Rainy-day returns

Hedge funds have helped drive a huge increase in activity in the weather risk markets, but end-user business is also ticking up, the winners of Environmental Finance’s Market Survey tell Mark Nicholls

It’s been a good 12 months for the weather derivatives market, rounded off as it was by news that volumes had almost doubled between 2003/04 and 2004/05. The results of the annual Weather Risk Management Association (WRMA) market survey, unveiled later than usual at a November meeting of the organisation, showed notional volumes for contracts which began between April 2004 and March 2005 standing at $8.4 billion, up from $4.6 billion for the previous 12 months.

Kendall Johnson, TFS:“We’re seeing more and more risk placed in different time zones to that in which it’s originated”

This dramatic growth – driven to a large extent by rocketing activity on the Chicago Mercantile Exchange (CME) – looks set to continue. Speaking at the November meeting, Felix Carabello, associate director of environmental products at the CME, predicted that notional volumes in the exchange’s weather contracts could hit $25 billion this calendar year.

But, despite its expansion, the market is on a less firm footing than many participants would like. Trading in the European secondary market has been sporadic (the WRMA survey showed a drop of approximately 25% year-on-year), in part illustrating the extent to which one firm – Swiss Re – had been driving activity in that region. And while interest from the investment and hedge fund community in the asset class is on the up, growth in end-user business has not been sufficiently strong to tempt many new providers into the market, or to encourage existing teams to staff up.

Nonetheless, it’s been a good year for TFS, which once more swept the board in the broker categories, winning in all three geographic regions. Such global coverage is becoming a growing imperative for the weather market, says its Stamford-based global head of weather derivatives, Kendall Johnson.

“We’re seeing more and more risk placed in different timezones to that in which it’s originated,” he says. “There are enough groups out there that will take on risk from another country – it allows us to get the most efficient pricing.”

The ability of the market to absorb larger deals was evidenced by TFS’ latest weather risk auction, carried out in October to place a $70 million-plus slug of temperature risk on behalf of UK gas utility Centrica. While Johnson is constrained by a confidentiality agreement from providing more details about the auction, he says it shows that “it’s no longer about needing to find someone with offsetting risk for the market to work”.

For Jason Pickard at Baltimore-based Constellation Energy – which was voted Best Trading Company, North America – the recent growth in interest from US-based hedge funds provides plenty of domestic risk-taking capacity for his company’s weather exposures.

Pickard, a director of trading in the Constellation Energy Commodities Group, joined the company from XL Weather & Energy in summer 2004, since when he’s overseen a steady increase in its weather hedging and own-account trading activities. “The biggest change in the market I’ve seen is a significant increase in hedge fund involvement, particularly in shorter-term trading,” he says.

And the company is taking advantage of the growing liquidity provided by the investment community. “The way the market has been growing presents a lot of opportunities to hedge weather exposures in our loadserving business, and in other commodities – for example, the weather market may present a better offset than power call [options], which might be thinly traded and expensive.”

The success of Constellation in this year’s survey has come at the expense of Swiss Re, which undoubtedly suffered in the poll from the departure in the summer of the majority of its New York-based weather desk, led by former Enron weather head Mark Tawney. Alongside Bill Windle and trader Bill MacLauchlan, Tawney has joined the investment community, setting up a weather hedge fund called Takara.

Nonetheless, Juerg Trueb, the Zurich-based head of environmental and commodity markets, is bullish about the insurance giant’s prospects in the weather markets: “There’s no change in focus – we still would like to be a major market participant, and we’re in the process of restaffing our New York team.”

The insurer’s weather risk capability has been combined with its groups covering emissions markets and contingent power price options. All three predominantly serve the energy sector, says Trueb, and all essentially address volume risk. “In all these areas, we aspire to be a principal risk taker,” he adds.

Despite the personnel shifts, Trueb reports significant growth in the weather team’s business, driven by “significant volatility in the weather” in the past couple of years. He points to the extremely mild summer in the US in 2004, followed by a relatively harsh winter in both the US and, in February and March, in Europe.

The combination of very hot weather in the US this summer and the energy supply shock caused by Hurricanes Katrina and Wilma has further alerted companies to their weather-related exposures, he adds. And a clear trend illuminated by the WRMA survey – which showed a jump in the value of summer hedges – is the re-entry, in size, of US utilities protecting themselves against a slump in electricity demand caused by a cool summer.

Brian O’Hearne, president of GuaranteedWeather, thinks growing involvement from US utilities in the summer months will provide an opportunity for dealers such as his – ranked second in Europe and, with its partner Mitsui Sumitomo Insurance, top in Asia – to make in-roads into the agricultural sector: “We started to see some of that come in about a year ago. They’re concerned about hot, dry summers – it’s a good offset for utilities concerned about cool summers.”

He also believes that trading in Europe is likely to pick up in 2006. “I’d expect Takara to come in and trade Europe, and we’re seeing banks and hedge funds looking at the market.” Indeed, Barclays Capital recently began trading (see Environmental Finance, May 2005, page 5), and some of those hedge funds which have contributed so much to volume growth in the US are understood to be considering trading European weather risk.

Home-grown hedge funds are also eyeing the European market, says Claude Brown, a partner at Clifford Chance, which took the Best Law Firm title again this year. “We’ve had enquiries from a number of Europe-based hedge funds – they’re a little way behind their US counterparts.”

Brown also reports a growing move towards structured products, in terms of the legal work his team is doing in the weather markets, “such as compound structures, combining weather and energy commodities, or portfolio trades,” he says. He also says that “we’re being asked to look at increasingly farflung jurisdictions – licensing and tax issues in the further corners of Europe, Africa and the Far East.”

Despite the drop-off in the traded markets in Europe, Jens Boening of Merrill Lynch says that his firm has had no problem finding risk-taking capacity for European trades or hedging large transactions – it’s simply a question of laying off risk on a more bespoke basis, he says.

The US bank – which bought Entergy Koch Trading (EKT) and its weather desk late in 2004 – was voted Best Dealer, European Weather, regaining a title EKT last won in 2003. Boening says that, in terms of customer business, the European market is becoming more diverse, with demand growing for precipitation and wind speed hedges, as well as more traditional temperature-linked contracts.

“It’s still mostly energy sector, but we’re seeing some transportation deals, and hedges for the construction sector – in addition to the large [Amsterdam] deal that the market has been talking about for five years,” he adds.

Many market participants attribute part of the drop in weather trading in Europe to the preoccupation of many European energy companies with the introduction last January of the EU Emissions Trading Scheme. Now, however, some are hopeful that the connections between weather and emissions – with cold weather pushing up energy usage, or low rainfall seeing a switch from hydro to coalfired generation – will provide a spur to the market.

Jens Boening, Merrill Lynch: “considerable interest” for structures combining weather risk and carbon emissions

“We definitely see the correlation,” says Boening, “and there’s considerable interest from the market for the kinds of structures that combine weather and emissions, and people are working on them. But the emissions market is young, so we don’t have the long-term data yet. That’s a bit of an issue.”

Utilities in Japan, meanwhile, have yet to face such distractions, with a domestic emissions trading scheme unlikely before 2008. Instead, says Yutaka Mouri, general manager of the financial solutions department at Mitsui Sumitomo, “it has been growing more popular for electric power and gas companies to hedge their temperature risk through weather derivatives. The total number of contracts we concluded in the utility sector has grown significantly.”

He adds that Japan has seen steady growth in the use of weather risk management by small and medium-sized companies – a development not seen to the same extent in Europe and the US – partly driven by regional banks offering standardised, and therefore relatively cheap, hedging products.

In addition, he notes that weather risk management is beginning to take root in India, Taiwan and South Korea. In the former, small farmers have enthusiastically embraced weather insurance products, in a market seeded by the World Bank. In Taiwan, the regulatory authorities have recently approved the sale of weather derivatives, while Korea’s are contemplating such a move.