In all industries, predictable profits are crucial in building investor confidence and gaining access to lower-cost funds. However, many companies have profits that are weather dependent and achieving predictability is nearly impossible due to the weather's inherent unpredictability.

The lesson for companies is clear: they should mitigate these financial risks by embracing new techniques for insulating themselves from financial fallouts. Fortunately, a number of tools for doing so are now coming to market and among the most notable of these is weather derivatives.

Many companies are taking advantage of these weather-linked risk management tools. Launched just four years ago, when Enron introduced swaps and options tied to weather variables such as temperature and precipitation, the market grew at a respectable if not extraordinary pace during the late 1990s, with energy companies among the earliest participants. From 1997 through June 2001, more than 5,200 weather contracts were traded industry-wide, with a notional value of approximately $7.5bn. Today, the market is still growing rapidly.

One reason volume is growing is that companies outside the energy industry recognise that managing weather risk makes sense. One appealing feature: weather contracts, unlike most other risk management tools, give companies the unique ability to hedge against volume volatility, not just price volatility. Just as electricity and heating oil consumption are closely linked to temperatures, so are sales of beverages, ski lift tickets, amusement park passes and hundreds of other products and services.

Online weather
Another impetus for the growth in weather trading was the January 2000 introduction of weather swaps to EnronOnline, Enron's web-based business-to-business commodity trading site and the largest e-commerce website in the world. By extending weather swaps to the internet, Enron created a highly transparent marketplace that quickly attracted the attention of corporate risk managers and commodities traders who had previously used weather trades sparingly, if at all. This tool, combined with Enron's market-making activities, made the market substantially more liquid, leading to more efficient pricing, which in turn increased its appeal to new users.

Numbers tell the story. Prior to the introduction of web-based weather trading, the bid-ask spread for an over-the-counter temperature swap typically ranged from 100 to 200 degree days, or as much as an entire standard deviation. Today, EnronOnline spreads are often as tight as three degree days. (A degree day is a term used by the weather industry to measure the variance in temperature from 65ºF.)

Adding to the growth of the weather market is the increased participation by global reinsurers. By the very nature of their business, reinsurers are typically exposed to taking on and managing risk. The weather market is introducing a new way for reinsurance companies to reduce this risk exposure by stripping out the portion associated with weather, enabling reinsurers to improve efficiencies and reduce costs.

For example, a reinsurance company seeks to hedge $100m-worth of risk and the premium associated with hedging this risk is 30%. Therefore the cost to the reinsurance company will be $30m. If the reinsurance company is able to strip out the portion of risk associated the weather, $40m with a 10% premium (given the better liquidity and tighter spreads in the weather market), for example, then the cost of the risk for the reinsurance company will be $22m [($100m - $40m x 30%) + ($40m x 10%)]. This example demonstrates how the weather product significantly reduced the cost to the reinsurer.

By using these weather instruments, reinsurers not only save costs and improve efficiencies, but they also have the ability to further negotiate premium costs associated with the initial portion of the risk.

Throughout their participation in the market, reinsurers have become comfortable with managing risk on a relative value basis by buying and selling options and forwards in a portfolio. Some reinsurers accomplish this through joint venture relationships while others hire commodities traders from outside the firm. It is anticipated that these relationships and structures will evolve to meet the demands of the market.

As weather markets continue to evolve, the participation of reinsurers will be key to ensuring market liquidity and in turn, price transparency. The result will be a marked increase in both the primary and secondary markets for weather-related products.

Future developments
Mark Tawney, vice president, Enron Global Markets – Weather Risk Management, is confident that the growth trend in the weather risk management market will continue, both in the US and abroad. Enron already trades weather from offices in London, Oslo, Sydney and Tokyo, and has transacted in seven different countries. As weather trading becomes more commonplace, fewer and fewer companies will be able to ignore this risk management tool regardless of industry or location.

“We've seen that equity and credit analysts are already starting to pay attention to which companies are hedging their weather risk and which are not, and they highlight that in reports to their clients,” observed Tawney. He noted, for example, that rating agency Moody's Investors Service recently downgraded its rating of several propane companies, citing as a major reason the fact that they were overly exposed to the weather.

“We estimate that three-quarters of all businesses are affected by weather,” Tawney continued. “For most of them, it's no longer acceptable – at least in the eyes of their shareholders – to blame the weather when their sales and earnings don't meet expectations. With the appropriate risk management tools, they can stay well ahead of the game.”