Pricing Weather Derivatives Dr Adam Kucera, EdgeCap & Dr Harvey Stern, Bureau of Meteorology Dr Adam Kucera, EdgeCap & Dr Harvey Stern, Bureau of Meteorology

OF DROUGHTS AND FLOODING RAINS... When Dorothea MacKellar wrote of her love of the sunburnt country, she succinctly identified our huge variances in weather as a feature of this vast continent. Weather is one of the biggest uncertainties facing business in Australia. We get the full range: droughts, floods, fire, cyclones, snow and ice. When the weather is bad, the impact travels through the entire business chain - from primary producer to transport operator to wholesaler, processor and retailer. Economic adversity is not restricted to disaster conditions - businesses can suffer simply because seasonal conditions are outside the norm. A mild winter can ruin the skiing season, below-average rainfall can reduce crop yields while too much rain during summer can ruin a Test match.

MANAGING THE RISK WITH WEATHERHEDGES If you run a business, there is now a way to manage the risk of uncertain weather. It’s called WeatherHedges. WeatherHedges is a full line of financial products that can be used by businesses to manage the risks associated with virtually all measurable weather conditions. These include rainfall, snowfall, and minimum, maximum and average temperatures. If public weather station statistics exist, then WeatherHedges cover will be available.

WHAT IS BAD WEATHER? YOU TELL US The benefits of WeatherHedges include limitless flexibility. Consider these: You decide the weather conditions that trigger a payout. You decide the term of the agreement - a day, a month, a season, or some other period. You can use multiple indicators - a combination of temperature and rainfall, or rainfall at a number of different public weather stations. If the agreed weather conditions occur, you get the payout, no questions asked. There is no need to show that your business has suffered. The weather report with all the relevant data is all we need.

IS WEATHERHEDGES RIGHT FOR YOU? Experience overseas shows that the performance of a vast range of businesses can be impacted by the weather. Here are some examples: Primary producers have long despaired about the impact of weather on their productions. The energy sector experiences peaks and troughs in demand when the climate changes. Consumer goods companies such as ice cream and soft drink manufacturers that are affected by seasonal demands. The construction industry can lose productivity when rainfall or heat leads to site shutdowns. Sporting associations, event managers and caterers can have their premier events ruined through rainfall or other inclement conditions. WeatherHedges can help all these industries guard against the financial loss which adverse weather conditions can bring.

Example 1 A dry summer means less fruit and vegetables A horticulture business in the Riverina was concerned that a dry growing season reduced crop yields by up to 50%. While the business could use commodity markets to hedge price risk, it was searching for a way of hedging the volatility of its crop yields. WeatherHedges could help this business by providing a Precipitation Hedge option that pays out for each millimetre below a predetermined level of rain over the growing season.

Example 2 Hot days spoil the bottom line A food manufacturing company has found that hot days are a drain on the bottom line. Electricity consumption and spoilage increase as the temperature rises. The business calculates that each day over 35 degrees costs an additional $100,000. WeatherHedges has a Maximum Temperature Hedge product that can pay out $100,000 for each day above 35 degrees for an agreed number of days within a defined period.

Example 3 Generating less energy A mild summer means less need for cooling and that means lower demand for an electricity generator. Less energy output equals lower earnings for the generator. For each degree that the temperature drops below normal, the generator estimates that its earnings drop by $56,000 per day. WeatherHedges offers a Cooling Degree Days Hedge option that pays out $56,000 per degree per day when the temperature drops below an agreed level during the defined period.

STRATEGIES  Physical assets Portfolio of Physical assets  Tolling capacity  Inter-regional interconnectors With such physical assets one has a natural long position that allows one to absorb the actuarial risk  Physical assets Portfolio of Physical assets  Tolling capacity  Inter-regional interconnectors With such physical assets one has a natural long position that allows one to absorb the actuarial risk  Financial capital Strong capital support allows one to internally warehouse the actuarial risk associated with these products International (energy merchant) suppliers Assuming the economics are favourable it is possible to back out the deals through existing international suppliers

Introduction The meteorological community is becoming skilled in applying risk management products. These products originate from the financial markets. The meteorological community is becoming skilled in applying risk management products. These products originate from the financial markets.

Background The energy and power industry has, so far, taken best advantage of weather derivatives. The first weather derivative contract was a temperature-related power swap in The energy and power industry has, so far, taken best advantage of weather derivatives. The first weather derivative contract was a temperature-related power swap in 1996.

Pricing Approaches Historical simulation. Direct modeling of the underlying variable’s distribution. Indirect modeling of the underlying variable’s distribution (simulating a sequence of data). Historical simulation. Direct modeling of the underlying variable’s distribution. Indirect modeling of the underlying variable’s distribution (simulating a sequence of data).

Example: A Cooling Degree Day Call Option Strike: 600 cooling degree days. Notional: $100 per cooling degree day (>600). Suppose, at expiry, the accumulated number of cooling degree days >600. The seller of the option then pays the buyer $100 for each cooling degree day >600. Strike: 600 cooling degree days. Notional: $100 per cooling degree day (>600). Suppose, at expiry, the accumulated number of cooling degree days >600. The seller of the option then pays the buyer $100 for each cooling degree day >600.

Defining Cooling Degree Days The accumulated number of degrees the daily mean temperature is above a base figure. The base figure is usually 18 deg C. Net cooling degree days might be regarded as a measure of the requirement for cooling. The accumulated number of degrees the daily mean temperature is above a base figure. The base figure is usually 18 deg C. Net cooling degree days might be regarded as a measure of the requirement for cooling.

Pay-off Chart for the Cooling Degree Day Call Option

Observational Data Issues Raised Quality control of data. Legal liability. Ensuring data are free from corruption. Observational site security. Exchange of data. Quality control of data. Legal liability. Ensuring data are free from corruption. Observational site security. Exchange of data.

Other Data Issues Raised Forecast verification data. Synoptic pattern data. Data sets of climate indices such as the Southern Oscillation Index (SOI). Forecast verification data. Synoptic pattern data. Data sets of climate indices such as the Southern Oscillation Index (SOI).

Example: A 38 deg C Call Option (assume at least 38 deg C is forecast) Location: Melbourne. Strike: 38 deg C. Notional: $100 per deg C (above 38 deg C). Suppose the maximum temperature >38 deg C. The seller of the option pays the buyer $100 for each 1 deg C > 38 deg C. Location: Melbourne. Strike: 38 deg C. Notional: $100 per deg C (above 38 deg C). Suppose the maximum temperature >38 deg C. The seller of the option pays the buyer $100 for each 1 deg C > 38 deg C.

Pay-off Chart for the 38 deg C Call Option

Determining the Price of the 38 deg C Call Option Between 1960 and 2000, there were 114 forecasts of at least 38 deg C. The historical distribution of the outcomes are examined. Between 1960 and 2000, there were 114 forecasts of at least 38 deg C. The historical distribution of the outcomes are examined.

Historical Distribution of Outcomes

Evaluating the 38 deg C Call Option (Part 1) 1 case of 44 deg C yields $(44-38)x1x100=$600 2 cases of 43 deg C yields $(43-38)x2x100=$ cases of 42 deg C yields $(42-38)x6x100=$ cases of 41 deg C yields $(41-38)x13x100=$ cases of 40 deg C yields $(40-38)x15x100=$ cases of 39 deg C yields $(39-38)x16x100=$1600 cont…. 1 case of 44 deg C yields $(44-38)x1x100=$600 2 cases of 43 deg C yields $(43-38)x2x100=$ cases of 42 deg C yields $(42-38)x6x100=$ cases of 41 deg C yields $(41-38)x13x100=$ cases of 40 deg C yields $(40-38)x15x100=$ cases of 39 deg C yields $(39-38)x16x100=$1600 cont….

Evaluating the 38 deg C Call Option (Part 2) The other 61 cases, with a temperature 38 deg C or below, yield nothing. So, the total is $ This represents an average contribution of $110 per case, which is the price of our option. The other 61 cases, with a temperature 38 deg C or below, yield nothing. So, the total is $ This represents an average contribution of $110 per case, which is the price of our option.

Climate Change Issues Raised Long-term trends due to global climate changes. Long-term trends due to the urban heat island. Long-term trends due to global climate changes. Long-term trends due to the urban heat island.

Trend in Melbourne Maximum

Trend in Melbourne Minimum

Example: A Monthly Rainfall Decile 4 Put Option for Echuca Strike: Decile 4 Notional: $100 per decile < decile 4. If the rainfall decile < 4, then the seller of the option pays the buyer $100 for each decile < 4. Note: Decile 1 is a rainfall total in the lowest 10% of historical records, decile 2 is in the 2nd lowest, etc. Strike: Decile 4 Notional: $100 per decile < decile 4. If the rainfall decile < 4, then the seller of the option pays the buyer $100 for each decile < 4. Note: Decile 1 is a rainfall total in the lowest 10% of historical records, decile 2 is in the 2nd lowest, etc.

Pay-off chart for the Monthly Rainfall Decile 4 Put Option

Historical Distribution of Outcomes (for cases when the Southern Oscillation Index is in the lowest 3 deciles - an indicator of dry conditions)

Evaluating the Decile 4 Put Option (for cases when the Southern Oscillation Index is in the lowest 3 deciles) 9 cases of Decile 1 yields $(4-1)x9x100=$ cases of Decile 2 yields $(4-2)x6x100=$ cases of Decile 3 yields $(4-3)x4x100=$400 The other 25 cases (Decile 4 or above) yield nothing. …leading to a total of $4300, & an average contribution of $98, which is the price of our put option. 9 cases of Decile 1 yields $(4-1)x9x100=$ cases of Decile 2 yields $(4-2)x6x100=$ cases of Decile 3 yields $(4-3)x4x100=$400 The other 25 cases (Decile 4 or above) yield nothing. …leading to a total of $4300, & an average contribution of $98, which is the price of our put option.

Concluding Remarks A challenge is presented to the meteorological community by weather derivatives. When approaching the subject of pricing, one needs to look at a variety of empirical data. Observational & other data issues, & also climate change issues, need to be considered. A challenge is presented to the meteorological community by weather derivatives. When approaching the subject of pricing, one needs to look at a variety of empirical data. Observational & other data issues, & also climate change issues, need to be considered.