Taking the Weather Option

Weather-contingent options are cheaper than other weather risk products and can be crafted to suit emissions allowance markets.

Weather is a pivotal demand factor in energy consumption, but one that is difficult to predict and impossible to control. With weather-hedging tools available in the over-the-counter (OTC) markets for several years, the market has grown to $4.2 billion, with approximately 4,000 contracts traded in 2001, according to Pricewaterhouse-Coopers.

The utility sector is particularly exposed to weather risk. Most companies have identified their financial exposure to weather events and trends, but now, with a firm understanding of the dollars at risk, companies are more likely to turn to weather markets to buy derivatives.

Utilities are moving beyond traditional plays in weather markets to hedge cost elements of their power production, including fuel procurement and emission allowances. Dual-trigger weather options-cross-commodity derivatives that combine these commodities and the weather-represent a cost-effective means to hedge risk without spending too much capital.

Traditional Utility Plays

Virtually all utilities have quantified their weather risk, and most are trying to do something about it. Some utilities put their weather risk on ratepayers through weather normalization clauses, which pass the cost of revenue shortfalls directly to the consumer. Other utilities have been hedging their weather risk in OTC markets using simple derivatives that have now become commonplace.