buying better weather john a. dutton the pennsylvania state university and weather ventures ltd...

Buying Better Weather

John A. Dutton

The Pennsylvania State University

andWeather Ventures Ltd

Department of Meteorology

30 Jan 2004

© John A. Dutton 2004

New Financial Strategies for ManagingWeather and Climate Risk

© John A. Dutton October 2004

Topics…

Weather, climate, and earnings volatility

Risk hedging strategies

Basics of weather options


Annual Report 2000

…results for the year were negatively impacted mainly by three items: (1) unseasonably cool weather in the northeast, especially during the summer months… …

We can not influence the weather, but…


UK firms face a bill for more than £7.6 billion a year because they have their heads in the clouds over the effects of the weather…

…95 per cent of those questioned admitted they’ve lost up to 10 per cent of their profits last year…

Only 17 per cent take weather into account as a vital part of their business planning.

The Met Office study also found: nearly half …think they can’t doanything to avoid losing money due to the weather.

Press Release 26 November 2001 A British Met Office study of 500 British businesses


The weather and climate appear

on the income statements

of many firms…

…as explanations for

changes in performance

Hourly Cost of Electrical Generation

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.0 20.0 40.0 60.0 80.0 100.0

Average Temperature (deg F)

$ M

illion

Virginia Electric and Power

FirstEnergy

Assumption:$33/MWHr

Electricity revenue -$122 M

Fuel, purchased power 28NET -94

4Q 2001 - 4Q2000

(Dominion Resources)

1Q 2002 - 1Q 2001

Electricity, gas -$52 M

Corporate hedge -$36 M

© Weather Ventures Ltd 2002


…the possibility that

something bad might happen

RISK…


A definition of risk...

Risk=

Probability

of Occurrence

Cost of the

Consequences


Risk Strategies

Severe weatheror weather events

Avoidance through flight or by taking refuge inresponse to forecasts or warnings, preparationincluding building codes, insurance,risk-hedging contracts

Unusualseasonalvariations

Preparation, insurance, hedges of risk throughfutures contracts on commodities orweather variables (weather derivatives)

Long-termclimate variations

Planning, reduction of sensitivity, very long-termhedging contracts

Weather and Climate Risk...…the possibility of injury, damage to property, or financial lossowing to severe weather, unusual seasonal variations, or long-term climate variation.


Wx & Cx Sensitive GDP Components (1999)

Industries (SIC 1987)GDP

Components ($B)

Weather Sensitive

Components ($B)

Agriculture, forestry, fishing 125 125Mining 112 94Construction 416 416Manufacturing 1501Transportation, public utilities 780 743Wholesale trade 643Retail trade 856 856Finance, insurance, real estate 1792 317Services 1987 162

Total 8212 2713

Source: GDP Components from Bureau of Economic AnalysisSource: GDP Components from Bureau of Economic Analysis


While we may be endlessly fascinated

by the weather

and the vagaries of climate…

…our clients are interested in the success

in their business…

…and in rewarding flows of cash and profits.


They don’t care about the weather…

…they care about the $


Risk transfer

with forward contracts

and future contracts


Forward contract

An agreement and obligation to trade a fixed quantity and quality of a commodity for a fixed price at a future date.

(Corn, wheat, oil, gold, currency, …)

Futures contract

A forward contract traded on an exchange (which provides bothliquidity and transparency)

(CBoT, CME, NYMEX,…ICE, LIFFE…)

Futures contracts are often called derivatives because their value derives from the underlying commodity or financial instrument


Producer FinisherFutures

Exchange

Speculator


Risk transfer

with

contingent contracts


Option

The right, but not the obligation,

to execute a specified trade for a fixed price before a future date

or to assume a position in a futures contract.

(Option on a futures contract, option on a stock,

‘option’ on a weather variable…)

A call is the right to buy, a put the right to sell.

Contingent contracts specify a quantity, a price, and an expiration

or settlement date.

Options are also derivatives, and in some cases, second derivatives.


Long

You bought it, own it, and can sell it

ShortYou sold it, evenif you didn’t own it, and eventually mustbuy it

CallA right to buy

PutA right to sell


$1.65$1.18


Risk transfer with contingent contracts

Partyat Risk

Counter-party

$ P

$ Hprobability w

CommoditiesEquity pricesInterest ratesCurrency conversion ratesEnergy pricesWeather variables

Firms with opposing riskBanks and brokeragesInsurance and re-insuranceHedge fundsInvestors and speculators


Total value of derivatives $95.2 TrillionForeign exchange contractsForeign exchange contracts 15.7 15.7Interest rate contractsInterest rate contracts 64.764.7Equity-linked contractsEquity-linked contracts 1.91.9Commodity contractsCommodity contracts 0.60.6OtherOther 12.312.3

Market value of equitiesMarket value of equities 26.5 Trillion26.5 TrillionNYSENYSE 17.117.1NASDAQNASDAQ 3.63.6TokyoTokyo 3.23.2LondonLondon 2.62.6

Outstanding over-the-counter derivatives

Sources: BIS, NYSESources: BIS, NYSE


Weather and climate…

impacts on the

business model


Information

Customer Demand Demands on

Suppliers

BUSINESS

Customers Suppliers

Stakeholders

Lenders Owners Society

CapitalReturn

Customer Needs

Plan & Design

Production

Sales & Support

Customer Satisfaction

Information

$$ $$

Goods

Services

Goods

Services

Information Information

DeliveryDelivery


Wx CxRisk

Transfer

BUSINESS

Suppliers

Stakeholders

Lenders Owners Society

CapitalReturn

Customers

Customer Needs

Plan & Design

Production

Sales & Support

Customer Satisfaction

Information Information

$$ $$

Goods

Services

Goods

Services


0

1

2

3

4

5

6

20 25 30 35 40 45 50 55 60

Average Winter Temperature (deg F)

A Weather Derivative -- a Call on TaveA Weather Derivative -- a Call on Tave


Payout on a Temperature Call

0

0.1

0.2

0.3

0.4

0.5

-4 -3 -2 -1 0 1 2 3 4 5

Differences from Tbar (Std Dev in deg F)

Pro

ba

bilit

y a

nd

Pay

ou

t D

en

sit

y

0

0.25

0.5

0.75

1

1.25

Strike Expected Payout 0.5 $0.168 L 0 0.315 L 1 0.075 L

$L

Normal (0,1)

Payout


Payout for calls, puts, and swaps

TT

$$

00

Buy a putBuy a put

TT

$$

00

Buy a swapBuy a swap

TT

$$

00

Buy a callBuy a call

Sell a callSell a call


Symmetric and Asymmetric Swaps

-0.2

-0.1

0

0.1

0.2

-4 -3 -2 -1 0 1 2 3 4

Deviations from Mean T (Units of std dev)

Payo

ut

Pro

bab

ilit

y

-1.2

-0.8

-0.4

0

0.4

0.8

1.2

Symmetric

Asymmetric (0.5

Expected Payout

Symmetric $0

Asymmetric +/- $2.4L

Buyer Pays Seller Pays

0

0.2

0.4

-3 -2 -1 0 1 2 3

Deviations from Mean T (Units of std dev)

Pro

bab

ilit

y D

en

sity

Risk Transfer

ContingentCapital

Below Normal

RiskFinancing

CatastrophicCoverageMuch Below

Normal

Contingency FundsRaised

Above Normal Summers

Fund Raising

38.3 %24.260.6 30.2 0.6

Original Risk Volatility

Reduced Volatility

Adapted from Frank Caifa, Swiss Re NM

A risk mitigation strategy for summer income A risk mitigation strategy for summer income


0

0.005

0.01

0.015

0.02

0.025

3000 3250 3500 3750 4000 4250 4500 4750

HDD

Pro

b

0

200000

400000

600000

800000

1000000

1200000

1400000

3773

228

4087

185

S 3900

$5K /HDD $1 Million

BTV JFM Payout

$168K $673K$673


-20

-15

-10

-5

0

5

10

15

20

25

30

0 2000 4000 6000 8000 10000 12000 14000 16000 18000

Day in 50 years starting 1949

Deg

F (

Ori

gin

al S

eri

es -

SV

D F

it)

NewSVDFits 13 July 2001

Central Park (+20 F)

Jersey City

Central Park & Jersey City: comparison withCentral Park & Jersey City: comparison withthree nearest neighborsthree nearest neighbors


Energy, Energy, AgricultureAgriculture

InsuranceInsurance Capital,Capital,InvestmentInvestment

Williams, CargillWilliams, Cargill,,End UsersEnd Users

AXA, Swiss ReAXA, Swiss ReML, MSDWML, MSDW

reduce wx riskreduce wx riskhedge across commoditieshedge across commoditiesprofit from tradingprofit from trading

diversify riskdiversify riskcreate cash flowscreate cash flows seek higher marginsseek higher margins

expand asset classesexpand asset classesAdapted from Frank Caifa, Swiss Re NMAdapted from Frank Caifa, Swiss Re NM

Wx market players … incentives and strategies

Wx Information

WRMA Survey Results

0

500

1000

1500

2000

2500

3000

3500

4000

4500

5000

1998/9 99/00 2000/1 2001/2 2002/3

Number of Reported Contracts(No CM E T rades)

W inter

Summer695

3,397

2,759

1,285

4,517

2001 SurveyN=19

2003SurveyN=19

2002SurveyN=20

Survey Results, Total Notional Value

0

500

1000

1500

2000

2500

3000

3500

4000

4500

5000

1998/9 99/00 2000/1 2001/2 2002/3

Total Survey Notional Value(m illions of dollars)

CM E

W inter

Summer

1,836

4,339

2,5173,003

4,188

2001 SurveyN=19

2003SurveyN=19

2002SurveyN=20

Survey Results, Notional Value by Type

Share of Notional Value by Type(No CME Trades)

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1998/9 99/00 2000/1 2001/2 2002/3

OtherRainOth TempCDDHDD

2001 SurveyN=19

2003SurveyN=19

2002SurveyN=20

Survey Results, Number of Contracts by Region

Number of Contracts by Region(No CM E Trades)

0500

1,0001,5002,0002,5003,0003,5004,0004,5005,000

1998/9 99/00 2000/1 2001/2 2002/3

Other

Europe

Asia

N. Amer. South

N. Amer. East

N. Amer. Midwest

N. Amer. W est

2001 SurveyN=19

2003SurveyN=19

2002SurveyN=20

Seek to reduce wx or cx risk by hedging

with options

Wx Derivative Investors

Aim for predictableand steady return

Accept wx and cx risk by writing

options

Aim for predictableand steady return

Wx Derivative End Users

Motivations in the weather derivative markets

© WeatherVentures 2002


Your clients don’t care about the weather…

…they care about the $


Coming Attractions

Return versus Volatility:

The Value of Climate Forecasts

buying better weather john a. dutton the pennsylvania state university and weather ventures ltd...

Documents

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climate risk slide

weather ventures

performance slide

severe weather

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financial instrument