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Weather Derivatives: Answering The Devil's Advocate

We prefer a more conservative approach. Hedging with weather derivatives is too unorthodox for our company.
Fortnightly Magazine - July 15 2003

Alliant uses weather derivatives to hedge this risk, resulting in more stable profit margins.

Alliant first looked into using weather derivatives in the mid-1990s but found the set of options limited and expensive. However, as the weather derivative market grew, the cost of hedging was reduced and the range of products increased. Hedging with weather derivatives became a viable solution for Alliant.

We tried it once, but the option didn't pay out.

The primary function of weather derivatives is to hedge risk, not to extend profits. Bailing out of weather derivatives because they didn't pay out on the first try is like canceling life insurance because it has not paid out.

We looked into using weather derivatives but found them too expensive.

Take another look. In the early days, the cost of derivatives was quite high. Many companies came to the conclusion that is was better to bank the premium and keep the risk. Today, however, the weather market is more robust, more efficient, more liquid, and less expensive.

The choice of available instruments isn't sufficient to cover our needs.

As the weather market has grown over the years, so has the range of available products. Between the Chicago Mercantile Exchange and numerous over-the-counter products, utilities can almost always find a contract to serve their needs.

We simply don't have the expertise or capability in-house to effectively use weather derivatives.

With so many factors affecting the utility industry today, it is more difficult to maintain robust margins. In this light, utilities should be taking all reasonable steps to protect their margins. If your utility does not have the capability to implement a weather derivative risk management strategy, you may want to consider building this capability.


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