Dr Harvey Stern, Climate Manager, Victoria and Griffith University Mr Glen Dixon, Associate Lecturer (Finance), Brisbane

Pricing Weather Derivatives in the Australian Agricultural Market Australian Agricultural and Resource Economics Society, Queensland Branch Brisbane (DPI), Friday 27 September 2002 Pricing Weather Derivatives in the Australian Agricultural Market Other applications Several Case Studies in the Australian Market including Agricultural, Theme Park, Mining, Power, Gas, Air Conditioning, Ice Cream and Soft Drink Sectors

Introduction Evidence of the challenge faced by the meteorological community to become skilled in applying risk management products from financial markets is growing. An empirical approach to the pricing of weather derivatives is presented. The approach is illustrated with several examples with focus on Agriculture.

Outline of Presentation The increasing focus on weather risk. Weather in company reports. Mitigating weather risk. New developments. Quantifying uncertainty in forecasts. Ensemble forecasting.

Background Weather risk is one of the biggest uncertainties facing business. We get droughts, floods, fire, cyclones (hurricanes), snow & ice. Nevertheless, economic adversity is not restricted to disaster conditions. A mild winter ruins a skiing season, dry weather reduces crop yields, & rain shuts-down entertainment & construction.

Weather & Climate Forecasts Daily weather forecasts may be used to manage short-term risk (e.g. pouring concrete). Seasonal climate forecasts may be used to manage risk associated with long-term activities (e.g. sowing crops). Forecasts are based on a combination of solutions to the equations of physics, and some statistical techniques. With the focus upon managing risk, the forecasts are increasingly being couched in probabilistic terms.

First Weather Derivative in Australia It is the energy and power industry that has, so far, taken best advantage of the opportunities presented by weather derivatives. Indeed, the first weather derivative contract was a temperature-related power swap transacted in August 1996.

First Weather Derivative Payout in Australia (1) Two temperature-based options contracts, which are claimed as Australia’s first weather derivatives deals, expired at the end of March 1998 with a pay-out for the purchasing party. US Electric Utility Utilicorp sold the options to United Energy Marketing in late January, with a profit for United if during February and March temperatures hit 35 deg C or above on 5 days or more in Melbourne, Victoria or 33 deg C or above on 3 days or more in Sydney, News South Wales. Source: Energy and Power Risk Management June, 1998

First Weather Derivative Payout in Australia (2) By the end of March, temperatures had hit the required level on 5 different days in Sydney, and 6 days in Melbourne, triggering payouts. Alan Rattray, VP of International Risk Management of Utilicorp Australia said “the Sydney contract returned eight times the premium paid”. Source: Energy and Power Risk Management June, 1998

Weather Derivatives Defined Clewlow et al...(2000) describe weather derivatives as being similar "to conventional financial derivatives, the basic difference coming from the underlying variables that determine the pay-offs", such as temperature, precipitation, wind, heating degree days, and cooling degree days.

Weather Derivatives Weather derivatives are similar to conventional financial derivatives. The basic difference lies in the underlying variables that determine the pay-offs. These underlying variables include temperature, precipitation, wind, and heating (& cooling) degree days as described by Clewlow and Strickland.

Pricing Methodologies Historical simulation (look at examples using this technique). Direct modeling of the underlying variable’s distribution. Indirect modeling of the underlying variable’s distribution (via a Monte Carlo technique as this involves simulating a sequence of data).