Dr. Christian Werner, Enron Australia Pty Ltd, Sydney, NSW 2000

Ph. (02) 9229 2319 Fax: (02) 9229 2350

e-mail: Christian.Werner@enron.com

An introduction into weather risk is presented from an industry perspective. Weather risk is the uncertainty in cash flow and earnings due to weather volatility. Weather derivatives can effectively minimize this risk. The underlying meteorological variables for weather contracts are temperature, precipitation, humidity, and wind speed, or any combination of those. Currently, the most contracted weather variable in the energy and financial sector is temperature.

Climate change and adverse weather conditions directly or indirectly affect many industries. The bottom line for these industries is that cash flow and earnings can be negatively impacted by volatile weather conditions. The idea is to minimize this risk by weather derivatives, which have as the underlying meteorological variables or derived quantities. It is estimated that about $ 1 trillion of the $ 7 trillion U.S. economy is weather sensitive. For example, weather conditions directly affect demand for energy products, and indirectly affect retail business. As for energy products such as electricity the earnings depend on the sales quantities and the retail price, but weather (temperature) is one of the most important factors impacting on demand, which can change the price of electricity.

Over the last few years the U.S. and Australian power markets have seen a process of deregulation, which increased competition. As a result energy companies started to hedge the volumetric risk caused by unexpected weather conditions by using over the counter weather derivatives. The over the counter market has been quickly followed by exchange traded contracts, securitized weather bonds and web based bulletin boards. Other derivatives relevant to the power industry may exist, but will not be discussed in this context.

Weather derivatives cannot only be applied to the power industry, but other industries like the agricultural, viticulture and insurance industries. The underlying weather variables for weather contracts include temperature, precipitation, humidity and wind speed, or any combination of those. To date, the most actively traded weather variable in the power and financial industry is temperature. These contracts are written on the daily average temperature; the so-called heating degree day (HDD) and cooling degree day (CDD) are defined on the daily average temperature departure from a pre-determined reference temperature (e.g. 18 ^oC):

HDD = max(18 – T_avg, 0),

CDD = max(T_avg – 18, 0).

A high correlation between electricity demand and HDDs/CDDs exists, and therefore most contracts are written on a specific accumulation period (e.g. Month or a season).

Large parts of the Australian economy are directly or indirectly exposed to climate and its variability. The Australian climate shows many extremes in which droughts and floods are a feature of the climate. In between anything is possible, which means that an increased level of weather uncertainty exists. This uncertainty cascades down to the business risk, and ultimately influences the decision making process. As an example,

The ’91-’95 drought resulted in the GDP falling $ 3.3 billion from 1993-1994 and 1994-1995 levels. Industries affected in Australia include the agriculture industry, viticulture industry, power generators, theme parks and the construction sector.

Various forms of weather derivatives can be provided for structured risk solutions in order to cater best for the specific risk exposures in the relevant industries. These weather derivatives are highly customized, and the underlying (e.g. Temperature) cannot be influenced by financial transactions. This is one of the reasons why weather transactions can be used to build a diversified portfolio.

A company’s crop yield is exposed to weather conditions either at one or many locations. Precipitation is a critical meteorological variable impacting on crop yields, especially during sowing and harvesting periods. The quality of the crop is also influenced by the spatial and temporal distribution of rainfall. A customized weather derivative may provide the right answer to manage the company’s cash flow and earnings. For example, the company in question could purchase a so-called weather strange option, which would pay out when the rainfall amounts were either above or below a pre-defined limit. The weather strangle option consists of a call (right to buy) and a put (right to sell) option, which provide coverage outside of an expected range in highly uncertain situations, but usually at a high cost. The risks covered would be above average or below average rainfalls. As a result the company would remain exposed to a defined normal range of precipitation.

Weather derivatives provide a means of transferring weather risk associated with fluctuation in the weather and climate system. These weather contracts offer the further advantage of trading like options, which traditional insurance or re-insurance contracts do not offer.