Weather Risk Management

A U S T R A L I A N

F I N A N C I A L

M A R K E T S

A S S O C I A T I O N

Weather Risk Management

Foreword

In the mid-1990's AFMA published a series of brochures explaining the workings of

various OTC markets. These were very well received and made an important contribution
to the development of deep and liquid markets in the products covered.
Earlier this year, we became aware that transactions in OTC Weather Derivatives were
becoming more common and an AFMA Weather Derivatives Working Group was
formed.
That Group identified the need in Australia for a brochure which explained the uses of
weather derivatives and provided some case studies to illustrate typical deals. From input
by members of the Working Group, led by the Chairman Norman Trethewey of Element
Re, this brochure resulted.
I believe it has achieved the desired outcome and provides an excellent introduction to
weather derivatives. It will be of considerable use not only to those who have already
identified their exposures to weather risk, but also to the myriad of potential users who
may not have contemplated this form of risk management.
The Weather Risk Management Association (WRMA), based in Washington, and AFMA
have entered into reciprocal memberships and we will be working together on a variety of
projects, including documentation and market conventions. We welcome the contribution
of WRMA to the development of the weather market in Australia.
AFMA is pleased to coordinate production of this brochure and I thank the sponsors
listed on the back cover who have made it possible.

Kenton G Farrow
Chief Executive
Australian Financial Markets Association
November 2002

Contents

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3
History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3
Rationale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3
Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4
How do weather derivatives work? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5
Contract Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5
Typical Indices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5
Types of Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6
Who buys weather derivatives? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6
Who sells weather derivatives? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8
Case study # 1: Agribusiness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8
Case study # 2: Energy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9
About the Australian Financial Markets Association . . . . . . . . . . . . . . . . .10
About the Weather Risk Management Association . . . . . . . . . . . . . . . . . .11

Weather Risk Management

Mark Twain said that "Everybody talks about the weather, but nobody
does anything about it".
Not any more - there are now financial products that manage weather
risk and the market in Australia is growing...

Introduction
The financial results of many companies depend, in
part, on favourable weather. Energy utilities,
distributors and generators, beverage manufacturers,
agribusiness concerns, tourism and leisure operators as
well as a host of other industries experience earnings
volatility with fluctuations in weather conditions.
In the United States, the Department of Commerce
has estimated that one trillion of the seven trillion
dollar Gross Domestic Product is weather sensitive.
This 14% proportion is likely to be higher in an
economy as reliant on primary production as is
Australia's.
There is now a rapidly expanding marketplace available
to fund and/or transfer weather risk. Variations in
temperature, rainfall, wind-speed and other weather
indices can be managed using either derivative or
insurance based hedge contracts. This booklet explains
this expanding market. In particular, it explores how
over-the-counter weather derivative contracts can be
effectively used.

The first known Australian weather deal was transacted

by Southern Hydro Partnership in Melbourne in mid2000. Since then, it is estimated that in excess of 25
deals have been done by Australian counterparties and
that the average nominal value (the value of the risk
transferred) of these trades is A$1.0m.

Snowy Hydro Trading in Sydney

executed a Heating Degree Day
strangle on Melbourne temperatures
in June 2000. The contract was struck
at levels that compensated Snowy
Hydro if temperatures for the
July - September winter season were
outside an expected range of
425 and 475 HDD's.
In this way, Snowy Hydro effectively
guaranteed optimum earnings by
structuring a hedge that
compensated them if the winter was
either too warm or too cold.

History
The weather derivative market commenced in the USA
in 1996 with the exchange of weather risk between
large merchant energy traders. As the market grew in
size and sophistication, energy retailers and generators
as well as other industries became involved.
A survey conducted by PricewaterhouseCoopers for
the Weather Risk Management Association (WRMA)
found that over 3,300 transactions were closed in 2001
and that representatives from most industry groups in
all major geographical regions are now hedging their
exposure to weather variability. Today the market is
worth in excess of US$4.3bn per annum.

Rationale
Even the best meteorologists are 100% accurate just
30% of the time. In the same way companies reduce
earnings volatility by protecting themselves against
equity, commodity and currency market gyrations
(and, in the extreme, avoid bankruptcy/insolvency),
businesses in a variety of industries are now buying
protection against unfavourable weather outcomes.
Under a regime of continuous disclosure and real time
share trading, stock and ratings analysts are
increasingly focussing on the quality of earnings
forecasts. Listed companies that exhibit little volatility
3

in reported results are likely, rightly or wrongly, to

benefit from higher P/E ratios and should certainly
receive more sympathetic hearings from their bankers
and credit rating agencies.

Examples
Weather derivatives can be applied in a variety of ways
and for different reasons, for example:

Financial Risk Management - hedging against

reduced revenues or increased costs due to weather
conditions in either single cities, regions or
multiple locations. For example, a national energy
retailer can purchase a hedge against an unusually
warm winter reducing sale volumes.

Marketing - managing the quantity and timing of

demand by embedding weather hedges in targeted
customer campaigns. For example, a retailer of
heating or cooling equipment may offer customers
a rebate against the purchase price of their product
should forecast conditions that prompted the
purchase of such equipment fail to materialize.

Financing - reducing the cost of borrowing and/or

enhance borrowing potential, by aligning the
timing or amount of interest and/or principal
repayment of debt with the company's economic
performance for a weather-sensitive enterprise.

Enterprise Risk Management - creating products

to hedge weather and any other market risks along

with traditional insurance risks. In an

environment of increasing insurance premiums,
the inclusion of uncorrelated risk into an
insurance portfolio can reduce the overall cost of
protection.

"Unseasonally cool weather in the

southern States has dented sales of
bottled water and carbonated soft
drinks, forcing listed beverage
companies to aim for a better
second-half performance if they are
to achieve earnings forecasts.
Water cooler supplier Neverfail
Springwater has borne the brunt of the
adverse weather conditions and has
seen its share price fall by
27 per cent since the beginning of
summer as analysts trimmed
interim and full-year profit forecasts.
Analysts also have attributed the
recent decline in Coca-Cola Amatil
Ltd's share price partly to the cool,
wet weather in various parts of
Australia over the past three months,
when CCA traditionally achieves 30 to
40 per cent of its annual sales."
Australian Financial Review - 28 February 2002

Notional Value (in millions), 1998 - 2001

Figure 1: Notional value of weather trades to date

(Source: PricewaterhouseCoopers)

Weather Risk Management

How do weather derivatives work?

Typical Indices

Unlike derivatives linked to the underlying price of an

exchange-traded commodity, weather contracts are
linked to weather indices. These indices are created
from data readily sourced from Bureau of Meteorology
stations. Such data needs to be matched against the
buyer's actual exposure. For example, energy
consumption in Western Sydney can be matched with
temperature at Bankstown Airport meteorology
station.

Whilst not exhaustive, the following are the primary

measures that serve as an index on which a weather
derivative contract can be based. That these indices are
derived from independent third parties, facilitates the
fair and timely settlement of payouts.

Once a correlation has been established, the next step

to link a financial contract to different temperature
outcomes, structuring a payout pattern to respond
should adverse conditions occur.

Contract Terms
A weather derivative contract typically has seven
integral components:
i.

ii.

Type of Risk - based on a measurable index,

usually temperature or precipitation, although
wind-speed, snowfall and misery (combination of
temperature & humidity) have been seen in other
markets;
Term of the contract period - the inception and
maturity dates;

iii. Location(s) - it is possible to base the contract on

a company's business in one or several cities as
long as each locale is covered by a weather station
that is monitored by an independent reporting
agency that is affiliated with the World
Meteorological Organisation, as is the Bureau of
Meteorology in Australia;
iv. Unit size - establishing a dollar value per unit of
weather i.e. per degree or millimetre of rainfall;
v.

Limit - the total dollar extent of coverage, i.e. the

maximum payout under the contract (also known
as Notional Value);

vi. Structure of the contract - such as swap, collar,

straddle, put or call; and
vii. Trigger or Strike level - the predetermined
weather index level at which the contract begins
to pay out.

Heating Degree Days (HDD) - A measure of how

much daily average temperatures deviate below a
threshold (typically 18 degrees Celsius) during a
predefined time period;

Cooling Degree Days (CDD) - A measure of how

much daily average temperatures deviate above a
threshold (typically 18 degrees Celsius) during a
predefined time period;

Maximum / Minimum Temperature - A measure

of the absolute temperature during a predefined
time period;

Precipitation - Accumulated rainfall during a

predefined time period; and

Snowfall - Accumulated snowfall during a

predefined time period.

Although somewhat counterintuitive,

the terms Heating Degree Days as a
measure of how cold it is and
Cooling Degree Days as a measure of
how hot it is, do have a logical
explanation. The baseline usually used
in the calculation of these indices is
18oC, which is seen
by the energy sector as the
temperature at which households
require neither heating nor cooling.
Heating Degree Days are therefore
a measure of the amount of
heating required during a cold spell
while a high number of Cooling Degree
Days tells us that it is hot
and the demand for cooling is strong.
5

Types of Contracts

Weather derivative contracts are extremely flexible

once exposure to the underlying weather index is
understood. Many different types of weather contracts
are achievable and in general the contract inception
date is not within the most recent short-term weather
forecast period. Following are examples of weather
derivative solutions in various formats.

Swap: Swaps are similar to collars, as they protect

companies from the impact of adverse weather
conditions but do not limit the opportunity to
profit from favorable weather. Unlike a collar, a
swap does not create a separate floor and ceiling
for the underlying weather variable, but a single
"strike" level. When the variable falls below the
strike, one counterparty makes payment to the
other. When the variable rises above the strike, the
payment flow is reversed.

Terminology is based on that used in other financial

market products:

Floor: A prepaid option that provides financial

compensation to the buyer if an underlying
variable, such as temperature, falls below a
predetermined level. Floors provide downside
protection if the buyer is adversely affected by
weather conditions below a set level.

Cap: A prepaid option that provides the buyer

with financial compensation if an underlying
weather variable goes above a predetermined level.

Collar: A two-part transaction in which a

company buys a cap (floor) to provide financial
protection against adverse weather conditions and
simultaneously sells a floor (cap) the effect of
which limits its financial upside in the event of
favorable weather. Collars can be structured so the
premium paid for the cap (floor) exactly offsets the
premium received for selling the floor (cap) and
the company has gained protection without any
up-front costs.

Who buys weather derivatives?

Utility and energy companies can protect their

volume-related revenue against cooler than average
summers or unusually warm winters. Depending
upon location and season, companies that sell
natural gas and electricity have financial exposure
to deviations from "normal" weather conditions.
Year-round opportunities exist within this sector
to utilise weather risk management products. In
winter, such companies require protection against
warmer-than-normal temperatures that reduce the
volume of energy or product that they will sell.
Conversely, in summer, electrical utilities look to
protect against cooler-than-normal temperatures,
which reduce volumes of electricity sold.
Increasingly, electrical utilities are also seeking
protection against extremely hot days, when
demand for electricity can outstrip available
supply and force providers into the open market to
purchase electricity when prices are at their
highest.

Number of Contracts, 1998 - 2001

Figure 2: Growth of the global weather market

(Source: PricewaterhouseCoopers)

Weather Risk Management

Manufacturers & retailers of beverages, icecreams, heating/cooling equipment and apparel

can make up for reduced sales when cool summers
and warm winters depress demand. Temperature
and, to an extent humidity, are major influences
on demand for soft drinks, beer and some seasonal
food items such as soup. Temperature,
precipitation and snowfall are major sales drivers
for products such as apparel, seasonal recreational
goods and home comfort products like air
conditioners and space heaters. The main adverse
impact is lower demand affecting inventory and
clearance costs in any season where temperatures
are unseasonably mild.
Agricultural companies can add stability to an
income stream made inherently unpredictable by
frost or drought. Depending on the crop, growers
may seek protection against warmer-than-normal
and/or colder-than-normal temperatures during
all four seasons. Common temperature indices are
based on variations of degree days as well as on
absolute temperatures. Protection against excessive
or insufficient seasonal precipitation is also in
demand.
Mining and construction companies can face
costly delays to projects from adverse weather
conditions. Compensation for these delays is
available from weather derivatives. Both heavy and
residential construction are at risk to various
aspects of the weather. Excessive rainfall is a key
element in determining the profitability of a heavy
construction company in a given period. Rain is
the weather variable most likely to delay the
completion of a contract, many of which have
incentive/disincentive clauses. The profitability of
residential construction projects is also exposed to
rainfall and extremely hot temperatures during the
summer.
Leisure and tourism operators whose turnover
depends on the existence of favorable sun or snow
conditions can compensate for poor seasons
through appropriately structured weather hedges.
Operators of ski resorts and theme parks, as well as
promoters of outdoor events, such as concerts, are
exposed to snowfall, precipitation and
temperature. The main effects are decreased

patronage lowering entrance/usage fees and

associated merchandise sales. Ski resorts also face
lower sales of resort real estate, which are a
growing component of total revenues.

Insurance companies can reduce exposure to

weather-related claims. Risk products tied to
rainfall, for example, can provide the funds to pay
flood claims.

Financial institutions can incorporate these

products as a way to broaden their offerings to
clients. With weather largely uncorrelated with
other financial products, including weather
derivatives can diversify portfolio risk.

"Merrill Lynch equity strategist

Mark Skocic has analysed the
companies in the S&P/ASX100 Index
with direct exposure to the agricultural
sector based on segment
breakdowns in annual reports.
BRL Hardy, Foster's Group,
Futuris, Goodman Fielder,
Orica, Southcorp, Wesfarmers and
WMC were among the companies
Mr Skocic identified that
could be affected by the
drought conditions.
Analysts said the dry weather
conditions also could influence the
insurance sector, as the number of
car accidents should fall with less
rain, potentially having a marginally
positive impact on Insurance
Australia Group's payouts. Global
reinsurance group QBE may benefit
from climatic conditions that
should produce fewer cyclones
and tropical storms."
Australian Financial Review - 12 August 2002

Who sells weather derivatives?

Case study # 1: Agribusiness

Although the market was initially driven by energy

companies, the increasing trend is for highly-rated
banks and insurers to provide weather derivatives to
their diverse client base utilizing their strong balance
sheets and risk management expertise.

Grain Traders Ltd (GTL) relies on an optimum

amount of rainfall during the growing season and a dry
harvest period in November/December. Excess rainfall
during these months impedes the harvest and can also
reduce the market value of the wheat crop as surplus
moisture lowers the protein content of the grain.

Weather derivative contracts are priced using actuarial

analysis of historical payouts, factoring in recent
weather trends and climatic cycles such as El Nino and
La Nina. Historical weather data and tailored weather
forecast services are available through the Australian
Bureau of Meteorologys Special Services Unit.

GTL's Treasurer determines that for each millimetre by

which the average rainfall measured at Wagin,
Wandering and Narrogin in Western Australia exceeds
50mm over the Nov/Dec period, revenue will reduce
by $100,000.

The Weather Risk Management Association, or

WRMA, is the industry body to which most
underwriters of weather risk, as well as many end-user
customers, belong.

The total value at risk, based on forecast crop grade &

volume and expected prices is calculated as
$5,000,000. The average rainfall for this region during
this period is 38mm.

WRMA holds annual weather risk management

seminars in the American, European and Asian
regions.

GTL buys a precipitation cap that pays $100,000 for

each mm in excess of 50mm which is the rainfall level
above which overall profitability begins to decline
sharply. Assuming this contract costs GTL $500,000,
the resulting payout pattern is represented by the graph
below.

For more information on weather risk management, as

well as several case studies that demonstrate the value
of weather hedging to various industries, visit the
WRMA website at www.wrma.org.

Revenue/Payout

Precipitation Cap

Rainfall in mm

Weather Risk Management

Payout ($m)

CDD Collar

Cooling Degree Days

Case study # 2: Energy

Megawatt Retail Ltd (MRL) benefits from hot
summers and cold winters but experiences reduced
sales in mild seasons. As the summer months are the
most critical to achieving annual budgets, MRL
decides to explore the cost of protection against a mild
summer in their major market, Sydney.
To gauge the relative warmth of the most recent
summer against previous years, MRL calculates the
number of Cooling Degree Days for the first quarter of
each year. This is done by summing on a daily basis,
over several sample years, from 1 January to 31 March
the maximum of (Average Temperature - 18oC) and 0.

decides to enter a zero cost collar with a payout of

$100,000 per CDD and a put strike of 340 CDD's
and a call strike of 475 CDD's. For a CDD total
between these strikes, no payout is made. The
maximum payout is set at $5,000,000.
Should CDD's for quarter exceed 475, MRL pays the
seller $100,000 per DD, up to 525 CDD's and for a
cooler summer, receives $100,000 per CDD below
340 to a minimum of 290.
The payout pattern for the above transaction is
reproduced above.

In other words, measuring the cumulative number of

degrees by which the average temperature on each day
exceeds 18o Celsius. In 2002 there were 408 CDD's
for the period, whereas the year before was
considerably warmer at 479 CDD's.
Although with extremely hot weather prevailing
during the Jan - Mar quarter, MRL will exceed budget,
to obtain downside protection it transacts a CDD
hedge. To mitigate the upfront cost of the hedge, MRL

Australian Financial Markets Association

For more than 15 years, the Australian Financial Markets Association (AFMA) has been at the
vanguard of the Australian over-the-counter (OTC) wholesale financial markets industry. Formed
in 1986 to streamline market practices and establish trading standards in OTC markets, AFMA is
recognised as the peak representative body of OTC markets in Australia.
OTC markets cover transactions in financial securities facilitated off an exchange. This includes trading in foreign
exchange; interest rate products; financial derivatives; repurchase agreements; commodities; equity and electricity
derivatives.
Today, AFMA has a community of more than 6000 individuals across almost 200 member organisations that
encompass the full range of participants in the Australian over-the-counter (OTC) wholesale financial markets.
AFMA seeks to maximise the knowledge, skills and success of its members, as well as the overall impact and
recognition of the OTC wholesale financial markets community.
Acting as an industry catalyst, AFMA accomplishes this goal in 5 ways:

Relationship Building: Provide members with high level, meaningful opportunities to network, exchange ideas
and information, so as to stay ahead of market issues.

Knowledge Management: Aggregating executives from member organisations and other decision makers to tap
into the latest thinking on current issues affecting their businesses.

Education Programs & Initiatives: Deliver top quality, timely and relevant programs that help our members
extend their market reach and presence.

Market Practices, Standards and Documentation: Originally formed in 1986 to streamline market practices
and establish trading standards in OTC markets, AFMA today has in place a comprehensive system of industry
accepted standards.

Market Data & Research: AFMA promotes the growth of Australia's OTC Financial Markets by increasing
market transparency. This is achieved by compiling and disseminating market data and information.

Australian Financial Markets Association

Level 6, 15 Castlereagh Street Sydney NSW 2001
GPO Box 3655 Sydney NSW 2001
Telephone: + 61 2 9776 4411
Fascimile: + 61 2 9776 4488
Email: info@afma.com.au
Web: www.afma.com.au

10

Weather Risk Management

Weather Risk Management Association

The Weather Risk Management Association (WRMA) was developed to
assist companies in managing the extent to which their revenue is affected
by uncontrollable weather patterns. It is an industry that has thrived and
succeeded in presenting financial weather products as marketable and
economically productive assets to a company's profitability.
The financial benefit of managing weather risk is evident in the surge of traders, brokers, insurers and government
agencies that are eager participants in the industry of risk management. WRMA has brought to the forefront the
significance of this industry and provides a standard of operation and business practices in the form of Standardized
Contracts/Confirms.
The goal of WRMA is to serve the weather risk management business by promoting the industry, providing forums
for discussion and interaction with others associated with financial weather products. These forums include working
committees on issues such as international opportunities, data issues, and tax and legal matters.
WRMA also provides membership links, on-line newsletters, and conferences that present current issues affecting
the weather market in addition to hosting an Annual Meeting which gives our members an opportunity to share the
latest developments in the industry.

Weather Risk Management Association

1156 15th Street, N.W., Suite 900
Washington, DC 20005
Telephone: +1 (202) 289-3800
Facsimile: +1 (202) 223-9741
Email: wrma@kellencompany.com
Website: www.wrma.org

11

Disclaimer
Whilst every care has been taken by the employees of AFMA in preparing the content of this document, the content covered is not intended nor should it be relied
upon as a substitute for other appropriate professional advice, and AFMA will not be liable for errors or omissions in the content, or for any consequences resulting
from any errors or omissions, including any loss resulting from reliance on this content.
Copyright
Australian Financial Markets Association - 2002
This document is subject to copyright. No part of it should be reproduced without the written consent of the copyright owner.

12

Brochure Sponsors

Website: www.westpac.com.au
Email: martingay@westpac.com.au or
Telephone: +612 9264 8016
Contact: Martin Gay

Website: www.tfsbrokers.com
Email: mhopkins@tfsbrokers.com.au
Telephone: + 612 9221 1957
Contact: Michael Hopkins

Website: www.aon.com.au
Email: ralph.butterworth@aon.com.au
Telephone: + 612 9253 7160
Contact: Ralph Butterworth

Website: www.elementre.com
Email: ntrethewey@elementre.com
Telephone: +612 8224 2102
Contact: Norman Trethewey

Website: www.nabmarkets.com
Telephone: + 612 9295 1150
Contact: John Kempler

Website: http://ssu1.bom.gov.au
Email: webssu@bom.gov.au
Telephone: + 613 9669 4990

Website: www.axa-re.com
Email: weather@axa-re.com
Telephone: + 612 9258 0450