Thursday, January 5, 2006
The use of weather derivatives in the energy industry
Weather derivatives are financial contracts that guarantee a weather index of some kind (e.g., temperature, wind, precipitation, streamflow) to buyer. While a seller of weather instrument can hardly deliver the desired weather, he can make the counterparty whole by compensating for differences between the “guaranteed' and actual weather. In fact, weather derivatives are quite similar to financial contracts on tangible commodities such as natural gas or precious metals that are settled by the buyer receiving or paying cash based on the difference between the guaranteed index and the current (“spot”) price of the commodity.
Although weather based contracts, like any other derivatives, can (and in fact are) used for speculation, their primary purpose is hedging weather related risks. Ski resorts, golf courses, farmers, builders, and even wine bars use weather derivatives to hedge for that “rainy day.” But the largest consumer in weather derivatives market is the energy industry. Indeed, much of the volumetric exposure in the energy sector is weather driven. Gas and electricity demand is tightly linked with heating (and cooling) degree days. Energy generated by hydro power plants is controlled by streamflow levels, and output of wind farms is at the mercy of wind speed and direction.
Modeling weather derivatives requires estimates of expected future weather conditions as well as building stochastic models for temperature, streamflow, wind, precipitation etc. While the former had always been the focus of atmospheric science, the latter remains much less explored.
One of the latest additions to financial markets, weather derivatives marry atmospheric science with mathematical finance and, when applied to energy risk management, with power system engineering. As trading volumes grow, so does the importance of the accurate modeling of weather instruments and their applications.
Victor Dvortsov is a Senior Consultant with Commercial and Trading department of PacifiCorp. Victor's foray into financial world started with a brief tenure at the Enron Weather Risk Management desk in 2001. Prior to that, Victor did postdoctoral research with Susan Solomon at NOAA Aeronomy Lab, where he was involved in stratospheric ozone modeling. Victor holds a Ph.D. in Atmospheric Science from SUNY Stony Brook and a M.S. in Mathematical Physics from St. Petersburg University.