Weather Derivatives

“œThe outlook: Much too cold for the time of year”
The weather has a substantial influence on the economy “” from the risk of a rainy summer for beer garden proprietors to the dependency of energy suppliers on the weather. Weather derivatives offer a range of tools for these industries to hedge against previously uninsurable weather risks.

Hedging against a cold summer

“When the temperature in Britain rises by 3°C, daily beer consumption increases by 10%”, says the UK Met Office in a study “” a very telling example that shows how much a particular industry’s turnover can be affected by the weather.

Meteorological research institutes estimate that more than 80% of all economic activities are weather-dependent. In other words, a huge variety of industries are involved “” fashion companies, breweries, construction firms, ice-cream producers and especially energy suppliers.

When national utility monopolies in the USA were turned into independent energy companies, demand increased for protection against the impact of the weather. Instruments for hedging weather risks were sought, and what more obvious idea than to use the tools of the capital market? And so weather derivatives came into being.

Objective of weather derivatives

A weather derivative differs from a customary derivative in that it is not based on tradable reference items such as shares, share price indices, bonds or exchange rates but on predetermined index data, such as the temperature. It follows that the purpose of a weather derivative is to hedge volume risks rather than price risks, since a rising or falling turnover need not affect the price.

In a cold summer, for instance, it is not usual for the price of ice-cream to suddenly fall “” the ice-cream industry’s decrease in turnover is due to the lower sales volume, then, not to a price reduction. In these cases, weather derivatives provide volume compensation.

A similar situation exists in future-oriented fields like renewable energy: particularly in the first few years, when high investment costs have to be recouped, a lack of wind or too little solar irradiation might reduce the volume of electricity generated to such an extent that the financing of the venture is jeopardised. Weather derivatives can then provide important balance-sheet protection.

From single trigger to multiple trigger

Of course there are also many industries where the weather has an impact on both the volume and the price, such as the oil industry. If a winter is warmer than average, people heat less “” there is a fall in the sales volume and the price of fuel oil.

In such cases, “cross-hedging” is recommended, a mixture of weather derivative and classic commodity derivative, which also hedges against a decrease in turnover as a result of price reductions.

Within the framework of integrated risk management, Munich Re offers multiple-trigger models that cover several risks simultaneously.

What constitutes bad weather?

The most widespread trigger used for weather derivatives is the temperature. However, other triggers are agreed on sometimes as well, such as certain amounts of precipitation, wind, sunshine or snowfall.

Weather derivatives are usually concluded for one season only, but we also offer our clients contracts that are valid for a shorter or longer period.

Munich Re’s know-how

Optimally designing and deploying weather derivatives for clients requires geoscientific expertise combined with know-how in statistical methodology and knowledge of the capital markets.

We have been offering extensive weather and climate consultancy services for over 30 years and assess over 500 weather risks a year. Besides this, we have a sufficiently diversified portfolio which we actively manage, thus meeting all the requirements for successful business with weather derivatives.

Via our subsidiary Munich American Capital Markets in New York, we are actively involved in weather derivatives trading, whilst the experts from our Special and Financial Risks Division in Munich mainly underwrite individualised weather risks.

Links

>> www.erneuerbare-energien.de
Federal Ministry for the Environment, Nature Conservation and Nuclear Safety on the subject of renewable energies
>> www.renewables2004.de
First international conference “renewables 2004” in Bonn
>> www.wbgu.de
German Advisory Council on Global Change
>> www.ipcc.ch
Intergovernmental Panel on Climate Change
>> www.iea.org
International Energy Agency

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