Weather Risk Management

A U S T R A L I A N F I N A N C I A L M A R K E T S A S S O C I A T I O N

Weather Risk Management

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Foreword

In the mid-1990's AFMA published a series of brochures explaining the workings ofvarious OTC markets. These were very well received and made an important contributionto the development of deep and liquid markets in the products covered.

Earlier this year, we became aware that transactions in OTC Weather Derivatives werebecoming more common and an AFMA Weather Derivatives Working Group wasformed.

That Group identified the need in Australia for a brochure which explained the uses ofweather derivatives and provided some case studies to illustrate typical deals. From inputby members of the Working Group, led by the Chairman Norman Trethewey of ElementRe, this brochure resulted.

I believe it has achieved the desired outcome and provides an excellent introduction toweather derivatives. It will be of considerable use not only to those who have alreadyidentified their exposures to weather risk, but also to the myriad of potential users whomay not have contemplated this form of risk management.

The Weather Risk Management Association (WRMA), based in Washington, and AFMAhave entered into reciprocal memberships and we will be working together on a variety ofprojects, including documentation and market conventions. We welcome the contributionof WRMA to the development of the weather market in Australia.

AFMA is pleased to coordinate production of this brochure and I thank the sponsorslisted on the back cover who have made it possible.

Kenton G FarrowChief ExecutiveAustralian Financial Markets AssociationNovember 2002

2Contents

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3

History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3

Rationale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3

Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4

How do weather derivatives work? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5

Contract Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5

Typical Indices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5

Types of Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6

Who buys weather derivatives? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6

Who sells weather derivatives? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8

Case study # 1: Agribusiness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8

Case study # 2: Energy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9

About the Australian Financial Markets Association . . . . . . . . . . . . . . . . .10

About the Weather Risk Management Association . . . . . . . . . . . . . . . . . .11

Weather Risk Management

The first known Australian weather deal was transactedby Southern Hydro Partnership in Melbourne in mid-2000. Since then, it is estimated that in excess of 25deals have been done by Australian counterparties andthat the average nominal value (the value of the risktransferred) of these trades is A$1.0m.

Snowy Hydro Trading in Sydneyexecuted a Heating Degree Day

strangle on Melbourne temperaturesin June 2000. The contract was struck

at levels that compensated SnowyHydro if temperatures for the

July - September winter season wereoutside an expected range of

425 and 475 HDD's.

In this way, Snowy Hydro effectivelyguaranteed optimum earnings by

structuring a hedge that compensated them if the winter was

either too warm or too cold.

Rationale

Even the best meteorologists are 100% accurate just30% of the time. In the same way companies reduceearnings volatility by protecting themselves againstequity, commodity and currency market gyrations(and, in the extreme, avoid bankruptcy/insolvency),businesses in a variety of industries are now buyingprotection against unfavourable weather outcomes.

Under a regime of continuous disclosure and real timeshare trading, stock and ratings analysts areincreasingly focussing on the quality of earningsforecasts. Listed companies that exhibit little volatility

Introduction

The financial results of many companies depend, inpart, on favourable weather. Energy utilities,distributors and generators, beverage manufacturers,agribusiness concerns, tourism and leisure operators aswell as a host of other industries experience earningsvolatility with fluctuations in weather conditions.

In the United States, the Department of Commercehas estimated that one trillion of the seven trilliondollar Gross Domestic Product is weather sensitive.This 14% proportion is likely to be higher in aneconomy as reliant on primary production as isAustralia's.

There is now a rapidly expanding marketplace availableto fund and/or transfer weather risk. Variations intemperature, rainfall, wind-speed and other weatherindices can be managed using either derivative orinsurance based hedge contracts. This booklet explainsthis expanding market. In particular, it explores howover-the-counter weather derivative contracts can beeffectively used.

History

The weather derivative market commenced in the USAin 1996 with the exchange of weather risk betweenlarge merchant energy traders. As the market grew insize and sophistication, energy retailers and generatorsas well as other industries became involved.

A survey conducted by PricewaterhouseCoopers forthe Weather Risk Management Association (WRMA)found that over 3,300 transactions were closed in 2001and that representatives from most industry groups inall major geographical regions are now hedging theirexposure to weather variability. Today the market isworth in excess of US$4.3bn per annum.

Mark Twain said that "Everybody talks about the weather, but nobodydoes anything about it".

Not any more - there are now financial products that manage weatherrisk and the market in Australia is growing...

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in reported results are likely, rightly or wrongly, tobenefit from higher P/E ratios and should certainlyreceive more sympathetic hearings from their bankersand credit rating agencies.

Examples

Weather derivatives can be applied in a variety of waysand for different reasons, for example:

Financial Risk Management - hedging againstreduced revenues or increased costs due to weatherconditions in either single cities, regions ormultiple locations. For example, a national energyretailer can purchase a hedge against an unusuallywarm winter reducing sale volumes.

Marketing - managing the quantity and timing ofdemand by embedding weather hedges in targetedcustomer campaigns. For example, a retailer ofheating or cooling equipment may offer customersa rebate against the purchase price of their productshould forecast conditions that prompted thepurchase of such equipment fail to materialize.

Financing - reducing the cost of borrowing and/orenhance borrowing potential, by aligning thetiming or amount of interest and/or principalrepayment of debt with the company's economicperformance for a weather-sensitive enterprise.

Enterprise Risk Management - creating productsto hedge weather and any other market risks along

with traditional insurance risks. In anenvironment of increasing insurance premiums,the inclusion of uncorrelated risk into aninsurance portfolio can reduce the overall cost ofprotection.

"Unseasonally cool weather in thesouthern States has dented sales ofbottled water and carbonated soft

drinks, forcing listed beveragecompanies to aim for a better

second-half performance if they are to achieve earnings forecasts. Water cooler supplier Neverfail

Springwater has borne the brunt of theadverse weather conditions and has

seen its share price fall by 27 per cent since the beginning of

summer as analysts trimmed interim and full-year profit forecasts.

Analysts also have attributed the recent decline in Coca-Cola AmatilLtd's share price partly to the cool,

wet weather in various parts ofAustralia over the past three months,when CCA traditionally achieves 30 to

40 per cent of its annual sales."Australian Financial Review - 28 February 2002

Figure 1: Notional value of weather trades to date (Source: PricewaterhouseCoopers)4

Notional Value (in millions), 1998 - 2001

Weather Risk Management

How do weather derivatives work?

Unlike derivatives linked to the underlying price of anexchange-traded commodity, weather contracts arelinked to weather indices. These indices are createdfrom data readily sourced from Bureau of Meteorologystations. Such data needs to be matched against thebuyer's actual exposure. For example, energyconsumption in Western Sydney can be matched withtemperature at Bankstown Airport meteorologystation.

Once a correlation has been established, the next stepto link a financial contract to different temperatureoutcomes, structuring a payout pattern to respondshould adverse conditions occur.

Contract Terms

A weather derivative contract typically has sevenintegral components:

i. Type of Risk - based on a measurable index,usually temperature or precipitation, althoughwind-speed, snowfall and misery (combination oftemperature & humidity) have been seen in othermarkets;

ii. Term of the contract period - the inception andmaturity dates;

iii. Location(s) - it is possible to base the contract ona company's business in one or several cities aslong as each locale is covered by a weather stationthat is monitored by an independent reportingagency that is affiliated with the WorldMeteorological Organisation, as is the Bureau ofMeteorology in Australia;

iv. Unit size - establishing a dollar value per unit ofweather i.e. per degree or millimetre of rainfall;

v. Limit - the total dollar extent of coverage, i.e. themaximum payout under the contract (also knownas Notional Value);

vi. Structure of the contract - such as swap, collar,straddle, put or call; and

vii. Trigger or Strike level - the predeterminedweather index level at which the contract beginsto pay out.

Typical Indices

Whilst not exhaustive, the following are the primarymeasures that serve as an index on which a weatherderivative contract can be based. That these indices arederived from independent third parties, facilitates thefair and timely settlement of payouts.

Heating Degree Days (HDD) - A measure of howmuch daily average temperatures deviate below athreshold (typically 18 degrees Celsius) during apredefined time period;

Cooling Degree Days (CDD) - A measure of howmuch daily average temperatures deviate above athreshold (typically 18 degrees Celsius) during apredefined time period;

Maximum / Minimum Temperature - A measureof the absolute temperature during a predefinedtime period;

Precipitation - Accumulated rainfall during apredefined time period; and

Snowfall - Accumulated snowfall during apredefined time period.

Although somewhat counterintuitive,the terms Heating Degree Days as a

measure of how cold it is and Cooling Degree Days as a measure of

how hot it is, do have a logicalexplanation. The baseline usually used

in the calculation of these indices is18oC, which is seen

by the energy sector as thetemperature at which households

require neither heating nor cooling.Heating Degree Days are therefore

a measure of the amount of heating required during a cold spell

while a high number of Cooling DegreeDays tells us that it is hot

and the demand for cooling is strong.

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Types of Contracts

Weather derivative contracts are extremely flexibleonce exposure to the underlying weather index isunderstood. Many different types of weather contractsare achievable and in general the contract inceptiondate is not within the most recent short-term weatherforecast period. Following are examples of weatherderivative solutions in various formats.

Terminology is based on that used in other financialmarket products:

Floor: A prepaid option that provides financialcompensation to the buyer if an underlyingvariable, such as temperature, falls below apredetermined level. Floors provide downsideprotection if the buyer is adversely affected byweather conditions below a set level.

Cap: A prepaid option that provides the buyerwith financial compensation if an underlyingweather variable goes above a predetermined level.

Collar: A two-part transaction in which acompany buys a cap (floor) to provide financialprotection against adverse weather conditions andsimultaneously sells a floor (cap) the effect ofwhich limits its financial upside in the event offavorable weather. Collars can be structured so thepremium paid for the cap (floor) exactly offsets thepremium received for selling the floor (cap) andthe company has gained protection without anyup-front costs.

Swap: Swaps are similar to collars, as they protectcompanies from the impact of adverse weatherconditions but do not limit the opportunity toprofit from favorable weather. Unlike a collar, aswap does not create a separate floor and ceilingfor the underlying weather variable, but a single"strike" level. When the variable falls below thestrike, one counterparty makes payment to theother. When the variable rises above the strike, thepayment flow is reversed.

Who buys weather derivatives?

Utility and energy companies can protect theirvolume-related revenue against cooler than averagesummers or unusually warm winters. Dependingupon location and season, companies that sellnatural gas and electricity have financial exposureto deviations from "normal" weather conditions.Year-round opportunities exist within this sectorto utilise weather risk management products. Inwinter, such companies require protection againstwarmer-than-normal temperatures that reduce thevolume of energy or product that they will sell.Conversely, in summer, electrical utilities look toprotect against cooler-than-normal temperatures,which reduce volumes of electricity sold.Increasingly, electrical utilities are also seekingprotection against extremely hot days, whendemand for electricity can outstrip availablesupply and force providers into the open market topurchase electricity when prices are at theirhighest.

Figure 2: Growth of the global weather market(Source: PricewaterhouseCoopers)6

Number of Contracts, 1998 - 2001

Weather Risk Management

Manufacturers & retailers of beverages, ice-creams, heating/cooling equipment and apparelcan make up for reduced sales when cool summersand warm winters depress demand. Temperatureand, to an extent humidity, are major influenceson demand for soft drinks, beer and some seasonalfood items such as soup. Temperature,precipitation and snowfall are major sales driversfor products such as apparel, seasonal recreationalgoods and home comfort products like airconditioners and space heaters. The main adverseimpact is lower demand affecting inventory andclearance costs in any season where temperaturesare unseasonably mild.

Agricultural companies can add stability to anincome stream made inherently unpredictable byfrost or drought. Depending on the crop, growersmay seek protection against warmer-than-normaland/or colder-than-normal temperatures duringall four seasons. Common temperature indices arebased on variations of degree days as well as onabsolute temperatures. Protection against excessiveor insufficient seasonal precipitation is also indemand.

Mining and construction companies can facecostly delays to projects from adverse weatherconditions. Compensation for these delays isavailable from weather derivatives. Both heavy andresidential construction are at risk to variousaspects of the weather. Excessive rainfall is a keyelement in determining the profitability of a heavyconstruction company in a given period. Rain isthe weather variable most likely to delay thecompletion of a contract, many of which haveincentive/disincentive clauses. The profitability ofresidential construction projects is also exposed torainfall and extremely hot temperatures during thesummer.

Leisure and tourism operators whose turnoverdepends on the existence of favorable sun or snowconditions can compensate for poor seasonsthrough appropriately structured weather hedges.Operators of ski resorts and theme parks, as well aspromoters of outdoor events, such as concerts, areexposed to snowfall, precipitation andtemperature. The main effects are decreased

patronage lowering entrance/usage fees andassociated merchandise sales. Ski resorts also facelower sales of resort real estate, which are agrowing component of total revenues.

Insurance companies can reduce exposure toweather-related claims. Risk products tied torainfall, for example, can provide the funds to payflood claims.

Financial institutions can incorporate theseproducts as a way to broaden their offerings toclients. With weather largely uncorrelated withother financial products, including weatherderivatives can diversify portfolio risk.

"Merrill Lynch equity strategist Mark Skocic has analysed the

companies in the S&P/ASX100 Indexwith direct exposure to the agricultural

sector based on segment breakdowns in annual reports.

BRL Hardy, Foster's Group, Futuris, Goodman Fielder,

Orica, Southcorp, Wesfarmers andWMC were among the companies

Mr Skocic identified that could be affected by the

drought conditions.

Analysts said the dry weatherconditions also could influence theinsurance sector, as the number of car accidents should fall with less

rain, potentially having a marginallypositive impact on Insurance

Australia Group's payouts. Globalreinsurance group QBE may benefit

from climatic conditions that should produce fewer cyclones

and tropical storms." Australian Financial Review - 12 August 2002

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Who sells weather derivatives?

Although the market was initially driven by energycompanies, the increasing trend is for highly-ratedbanks and insurers to provide weather derivatives totheir diverse client base utilizing their strong balancesheets and risk management expertise.

Weather derivative contracts are priced using actuarialanalysis of historical payouts, factoring in recentweather trends and climatic cycles such as El Nino andLa Nina. Historical weather data and tailored weatherforecast services are available through the AustralianBureau of Meteorologys Special Services Unit.

The Weather Risk Management Association, orWRMA, is the industry body to which mostunderwriters of weather risk, as well as many end-usercustomers, belong.

WRMA holds annual weather risk managementseminars in the American, European and Asianregions.

For more information on weather risk management, aswell as several case studies that demonstrate the valueof weather hedging to various industries, visit theWRMA website at www.wrma.org.

Case study # 1: Agribusiness

Grain Traders Ltd (GTL) relies on an optimumamount of rainfall during the growing season and a dryharvest period in November/December. Excess rainfallduring these months impedes the harvest and can alsoreduce the market value of the wheat crop as surplusmoisture lowers the protein content of the grain.

GTL's Treasurer determines that for each millimetre bywhich the average rainfall measured at Wagin,Wandering and Narrogin in Western Australia exceeds50mm over the Nov/Dec period, revenue will reduceby $100,000.

The total value at risk, based on forecast crop grade &volume and expected prices is calculated as$5,000,000. The average rainfall for this region duringthis period is 38mm.

GTL buys a precipitation cap that pays $100,000 foreach mm in excess of 50mm which is the rainfall levelabove which overall profitability begins to declinesharply. Assuming this contract costs GTL $500,000,the resulting payout pattern is represented by the graphbelow.

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Precipitation Cap

Rainfall in mm

Rev

enue

/Pay

out

Weather Risk Management

Case study # 2: Energy

Megawatt Retail Ltd (MRL) benefits from hotsummers and cold winters but experiences reducedsales in mild seasons. As the summer months are themost critical to achieving annual budgets, MRLdecides to explore the cost of protection against a mildsummer in their major market, Sydney.

To gauge the relative warmth of the most recentsummer against previous years, MRL calculates thenumber of Cooling Degree Days for the first quarter ofeach year. This is done by summing on a daily basis,over several sample years, from 1 January to 31 Marchthe maximum of (Average Temperature - 18oC) and 0.

In other words, measuring the cumulative number ofdegrees by which the average temperature on each dayexceeds 18o Celsius. In 2002 there were 408 CDD'sfor the period, whereas the year before wasconsiderably warmer at 479 CDD's.

Although with extremely hot weather prevailingduring the Jan - Mar quarter, MRL will exceed budget,to obtain downside protection it transacts a CDDhedge. To mitigate the upfront cost of the hedge, MRL

decides to enter a zero cost collar with a payout of$100,000 per CDD and a put strike of 340 CDD'sand a call strike of 475 CDD's. For a CDD totalbetween these strikes, no payout is made. Themaximum payout is set at $5,000,000.

Should CDD's for quarter exceed 475, MRL pays theseller $100,000 per DD, up to 525 CDD's and for acooler summer, receives $100,000 per CDD below340 to a minimum of 290.

The payout pattern for the above transaction isreproduced above.

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CDD CollarPa

yout

($m

)

Cooling Degree Days

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Australian Financial Markets Association

For more than 15 years, the Australian Financial Markets Association (AFMA) has been at thevanguard of the Australian over-the-counter (OTC) wholesale financial markets industry. Formedin 1986 to streamline market practices and establish trading standards in OTC markets, AFMA isrecognised as the peak representative body of OTC markets in Australia.

OTC markets cover transactions in financial securities facilitated off an exchange. This includes trading in foreignexchange; interest rate products; financial derivatives; repurchase agreements; commodities; equity and electricityderivatives.

Today, AFMA has a community of more than 6000 individuals across almost 200 member organisations thatencompass the full range of participants in the Australian over-the-counter (OTC) wholesale financial markets.

AFMA seeks to maximise the knowledge, skills and success of its members, as well as the overall impact andrecognition of the OTC wholesale financial markets community.

Acting as an industry catalyst, AFMA accomplishes this goal in 5 ways:

Relationship Building: Provide members with high level, meaningful opportunities to network, exchange ideasand information, so as to stay ahead of market issues.

Knowledge Management: Aggregating executives from member organisations and other decision makers to tapinto the latest thinking on current issues affecting their businesses.

Education Programs & Initiatives: Deliver top quality, timely and relevant programs that help our membersextend their market reach and presence.

Market Practices, Standards and Documentation: Originally formed in 1986 to streamline market practicesand establish trading standards in OTC markets, AFMA today has in place a comprehensive system of industryaccepted standards.

Market Data & Research: AFMA promotes the growth of Australia's OTC Financial Markets by increasingmarket transparency. This is achieved by compiling and disseminating market data and information.

Australian Financial Markets AssociationLevel 6, 15 Castlereagh Street Sydney NSW 2001GPO Box 3655 Sydney NSW 2001Telephone: + 61 2 9776 4411Fascimile: + 61 2 9776 4488Email: info@afma.com.auWeb: www.afma.com.au

Weather Risk Management

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Weather Risk Management Association

The Weather Risk Management Association (WRMA) was developed toassist companies in managing the extent to which their revenue is affectedby uncontrollable weather patterns. It is an industry that has thrived andsucceeded in presenting financial weather products as marketable and

economically productive assets to a company's profitability.

The financial benefit of managing weather risk is evident in the surge of traders, brokers, insurers and governmentagencies that are eager participants in the industry of risk management. WRMA has brought to the forefront thesignificance of this industry and provides a standard of operation and business practices in the form of StandardizedContracts/Confirms.

The goal of WRMA is to serve the weather risk management business by promoting the industry, providing forumsfor discussion and interaction with others associated with financial weather products. These forums include workingcommittees on issues such as international opportunities, data issues, and tax and legal matters.

WRMA also provides membership links, on-line newsletters, and conferences that present current issues affectingthe weather market in addition to hosting an Annual Meeting which gives our members an opportunity to share thelatest developments in the industry.

Weather Risk Management Association 1156 15th Street, N.W., Suite 900 Washington, DC 20005 Telephone: +1 (202) 289-3800 Facsimile: +1 (202) 223-9741 Email: wrma@kellencompany.com Website: www.wrma.org

DisclaimerWhilst every care has been taken by the employees of AFMA in preparing the content of this document, the content covered is not intended nor should it be reliedupon as a substitute for other appropriate professional advice, and AFMA will not be liable for errors or omissions in the content, or for any consequences resultingfrom any errors or omissions, including any loss resulting from reliance on this content.

Copyright Australian Financial Markets Association - 2002This document is subject to copyright. No part of it should be reproduced without the written consent of the copyright owner.

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Website: http://ssu1.bom.gov.auEmail: webssu@bom.gov.au

Telephone: + 613 9669 4990

Website: www.westpac.com.auEmail: martingay@westpac.com.au or

Telephone: +612 9264 8016Contact: Martin Gay

Website: www.tfsbrokers.comEmail: mhopkins@tfsbrokers.com.au

Telephone: + 612 9221 1957 Contact: Michael Hopkins

Website: www.elementre.comEmail: ntrethewey@elementre.com

Telephone: +612 8224 2102Contact: Norman Trethewey

Website: www.axa-re.comEmail: weather@axa-re.comTelephone: + 612 9258 0450

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Contact: John Kempler

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Telephone: + 612 9253 7160Contact: Ralph Butterworth

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