Weather Risk quantification and

hedging in practice
Jake Beharall June 2010

E.ON UK provides Gas and Power to residential, SME and corporate

customers.

Introduction
8m
accounts
12k gas sites
31k power
sites

100k gas meters

400k power
meters
2007 E.ON
Pricing & Portfolio Management are responsible for a range of commercial
functions:
- Demand forecasting
- Energy purchasing
- Pricing tariffs and contracts
- Risk Management
- Hedging
22 June 2010, E.ON, Page 2
accounts
sites
meters
Contents and coverage
Climatic drivers of short term energy demand
- Gas vs. Power
Price interactions and the quantification of risk
- Modelling and calibration
Structuring and placing hedges
2007 E.ON 22 June 2010, E.ON, Page 3
Structuring and placing hedges
- The weather market
- Liquidity and appetite
- Setting strikes: Meteorological or Statistical?
Summary and questions
Climatic drivers of energy demand
Gas
- Balanced Daily.
- Primarily residential use, and most
volatile in the short term is space
heating.
- Mainly temperature driven with some
tweaks:
-5.00 0.00 5.00 10.00 15.00 20.00 25.00
D
e
m
a
n
d
ET
2007 E.ON 22 June 2010, E.ON, Page 4
tweaks:
Expectation
Wind chill
Lags
Non-linearity at extremes
Adjusted measure -> CWV
- Designed so demand linear w.r.t.
CWV
-5.00 0.00 5.00 10.00 15.00 20.00 25.00
ET
R = 0.9932
-5.00 0.00 5.00 10.00 15.00 20.00
D
e
m
a
n
d
CWV
CWV
Climatic drivers of energy demand
Gas CWV
where is a mean reversion parameter; is a wind sensitivity; is a wind
seasonal normal and is a temperature switch.
E / A / S denote effective / actual / seasonal normal temperatures respectively and
t t t
A E E 5 . 0 5 . 0
1
+ =

) , 0 max( ) , 0 max( ) 1 (
t t t t t
A W S E CW + =
2007 E.ON 22 June 2010, E.ON, Page 5
E / A / S denote effective / actual / seasonal normal temperatures respectively and
all are gas day weighted (6 am 6am 2 hour steps). W denotes wind-speed.
L CWt N (Normal range)
U CWt (Summer cut off)
N CWt U (Transition to summer)
L > CWt (Cold weather boost)
where L, N, U are 3 CWV thresholds. is a dampening factor at higher
temperatures and is a cold weather response factor.
t t
CW CWV =
) ( N U N CWV
t
+ =
) ( N CW N CWV
t t
+ =
) ( L CW CW CWV
t t t
+ =
Climatic drivers of energy demand
Gas
- Although sensitivity is well specified there is still sufficient scope for unpredictability
and feedback loops must be employed to fine-tune forecasts of individual days
demands. E.g. Snow boosts demand by more than the CWV formula would predict;
snowy periods few and far between in history so calibration difficult.
- Sensitivity different between classes 120.00
Jan 2010
2007 E.ON 22 June 2010, E.ON, Page 6
of user ( residential, SME, Industrial)
and between day types
- Gas forecasting is a blend of science and
art and is hugely valuable to the business.
Cost of getting it wrong can be huge...........
0.00
20.00
40.00
60.00
80.00
100.00
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31
P
e
n
c
e

/

T
h
e
r
m
DA
SBP
SSP
(The risk to system prices is a
modelling topic in itself)
Our demand forecasting team had a sub
1% error on 1/3 of the days in January
Climatic drivers of energy demand
Power
Balanced half hourly / Myriad of uses compared to
gas.
Climatic sensitivities: temperature; humidity; cloud,
precipitation & solar radiation; wind, sunset / sunrise
and
lags of these variables.
Because prices have strong within day shape it is not
1.00%
1.20%
1.40%
1.60%
1.80%
2.00%
2.20%
2.40%
2.60%
2.80%
3.00%
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47
%
Demand Shape
Fri
Sat
2007 E.ON 22 June 2010, E.ON, Page 7
Because prices have strong within day shape it is not
sufficient to diversify errors across the day.
Approaching the problem through multiple regression
necessitates the inclusion of dummy variables for days
of
the week (not necessarily one per day), special days,
shoulder days, seasons etc. in order to reflect the
hierarchy of seasonality (annual, weekly, daily).
Different studies have reached markedly different
conclusions around the significance of lagged climatic
variables; some regard temperature as the only
0
10
20
30
40
50
60
70
80
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47

/
M
W
h
HH Power Prices (APXMID)
Climatic drivers of energy demand
Because gas sensitivity is (relatively) well understood it is easier to hedge.
For Power it is harder to create a formulaic hedge to capture both volume and value
due to the drivers of power demand being that much harder to isolate. Although E.ON
has a fleet of generating assets that can provide the shaped volume hedge, these are
best optimised from a value perspective by exploiting the real optionality within them
and are thus best placed outside of the retail business.
2007 E.ON 22 June 2010, E.ON, Page 8
and are thus best placed outside of the retail business.
Gas has higher relative sensitivity to weather so higher priority (Jan 2010 = +8%
Power demand but +18% Gas demand)
Hedges ideally should be cross-commodity to deal with value and volume risk.
Focus of the following slides is on gas.......
Price interactions and the quantification of gas risk
Given the short range of (reliable) weather forecasts, balancing of gas positions
happens at the short end of the curve, and often has the attribute of negative
convexity given the price / temperature relationship.
Retail sales prices are generally a function of longer
term wholesale prices and the disconnect
between the two ends of the curve can generate
significant risk. Spot volatility is at a
premium to even front month......
COLD WARM
+ -
CHEAP
2007 E.ON 22 June 2010, E.ON, Page 9
premium to even front month......
- +
EXPENSIVE
-0.15
-0.10
-0.05
0.00
0.05
0.10
0.15
0.20
0
6
-
A
p
r
0
8
-
A
p
r
1
0
-
A
p
r
1
2
-
A
p
r
1
4
-
A
p
r
1
6
-
A
p
r
1
8
-
A
p
r
2
0
-
A
p
r
2
2
-
A
p
r
2
4
-
A
p
r
2
6
-
A
p
r
2
8
-
A
p
r
3
0
-
A
p
r
0
2
-
M
a
y
0
4
-
M
a
y
0
6
-
M
a
y
0
8
-
M
a
y
1
0
-
M
a
y
1
2
-
M
a
y
1
4
-
M
a
y
1
6
-
M
a
y
1
8
-
M
a
y
2
0
-
M
a
y
2
2
-
M
a
y
2
4
-
M
a
y
L
o
g

(
P
t

/

P
t
-
1
)
Day Ahead vs Front Month
DA
MM01
Annualised Vol:
DA: 101%
MM01: 65%
Additionally the price / temp
correlation has altered over the
last year with the changing
dynamic of the market.
Price interactions and the quantification of gas risk
Modelling
- Gas forward curve modelled as multi factor with forward correlations considered; spot prices
modelled as a distinct process with the general level set by the front month.
- How to handle jumps in a mean reverting world? Fast die out a result of physical outages
and so need to avoid cross-pollution of mean reversion rates between different states.
- Pressure to move states can come at any time but is heightened when demand peaks (so
temperature related state transition probabilities).
2007 E.ON 22 June 2010, E.ON, Page 10
temperature related state transition probabilities).
- Volatility made state conditional with mean reversion switches handling the up jump/down
jump sequence.
0
50
100
150
200
250
300
1
2
7
5
3
7
9
1
0
5
1
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1
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9
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7
P
e
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/
t
h
e
r
m
Price path simulation
Price interactions and the quantification of gas risk
Modelling
Monte Carlo methods:
Temperature / Climate
AR model used for
temperature with CWV
basis simulated
Forward curve
Multi factor
2007 E.ON 22 June 2010, E.ON, Page 11
Demand impacts
Purchase? / Sell? Random
errors also considered
Spot prices
Cost of weather effect vs.
sales revenue?
@
Weathe
r Risk
=
Structuring and placing hedges
The weather market
Trade off much more acute in the weather market:
What is desired against what can be placed is always a key consideration.
Standard products not always useful - HDD, CDD, CAT (swaps & options) as fixed tick size
neglects
correlation with gas prices. Liquidity sporadic on European stations except for majors
(Heathrow,
Paris, Amsterdam).
2007 E.ON 22 June 2010, E.ON, Page 12
Paris, Amsterdam).
CWV drives risk but CWV is practicably un-hedgeable at the moment given the constituents
of the
weather market. Is the cost of getting a perfect fit more than the cost of wearing the basis
risk?
Complex products:
Many of the natural counterparties to this risk are used to weather only structures with more
standard indices (Tmax, Tmin, T24). Exposure to energy prices is not always in their comfort
zone
(subtle cross-over in mentality from insurance to derivative product....).
Not used to risk flipping around about the price strikes.
Some players like the diversification weather risk brings whilst others will decompose what
they can
Structuring and placing hedges
Trade off.....
-1.00
0.00
1.00
2.00
3.00
4.00
5.00
6.00
B
A
S
I
S

(
D
e
g
r
e
e
s


D
i
f
f
)
The temperature hedge basis & dampening
T24 Diff
Damped T24 Diff
If CWV
cannot be
hedged
use proxy
2007 E.ON 22 June 2010, E.ON, Page 13
-5.00
-4.00
-3.00
-2.00
B
A
S
I
S

(
D
e
g
r
e
e
s


D
i
f
f
)
-5.00
-4.00
-3.00
-2.00
-1.00
0.00
1.00
2.00
3.00
4.00
5.00
-8.00 -6.00 -4.00 -2.00 0.00 2.00 4.00 6.00 8.00
C
W
V

U
K

W
e
i
g
h
t
e
d
Single Site T24
T24 / CWV Basis April
-2.00
-1.50
-1.00
-0.50
0.00
0.50
1.00
-8.00 -6.00 -4.00 -2.00 0.00 2.00 4.00 6.00 8.00
C
W
V

U
K

W
e
i
g
h
t
e
d
Single Site T24
T24 / CWV Basis July/Aug
Structuring and placing hedges
Strikes?
Concept of seasonal normal central to pricing - how to derive one? Statistical or
Meteorological?
Central case for forecasting increasingly uses meteorological results (E.g. EP2 project
from the Met Offices Hadley Centre) whereas the weather market uses a more statistical
approach (or so evidence suggests....)
2007 E.ON 22 June 2010, E.ON, Page 14
What history can tell us:
(i) Use straight average e.g. 10 year?
(ii) Detrend using linear regression?
(iii) Detrend using some form of weighed regression e.g. LOWESS 80?
Trade off between bias and efficiency drives the choice, and this choice is itself a
function of the number of years data (N) available (discussed overleaf).
How to smooth data? Monthly averages shaped into daily normals.
Structuring and placing hedges
Data since 1973 on Nottingham April T24
shows warming trend.
(a) Straight average:
- Biased but using more recent data
(smaller N) is less so.
- But bigger N reduces the standard
error.
- MSE allows consideration of both
aspects
7.18
8.18
9.18
10.18
11.18
2007 E.ON 22 June 2010, E.ON, Page 15
aspects
- MSE tends to be minimised around N
= 10
(b) Linear detrending:
- Bias is reduced as trend accounted
for (although Bias = + f (N) suggesting
non-linearity)
- Standard error increased (for given N)
as size of trend small compared to
natural noise
- N > 30 beats straight average on
MSE score.
) ( ) (
2
V Mean MSE + =
4.18
5.18
6.18
7.18
0 10 20 30 40
Structuring and placing hedges
Data since 1973 on Nottingham April T24
shows warming trend plus LOWESS 60 fit
(c) Lowess detrending
- Bias almost eliminated as captures
non-linear trends.
- Standard error worse than linear
detrending as supposed trend
captured more completely (negative
function of LOWESS bandwidth)
4.18
5.18
6.18
7.18
8.18
9.18
10.18
11.18
yi
Model Fit
2007 E.ON 22 June 2010, E.ON, Page 16
function of LOWESS bandwidth)
- Requires high N for MSE to compare
favourably.
Other considerations?
Extrapolation of trend for Index @ t + 1......?
Extreme values (especially at the ends of the data window) should we dampen the
slope?
4.18
0 10 20 30 40
BUT...Lowess trend
actually got 2010 pretty
much spot on
@ 9.04 degrees C....
Structuring and placing hedges
An April HDD swap could price at 15 ticks
difference depending upon the method (about of
the index SD)
For say 50,000 a tick the swap could be off by
750,000.
Empirically pricing seems to sit at around a mixture
of 10 year and Lowess.
Method April HDD
5 year 8.85 274.5
10 year 8.57 282.9
37 year 7.78 306.6
Linear 8.83 275.1
Lowess 60 9.06 268.2
Lowess 80 9.01 269.7
Linear + 1 8.89 273.3
2007 E.ON 22 June 2010, E.ON, Page 17
of 10 year and Lowess.
Note Lowess 60 captures more of the observed
curvature in the locally weighted regression hence
warmer.
The linear + 1 model (extrapolated) can be
constructed through the following formula (when data
is spaced evenly):

=
+
=
n
i
i i i
W T T
1
1

+
+

=
2
) 1 ( 3 ) 1 (
3
2
2
n d n
di
n n
W
i
Where the weights W are:
and d is a dampening factor that rotates the regression line about the mean (d = 1 is un-
damped)
Actual 9.04 268.8
Range 0.49 14.7
Gap between meteorological and statistical methods seen clearly in
daily
shape:
Structuring and placing hedges
14
16
18
20
Daily shape
14
16
18
20
Daily shape
2007 E.ON 22 June 2010, E.ON, Page 18
0
2
4
6
8
10
12
14
D
e
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r
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s

C
e
l
s
i
u
s
Kernel Raw
Meteo GW
0
2
4
6
8
10
12
14
D
e
g
r
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e
s

C
e
l
s
i
u
s
Spline DET
Meteo GW
Kernel DET
Summary
Size and complexity of risks within retail sector is large.
We cannot lay these off to our customers blindly through uncompetitive price
structures.
Key task for us is to find an acceptable trade-off between an ideal hedge and a
marketable cost-effective one.
Pricing of hedges opaque and involves considerable degree of second guessing.
2007 E.ON 22 June 2010, E.ON, Page 19
Pricing of hedges opaque and involves considerable degree of second guessing.
Additionally the job of making risks (hedged and un-hedged / un-hedgeable) visible
is a critical one.
Within Retail the development of quantitative techniques to suit our needs is
continually evolving as we are able to refine models. However we are always
mindful of the necessity for models that are robust we would rather understand
shortcomings than have blind faith...
Topics not touched upon include Index distributions and option pricing; a thorough
treatment of these topics (and weather derivatives in general) can be found in the
excellent book by Jewson et al (Cambridge ISBN 0 521 84371 5).