WEATHER DERIVATIVES
By Mehdi Sadeghi, Macquarie University
Southern Hydro Partnership (SHP) is the largest hydroelectric company in Australia with 600
megawatts of electricity generating capacity. The company is based in Melbourne and operates
throughout rural Victoria and New South Wales. SHP’s ability to produce electricity from its
hydroelectric system depends largely on annual precipitation. A sustained shortfall of rain or snow
reduces stream flows, curtailing the amount of electricity the company can generate. Lower
generating capacity, in return, translates into a higher marginal cost and/or lower marginal revenue.
Recently developed weather derivatives have helped SHP find a way to protect itself from the
adverse effects of low annual rainfall and snowfall on its revenue. In February 2003, SHP made an
over-the-counter (OTC) five-year option contract with XL Trading Partners (XLTP) to receive a
predetermined compensation based on annual precipitation, in return for an undisclosed premium. It
has been agreed that the number of payments will increase as the level of precipitation declines,
hedging SHP’s volumetric risk. The precipitation deficit is determined by comparing actual
precipitation measurements to a predetermined average precipitation in a reference location
(probably Melbourne). However, if the level of rainfall is high, XLTP receives additional payment
on the top of the premium. At the end of the five-year contract, SHP will be eligible for a partial
refund of unused premium and any payments made to XLTP during years of high precipitation.
SHP has also made a three-year precipitation collar1 contract with Credit Lyonnais Rouse
Derivatives (CLRD) for the same reason at a notional value of A$20 million. An important aspect
of this recent derivative transaction is that it is based on the level of precipitation in a more remote
location (Lake Eildon). This automatically eliminates geographical basis risk. The payoff from this
derivative is based on the difference between a negotiated weather condition and actual weather
observation. According to the contract, SHP receives payments if rainfall is lower than the threshold
amount and pays CLRD in years where there is a lot of rainfall.
Darryl Flukes, General Manager of Energy Trading at SHP, put a premium on the stability of cash
flow and revenue for Southern Hydro and believes derivative contracts protect it from the risk of
production variability that is inherent in hydro generation.
Weather derivatives are relatively new financial products. The first transaction in weather
derivatives took place in the United States in 1996, while in Australia SHP was one of the first
hydroelectric companies that realised its benefit. The key advantages of weather derivatives are in
covering low-risk, high-probability events compared to the major other type of insurances that
cover high-risk, low-probability events. The most recent weather products on the market include
off-the-shelf derivatives for cold summers, hot summers, warm winters and long periods of rain.
Questions
1. What is ‘exercise price’ in the type of weather derivatives discussed above?
2. What is geographical basis risk?
3. Describe how a collar strategy can help SHP to stabilise its revenue.
Source Paul Lyon, ‘Singing in the rain’, Weather, Special Report, August 2004
(www.energyrisk.com)
1
A collar is a combination of a call and a put with identical exercise price. SHP bought a rainfall put option with a low
‘strike’ level of precipitation and sold a call option with a high ‘strike’ level of precipitation.
Case studies t/a Business Finance 9e by Peirson et al.
1