A quanto of solace – The efficient way to manage weather risks

The efficient way to manage weather risks

Quanto financial products give power utilities a cost-efficient way to guard against both weather risks and the associated gas and electricity price risks.

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Using weather derivatives as insurance against the negative impact of any and every form or combination of weather influences has long been standard practice in the farm industry.

Now, it is also gradually growing in importance in other industries too. One example is the power supply industry: Witness a steady stream of new market contracts – such as the Wind Power Futures recently introduced on the European Energy Exchange (EEX), in Leipzig and on the NASDAQ in New York.

The growing popularity of such instruments is understandable. As described in “Get a grip on the weather — risk management with weather derivatives" in the January edition of our newsletter, weather derivatives can be put to good use in an extremely broad spectrum of applications.

In the OTC market, there are few restrictions on the design of financial products. Depending on the risk potential, contracts can span any conceivable combination of weather stations, weather parameters (e.g. temperature, rain level, sunshine duration), measurement periods, payout formulas and other factors. For example, it is possible to model products that hedge the risk of frost due to a mixture of humidity and temperature, or that trigger payouts if the cumulative temperature drops below 0° Celsius between 7:00 and 9:00 a.m. for three days in a row.

Comprised solely of weather parameters, these pure weather derivatives are often complemented by an extra commodity component in the energy industry. The resultant quantity-adjusted option financial products – "quantos" – have a huge advantage over conventional hedging instruments such as commodity and swing options: They not only hedge the volume risk of demand for gas or electricity being too low or too high. At the same time, they also hedge the associated risk of price volatility on the gas or electricity market.

The principle can be illustrated by the example of a gas utility that has purchased enough gas to keep its customers supplied through a "normal" winter. In a very warm winter, lower demand would mean that the company sells less gas (volume risk), forcing it to sell off its surplus gas on a market with falling prices (pricing risk). Conversely, in a very cold winter, demand for gas would be higher than the expected (and purchased) volume, compelling the supplier to buy more gas at high cost in a rising market. Since all gas suppliers are exposed to this constellation, they always find themselves "on the wrong side".

For both scenarios, gas utilities can pay a premium agreed with their contractual partner to buy a product that promises a payout if it is either very warm and the gas price is low or if it is very cold and the gas price is very high. The payout amount can, for example, be shown using a formula that multiplies the temperature delta (the difference between the measured temperature and the historical mean) and a commodity delta (the difference between the contractually defined strike price and the market price). Payouts thus materialize precisely when both deltas are positive (i.e. when it is warmer than expected and the market price is low) or when both are negative (i.e. when it is colder than expected and market prices are higher).

Here again, there is plenty of leeway to fine-tune specific products. Depending on the case in point and on a utility's appetite for risk, it is thus possible to vary individual parameters such as the strike price, the cap, the option type, the price index, the weather stations used, and so on. It is, of course, also possible to look for a contractual partner with the opposite risk and/or business case and negotiate a swap structure which, depending on the weather and price trends, permits payouts to both partners.

What quickly becomes apparent is that quanto financial products are a cost-efficient way to flexibly and comprehensively hedge weather and price risks in light of the correlations that exist between them. Given the complexity of the derivatives involved, it is imperative to establish appropriate weather risk management within the company. Only then can what is often one of the biggest influences on revenue be managed professionally and proactively. However, it is not enough merely to identify and quantify these risks correctly: Additional expertise is also needed to measure the derivatives both during the pricing phase and, subsequently, in the context of end-of-day reporting. A professional infrastructure is in place for most of the other risks that companies actively manage – exchange rate and commodity price risks, for example – and lays a firm foundation on which to expand the range of hedging instruments. At the same time, using quanto financial products can widen a company's perspective on commodity price risk management, as further products can also be added.

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