Constraints on the Weather Derivatives Market

In the United States, the entire power generation industry has faced regulatory pressures, costly restructuring and massive losses in the wake of the California power crisis in 2000-2001, leaving little to be spent on weather risk management. Meanwhile, utilities in Europe appeared to be more concerned about the EU Emissions Trading Scheme than weather hedging possibilities (Nicholls 2004e). It has been suggested that this will change:

Going forward the [EU ETS] scheme should contribute to renewed growth in [weather derivatives] activity in Europe, given the effects that temperature and precipitation (via hydro capacity) have on electricity supply, and therefore carbon emissions. (O'Hearne 2005, p. 16)

Further hybrid opportunities will be developed by melding commodity trading and weather trading:

Weather can serve as a hedge or as a source of incremental value in trading commodities. This can be done on an outright basis, by betting on a cold winter while, at the same time, also buying natural gas or heating oil. A hedged strategy might involve buying natural gas and selling cold-side weather exposure, where the weather position will lose if the winter is indeed cold, but be more than offset by the value of the natural gas contracts. (O'Hearne 2005, 16; Nicholls 2005b)

To date, the U.S. natural gas utility sector has been one of the most reliable buyers of weather derivative products. One disincentive for this sector to seek weather protection lies in recent weather normalization agreements that have been struck between gas utilities and state regulators. These agreements allow utilities to charge customers higher rates during milder winter when temperatures rise above prearranged norms and demand for gas is reduced. Atmos Energy of Louisiana, for instance, canceled the last year of its three-year weather insurance program with XL Weather and Energy, after regulators approved its weather normalization clause. Participants in the weather markets argue that such agreements are not in the best interest of the consumer (Nicholls 2003).

While the number of investors in weather risk instruments is growing, the problem in developing this market appears to be in finding new companies that are prepared to hedge their weather risks. Nicholls (2004c) claims that this reflects the immaturity of the weather market, when end users are reticent to talk publicly about their use of weather derivatives, and consider the use of these novel instruments as a source of competitive advantage. In addition, dealers themselves like to protect the identity of their clients from their peers. Presumably, this constraint will weaken as exchange-based contracts become more important than OTC transactions. Exchange-based trading should provide greater volume and greater price transparency, both of which will contribute to the liquidity required for a successful market.

Data availability is another significant constraint to the rapid development of the market. Whereas the world has access to a huge and growing volume of weather data there still remain major issues to be resolved before the data appear widely in usable form. The availability of raw data is not the only issue. For example, temperature regimes at different locations and for different seasons each present their own challenges for interpretation (Dischel 2002; Jewson and Caballero 2003b; Pardo et al. 2002).

As long as good-quality data are not available at a reasonable price, all weather derivative contracts will carry a higher premium for the implicit uncertainty in the contract. Climate change will further complicate this already complex issue (Jewson and Caballero 2003a; Hertzfeld et al. 2004).

Another major factor affecting the maturing of the market is a clear understanding of the importance of regulation. The market evolved because the U.S. government (among others) deregulated gas and electricity markets, thereby exposing producers and consumers to price and volume volatility. A supervisory body is still essential to ensure that the market works in an unfettered fashion and is not subject to manipulation by the suppliers—as appears to have happened in California in 2000. It is equally important that the government does not lose its nerve and return to price regulation.

Markets in novel and complex financial products can fail, as was demonstrated by the withdrawal of catastrophe options from the Chicago Board of Trade (CBOT) in 1999 (White 2001). Even when markets manage to establish themselves this can take some time. Richard Sandor noted: ''It took almost three years for the first trade to occur in the Acid Rain Program, and now that same market is worth $4 billion. History has taught us that environmental markets need time to mature'' (Sandor 2004a).

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