Trading in weather derivatives has grown steadily in Europe since the first deal was struck in 1998.

Trading in weather derivatives has grown steadily in Europe since the first deal was struck in 1998. Potential new entrants show increasing interest, say Gautam Jain and Charlotte Baile

Around 100 weather deals have been completed in Europe, with a total notional principal of about £30 million. This compares with an estimated 3,000 deals and $5.5bn of notional traded in the US. However, industry observers believe that the current size of the US market represents only a small fraction of its long-term potential, and that it will experience exponential growth in the short term. A similar growth pattern for Europe would be a compelling reason for players to enter the market.

US development
The US weather derivatives market began in 1997, spearheaded by the energy industry. The introduction of weather derivatives as a way to offset earnings volatility was a natural progression for an industry that has an extremely sophisticated understanding of the way in which unseasonable weather impacts on its profitability.

Since 1997, the over-the-counter (OTC) market has grown rapidly. Partly as a result, the Chicago Mercantile Exchange (CME) launched exchange traded temperature products in 1999. Although this trading is still in its infancy, it is proving useful in increasing liquidity for the weather derivatives market. As well as placing trades directly in the CME market, traders can use it as a secondary market to back out positions taken on OTC deals, leaving only the basis risk between the contracts.

The market is now expanding to include players from other sectors, challenging the energy industry's domination. Companies from the agricultural, retail and leisure sectors are looking to weather derivatives to hedge their weather-related business risks. Representatives from a large cross-section of industries, looking to become more active in the weather derivatives market, attended the Weather Risk Management Association (WRMA) annual convention in June this year.

The Japanese market
The Japanese market saw its first weather deal in 1999. In contrast to the US market, it is dominated

by participants from outside the energy sector. For example, Societe Generate transacted a deal with a Japanese ski resort in Nagano to protect it against the impact of low snowfall last December. It also completed a deal with a retail chain which was exposed to weather-related fluctuations in revenues during March.

The energy industry is likely to become more involved, with the deregulation of 27% of the Japanese energy market in March this year, and further liberalisation on the way. However, it is significant that the Japanese weather derivatives market has developed without the energy industry acting as a catalyst. Market growth has been achieved through early adoption by companies in a number of different industry sectors. This is an encouraging indicator of future market robustness.

Early days in Europe
The European market for weather derivatives began with a swap transacted in September 1998 between Enron and Scottish Hydro Electric. It has experienced rapid growth since then. Market players in Europe benefit from knowing how the US market is developing, making it easier for them to become active users of weather derivatives.

Growth potential
A number of factors indicate enormous growth potential for the European market.

  • Continuing energy industry deregulation
    Europe's energy industry is still in the early days of deregulation, following an EC directive requiring member states to open up 33% of power markets to competition by 2003. The response to this directive has varied considerably across Europe, with countries such as Finland, Sweden and the UK leading the way while others, such as France, remain predominantly regulated.

    As deregulation spreads throughout the industry, the volume of weather deals traded in Europe should increase substantially, bringing much-needed liquidity to the market, and in turn encouraging new entrants.

  • Standardised exchange traded contracts
    London International Financial Futures Exchange (LIFFE) is currently developing pan-European weather futures. These should introduce greater liquidity and develop the overall weather derivatives market considerably.

  • Banks' and insurers' involvement
    A number of European banks and insurers are looking to join their peers as active participants in the weather derivatives market, introducing additional risk capital to the market. They will bring with them their existing client bases, drawn from a range of industry sectors.

  • Participation of non-energy companies
    Companies from outside the energy sector are increasingly looking at the weather derivatives market as a means to hedge their risk. In early June, for example, it was reported that Corney & Barrow, a London based wine bar chain, entered into a temperature-based deal with Enron as the counterparty. This trend suggests enormous growth potential for the overall market, as energy represents only about 3.5% of GDP for most European countries. Several industry sectors face weather risk: it is likely to be companies from these that will drive market growth.

  • Despite constantly seeking improved productivity through technological dvances, such as high yielding seed varieties, the agricultural industry.remains exposed to weather risk. The biggest threat to crop yield is lack of sunlight -which no number of technological advances can alter.
  • The retail industry is also affected by the weather. UK retailer Marks and Spencers noted in its half-yearly results in November 1999 that UK sales of its autumn range of clothing had been significantly reduced by the exceptionally warm weather.
  • Roughly 35% of Europe's leading ice cream manufacturers' sales are made in their third financial quarter, equating to 50% of their annual ice cream profits. Cool, wet summers can significantly affect profit and have even been cited as a reason for companies going into receivership.
  • Sales of beer drop during cooler than normal summers. Brewers suffer, not just from lost sales, but from the expense of having to store beer that cannot be sold.
  • Many theme parks are open all year round, yet by far their busiest periods arc the summer months. Attendance figures are highly correlated with the weather. Even the lightest rainfall will deter some visitors. Those travelling from very long distances may still make their planned journeys, but a large percentage of local visitors to the park postpone their visit if the weather is considered too inclement.

    For businesses such as these, weather derivatives provide an opportunity to offset the risk, reducing the volatility of financial performance.

  • A source of competitive edge
    Leading companies are looking to weather derivatives, not merely as hedging tools, but as the basis for creative marketing. The underlying concept is risk transfer from the customer to the company. For example, a travel company might offer its customers a "Good Weather Guarantee", offering to give a partial refund if the weather falls outside a defined range.

    Such products are likely to be more attractive to customers than standard offerings. The company can choose to raise the sale price, creating a premium product, or to allow demand to rise while keeping the price constant. The advantages are not just increased earnings, but clear differentiation from the competition, enhanced brand image, positive customer perception and favourable press coverage.

    The company can back out the increased weather risk to which it is exposed by using an appropriately structured weather derivative. It should recoup the cost from the increased revenues.

    Barriers to development
    Despite its huge potential, the European weather derivatives market faces a number of obstacles. » Availability of data

    The quality and cost of weather data vary considerably across Europe. Companies looking to analyse business performance against historical weather data must, at present, buy information from the national meteorological offices in Europe, and the. cost can be relatively high.

    The quality of data is more significant. For some countries in Europe, weather data availability cannot be guaranteed. This may affect the confidence with which weather deals can be priced. One way of mitigating this is to construct a "replicating basket" of weather stations, to serve as a reference for historical data obtained from the chosen location. Even so, there will residual uncertainty, which can be adjusted for by increasing bid-offer spreads. i Standardised contracts

    At present, there is no pan-European standard legal contract for weather derivatives trades. This may result in the introduction of legal basis risk for traders looking to lay off their risks. The WRMA will be seeking to agree a standard.

  • Time to structure a deal Negotiating a deal can be complex and may take longer than expected. Time taken to arrange a trade varies, not just by the complexity of the deal, but also by location. Negotiating a vanilla deal struck in Europe typically takes three weeks, in contrast to approximately three hours in the US. This has clear ramifications for the overall cost.
  • Corporate understanding Lack of understanding about weather risk management is often cited as the biggest obstacle to market growth. Weather risk management is a complex process. There can be a significant gap between understanding that business performance is affected by weather and putting in place appropriate structures to mitigate that risk. Before considering hedging strategies and structuring deals, risk managers must know the precise weather factors that affect key operational areas, quantify the impact of weather on revenue and cost streams and assess weather risk in the context of overall business risk.

    There are a number of independent specialist consultancies with the skills necessary to guide corporate hedgers through these issues, ensuring that the deals are structured in the best way for their business and priced fairly.

    Exponential growth?
    The European weather derivatives market is still at the early stages of development, but there are signs that it is about to enter a stage of exponential growth. OTC deal volumes are steadily rising, and the imminent arrival of exchange-traded products provided by exchanges such as LIFFE will further spur expansion.

    There is also growing interest from new players looking to enter the market. Some major banks, insurance companies and hedge funds are beginning to see the weather derivatives market as a highly profitable new area. Moreover, companies from a large cross-section of industry sectors are recognising that their weather risks can be effectively hedged through weather derivatives.

    The impact of weather on business performance is pervasive throughout most sectors. As companies realise that this is a manageable risk, the European weather derivatives market will take off. Gautam /am is a director and Charlotte Baile a consultant, both with Weather Risk Advisory Ltd.

    The Weather Risk Management Association (WRM A) provides forums for discussion on weather risk management, with working committes looking at a range of issues. It says:

  • the ever changing landscape, of the energy industry means that risk managers must be nimble in their approach to eevering exposures
  • as these exposures become less acceptable to shareholders, risks must be managed ever more precisely
  • other industries have seen the change too. Retail sales, agriculture, chemical, entertainment and banking companies have taken advantage of financial weather products