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 by the weather.

More importantly, weather-contingent options can be purchased for less than the cost of standard options. Experience from natural gas markets indicates that a weather trigger can reduce option premiums by as much as 50 to 75 percent. If the two commodities are not exactly correlated, there will be a low probability that the option strikes will be breached.

Although there is a correlation between the strike parameters, the probability of both being hit at the same time is less than that of a single-strike option. Supply and demand for natural gas, coal, or emissions allowances is not based solely on temperature. For example, even during hot summers there could be an oversupply of nitrogen oxide (NOX) allowances in the market, due in part to banking provisions or increased use of a cleaner fuel as part of a generator's overall fuel mix. Moreover, cross-commodity hedging enables utilities to cover their price risk for certain commodities, assoicated with one of the more important price drivers for these commodities-the weather.

Double Triggers for Natural Gas and Coal

For several years, utilities have purchased dual-contingent options for natural gas supplies. These derivative structures are triggered not only by price, as is the case with traditional commodity derivatives, but by temperature as well.

It is no secret that natural gas prices rise during exceptionally cold winters in the Northeast. As witnessed this last winter, the price swings can be dramatic, and purchasing natural gas under these conditions to fuel a power plant or serve residential load can put a major dent in a utility's earnings. Meanwhile, coal is the most common fuel source for power generation in most countries, and consumption has always been affected by the weather.

Unlike the potential of dual-trigger options in the natural gas markets, where weather derivatives can be used to hedge against major price spikes tied directly to falling temperatures, the coal market is likely to use weather-contingent options to assist in overall coal-buying or coal-producing strategies.

An extended hot summer can cause power production to be ramped up, which may result in a shortage of coal stocks and a rise in coal prices. A mild winter may leave power producers with a glut of coal, driving coal prices down during the spring and summer as plants burn through their inventories.

While most of the coal consumed in the United States is still procured under long-term contacts with suppliers, many generators hedge their price volatility risk and make inventory adjustments in the OTC markets.

The link between this nascent OTC market and weather derivatives shows promise. The opportunity is in the margins. Utilities can be caught short on coal supplies during a prolonged hot summer. Similarly, they have been saddled in the past with excessive coal stocks during abnormally cool summer seasons and, more recently, during mild winters.

The coal/weather derivative would be structured with strikes based on both the coal price and the weather. A generator concerned that a mild winter may leave it with larger-than-optimal inventory levels could structure a weather-contingent option that gives it the right to sell coal stocks at a set price if a minimum number of heating degree days are not reached during a winter season, or if an average winter temperature is not met. The number of heating degree days is calculated by taking 65 F minus the average of the high and low temperatures of the day. Again, both events would have to occur for the payout to be made.

Beating the Heat in NOX Markets

Weather-contingent option structures also are now being crafted to suit emissions allowance markets. The market in NOX allowances, for example, has become much more liquid over the past year. Trading volume has increased and exceeded 75,000 tons in 2002, nearly double the volume from the previous year. Liquidity is the key to developing cross-commodity weather swaps. Counterparties must see an opportunity to hedge their risk if they are going to participate in cross-commodity weather-contingent options.

The other critical factor is correlation: the two components of the dual-contingency option must be related. The correlation between NOX allowance prices and the weather is particularly pronounced. The federal NOX emissions reduction program runs during the summer months, when the combination of NOX and summer heat contributes to smog.

Hot summer days mean power plants run at full tilt and peaking units come on line to meet increased demand. As plants churn out electricity, revenues soar, but so do corresponding plant emissions, and particularly NOX emissions. Peaking units, in fact, emit more NOX emissions per megawatt-hour than typical baseload plants, since most operators find it uneconomical to install pollution control equipment on units that run only periodically.

The converse is also true, as this ozone season has demonstrated. Prices for NOX allowances began the ozone season, which runs from May 1 to Sept. 30, at $8,000 a ton for 2003 vintages. But temperatures in the Northeast, where sources regulated under the current NOX program reside, have been well below average-particularly in May. As a result, the bottom fell out of the NOX market (see Figure 2, p. 31).

At the same time, summer CDDs for the Northeast were taking a nosedive. This reflected the opinion of many in OTC weather markets that continued cool temperatures in June would leave this summer well below the average for cooling degree days (see Figure 1, p. 31).

Downward pressure on NOX prices, however, is not nearly as consequential as suffering through an exceptionally hot summer, such as those the Northeast has experienced in recent years. If the temperature rises, power producers could be faced with having to buy NOX allowances to cover their increased emissions. Elevated summer temperatures, therefore, represent a NOX allowance price risk for power generators.

With this direct and quantifiable correlation between NOX production and temperature, the market is tailor-made for weather-triggered options. In addition, NOX is about to become a concern for more utilities. The regional NOX program is in the first year of a two-year transition to a more stringent and widespread emission reduction scheme. It will eventually add 11 Midwestern and Southeastern states and 1,200 sources to the program.

How to Hedge: NOX Case Study

A power producer's internal audit may determine that when the temperature rises above 95 F, its corresponding increase in power generation to meet demand may increase the company's need for NOX allowances. Options can assist in hedging the price risk the company will face in the NOX market.

A weather-triggered option could be structured by defining a NOX trigger price and a weather trigger. The power producer could structure an option contract that would give them the right, but not the obligation, to purchase NOX allowances every time the temperature rose above 95 F and the price of NOX allowances exceeded a specified strike. There is no payout on the option until both the NOX allowance and temperature strikes are breached. In addition, the table demonstrates how the payout escalates as the temperature and NOX prices rise.

As the first few months of the NOX ozone season have shown, markets can be swayed by the weather. Utilities, which know full well the impact weather can have on financial results, are taking heed. Utilities continue to become more accustomed to the weather derivative market and expanding its use to manage across their enterprise.

  1. HDD The baseline of 65 F less the average temperature for a given day a. Average temp 55 F; b. [65 F-55 F] = 10 HDD
  2. CDD The average temperature for a given day less the baseline of 65 F a. Average temp 75 F; b. [75 F-65 F] = 10 CDD

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