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Dr Harvey Stern, Shoni Dawkins & Robin Hicks Bureau of Meteorology, Melbourne

Latest Developments in Weather Risk Management presentation to “Risk Finance” , 22-24 March, 2004 The Finance and Treasury Association. Dr Harvey Stern, Shoni Dawkins & Robin Hicks Bureau of Meteorology, Melbourne. Important WEB Sites. http://www.bom.gov.au

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Dr Harvey Stern, Shoni Dawkins & Robin Hicks Bureau of Meteorology, Melbourne

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  1. Latest Developments inWeather Risk Managementpresentation to “Risk Finance” , 22-24 March, 2004The Finance and Treasury Association Dr Harvey Stern, Shoni Dawkins & Robin Hicks Bureau of Meteorology, Melbourne

  2. Important WEB Sites • http://www.bom.gov.au • http://www.artemis.bm/artemis.htm • http://www.wrma.org

  3. Outline of Presentation • Introduction • The foundation of the weather market. • The growing diversification of weather risk products and their interest. • Sources of meteorological data, their quality control and application. • Managing weather risk using daily weather forecasts and seasonal outlooks.

  4. Outline of Presentation • Introduction…

  5. The Noah Rule “Predicting rain doesn’t count; Building arks does”. Warren Buffett, Australian Financial Review,11 March 2002.

  6. Weather-linked Securities • Weather-linked securities have prices which are linked to the historical weather in a region. • They provide returns related to weather observed in the region subsequent to their purchase. • They therefore may be used to help firms hedge against weather related risk. • They also may be used to help speculators monetise their view of likely weather patterns.

  7. Some Recent News • The next few slides illustrate some recent news.

  8. Outline of Presentation • The foundation of the weather market…

  9. Foundation of the Weather Market “The foundation of today’s financial weather contracts is in the US power market … For the weather-sensitive end-user, not to hedge is to gamble on the weather.” Robert S. Dischell

  10. Outline of Presentation • The growing diversification of weather risk products and their interest…

  11. WRMA 2002 Survey Results.The Growing Interest. • 3,937 contracts transacted in last 12 months (up 43% compared to previous year). • Notional value of over $4.3 billion dollars (up 72%). • Market dominated by US (2,712 contracts), but growth in the past year is especially so in Europe and Asia. • Australian market accounts for 15 contracts worth over $25 million (6 contracts worth over $2 million, previously). Source: Weather Risk Management Association Annual Survey (2002)

  12. WRMA 2002 Survey Results. The Diversification. • Another significant development is the diversification of the types of contracts that were transacted. • Temperature-related protection (for heat and cold) continues to be the most prevalent, making up over 82 percent of all contracts (92% last year) • Rain-related contracts account for 6.9% (1.6% last year), snow for 2.2% (0.6% last year) and wind for 0.4% (0.3% last year). Source: Weather Risk Management Association Annual Survey (2002)

  13. Views prior to the release of the WRMA 2003 Survey Results “Most market participants … are predicting an increase in total notional volumes” “The general malaise that has clouded the weather risk market in the past year may be on the wane” “…we will see a sizeable decrease in volumes … as Enron, Aquila … have left the market” “The effect of market departures was clearly felt …[but]… big players more than compensated for the loss, providing liquidity and execution of service” “…weather forecasting improvements could pose a threat to market development” Energy Power Risk Management May2003

  14. WRMA 2003 Survey Results (a) A near tripling of contracts transacted (11,756 contracts compared with 3937 previously) Notional value of contracts fell slightly ($US4.2b compared with $US4.3b previously) Indicates a surge in smaller contracts, and a broader spectrum of users Total business generated over the past 6 years: $US15.8b

  15. WRMA 2003 Survey Results (b) North American market: 2217 contracts compared with 2712 previously (20% decline) European market: 1480 contracts compared with 765 previously (90% increase) Asian market: 815 contracts compared with 445 previously (85% increase)

  16. WRMA 2003 Survey Results (c) Diversification Increasing: Temperature related contracts 85% compared with 90% previously Rain related contracts 8.6% compared with 6.9% previously Wind-related contracts 1.6% compared with 0.3% previously Snow related contracts 2.1% compared with 2.2% previously

  17. The Asia-Pacific Region • Interest in weather risk management has grown in the Asia-Pacific Region (covering electricity, gas, & agriculture). Countries involved include: • Japan; • Korea; and, • Australia/New Zealand. Source: Weather Risk Management Association.

  18. Australian Developments • For many years, the power industry has received detailed weather forecasts from the Bureau. • Now, Australia has joined the global trend towards an increased focus on the management of weather-related risk. • The first instance of an (Australian) weather derivative trade occurred about three years ago. • A number of businesses have now moved into the trading of weather risk products, almost all “over the counter”. • Partnerships are emerging between merchant banks and weather forecasting companies.

  19. Securitisation • The reinsurance industry experienced several catastrophic events during the late 1980s & early 1990s. • The ensuing industry restructuring saw the creation of new risk-management tools. • These tools included securitisation of insurance risks (including weather-related risks). • Weather securitisation may be defined as the conversion of the abstract concept of weather risk into packages of securities. • These may be sold as income-yielding structured products.

  20. Catastrophe Bonds • A catastrophe (cat) bond is an exchange of principal for periodic coupon payments wherein the payment of the coupon and/or the return of the principal of the bond is linked to the occurrence of a specified catastrophic event. • The coupon is given to the investor upfront, who posts the notional amount of the bond in an account. • If there is an event, investors may lose a portion of (or their entire) principal. • If there is no event, investors preserve their principal and earn the coupon. Source: Canter & Cole at http://www.cnare.com

  21. Catastrophe Swaps • A catastrophe (cat) swap is an alternative structure, but returns are still linked to the occurrence of an event. • However, with swaps, there is no exchange of principal. • The coupon is still given to the investor upfront, but the structure enables investors to invest the notional amount of the bond in a manner of his own choosing. Source: Canter & Cole at http://www.cnare.com

  22. Weather Derivatives • Weather derivatives are similar to conventional financial derivatives. • The basic difference lies in the underlying variables that determine the pay-offs. • These underlying variables include temperature, precipitation, wind, and heating (& cooling) degree days.

  23. Derivative or Insurance? • A Derivative: -has ongoing economic value, -is treated like any other commodity, -is accounted for daily, & -may therefore affect a company’s credit rating. • An Insurance Contract: -is not regarded as having economic value, & -therefore does not affect a company’s credit rating.

  24. A Weather-linked Option • An example of a weather linked option is the Cooling Degree Day (CDD) Call Option. • Total CDDs is defined as the accumulated number of degrees the daily mean temperature is above a base figure. • This is a measure of the requirement for cooling. • If accumulated CDDs exceed “the strike”, the seller pays the buyer a certain amount for each CDD above “the strike”.

  25. Specifying the CDD Call Option • Strike: 400 CDDs. • Notional: $100 per CDD (> 400 CDDs). • If, at expiry, the accumulated CDDs > 400, the seller of the option pays the buyer $100 for each CDD > 400.

  26. Pay-off Chart for the CDDCall Option

  27. An Historical Note: An Early Example • In 1992, the present author explored a methodology to assess the risk of climate change. • Option pricing theory was used to value instruments that might apply to temperature fluctuations and long-term trends. • The methodology provided a tool to cost the risk faced (both risk on a global scale, and risk on a company specific scale). • Such securities could be used to help firms hedge against risk related to climate change.

  28. Carbon Disclosure Project (2003) • "Investors failing to take account of climate change and carbon finance issues in the asset allocation and equity valuations may be exposed to significant risks which, if left unattended, will have serious investment repercussions over the course of time."

  29. Cooling Degree Days (1855-2000)(and climate change) • Frequency distribution of annual Cooling Degree Days at Melbourne using all data:

  30. Cooling Degree Days (1971-2000)(and climate change) • Frequency distribution of annual Cooling Degree Days at Melbourne using only recent data:

  31. Outline of Presentation • Sources of meteorological data, their quality control and application…

  32. Types of Data Available • Rainfall – daily, monthly, seasonal, analyses, • Temperature – hourly, maximum and minimum, dew point, monthly averages and extremes • Wind speed, hourly , maximum wind gust, wind run

  33. Sources of Observations • Bureau Staffed Sites • Fully trained observers • Equipment maintenance

  34. Bureau Stations • Some in remote locations • Some located at major airports

  35. Automated Weather Stations Currently 513 sites

  36. Features of an AutomaticWeather Station • In general, compared to human observers: • AWS are more consistent in their measurement • AWS provide data at a significantly greater frequency • AWS provide data in all weather, day and night, 365 days per year • AWS can be installed in sparsely populated areas • AWS are significantly cheaper than human observers

  37. Features of an AutomaticWeather Station (cont.) • However, AWS suffer a number of disadvantages. These are: • Some elements are difficult to automate (e.g. cloud cover) • AWS require a large capital investment • AWS are less flexible than human observers

  38. Automatic Weather Stations (cont.) • Consistency between sites • Bureau Specification 2013, based on WMO guidelines • Different sensors because some sites are designed around specific users / programs • Aviation, agriculture, climate, marine • Inspection routine to ensure calibration, preventative maintenance, software upgrades

  39. Automated Weather Stations (cont.) • Sites are fenced to • minimise obstructions, • reduce • vandalism, interference from animals • Rural locations generally representative of local area

  40. Cooperative Observers • Currently about 300 sites • Historically main source of surface observations • Lighthouses • Post Offices • Generally up to 7 observations per day • Replacement with AWS, or concurrent for cloud, visibility observations

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