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Weather derivatives evolve as risk mitigation device

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Weather derivatives, originated in the late 1990s by recently deregulated U.S. energy companies looking to mitigate revenue lost to adverse temperatures, have evolved to become a multibillion-dollar worldwide business.

Today, observers and proponents say, the weather derivative market serves numerous business sectors and regions, as well as a host of risks.

Those advances, they note, are the primary reason the number of weather derivative contracts written globally last year reached more than 1.4 million through March, a record for the market, according to the Washington-based Weather Risk Management Assn.

The total value of those contracts rose as high as $45.24 billion in 2006, the year after Hurricane Katrina, and totaled $11.82 billion last year, according to the association.

“It was essentially a U.S. business focused on retail energy companies,” said Juerg Trueb, a Zurich-based managing director at Swiss Reinsurance Co. “Now, it's a market that's become worldwide and grown to include a lot of varying solutions in a number of different sectors. There's a much broader range of underlying risk that's being contracted, and all kinds of indexes being used to quantify the impact of the weather.”

There are two main types of weather derivative contracts.

Standardized, exchange-based contracts are placed by a broker and bought and sold by traders, largely through the Chicago Mercantile Exchange. The buyer's account with the broker is debited or credited based on the fluctuating price of the weather risk covered in the contract.

The second type, over-the-counter contracts, are placed directly with capital providers such as hedge funds or reinsurers and are either warehoused or traded against other nonstandardized products.

OTC contracts offer greater flexibility in specific weather triggers and payment plans, but experts say they carry greater liability to the end user in that they do not mitigate the risk of default of a capital provider.

Where a weather derivative contract differs from a traditional insurance policy—and where it can provide buyers with additional protection—is its coverage of low-severity, high-frequency events like rain, snow and temperature fluctuations, as opposed to one-time catastrophes and natural disasters.

At the market's genesis, energy companies purchased contracts based solely on temperatures, collecting payouts for the number of days the average winter or summer temperature registered above or below a preset threshold.

Proponents attribute the market's growth largely to the addition of bespoke weather risk contracts on rain, snow, wind and other adverse conditions, as well as a cross-commodity products structure basing the payout on the frequency of a weather occurrence combined with the underlying market price or volume of a commodity produced.

“Over the last decade or so, a lot of companies have looked more closely at their risks and found that an off-the-rack solution like heating and cooling degree day products didn't really fit that well,” said Martin Malinow, CEO of the New York-based Galileo Weather Risk Management Advisors L.L.C. and a former WRMA president. “They needed a much more tailored solution that really fit not only the location but also the true nature of the underlying exposure,” he said.

The broader range of risks covered has fueled the expanded demographic and geographic diversity of customers using weather derivative products, said Bill Windle, president of WRMA's board of directors and a Woodlands, Texas-based managing director at RenRe Energy Advisors Ltd. Energy remains the market's dominant participant, but surveys have shown increased interest from the agriculture, construction, transportation and hospitality industries.

“Especially in the last two or three years, the market has shown a much greater diversity in its customer base,” Mr. Windle said.

In 2004, 69% of all inquiries about weather derivatives were attributed to the energy sector. Last year, that fell to 46%, while 23% of the interest came from construction companies and 12% from the agriculture industry. Companies in the outdoor entertainment industry—such as amusement parks, concert venues and open-air sports stadiums—also have entered the market in recent years, Mr. Windle said.

Weather derivatives also have enjoyed significant market growth outside the United States, particularly in Europe and Asia. Some 63% of last year's 998,000 OTC contracts were written in Europe compared with just 13% in 2005, according to WRMA.

When the CME entered the weather derivatives market in 1999, it had only two product forms for futures and options based on heating and cooling degree days, said Paul Peterson, director of commodity research and product development for CME. Those contracts were solely for energy companies and available in just 10 U.S. cities, he said.

“Today, we're up to 67 different products,” Mr. Peterson said. “We're also up to 24 U.S. cities and we have contracts available in 11 other countries, including several European countries, Japan, Canada and Australia.”

Looking forward, proponents said there is ample opportunity for growth in the market, primarily in the green energy sector.

Contracts for wind, solar and hydroelectric energy producers are in development, but have yet to be brought to market. Mr. Peterson said the CME is only in the beginning stages of crafting a contract tailored to the green energy sector.

“It's a very complex process, but we're going to keep chipping away at it,” Mr. Peterson said. “They're all viable topics, and all very good areas for future work.”