The weather derivatives industry is one of the most rapidly growing fields of risk management today. Such instruments, whose underlyings are functions of temperature and other weather variables, enable purchasers to manage the volumetric risks associated with warmer or colder-than-average weather. The great power of weather derivatives lies in their potential for diversifying weather-related risks across the entire economic spectrum, not just between energy producers and consumers. Indeed, the range of industries susceptible to adverse weather is large, including amusement parks, beverage companies, winter apparel manufacturers, retailers, restaurants, resorts, golf courses and agricultural companies.
Putting the concept into practice, however, is no easy task, and many of those who stand to benefit from weather derivatives find it difficult to translate weather into the quantities they are familiar with. Therefore, it is often left to the weather derivative marketer to design products peculiar to the weather risks that concern a given class of end-user.
One way of trading this market is via swaps based on electricity demand at a given location, where electricity demand and weather patterns are closely correlated.
Weather derivatives began as instruments for energy consumers and suppliers to hedge against energy volume risks associated with warm or cold seasonal weather. An energy utility, for example, could purchase a floor on seasonal heating degree-days, which would pay out in proportion to the deficit between actual and desired energy usage. Enron and a Florida power utility transacted the first weather derivative, a temperature-linked power swap, in August of 1997 (DW, 8/25/97).
At first glance, a derivative on power demand might seem an odd type of weather derivative. Yet given that more than 90 percent of the power load at some locations, for example the Pennsylvania-New Jersey-Maryland (PJM) delivery point, is explained by temperature, the fit is a natural one.
How power demand swaps work
The main idea of power demand products is to provide a volumetric index for the power market, which can then make transactions using the index rather than degree-days, thereby eliminating the basis risk between consumption and power demand. The index used is the average on-peak hourly demand for an entire power region (e.g. PJM) over a period of time (e.g. one week). Parties can transact financially settled derivatives (options or swaps) with this demand index serving as the underlying.
A standard contract pays $10/megawatt for each megawatt difference from the agreed swap "price" (denominated in megawatts). For instance, party A agrees to sell a swap at 35,000 MW to party B. If the actual outcome is 36,000 MW, then party A will pay party B $10,000 ($10/MW x [36,000 35,000] MW) per contract. Also, options can be transacted as well as swaps.
Power Demand and Weather
The graph (above) shows daily PJM demand (weekdays only) as a function of average temperature at Philadelphia, New York and Washington DC.
In general, the PJM weekday load can be well approximated as a function of weather. The temperature is the most important factor, though wind speed, humidity and cloud cover can also affect the demand.
Uses for the load swap
Any power provider (consumer) that participates in the PJM pool and whose demand (usage) is highly correlated to the overall load for the PJM pool has long been able to construct weather products to hedge any volumetric risks. With demand swaps, finding the right hedge is much more convenient. Instead of having to create a highly structured weather derivative product with inherent basis risk, power market participants can now protect their volumetric risk in terms with which they are more familiar, with no basis risk.
An equally promising application for demand swaps is their role in power pricing. Obviously, a proper understanding of how increases or decreases in demand affect power prices greatly increases a trader's ability to predict price movements. It is also the case that some of the more promising theoretical models of power prices are based on a fundamental analysis of power supply and demand. For such so-called stack models, power prices are modeled as random motion around the supply/demand equilibrium. For all such models based on market fundamentals, an accurate determination of load is of course critical.
Capacity
Some economic forecasters have indicated that the weather derivatives market may one day match or even surpass the power market in size and range of participants, given the enormous and diversified impact that weather has on the economy. Currently, however, it is the weather market that seeks to benefit from the power market's increased size, maturity, and most of all, capacity. Power marketers also stand to benefit enormously, gaining access to new products and counterparties, as well as additional market information.
Power revenues are a product of volumes consumed and market price, leaving market participants exposed to both volumetric risk and pure price risk. There is a clear application for using demand swaps and options to manage volumetric risk, but sophisticated power traders can use demand products to manage price risk as well.
Indeed, a trader with a good grasp of how a shift in demand will affect prices can construct a portfolio of demand call options of differing strikes whose payout profile is similar to that of a call on power.
True, the demand/price relationship is not fixed and can change drastically due to interruptions in power supply or demand, but such shocks can severely impact power options as well. Given that transacting power calls is difficult to do in today's power market, power demand products can therefore be used to fill the capacity gaps in both the power and weather derivative markets.
It is no revelation to say that short-term volumetric and even price risks in the power industry are largely a function of weather. For several years, products have been available to allow such risks to be managed. However, structuring the right portfolio of weather products to isolate an exposure for a specific pool is not a trivial task. It is therefore incumbent on weather derivative market makers to design products that allow customers to lay off their weather risk even as they continue to deal with the quantities they understand best. As such, demand swaps are a significant development in the risk management industry. Moreover, these products are a portent of other weather derivatives designed to isolate a specific industry risk. Their introduction demonstrates not only the weather market's increasing maturity, but also its fundamental role in the management of power risk.
This week's Learning Curve was written by H. Joseph Hrgovcic, head of weather derivatives research, and Claudio Ribeiro, head of new product development at Enron in Houston.
