Weather Risk Management Association

Great Weather Risk Management Transactions

Great Weather Risk Management Transaction No. 1

Managing Human Catastrophe Risk

In a widely publicized transaction the World Food Program purchased a precipitation cover from Axa Re in order to prefund an emergency response in the event the drought affecting Ethiopia continued in 2006.

Summary Technical Details:

Type: Aggregate precipitation cover
Period: Agricultural growing period in Ethiopia, March-October
Form: Derivative – call option
Index: Precipitation as measured at 26 sites throughout the country, converted into crop water-stress indices and combined in a national basket
Trigger: Crop water-stress index above a pre-specified level at the end of the season indicating wide-spread drought and crop failure.
Limit: $7.1 million
Premium: $0.93 million

Rationale:

  • Efficient use of donor funds (i.e. purchased $7 million of financial resource for less than $1 million to be available in the event of continued drought emergency)
  • Rapid response to drought emergency. The instrument pays immediately upon the drought condition – i.e. crop water-stress above the trigger level indicating widespread crop-failure. Normal donor response requires months before funds are available.

Rapid availability of funds means that World Food Program can move quickly to provide aid on a timely basis, thereby reducing human misery, limiting population dependence on outside support and ultimately reducing the total cost to the world donor pool of humanitarian assistance for this crisis.

Outcome:

In the rainfall levels in 2006 were above average in Ethiopia and so that no call will be made on the stress index call. World Food Program established a mechanism for accessing global risk markets to supplement traditional donor-based humanitarian relief. Axa Re has demonstrated methods for working effectively with difficult technical and data issues.

NB: This transaction received extensive press coverage, which included publication of financial aspects of the transaction normally not disclosed. Discussion of other transactions may not include such details.

Great Weather Risk Management Transaction No. 2 

Managing Costs of Generating Electricity

Hydro generation is among the cheapest sources of electric power. When water is in short supply hydro-electric plants produce less electricity, increasing the cost of production per Kwh. Additionally lost power must be made up from other sources, e.g. from sources for which there is a cost for the underlying energy such as gas-fired generation. The combination of drought and summer heat waves creates scenarios of reduced availability of water and heightened demand. Both factors increase the per Kwh cost of providing electricity to customers.

In 2000 the Sacramento Municipal Utility District (SMUD), a customer owned generator and distributor of electricity, purchased a three year structure to protect it from the volatility of the major components of its cost of generation: water supply and the price of natural gas. The risk takers were two energy trading firms.

Summary Technical Details:

  • Type: Aggregate precipitation cover.
  • Period: October 1, 2000, to September 30, 2003, in three twelve month periods.
  • Form: Derivative – collar
  • Index: Precipitation as measured at Pacific House, California.
  • Trigger: SMUD receives payment when precipitation is less than xx inches (A). SMUD makes payment when precipitation exceeds yy inches (B).
  • Payment: Based on average spring and summer daily price of natural gas at Henry Hub, multiplied by an agreed factor, per inch of precipitation.
  • Maximum Payment SMUD receives payment up to the amount corresponding to qq inches precipitation below trigger A. SMUD pays up to the amount corresponding to rr inches of surplus precipitation greater than trigger B.
  • Premium: $0 (costless collar) plus frictional costs.

Rationale:

  • As a mutual, SMUD sought to minimize costs to its owner-customers. It chose to surrender a portion of its possible excess generation in times of surplus water supply in exchange for protection against possible increases in generation costs due to a shortfall of water and high natural gas prices.

Outcome:

  • Cost of power to SMUD customers remained among the lowest in the State despite turmoil in California electricity market during this period.
  • Successful early example of combining weather risk (which translates into volumetric risk of power supply) and price risk (cost of fuel for alternative, second tier generation) to manage buyer’s own weather risk exposure.