Stream flow deals quicken

Californian hydro firms are too busy getting money out of the government to put on new weather hedges – but Emily Saunderson finds growing interest in stream deals up the West coast, and rainy-day protection for farmers

Precipitation-based weather derivatives looked poised for take-off in the US early this year. In the face of the Californian power crisis and forecasts for a dry summer, dealers reported strong interest from the state’s hydroelectric power producers in weather derivatives to help them better manage their electricity price and production risk.

But while hopes of a surge in precipitation deals from this source have proved premature, hydro firms in the Pacific North West, the other major source of hydroelectric power in the US, are turning to stream flowbased products which better match their exposures. So, although there is general agreement that the market for precipitation hedges in the US will grow, there is some debate about whether hydroelectric utilities will be the main drivers behind this growth.

“The use of precipitation derivatives by hydroelectric producers on the West Coast is really a function of electricity regulation,” says Tom Ruck, senior vice president of weather origination at Entergy-Koch in Houston. “Business has been slow so far this year because so many of these firms are trying to get government rebates. And, with the government allowing them to pass on the rising cost of power to consumers, there is less of an incentive for them to manage their risks,” he adds.

After early interest in precipitation hedges this year, dealers say that power firms have become increasingly embroiled in litigation seeking rebates on power prices from the government. This has diverted management resources from considering other, more novel approaches to risk management – and, in the short-term at least, offered a more certain return.

Hopes of a surge in precipitation business were high after the Sacramento Municipal Utility District (SMUD) entered into a fiveyear precipitation deal last September with Aquila, the Kansas City-based trading firm, to protect it against the effects on electricity production of low levels of precipitation. Aquila agreed to pay SMUD annually up to $20 million when less water flowed through the utility’s hydro plants, while SMUD would pay Aquila $20 million in wet years. Payments were capped at $50 million over the duration of the deal.

“The SMUD trade did little but inflate the secondary market for a while, giving a false impression of the amount of precipitation business compared with the overall weather market,” says one US weather broker. But now, he adds, precipitation has returned to its previous low level of activity.

Many dealers, however, predict steady but slow growth for precipitation derivatives.

“We will see more precipitation deals this year than last as awareness about the market and what is possible grows; but we’re still in a period of education, so progress is bound to be slow,” says Mike Corbally, executive vice president of trading at Element Re in Connecticut. And traders say growth in precipitation business is likely to come as much from agricultural firms as from power producers.

Deals based on rain and snow made up around 3% of the global weather market in the winter of 2000, according to the Weather Risk Management Association. “Precipitation is still likely to account for less than 10% of the overall weather market by the end of 2001, although we are seeing growing interest in rain, snow and particularly stream flow deals,” says Ruck at Entergy-Koch.

Stream flow accounts for the snowmelt and rain that reaches a river so it is directly correlated to the output of many hydro generators. Straightforward precipitation is often not, since it is difficult to predict how much rain or snow that reaches a particular measurement station will end up contributing to stream flow.

“Hydroelectric customers in the North West object to using precipitation contracts because of the high basis risk,” explains Ruck. Stream flow hedges eliminate the risk that precipitation levels and stream flow do not move in tandem.

“A number of companies have expressed an interest in stream flow deals and we have been quoting indicative prices for the North West since late last year.We expect to finalise our first deals with hydroelectric producers in the next few months,” he adds.

Although one broker says that talk about stream flow hedges has been sporadic, and that the “very few deals done” have taken the form of insurance contracts, he also predicts growing demand. This could be fuelled by the lack of rainfall in the North West this year, he adds.

According to data from the government’s North West River Forecast Center, levels of precipitation in the region are close to drought conditions compared with figures going back to 1961. Companies such as Bonneville Power Administration, an Oregonbased firm selling power generated by dams in the North West, which has previously considered using precipitation derivatives to manage its risk, could return to take another look at the market, the broker adds.

But the going will be slow, and Corbally predicts that precipitation and stream flow deals may initially have to be highly tailored to convince hedgers that the contracts will meet their specific needs.“It is important that new market users get comfortable with the idea of precipitation and stream flow derivatives – otherwise they will never take off.We will need to use structured products,” he says.

This could create more challenges for protection providers when they come to manage their own weather risks. Corbally says trading houses can bundle up their weather risks and offload some in repackaged baskets of risk to other secondary market players. But there are limited secondary markets (in which dealers can trade to offset their own risks) in precipitation generally, and highly tailored products are even harder to hedge.

Other traders add that it is sometimes possible to use temperature as a proxy for precipitation, so they can cover their precipitation risks to a certain extent with standard heating or cooling degree day contracts. Another option is simply to hold the position: “Diversifying the types of weather risk you hold is one way to manage them,” says one trader at a US firm.

While some hydroelectric power producers have turned their attention away from precipitation and towards stream flow, traders report more interest in precipitation derivatives from the agricultural sector. “We have seen growing interest from farmers in protecting their crops from too little rain,” says Ruck. Entergy-Koch recently provided EF protection for a consortium of corn farmers against just such an eventuality. Ruck declines to say where the deal was based or who was involved, but it covered some 50,000 acres of corn land against insufficient rain during July and August this year.

“There is huge potential for precipitation derivatives among the agricultural community, and their risks are not just ‘one way’ [in the way that many electricity utilities, say, have similar exposures to each other] since they might need protection against too much or too little rain,” adds Corbally. But again, it will be a long process of education before the market really takes off.