Weather derivatives

The weather derivative is a relatively new instrument, but it is growing in popularity because many businesses depend on or are affected by the weather. Examples are:

• Retailers in London (example: loss of sales in bad weather).

• Agricultural concerns (example: loss of crops).

• Insurers of agricultural concerns (example: claims for hail damage).

• Construction enterprises (example: loss of time spent on a contract as a result of inclement weather).

• Football stadiums (example: lower turnstile takings as a result of bad weather).

• Large landlords (example: additional heating costs in cold periods).

According to Applied Derivatives Trading Magazine, 75% of the profits of enterprises rise and fall as a result of changes in the weather. The magazine also reported that in the first 18 months since weather derivatives were introduced some 1 000 contracts were signed.

Weather derivative contracts are usually structured as futures, options (caps, floors, collars) and swaps, and are settled in the same way as these. The contracts have a number of parameters as follows:

• Contract type (cap, floor, swap).

• Contract duration.

• Official weather station (often weather service data stations located at major airports).

• Definition of underlying weather index (temperature, rainfall, snow, frost).

• Strike for options or index for swap.

• Tick for linear payout or fixed payment for binary payment scheme.

As seen, weather hedges can be based on temperature, rainfall, etc. The most common is contracts based on temperature. The underlying "instrument" or "value" in the case of temperature-related weather derivatives is Celsius-scale temperature as measured by "degree days" (DD). A DD is the absolute value of the difference between the average daily temperature and 18oC. The winter measure of average daily temperature below 18oC is called heating degree days (HDDs), and the summer measure of average daily temperature above 18oC is termed cooling degree days (CDDs). If for example the mean temperature of a day in December were 3oC, the HDD would be 15. The number for the month is the total of the daily HDDs (negatives are ignored).

Examples of temperature contracts:

• Caps (also known as call options) establish a DD ceiling. The holder is compensated for every DD above the ceiling up to a maximum amount.

• Floors (also known as put options) establish a DD minimum. The holder is compensated for every DD below the floor up to a maximum amount.

• Collars or swaps establish a DD ceiling and a DD floor. The holder is compensated for every DD above the ceiling or below the floor.

An example is required. A London retailer reviews historical weather and revenue data to uncover the correlation between temperature and sales. They find that 225 HDDs in December is the point below which winter apparel sales start to fall. Each DD below 225 corresponds to a potential GBP 10 000 in lost sales. The retailer decides to buy a weather floor for December of 225 HDDs, with a payout of GBP 10 000 per DD and a maximum of GBP 1 million. The weather index used is the weather station at London Weather Centre. The premium is GBP 85 000.

December passes and the data is available on 3 January. The December cumulative number of HDDs is 200 (i.e. 25 below the floor of 225), i.e. it was warmer and winter apparel sales were indeed down. The seller of the hedge pays out:

GBP 10 000 x 25 = GBP 250 000,

and the total income of the retailer is:

GBP 250 000 - GBP 85 000 (the premium paid) = GBP 165 000.

Carbon credit derivatives

In order to comprehend carbon credits, some background information is required. In 1979 an international climate conference took place. This led to the formation in 1992 (at the Rio Earth Summit) of the United Nations Framework Convention on Climate Change (UNFCCC), which became operational in 1994. The countries which ratified the UNFCCC (now close to 200) are called Parties to the Convention and their frequent meetings are called Convention of the Parties (COP). Each meeting is given a COP-number and a name, for example, the Kyoto Protocol (COP3), and the 2011 Durban Platform for Enhanced Action (COP17).

The ultimate objective on the UNFCCC is to stabilise greenhouse gas concentrations "at a level that would prevent dangerous anthropogenic (human induced) interference with the climate system." It further states that "such a level should be achieved within a time-frame sufficient to allow ecosystems to adapt naturally to climate change, to ensure that food production is not threatened, and to enable economic development to proceed in a sustainable manner."

According to the UNFCCC, by 1995 "countries realized that emission reductions provisions in the Convention were inadequate. They launched negotiations to strengthen the global response to climate change, and, two years later, adopted the Kyoto Protocol. The Kyoto Protocol legally binds developed countries to emission reduction targets. The Protocol's first commitment period started in 2008 and ends in 2012." In essence, the Kyoto Protocol sets binding emission reduction targets for 37 industrialized countries and the European Community. On average the target is an emissions-reduction of 5% compared to 1990 levels over the period 2008-2012.

At the latest Convention, COP17 in 2011, the parties agreed on a pathway to a legally binding instrument that will compel all countries to take action to slow the pace of global warming. It is to be agreed by 2015 and implemented by 2020). The parties also agreed to a second commitment period of the Kyoto Protocol starting in 2013.

What is a carbon credit? Unfortunately, the answer is not a short one. In terms of the Kyoto Protocol the developed countries are assigned quotas (aka caps) for greenhouse gas (GHG) emissions, termed assigned amounts. The initial assigned amounts are made up of units termed assigned amount units (AAUs). Each AAU is an allowance to emit one metric ton of CO2 (or CO2 equivalent GHGs), and each developed country has a National Registry of its AAUs. The AAUs are known as carbon credits (and they can also be created - see below).

The developed countries, in turn, set quotas for the GHG emissions of local private and public enterprises (called operators), managed through their National Registries (and required to be validated and monitored for compliance by the UNFCCC). Thus, each operator has an allowance of carbon credit units, and each carbon credit unit represents the right to emit one ton of CO2 (or other equivalent GHGs).

In addition to the AAUs, another tradable carbon credit exists (created under the Clean Development Mechanism (CDM) of the Kyoto Protocol): an offset of emissions, termed certified emission reductions (CERs), when approved by the UNFCCC. A developed country can fund a GHG reduction project in a developing country (which has ratified the Kyoto Protocol), and the developed country would be allocated credits for meeting its emission reduction targets.

Operators that are about to exceed their quotas can buy carbon credits (AAUs and / or CERs) from operators that have not used up their quotas. This can be done on the open market or privately. Each transfer is reported to and authorized by the UNFCCC.

In addition to the UN-regulated market a voluntary market exists, elucidated by Nadaa Taiyab as follows: "Parallel with the CDM market, there has emerged a voluntary market for carbon offsets. The voluntary market consists of companies, governments, organisations, organisers of international events, and individuals, taking responsibility for their carbon emissions by voluntarily purchasing carbon offsets. These voluntary offsets are often bought from retailers or organisations that invest in a portfolio of offset projects and sell slices of the resulting emissions reductions to customers in relatively small quantities. As retailers generally sell to the voluntary market, the projects in which they invest do not necessarily have to follow the CDM process. Free of the stringent guidelines, lengthy paper work, and high transaction costs, project developers have more freedom to invest in small-scale community based projects. The co-benefits of these projects, in terms of, for example, local economic development or biodiversity, are often a key selling point."

There are a number of exchanges that trade in carbon credits: Chicago Climate Exchange, European Climate Exchange, NASDAQ OMX Commodities Europe, Power Next, Commodity Exchange Bratislava and the European Energy Exchange. There are spot markets and futures and options markets. The trading unit is one allowance / carbon credit.

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