

Utilities are moving beyond traditional plays in weather markets to hedge cost elements of their power production, including fuel procurement and emission allowances. Dual-trigger weather options-cross-commodity derivatives that combine these commodities and the weather-represent a cost-effective means to hedge risk without spending too much capital.

Traditional Utility Plays

Virtually all utilities have quantified their weather risk, and most are trying to do something about it. Some utilities put their weather risk on ratepayers through weather normalization clauses, which pass the cost of revenue shortfalls directly to the consumer. Other utilities have been hedging their weather risk in OTC markets using simple derivatives that have now become commonplace.

Traditionally, utility plays in OTC weather markets have been hedges against temperature. For instance, a utility during peak summer months will protect its downside revenue risk of an abnormally cool summer. Or, another utility, whose risk lies in the peak winter months, will protect its downside revenue risk of a mild winter.

In practice, this means buying options, which act as insurance against adverse weather trends. For instance, a natural gas utility may protect its peak demand by purchasing an option that pays out if a minimum amount of heating degree days (HDD) 1 is not reached during its peak winter season. An electric utility would similarly purchase an option that pays out if a minimum amount of cooling degree days (CDD) 2 is not reached during its peak summer season.

Cross-Commodity Options

This approach to weather risk has worked well for many utilities. In an increasingly competitive marketplace, revenue stability has been a positive event in the eyes of most shareholders.

With weather-hedging experience under their belts, many utilities are looking to combine weather risk with other areas of operations. They are looking for products that combine their underlying price component and the volume of the product they are purchasing.

The supply of natural gas or coal to run power plants can be sensitive to major swings in temperature. Just as directly, the cost of emissions allowances, which are an integral part of power production operations, has a strong correlation to the weather, and therefore compounds a utility's exposure to increased costs for environmental compliance.

Why Use Weather-Contingent Options?

The benefits of weather-contingent options are two-fold. First, they put commodity purchases more directly in line with business needs. Weather affects the bottom line, so companies are protecting the bottom line with hedges triggered