Banks are playing an important role in the development of the European weather derivatives market. Valerie Denney reports.
Hard data on the current size of the global weather derivatives market is hard to come by. There's lots of talk about large deals being inked, but precise figures are not always forthcoming. At the last count, which was conducted in early 2001 by the WRMA in conjunction with PricewaterhouseCoopers, the market was worth some $7.5bn. (See this edition's introduction for WRMA/PwC survey details.) Modest in the wider scheme of trading but healthy enough for a market which started out as recently as late 1997, when the first weather derivative, a first degree day swap, was traded between Enron and Koch. All sorts of estimates are flying around concerning the market's anticipated growth, from the cautiously optimistic to the downright delusional. Suffice to say that while expansion continues apace with an ever-broadening variety of players and products, it remains to be seen whether end-user demand will reach significant proportions and a robust secondary market emerges.
Playing its part in this expansion are the banks/investment banks, attracted by the prospect of portfolio diversification and increasing returns. While some merely offer structuring advice and help with placements, others have plenty to bring to the weather derivatives table. As one player points out: "We are looking at much more structured transactions, potentially much longer dated transactions, or transactions with features that are able to be structured and fine-tuned to the customer's risk management needs. The added value we offer our clients is the ability to work with them to figure out what their exposure is and provide them with a structure that precisely fits their needs."
Echoing this observation, it is generally agreed that there are two sides to a bank's role in this market. One is to work with clients so that their weather risk is properly understood. The other is to design products which allow weather risk management to enter the client company in an amenable, efficient way to the accounting process.
There is little doubt that involvement by investment banks has boosted the European market, albeit witnessing a fraction of American activity. (It was estimated earlier last year that the notional volume was around $28m which is approximately 1.5% of that in the US.) Analysts indicate that banks are showing interest in trading contracts, brokering them and in some cases buying them to supply as part of the risk management packages for their clients.
The first weather transaction in Europe was a heating degree day swap between Enron and Scottish Hydro-Electric in September 1998. Since then, the market has experienced rapid development and currently enjoys enormous growth potential, due to a number of factors. Ongoing energy deregulation is having the desired effect as the American energy industry - which pioneered weather derivatives - can testify. Utility deregulation unglues the natural weather hedge from the regulated rate formula and places the financial onus of all fundamentals, including weather, on the company and its shareholders.
Moreover, in line with the US, companies from industries other than energy are increasingly looking at the weather derivatives market as a means to hedge their risk. There is a growing demand among a wide variety of businesses which are at the mercy of the weather, from bars to rail track providers.
The likes of DrKW (Dresdner Kleinwort Wasserstein), HypoVereinsbank and Deutsche Bank have entered the market in the last year in direct response to client demand, although Hypo- Verinsbank is keen to stress it has been observing the market for three years now. DrKW has gone on record saying that its main areas of interest are degree day or precipitation-based swaps and options. These can be sold as stand-alone products, or embedded into structured products - for example, hedging temperature or rain against fixed-income or floating rates.
Some have it that despite an increase in requests actual trades remain low, while others maintain that trade activity is brisk. Whatever the experience, most compare the weather derivatives market with the early days of credit derivatives. Although slow to start, the credit derivatives market is now reckoned to be a good size.
Indeed, as was the case on the credit derivatives side which saw firms pull out as the market took time to establish itself, the weather derivatives sector recently lost a player. BNP Paribas has withdrawn from the market, stating that the trading was not providing the return on capital that was initially expected. Remarks Denis Autier, the London-based head of the bank's global risk solutions division: "Weather trading is a complex business and we review our involvement across all products regularly. We decided the resources both in terms of capital and staff, could be better used elsewhere in the business. Weather derivatives are interesting products. However, it's a relatively time-consuming business for what on average are small transactions."
Does this signal further fall-out? Certainly, the exit is unlikely to help a market which is struggling to find greater liquidity. The general consensus thinks not. If anything, observers expect more banks to become involved in the near-term. While weather derivatives are still a relatively new concept in Europe and have yet to take hold in the corporate mind-set, the opportunities are clear. As one banker puts it: "If you want a cross-selling product, this is it." While negotiating deals involving financial trading, banks can bring their clients' attention to the need to manage weather exposures. Reiterating the earlier point about structured transactions, banks are in a position to factor weather derivatives into a total risk management package.
As ever, creativity is paramount. It is generally accepted that players have merely scratched the surface as to how weather products can be used both domestically and on a cross-border basis. Transactions are likely to become increasingly structured with options linked either to a commodity or to another form of weather, such as precipitation. Everyone is learning about and continually developing their weather products. Olivier Toutain of Moody's in France points to the important role insurers also have to play. "It will take a cultural revolution, but insurers need to think of insurance more as a banking product."
Looking ahead, it is anticipated that activity will divide into two distinct camps, one dominated by short-term, highly liquid deals such as degree day products transacted by market-makers, the other consisting of more exotic, esoteric structures transacted by investment banks and the insurance industry.
For now, however, the European market has been slow to take off compared to the US. Nobody disputes the long-term potential demand for weather products, but many are waiting for more liquidity. Trading for weather derivatives is expected to increase following LIFFE's introduction of its weather indices. LIFFE hopes the development will raise awareness of weather derivatives as a tool. While the move is welcomed in the sense that it will provide some pricing transparency and liquidity to the secondary market, traders believe that LIFFE will struggle to draw volume as corporates usually require contracts tailored to their own needs. The Chicago Mercantile Exchange in the US has certainly found this to be the case.
A major factor in the market's modest progress to date is the lack of end-user awareness. Of the more sophisticated companies which are asking about weather derivatives, few are willing to commit. Education is therefore key when it comes to developing the market. "Clients still need to be convinced," contends Mr Toutain. "Weather is not yet seen as a real risk." Those banks currently marketing weather derivatives concur, stressing that their main role at the moment is to inform clients of the benefits of weather risk management. As one player concludes: "The more this is discussed, the more likely it is that the product will be accepted. It will be a self-fulfilling prophecy."
Perhaps another impetus will come from equity and debt analysts who are increasingly coming to the conclusion that a company's weather risk mitigation can bolster the balance sheet. If these professionals start penalising companies for not hedging weather risks, then watch the market take off in dramatic fashion.
By Valerie Denney