Even in our advanced, technology-based society, we still live largely at the mercy of the weather. Unfortunately, this production factor can hardly be controlled. It influences our daily lives and choices, and has an enormous impact on corporate earnings. Until recently, there were very few financial tools offering companies' protection against weather-related risks. However,the inception of the weather derivative - by making weather a tradable commodity - has changed this.
The weather market traces its roots to deregulation of the U.S. energy industry. With deregulation, the various participants in the process of producing, marketing, and delivering energy to U.S. households and businesses were left to confront weather as a new and significantrisk to their bottom line. The first transaction in the weather derivatives market took place in 1997.
Since that time, the market has expanded rapidly into a flourishing over the counter (OTC) market, the first deals were structured as protection against warmer or cooler than average weather in specific regions for the winter or summer seasons. Soon it expanded to address a wide array ofweather risks faced by numerous other industrial sectors and to other countries like the U.K., Australia, France, Germany, Norway, Sweden, Mexico and Japan.
The early market participants saw weather derivatives as both a mechanism to hedge inherent weather exposure in their core energy assets and other energy commodity trading operations as well as a new risk management product to offer toregional utilities and other energy concerns alongside the array of structured products they were already providing.
Primarily the market was reserved to end users, in other words, companies covering against weather risk, but on the other hand, with the growth of the market, there came the secondary market, where salesmen of these covers negotiated between them and standardized contracts and stillmanaged them well. With the rapid increase of the size of the market as well as to help the market grow and remove credit risk from the trading of the contracts, the Chicago Mercantile Exchange (CME) started an electronic market for weather derivatives in 4 September 1999 and this was the first exchange where standard weather derivatives could be traded. Among the major market makers for the ChicagoMercantile Exchange (CME) are Aquila Energy, Koch Energy Trading, Southern Energy, Enron and CastleBridge Weather Markets, all these firms were also very active in the Over-the-Counter (OTC) market for weather derivatives in the United States weather derivatives market.
Standard weather derivative contracts are now listed on the Chicago Mercantile Exchange (CME), the Intercontinental Exchange(ICE), and the London International Financial Futures and Options Exchange (LIFFE) and this is increasing the trading volumes of these contracts and also having a positive impact on price discovery and market liquidity.
A derivative is a contract or a security whose value or payoff derives from the price of an underlying asset. Derivatives help an investor to control the risks of changes in theprices of the underlying asset.
So as a definition we can say that weather derivatives are financial instruments that can be used by organizations or individuals as part of a risk management strategy to reduce risk associated with adverse or unexpected weather conditions. The underlying value of a weather derivative is a measurable variable, because temperature is not a marketable good, standardderivative valuation techniques do not apply.
The difference from other derivatives is that the underlying asset (rain/temperature/snow) has no direct value to price the weather derivative.
The main players who take part in the weather derivatives markets industry can be grouped in to five main categories, namely:
1) End users who are also referred to as hedgers