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Weather Derivatives?

Posted by libhom Thursday, April 09, 2009

tornado
Photo: NOAA Photo Library

If you think our financial markets are getting farther and farther away from sound investment and much closer to reckless speculation, this might interest you. I recently learned about an incredibly flaky financial instrument: the weather derivative. Wikipedia has a description of weather derivatives(taken today):

Weather derivatives are financial instruments that can be used by organizations or individuals as part of a risk management strategy to reduce risk associated with adverse or unexpected weather conditions. The difference from other derivatives is that the underlying asset (rain/temperature/snow) has no direct value to price the weather derivative. Farmers can use weather derivatives to hedge against poor harvests caused by drought or frost; theme parks may want to insure against rainy weekends during peak summer seasons; and gas and power companies may use heating degree days (HDD) or cooling degree days (CDD) contracts to smooth earnings. A sports event managing company may wish to hedge the loss by entering into a weather derivative contract because if it rains the day of the sporting event, fewer tickets will be sold.

Heating degree days are one of the most common types of weather derivative. Typical terms for an HDD contract could be: for the November to March period, for each day where the temperature falls below 18 degrees Celsius keep a cumulative count of the difference between 18 degrees and the average daily temperature. Depending upon whether the option is a put option or a call option, pay out a set amount per heating degree day that the actual count differs from the strike.

The first weather derivative deal was in July 1996 when Aquila Energy structured a dual-commodity hedge for Consolidated Edison Co. The transaction involved ConEd's purchase of electric power from Aquila for the month of August. The price of the power was agreed to, but a weather clause was embedded into the contract. This clause stipulated that Aquila would pay ConEd a rebate if August turned out to be cooler than expected. The measurement of this was referenced to Cooling Degree Days measured at New York City's Central Park weather station. If total CDDs were from 0 to 10% below the expected 320, the company received no discount to the power price, but if total CDDs were 11 to 20% below normal, Con Ed would receive a $16,000 discount. Other discounted levels were worked in for even greater departures from normal.

After that humble beginning, weather derivatives slowly began trading over-the-counter in 1997. As the market for these products grew, the Chicago Mercantile Exchange introduced the first exchange-traded weather futures contracts (and corresponding options), in 1999. The CME currently trades weather derivative contracts for 18 cities in the United States, nine in Europe, six in Canada and two in Japan. Most of these contracts track cooling degree days or heating degree days, but recent additions track frost days in the Netherlands and monthly/seasonal snowfall in Boston and New York. A major early pioneer in weather derivatives was Enron Corporation, through its EnronOnline unit.

A logical thinker should note that these weather derivatives got their initial push from Enron, yes Enron.

I'm sure a blindly conservative or libertarian person would defend this as spreading risk. However, when people speculate on derivatives this flaky, its overall effect on the economy is destabilizing. When futures markets try to take on the function of the insurance industry in a crass and greedy way, it's both bizarre and dangerous. We need to strictly regulate derivatives and other dodgy financial instruments and limit the varieties that are legal.

If turning Wall St. into the Las Vegas strip only hurt wealthy investors, then no one would have a reason to care about this. But, speculation is a root cause of the huge bailouts and the economic crises we face today.

 

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