Sun shines again on weather derivatives

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Many assumed that weather derivatives had disappeared with Enron, and that these financial instruments were but a byproduct of those over-exuberant days.

But weather is rapidly becoming the centre of the one of the most attractive sectors in the financial markets. Increasing volatility in the weather is helping to fuel the trading of related derivatives, or futures contracts that allow investors to bet on or hedge against fluctuations in the weather.

Among the most powerful catalysts has been the entry of hedge funds into weather derivatives market over the past five years.

“The market was struggling along at $4bn or so until the hedge funds arrived – now it’s some 10 times that,” says Pablo Triana, a professor at Madrid‘s Instituto de Empresa and an expert in weather derivatives.

Peter Brewer, fund manager for the Cumulus Weather Fund, says weather derivatives are an attractive investment proposition.

“I think it’s a perfect market. You can’t spook it, you can’t manipulate it. You can’t make people think it’s going to be 110 degrees in London next week,” he says. “And of course, weather is absolutely uncorrelated [to other asset classes].”

Ilija Murisic, executive director of Hybrid Derivatives Trading at UBS says interest in the bank’s new Global Warming Index – launched last month – was driven by investors’ desire to diversify their portfolios. Global warming and climate change have also attracted investors to the market, says Juerg Trueb, managing director at Swiss Re.

“In those regions where you see significant weather events going on, you definitely see demand popping up,” Mr Trueb says, citing a recent drought in Australia and Hurricane Katrina in the US.

That development has left enthusiasts such as Mr Triana arguing that the market has the potential to be the biggest in the world. “Anything is possible, because there’s no weather risk you can’t hedge,” he says.

However, not everybody agrees – not least because past attempts at expanding the weather derivatives market have run into serious obstacles and products have failed to gain traction among mainstream investors.

Enron, the fallen US energy company, launched the first widely known weather derivatives deal with Koch Energy Trading in 1997, structured around temperature fluctuations that winter.

Under the terms of the deal, Enron would pay Koch $10,000 for every degree the temperature fell below a predetermined level, while Koch would pay the same for every degree above it.

Enron expected companies of all shapes and sizes to embrace the new product. Potential customers ranged from retailers to ski resorts.

But even today, a decade later, companies are slow to embrace these products. This is despite the fact that most companies in the world have exposure to changes in weather.

Mr Triana blames this slow uptake partly on the relative complexity of the market. “Participants have to be able to calculate what their exposure is to the weather,” he says. “A company can easily gauge its interest rate exposure, or assess the effects of exchange rate fluctuations. Measuring the impact of weather on revenues is trickier, and much tougher for corporate treasurers.”

Dealers selling the product also have few incentives to target corporate clients aggressively. “A lot of the possible transactions would be smallish in size – a London pub worried about £15,000 in losses because it rained and customers couldn’t sit outside, drinking in the sunshine,” Professor Triana said.

Several leading investment banks – including Société Générale and BNP Paribas – shuttered their weather derivatives operations earlier this decade
for just those reasons. Yet other market participants are increasingly optimistic. WeatherBill, a San Francisco-based start-up run by former Google employees, is a prime example.

“Our mission is to remove the risk of weather from all businesses, for all needs and all purposes,” chief executive David Friedberg said, adding that “no contract is too small. We’ve sold a weather derivative contract for a dollar”.

Mr Friedberg’s clients include car wash companies, hair salons and golf courses. “I’m also on the phone to farmers all the time,” he said. “The other day one farmer rang me up and said his sows wouldn’t make a move to mate if the temperature went above 95 degrees Fahrenheit. He wanted to hedge against that.”

Still, it’s unclear whether a reliance on small contracts will sustain such a business.

In fact, Weatherbill only offers contracts to businesses with assets of at least $1m or individuals worth $5m or more. But the company is pursuing larger clients. Last Week, Weatherbill announced a C$100m ($94m) contract with Canada’s largest online travel retailer, which will be paid out based on snowfall.

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