http://nvonews.

com/2010/05/13/indian-weather-market-could-see-
dramatic-growth-wrma/

Florida (MW): The Weather Risk Management Association (WRMA) released an

industry survey of the Indian Weather Market today at its 12th Annual Meeting in Miami,
Florida. The survey finds that the Indian weather risk management market could see
major growth in several sectors with a total potential notional value of $2.35-billion (Rs.
105-billion) over the next two to three years.

The survey was conducted for WRMA by Weather Risk Management Services Ltd.
India.

The agricultural sector is a major contributor to the Indian GDP. With its high risk
exposure to weather, agriculture has the biggest growth potential of all the sectors. Last
year, the weather risk market for agriculture grew four-fold due to the huge growth in
weather insurance linked to farmers with outstanding loans. The market rose from $22-
million in 2008-2009 (Rs. 1-billion) to $100-million (Rs. 4.5-billion) in 2009-2010.
Subsidized weather insurance accounts for 95% of the market.

The survey estimates that Indian farmers and banks could become a notional $2.2-billion
(Rs. 98-billion) market over the next two to three years. In five years, the weather risk
market for agriculture is expected to rise to $7-billion (Rs. 314-billion) and could reach
as $20-billion (Rs. 896-billion). Whether this growth materializes depends on
government policies regarding weather derivatives.

There’s great interest in weather risk management tools by the renewable energy sector to
offset the impact of weather on wind, solar and hydropower. The renewable energy
market’s use of weather risk tools is expected to grow to $1-billion (Rs. 44.8-billion) over
the next five to seven years.

In the travel sector, airlines are often grounded due to winter fog.The survey forecasts
that travel sector use of weather risk tools such as fog insurance could grow to $25-
million (Rs. 1.1-billion) over the next five to seven years.

“The concept of using weather risk management tools is being accepted by more and
more organizations around the world,” says Sandeep Ramachandran, WRMA board

member and Director, Property and Specialty at Swiss Re. “WRMA’s Indian Weather
Market Survey shows how these risk mitigation tools could benefit several important
sectors of the Indian economy, especially the agricultural sector which is heavily
dependent on the outcome of the monsoon season. Using weather risk management tools,
the weather’s adverse impact on the these sectors can be mitigated.”

What is Weather Risk?

by Jack Cogen
President, Natsource Inc.
(originally published by PMA OnLine Magazine: 05/98)

Weather Risk is the uncertainty in cash flow and earnings caused by weather
volatility. Many energy companies have a natural position in weather which is
their largest source of financial uncertainty.

• Colder than normal summers reduce electric power sales for residential
and commercial space cooling. These cooler temperatures idle capacity,
raise the average cost of power production, and reduce demand for
natural gas and coal energy feedstocks.
• Above average winter temperatures reduce natural gas and electric power
sales for space heating.
• Lower than normal precipitation upstream of hydropower facilities reduces
power production. This reduces revenues to the facility and diverts buyers
of hydropower to higher cost power alternatives.
• Independent power producers often have weather adjustments built into
their fuel supply contracts. When weather events trigger these
adjustments, fuel supply costs can skyrocket. In extreme cases, fuel
supply and business operations are temporarily interrupted.

In a survey of 200 top U.S. utility company annual reports, 80% cited weather as
a major determinant of earnings performance. About 50% claimed weather was
responsible for poorer than expected performance. These figures demand
effective Weather Hedging and Risk Management programs. However, in
comparison to other types of business risk, weather risk has been deficient in
hedging and management alternatives.

Weather Risk’s Distinctive Aspects

Weather Risk is unique. It has special attributes that set it apart from commodity
price risk and other sources of risk. First and foremost, weather affects the
"volume" or unit quantity of energy transacted. In contrast, commodity prices
affect the margin at which a single energy unit is transacted.

Both contribute to total risk as independent variables and as components of

covariant risk (see chart, right). Experience and theory suggest that commodity
prices and weather indices do not correlate well in a local area. This makes it
virtually impossible to manage weather risk with a price hedge.

More Facets Of Weather Risk To Consider

• There are no physical markets in weather. Try as you might, you can’t
store a hot July day until December. You can’t transport a Houston
rainstorm to the Pacific Northwest either.
 • Weather Risk is localized. There are few, if any, benchmark indices in
weather that have commercial meaning to broad markets. There is no
analogy in weather to natural gas at the Henry Hub or electric power at the
COB Interchange.
• Physical weather is completely beyond human control. It can’t be
influenced, modified or manipulated by regulation, speculation, cartels,
major market players or mass market dynamics. Everyone gets the same
raw deal in weather, because Mother Nature doesn’t bargain.

Weather Hedging And Weather Risk Management

Everyone knows you can’t change the weather.

One-hundred years of scientific research has proven that you cannot forecast the
weather beyond a few days with enough accuracy to support sound commercial
decisions. However, if you cannot forecast the weather beyond a few days with
enough accuracy to support sound commercial decisions. However, if you’re like
many energy companies, you do experience operating results that correlate well
with common weather statistics, such as cooling and heating degree-days. This
makes it possible to derive financial products based on weather outcomes which
can be used to transfer your weather risk to counterparties in a better position to
manage it. Today we find insurance companies, commercial banks, investment
banks, large energy companies and trading companies maintaining large
portfolios of diverse risk investments. They are now ready and willing to
underwrite weather hedges in the form of custom OTC contracts that settle on
weather statistics.

When carefully constructed to meet your needs, these weather hedges provide
protection against your performance volatility caused by weather.
Why Hedge Weather?

For years energy companies have been profitable in the midst of Weather Risk.
Some regulated utilities have dealt with the problem by including weather
normalization as an adjustment in their rate making process. However, our
regulated energy industries are heading quickly towards free market enterprise
where customers, rather than utility managers and rate boards, will make such
decisions. With this change comes new opportunity...and new responsibility.

Upon the heels of deregulation, open market Weather Hedging will soon be a
mainstream activity. Dozens of institutional level transactions have been
concluded in the second half of 1997. If you haven’t seriously considered
Weather Heading in your energy business, you may already be behind the
competition. It may not be long before explanations of low revenues and volatile
earnings caused by weather are viewed by investors as excuses.

Investors don’t like excuses.

Additional Reasons To Consider Weather Hedging

• The cost of Weather Hedging can be lower than other risk management
products. This is particularly true for long-term agreements reaching out 5-
10 years.
• Retail demand is here! One new partnership has already experienced
explosive growth marketing fixed cost heating and cooling contracts to
residential and commercial end users. The program allows customers to
lock in energy budgets, regardless of weather outcomes.
• Weather Hedging provides customized solutions by using weather indices
specifically tailored to an individual client’s needs. Basis risk is
dramatically lower, providing a better hedge and adding greater value to
the hedger’s enterprise.
• Weather Hedging brings an entirely new dimension to risk management. It
is the only known vehicle for managing volume risk in the energy industry.
This allows end users greater flexibility in developing multi-faceted risk
management programs.
• Weather Hedging is reliable, safe and fair. Weather data is accurate and
more objectively collected than any other major commodity or financial
index. At least 50 years of official weather data is on record for most major
cities in North America, and readily available from government sources.

Weather Hedging Strategies

The five examples that follow will give you a better idea of structures that
producers, consumers, marketers, distributors and transporters of weather-based
energy can use to modify their cash streams.
Cooling & Heating: Degree-Day Swaps
Swaps can be used to stabilize cash streams associated with cooling and
heating energy.

In the example below, an energy producer sells a swap and gets compensated
pro rata per degree-day whenever degree-days settle below an agreed strike
level. When degree-days settle above the strike, the producer pays the buyer of
the swap. The combination of the swap and the producer’s revenue from
operations is a more stable revenue stream. The buyer of the swap sees a mirror
effect. This might be a consumer looking to stabilize his total cost of energy
consumption.

Cooling & Heating - Degree-Day Options

In their simplest form, options provide a one-sided hedge towards the downside,
while preserving upside potential. This sounds better than a swap on the surface,
but it comes at the expense of a premium the buyer must pay up front for the
hedge. In the example shown, a producer buys a put option and gets paid pro
rata per degree-day whenever degree-days settle below an agreed strike level.
This offsets lower revenue from operations, and sets a minimum floor on total
revenues. If degree-days exceed the strike level, the producer pays nothing more
than the option premium, and enjoys full upside operating revenues.
Collars
Collars put boundaries on natural outcomes, limiting them to a desired range.
Collars are constructed using a combination of put and call options. In the
example shown, a producer buys a rainfall put option with a low strike level and
sells a call option with a high strike level. If rainfall settles between the two strike
levels (the strike range), there is no payout to either the buyer or the seller of the
hedge.

If rainfall settles below the low strike, the producer receives pro rata payment per
inch of rainfall from the seller of the put option.

If rainfall settles above the high strike, the producer pays the buyer of the call.
When combined with the producer’s natural revenues from operations, the total
revenue pattern is stabilized by the hedge outside of the strike range. Within the
strike range, total revenue follows the unhedged trend.
Digital Structures
Digital structures are used to cause lump sum cash transfers between contract
parties whenever specified conditions are met. These structures are useful in
situations where risk and associated costs come in discreet amounts instead of a
variable scale. An example would be a power producer who incurs a fixed cost of
bringing a peaking facility on line whenever temperatures exceed a threshold
level.

In the example shown, a two-tier cost structure occurs from normal unhedged
operations. The exposed party buys a digital hedge which mirrors this condition,
thus compensating for the costs when they occur. The digital hedge ensures a
fixed cost of operations regardless of the weather outcome.
Embedded Weather Agreements
These types of agreements can be used to combine weather hedges and
physical energy delivery in a single transaction. The payout of the weather hedge
is embedded in the energy supply cost. This can be useful as a matter of
convenience, or when policy restricts the use of naked hedge agreements.
Embedded agreements sometimes make it easier to see the result of combining
weather hedges with operating results. Weather hedges can also be combined
with price hedges and physical energy supply. For example, the diagram at right
shows a total cost hedge for an energy consumer who is sensitive to both
degree-days and price volatility.

The shaded area between the dashed lines shows the unhedged range of highly
probable outcomes. After hedging (dark line), both price and volume risk are
eliminated, guaranteeing a fixed energy cost to the consumer. This type of hedge
can be useful for consumers who want to meet energy budgets.

Jack Cogen is President of Natsource, Inc. Natsource has concluded weather transactions with every active
market participant, and are the leading specialists committed full-time to weather hedging products and
services.

Jack Cogen
President
Natsource, Inc.
Weather Hedging Services
140 Broadway
30th Floor
New York, NY 10005

(212) 232-5305 Tel | (212) 232-5353 Fax

New Tools of the Risk Trade
BY
SALLY STEWART
PRODUCT MANAGER, RISK OF TRANSENERGY MANAGEMENT
INC.
(originally published by PMA OnLine Magazine: 07/98)

As the structure of electricity industry unbundles, specialized market

sectors wield more sophisticated Wall Street-savvy financial tools and
trading systems.

As regulatory change hammers and splinters apart the generation, transmission,

marketing and distribution functions of the electricity industry, newly created
niche market sectors are looking to help nail down risk with very sophisticated
and specialized risk management tools. Despite the chiseled-down functions of
these new market sectors, each sector’s ability to identify and manage risk will
determine its foothold in the deregulated future.

Within this evolving "new world" order, companies will need to determine what
type(s) of risks – research and development, credit, operational (transmission,
distribution), market (fuel cost fluctuations, price exposure), marketing, legal,
customer service, customer aggregation (retailing function), regulatory – they are
willing to accept and manage. In the end, utilities and energy conglomerates will
be forced to determine: "What business do we want to be in?" and "What risks do
we want to take on?"

Commodity Management and Cross-Over

After a company has decided to take on and manage the mercurial commodities
of energy – electricity, natural gas, coal – it should thoroughly evaluate each
commodity’s unique market risk and physical properties. Electricity, especially,
offers a number of challenges that are not apparent in other energy commodities.
Unlike the comforting ability to store natural gas to counter market upswings or
dips, non-storable electricity by its sheer physical make-up, exacts a minute-by-
minute demand. Consequently, electricity is branded as the most challenging
commodity to manage. Not only is the power industry faced with price volatility,
as seen in other emerging markets, the physical properties of power (electricity is
"consumed" as it is generated) offers less flexibility in managing trading
positions. Embedded options are often a significant component of physical power
trades, providing traders with the ability to shift on receipt and delivery
alternatives.

Yet another property that differentiates electricity from other commodities is its
hourly increments of receipts and deliveries. Due to this hourly segmentation, the
sheer volume of components for each trade is significantly larger in power trading
than in other commodities. As market niches develop further, the level of
resolution in power trading will likely become even finer.

Pushing the challenge further, the feedstock for electricity is other energy
commodities, making cross-commodity arbitrage crucial. A prudent tool in
successful cross-commodity trading is a company’s ability to manage a "Btu
Book," positions stated in equivalent units of measure, used specifically for cross-
commodity trading. When assessing a deal – in coal, electricity, natural gas – the
Btu Book can help traders calculate how a trade breaks down into a single
common denominator of Btu units.

To derive power prices from natural gas prices, the gross power cost equals the
gas cost multiplied by the heat rate; the net power cost equals the gross power
cost (plus the tolling cost and cost of transmission). The spark spread, or the
difference between the price of gas and the price of electricity at specified heat
efficiencies, is fast becoming a favorite tool among energy traders.

Also opening up exciting new opportunities in the energy marketplace is the

practice of coal tolling. Coal tolling, the conversion of coal to electricity for a fee,
is currently making an attention-grabbing debut in power marketing. The tolling of
coal gives marketers, suppliers and generators a solid opportunity to manage the
disparity between coal and electricity prices while providing liquidity to use the
volatility between the two commodities.

Already, the segregated and clear-cut boundaries between energy sources are
becoming blurred, somewhat indistinct. In the not-so-distant future, it will become
commonplace to routinely substitute and trade one form of energy for another,
without ever first considering the diverse physical properties of each commodity.

Wall Street Savvy

Due in part to the influx of Wall Street-savvy traders, marketers and arbitrageurs
into the electricity industry, the buzz of water-cooler talk now includes the likes of
"floors, caps, collars, lookbacks and butterflies."

In short order, energy trading has accelerated from plain vanilla to increasingly
exotic flavors of options, risk management and hedging techniques like:

• Lookback – an option that grants the holder the right to buy at the lowest
referenced price or sell at the highest referenced price reached, during the
life of the option ( an option is a contract that gives the holder the right, but
not the obligation, to buy or sell at a certain price prior to or upon an
agreed date).
 • Floor – an option contract which sets a minimum sales price for the
holder. By establishing a minimum sales price, the holder is protected
against falling commodity prices.

• Cap – also known as a ceiling, is an option which sets a maximum

purchase price for the holder. By establishing a maximum price to be paid,
the holder is protected from rising commodity prices.

• Collar – an option position which combines a floor and a cap; establishing

commodity price settlements within a defined range. A producer may use
a collar to protect against declining commodity prices by limiting the extent
of upside benefits related to market increases. With a zero or "costless
collar", the strike prices for the floor and cap are set so that the premium
charges are eliminated.

• Barrier Option – an exotic option which is enacted (known as "Knock-in")

or terminated (known as "Knock-out") as referenced prices reach specified
levels in the contract.

• Swaptions – an option to purchase or sell a swap at some future date and

may include the ability to increase or decrease the swap volume or
increase the period of the swap.

• Double Downs – a swap with an embedded option that allows the seller
to reduce the notional quantity of the contract. In exchange, the holder
receives a more desirable price. A Double Up is the reverse scenario.

• Trigger Deal – a form of option, which allows the holder to set a deal
price, based on an exchange-traded commodity price.

• Butterfly Spreads – the simultaneous sale of an at-the-money straddle (a

straddle is the combo of a put and a call with the same expiration date and
the same strike price) and the purchase of an out-of-the-money strangle (a
strangle is the combo of a put and call with the same expiration date, but
different strike prices) reducing the risk of market movements to a fixed
amount.

Another risk management tool plied by the financial community, and recently
employed by the energy community, is Value-at-Risk (VAR). A statistical
measure of the largest likely loss expected over a given time with a given
probability, Value-at-Risk calculates commodity risk exposure from trading
activities. VAR methodologies model how market factors will change over the
time the trading company holds a commodity position, and how these changes
affect each other. The VAR analysis can assist energy traders, risk managers
and upper management professionals evaluate the impact of these changes on
the company’s portfolio.
For example, if a firm estimates its VAR over 1 week to be $5 million with a 95%
confidence level, the company then would be expected to lose less than $5
million for 95 weeks out of 100. This estimate is based on the market conditions
and composition of the portfolio at the time of the calculation. Since these
parameters are constantly changing, most companies are performing VAR
calculations on a daily basis. Particularly for upper management, VAR can be
used to report risk, define risk-reward ratios of trading desks and evaluate trader
performance.

Value-at-Risk determines commodity risk exposure from trading activities through

the principal methods of Monte Carlo simulations, estimated variance-covariance
(correlation or short-term variation) and historical simulations. Statistical methods
may be supplemented with stress tests, or worst-case/ "what if" scenario testing.
The choice among the various VAR methodologies largely depends upon the
composition and complexity of a company’s portfolio. Many of the VAR
methodologies are currently packaged in a widening cyber-genre of energy risk
management software systems.

Commodity Trading Tools

From power marketers or arbitrageurs who buy and sell electricity as a

commodity, to the new marketing division of unbundled utilities, to retail level
distribution companies, it is clear that commodity trading systems will play a key
role in the successful development of each organization. The "real-time" trading
dynamics of this evolving market has resulted in a demand for a whole new
breed of trading systems. Not only do the information requirements differ for the
specialized units, the complexities of the power industry place even higher
demands on finding successful commodity trading solutions.

In order to meet the needs of power marketers or arbitrageurs, a commodity

trading system may be adequate if it aggregates physical and financial positions
from a standard product perspective for the forward months, with the ability to
query non-standard positions. However, for spot month trading, the power
marketer requires the commodity trading system to support physical and financial
position management on an hourly basis. With this level of resolution, traders can
assess the impact of standard and non-standard product positions with
schedulers completing physical receipt and delivery transactions.

In contrast, the commodity system requirements of a power marketing arm of a

utility are far more comprehensive than that of a power arbitrageur. The hourly
resolution of both physical and financial positions for all forward periods is
essential to this type of organization. With this level of resolution, the trades are
disaggregated into the individual risk components for specific time periods, so the
system must be robust. Also, many of these organizations have portfolios well
beyond the one-year time frame, so the ability to disaggregate the risks, and then
aggregate on selected criteria is critical for traders and risk managers, since this
level of resolution quickly becomes impossible to manage. Additionally, real-time
position updates of a trading system is a necessary feature for these
organizations as they assess trading strategies, power supply and wheeling
capabilities with market opportunities.

In effect, a first-rate energy trading system must integrate both derivatives and
physical trades for risk management in a real-time environment in order to meet
the demands of the marketplace. Further, a command of the complexities of
scheduling receipts, deliveries and transmission of the underlying commodity is
essential. The commodity trading system that offers the ability to manage a Btu
Book, incorporating multiple commodities and risks, is the wave of the future.

In the soon-to-be restructured U.S. power market, competition and sheer market
force will make the industry more efficient by carving out specialized niches and
widening the assortment of risk management tools and trading systems. With
certainty, the current spin-off of previously integrated business functions will
continue, as organizations shed more and more risks that no longer fit into the
"new world" corporate risk strategy.

http://www.thehindubusinessline.in/2008/07/24/stories/2008072450270901.htm

Use `weather derivatives' to weather droughts

With drought looming large over 14 meteorological sub-divisions, spare a thought for the planted crops that
are in grave danger. For the farmers in Maharashtra, Andhra Pradesh, Karnataka and Kerala this monsoon
has brought everything except the much-needed moisture. "Come rainy season and nearly 59 per cent of
the Indian population, the people dependent on agriculture, keep their fingers crossed. Some pray to the rain
God to ensure that it does not pour so hard that their crops get destroyed. On the other hand, in some
villages, the farmers tie two frogs to a pole and get them married, a superstition which is supposed to bring
good rainfall," quips Dr Nupur Pavan Bang, Faculty Member at ICFAI Business School (Hyderabad).

Superstitions apart, the seriousness of weather cannot be overemphasised. "When livelihoods are
dependent on rainfall, it is only fair that people will go to any extent to make sure that their farms get
adequate amounts of rains...the farmers and various other businesses in the US have been using the
weather derivatives since 1997, to mitigate risks due to adverse weather conditions," Dr Bang told Business
Line.

Weather derivatives, what are those? These derivative contracts are being used successfully by farmers,
theme parks, ski resorts, ice-cream manufacturers, energy and utilities companies, etc., since over a decade
now. To gain new insights on `weather these derivatives', read the short Q&A on `weather derivatives' with
Dr Bang done over the email to gain new insights.

Edited excerpts from the interview:

Does India's size often become a disadvantage?

India, as a country, faces great variations in weather conditions due to its diverse geographical structure.
While some places are hit by flood, some others by drought, rising temperatures are scaling new peaks and
chilling winters are breaking old records. Such diversity in weather conditions affects the business processes
of many industries directly or indirectly. Fog in northern India during winter takes it toll on the aviation
industry takes the toll of fog in northern India during winters; floods in many parts leave their impact not only
on agriculture but also on the tourism industry.
Tell us about these weather derivatives.

Weather derivatives are unique in many ways. The primary being, there is no physical underlying asset. The
underlying asset is the weather, that is, the temperature measured in degrees Celsius or Fahrenheit or
rainfall measured in centimetres. On the Chicago Mercantile Exchange, the values of these contracts are
calculated based on a weather index. The index can represent either a Heating Degree Day (HDD) or a
Cooling Degree Day (CDD).

A HDD is the difference between a baseline temperature and the average temperature for a day in winters.
A CDD is the difference between the average temperature for a day and a baseline temperature in
summers. The baseline temperature is fixed; it is 65 degrees Fahrenheit in the US and 18 degrees Celsius
in Europe.

From where will the derivatives derive their value?

The value of the contract would be some multiple of the HDD or the CDD. The contract can be valued on a
daily basis, or weekly, or fortnightly or monthly or for a season; depending on the contract specifications. In
2005, NCDEX launched a rain day index for the Mumbai city for informational purposes only.

Can you explain the utility of weather derivatives with an example?

Let's consider a farmer growing paddy in a village in Andhra Pradesh. He is worried because of the
expectations of unusually low rainfall in the State this year. He usually produces 50 quintals of paddy in his
farm. But this year, he thinks the production will drop to 40 quintals. The Minimum Support Price (MSP) for
paddy is Rs 770/quintal. This means that the farmer fears losing Rs 7,700 this season due to poor rainfall.

If the farmer had access to weather derivatives, he could have bought or sold (depending on the future
outlook for rainfall) rain day futures contracts today and entered into an equal but opposite contract at a later
date, making a profit on the transaction, thus offsetting the losses due to low volumes produced.

What are the other uses of these weather derivatives?

Apart from applying weather derivative as a measure of hedging risk against adverse weather conditions it
can also be used as the mode of trading in derivatives. The most advantageous factor of weather derivatives
is the fact that they can't be manipulated by any means like insider trading, as the raining patterns are
natural and beyond the scope of humans.

Are there challenges to a widespread adoption of this type of financial instrument?

The key challenge is to educate the people about such contracts and their usage. The knowledge of
derivatives in itself is limited to certain segments of the society, leave alone the weather derivatives. In spite
of the challenges, it is time the Government speeded up the process of launching weather derivatives in
India too.