Buying Better Weather John A. Dutton The Pennsylvania State University and Weather Ventures Ltd Department of Meteorology 30 Jan 2004 © John A. Dutton 2004 New Financial Strategies for Managing Weather and Climate Risk

© John A. Dutton October 2004 Topics…  Weather, climate, and earnings volatility  Risk hedging strategies  Basics of weather options

© John A. Dutton October 2004

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 do anything to avoid losing money due to the weather. Press Release 26 November 2001 A British Met Office study of 500 British businesses

© John A. Dutton October 2004 The weather and climate appear on the income statements of many firms… …as explanations for changes in performance

© Weather Ventures Ltd 2002

Assumption: $33/MWHr Electricity revenue -$122 M Fuel, purchased power 28 NET -94 4Q Q2000 (Dominion Resources) 1Q Q 2001 Electricity, gas -$52 M Corporate hedge-$36 M © Weather Ventures Ltd 2002

© John A. Dutton October 2004 …the possibility that something bad might happen RISK…

© John A. Dutton October 2004 A definition of risk...

© John A. Dutton October 2004 Weather and Climate Risk... …the possibility of injury, damage to property, or financial loss owing to severe weather, unusual seasonal variations, or long-term climate variation.

© John A. Dutton October 2004 Wx & Cx Sensitive GDP Components (1999) Source: GDP Components from Bureau of Economic Analysis

© John A. Dutton October 2004 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.

© John A. Dutton October 2004 They don’t care about the weather… …they care about the $

© John A. Dutton October 2004 Risk transfer with forward contracts and future contracts

© John A. Dutton October 2004 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 both liquidity and transparency) (CBoT, CME, NYMEX,…ICE, LIFFE…) Futures contracts are often called derivatives because their value derives from the underlying commodity or financial instrument

© John A. Dutton October 2004 ProducerFinisher Futures Exchange Speculator

© John A. Dutton October 2004 Risk transfer with contingent contracts

© John A. Dutton October 2004 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.

© John A. Dutton October 2004 Long You bought it, own it, and can sell it Short You sold it, even if you didn’t own it, and eventually must buy it Call A right to buy Put A right to sell

© John A. Dutton October 2004 $1.65 $1.18

© John A. Dutton October 2004 Risk transfer with contingent contracts Party at Risk Counter- party $ P $ H probability w Commodities Equity prices Interest rates Currency conversion rates Energy prices Weather variables Firms with opposing risk Banks and brokerages Insurance and re-insurance Hedge funds Investors and speculators

© John A. Dutton October 2004 Total value of derivatives$95.2 Trillion Foreign exchange contracts 15.7 Interest rate contracts64.7 Equity-linked contracts1.9 Commodity contracts0.6 Other12.3 Market value of equities26.5 Trillion NYSE17.1 NASDAQ3.6 Tokyo3.2 London2.6 Outstanding over-the-counter derivatives Sources: BIS, NYSE

© John A. Dutton October 2004 Weather and climate… impacts on the business model

© John A. Dutton October 2004 Information Customer Demand Demands on Suppliers BUSINESS Customers Suppliers Stakeholders LendersOwnersSociety CapitalReturn Customer Needs Plan & Design Production Sales & Support Customer Satisfaction Information $$ Goods Services Goods Services Information Delivery

© John A. Dutton October 2004 Wx Cx Risk Transfer BUSINESS Suppliers Stakeholders LendersOwnersSociety CapitalReturn Customers Customer Needs Plan & Design Production Sales & Support Customer Satisfaction Information $$ Goods Services Goods Services

© John A. Dutton October 2004

A Weather Derivative -- a Call on Tave

© John A. Dutton October 2004

BTV JFM Payout $168K $673K $673

© John A. Dutton October 2004 Central Park & Jersey City: comparison with three nearest neighbors

© John A. Dutton October 2004 Energy, Agriculture Insurance Capital, Investment Williams, Cargill, End Users AXA, Swiss Re ML, MSDW reduce wx risk hedge across commodities profit from trading diversify risk create cash flows seek higher margins expand asset classes Adapted from Frank Caifa, Swiss Re NM Wx market players … incentives and strategies Wx Information

WRMA Survey Results

Survey Results, Total Notional Value

Survey Results, Notional Value by Type

Survey Results, Number of Contracts by Region

Seek to reduce wx or cx risk by hedging with options Wx Derivative Investors Aim for predictable and steady return Accept wx and cx risk by writing options Aim for predictable and steady return Wx Derivative End Users Motivations in the weather derivative markets © WeatherVentures 2002

© John A. Dutton October 2004 Your clients don’t care about the weather… …they care about the $

© John A. Dutton October 2004 Coming Attractions Return versus Volatility: The Value of Climate Forecasts