For sale: one summer, unusually hot
(Filed: 19/07/2003)
Weather derivatives are helping firms that can't stand the heat, writes James Moore
Whatever the weather, it's always Britain's national obsession and the City is no exception. As Britain baked this week in some of the hottest temperatures since the sweltering summer of '76, financiers, staying cool in their air-conditioned offices, were heating up plans to make money from our volatile climate.
Changes in the weather cost British companies up to £8 billion a year, according to the Met Office, which says 70pc of British businesses are affected by the weather in one way or another.
And they are not shy about using it as an excuse. Chocolate group Thorntons fell back on the unseasonably hot weather to explain why sales melted away during the Easter holiday. Heineken also blamed poor weather in parts of Europe and North America for its profit warning in June.
Markets have long been established in commodities such as cocoa, sugar, wheat and even pork bellies and frozen concentrated orange juice. But attempts to trade the weather, buying and selling weather derivatives to protect against the wrong sort of conditions, have until recently proved about as successful as a wet weekend in Blackpool.
Things are beginning to change, however. A recent report from the Weather Risk Management Association, the US-based trade body, found that the number of contracts traded by companies seeking protection against the wrong sort of weather worldwide had nearly tripled between April 2002 and March 2003, compared with the previous year.
Lynda Clemmons, the association's president, says: "In less than six years the industry has generated business of more than $15.8 billion. During the past year the number of contract transactions in Europe and Asia nearly doubled in each region."
In the early years of the decade, energy companies, perhaps most obviously hurt by changes in the weather, began to see the benefits of using weather derivatives to hedge against the effects of overheating.
Innogy, the energy company that supplies gas and electricity, set up a weather trading desk in 2001. Nancy Williams, weather risk marketer, says that at the moment the firm would be using protection against the unusually hot weather.
This causes outages at many power stations as cooling becomes difficult, reducing generating capacity. They also tend to need to take time out to perform maintenance.
But demand for energy is increasing as power-guzzling air conditioning units work on overdrive, not least to keep the money men cool as they pore over screens in their towers in the City and Docklands.
The weather derivative a company like Innogy might use works like this. Earlier in the year a broker would be called to arrange protection against exceptionally hot weather. The broker's job would be to find a company wanting protection against cooler summer weather.
The terms of the contracts vary, but in essence Innogy would pay a company on the other end of the contract if the summer was particularly cold, with the reverse happening in the current overheated conditions. This helps to keep earnings stable from year to year. Such contracts can work for any conceivable kind of weather.
Corney & Barrow, the City wine bar chain, famously hedged against a chilly summer in 2000 while bringing in extra staff to help cope if, as hoped, the company benefited from warm summer evenings.
The tool was also used for last year's World Cup, with the Japanese covering themselves against rain, while film companies have made use of the product when they have just a short period to film expensive scenes.
Williams says that weather hedging has proved an effective tool for Innogy, but admits that the market has problems because it is dominated by energy companies, which tend to need similar sorts of protection. Corney & Barrow aside, there just are not enough companies which will sit on the other side of contracts to the energy sector.
"The market is still dominated by energy companies which tend to move it in one direction. There are not enough companies on the other end," she says.
"There is a lot of interest, though. You only need to look at the numbers - like the one from the Met Office which showed 70pc of businesses have to deal with risks associated with the weather - to see the potential.
"Weather derivatives are also more flexible than insurance contracts. Take a sheep farmer who needs protection against hail storms. With an insurance contract he would have to prove that he had made an actual financial loss. With derivative contracts you don't have to do that - their payouts are based on the conditions."
WeatherXchange, which is 49pc owned by the Met Office, was set up to provide data to companies involved in the weather derivatives market as well as brokerage and consultancy services.
Duncan Wilson, WeatherXchange consultant, says: "Most companies have got used to protecting themselves against changes in interest rates and foreign currency through derivatives. Remember, though, 15 years ago it was unusual for companies to hedge interest rates and it was only in 1996 that UK travel companies started to hedge against foreign exchange movements.
"The market definitely has a feel that it is starting to gather momentum. I would suggest that it will probably take around 12 to 15 months and then things will really start to take off. I think shareholders will increasingly not be prepared to accept the weather as an excuse any more."
So far most of the trading in weather derivatives that has been done has been controlled by brokers who match a company, for example, wanting protection against unusually warm weather against one wanting protection against unseasonably cold weather.
These so-called "over the counter" contracts carry one big risk. If one of the companies involved goes bust the other can be left nursing substantial losses. This is what hurt many companies which had dealings with Enron, the collapsed US energy trading group.
Contracts traded over an exchange are less flexible, but carry protection if one side defaults. Liffe, the London futures exchange, has tried to kick-start trading in three contracts based on temperatures in London, Paris and Berlin.
However, the venture has so far proved to be something of a damp squib which has traded just five contracts since it was set up in December 2001. "We set it up because we were asked by customers who wanted an exchange-traded product after Enron collapsed. It will take time, but it is there if people want it," says James Barr from Liffe.
The Chicago Mercantile Exchange has, however, been rather more successful with a smaller contract that is based on measures commonly used by the energy industry. It has also allowed speculators to take bets on the weather.
It is not only the weather where the moneymen have been active. Such trading has also become increasingly common with the overall climate.
The green lobby gets terribly cross about it, but countries falling short of their Kyoto Treaty obligations to cut carbon emissions have for some time been buying the right to pollute more from cleaner countries. And when trading in an underlying commodity takes off, derivatives usually follow. Next stop carbon dioxide derivatives?
| 12 July 2003: Warm wind blows no good for Thorntons |
| 24 June 2003: Heineken warning reaches UK brewers |
| 25 March 2003: Derivatives mean they can't blame the weather |
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