The CME Group suite of weather derivatives has expanded to include futures on the newly listed cities of Paris, Essen, Burbank, Houston, Philadelphia, and Boston; complementing the preexisting domestic listings of Atlanta, Chicago, New York, Cincinnati, Dallas, Las Vegas, Minneapolis, Sacramento, and Portland and international cities London, Amsterdam, and Tokyo.
Risk Management for Changing Times
Volume and open interest across listed cities for both futures and options have become increasingly robust over recent years. This growth in participation reflects the increased appetite both from existing and new market participants to manage mounting weather-related risk across geographies. According to the latest seasonal outlook from the National Oceanic and Atmospheric Administration (NOAA) and the National Weather Service, the majority of the United States will likely endure a summer of above average temperatures in 2023. The predicted highs are due in part to the end of La Niña, a cooling influence, and the beginning of El Niño, a climate pattern impacting global precipitation and thus temperature, in addition to underlying long-term global climate change. The World Meteorological Organization predicts that accordingly the five-year period of 2023 through 2027 will be the warmest five-years on record. Petteri Taalas, the secretary general of the World Meteorological Organization, stated with respect to the forecast, “This will have far-reaching repercussions for health, food security, water management and the environment…We need to be prepared.”
Using Weather Futures
The CME Weather contracts for winter months in the United States are based on heating degree days (HDDs), while the U.S. summer month contracts are based on cooling degree days (CDDs). Contracts for European cities are based upon Monthly Cumulative Average Temperature (CAT) for the summer months and Heating Degree Days (HDD) in the winter months. For Tokyo, all contracts utilize the CAT index regardless of the season. Paris, Essen, and Amsterdam are listed in Euros, London is listed in British Pounds, Tokyo is listed in Japanese Yen, and all U.S. cities are listed in U.S. Dollars.
The concept of a heating degree day (HDD) index was developed by engineers who observed that commercial buildings were frequently heated to maintain an indoor temperature of 70° Fahrenheit whenever daily mean (average) outdoor temperatures fell below 65° Fahrenheit. Each degree of mean temperature below 65° Fahrenheit is counted as “one heating degree day.” Conversely, air conditioning may be employed when temperature rises above the 65° Fahrenheit standard. Thus, each degree of mean temperature above 65° Fahrenheit is counted as "one cooling degree day. These concepts are expressed mathematically as follows:
HDD = Max (0, 65°F - daily average temperature)
CDD = Max (0, daily average temperature - 65°F)
To illustrate, if the average of a day’s maximum and minimum temperature on a midnight-to-midnight basis is 40° F, that day’s HDD is 25 (= 65°F - 40°F) and the CDD is zero (0). If the average of a day’s maximum and minimum temperature on a midnight-to-midnight basis is 50° F, that day’s HDD is 15 (= 65°F - 50°F). If the average daily temperature were in excess of 65°F, the HDD for that day would be zero.
Monthly HDD and CDD index values are simply the sum of each daily HDD or CDD value calculated according to how many degrees an average daily temperature rises above or below a baseline of 65° Fahrenheit in the US and 18° Celsius in Europe. Taking from the example used above, assume that the month had 30 days and the average daily temperature for all those days was 50°F. Accordingly, the cumulative monthly HDD would equal 450 (= 30 days x 15). The futures contract value would be identified by multiplying that figure by $20. In this example, the cash value of the contract would be $9,000 (= $20 x 450).
As mentioned previously, the European summer cooling month contracts and all Tokyo contracts are based on a cumulative average temperature (CAT). Each monthly CAT index is simply the accumulation of daily average temperatures over a calendar month. These contracts further depart from the U.S. standards in the sense that temperature readings are recorded in Celsius rather than Fahrenheit. Using Essen to illustrate, assume that the month had 31 days and the average daily temperature for each of the first 15 days was 25°C and the average daily temperature for each of the remaining 15 days was 20°C. Accordingly, the CAT would equal 675 (= (15 days x 25) + (15 days x 20)). The futures contract value would be identified by multiplying that figure by €20 (Euros). In this example, the cash value of the contract would be €13,500 (= €20 x 675).
Some market participants will look to hedge risk throughout a cooling or heating season rather than just individual months. To facilitate this, seasonal strip contracts are offered. A seasonal strip is based on the cumulative HDD or CDD values during a certain period within the season. Seasonal strips are offered for both two-month, three-month, and five-month tenors. Similarly, a CAT seasonal strip is based on the cumulative average during the respective period within the season. The traditional heating season runs from November through March while the traditional cooling season runs from May through September:
HDD/CAT Seasonal Strips (Nov-Mar & Dec-Feb)
CDD/CAT Seasonal Strips (May-Sep & Jul-Aug)
Case study: Volumetric risk
Weather-related risk is broad in scope and spans across many industries and sectors. One sector that is particularly susceptible to temperature-based impacts on earnings and profitability is the electric utility sector. Utility firms expect to market a certain quantity of energy for a given season based on historical results and forecast data. Still, the quantity of energy they ultimately sell over a summer or winter season can vary significantly from expectations. This risk is referred to as “volumetric risk:” risk based upon the quantity of energy that might be expected to be marketed throughout the course of a heating or cooling season. As such, firms like electric utilities can use CME Weather futures and options to guard against volumetric risks and smooth out revenue fluctuations that are tied to unanticipated weather conditions.
If the daily average temperatures during the course of a winter season were abnormally high, for example, utility firms might face depressed demand for heating. Hedging risk with HDD instruments could mitigate the need for firms to increase unit costs. The long, hot summer currently predicted in much of the U.S. would mean greater electrical demand than the historic average during the months of June, July, and August. This will put potential stress on the electrical supply and grid if not accurately anticipated.
CoolCo and Cooling Degree Days (CDD)
Heading into the summer, Coolco Utility Co. sells electricity in the Boston, Massachusetts area at a cost of $0.26/Kilowatt hour. Under normal summer weather conditions, CoolCo may forecast sales of 200 million Kilowatt-hours (kWh) with a projected revenue of $52 million in July. CoolCo is expecting cooler than normal weather conditions in the coming summer and may face reduced revenues due to less customer demand for cooling.
To hedge the risk of depressed revenues, CoolCo constructs a hedging ratio that might balance the anticipated change in revenues (denoted as ∆Revenues) with the changing value of the subject derivatives contracts (∆Value of Futures). A statistical regression between revenues and weather conditions is frequently useful in assessing these quantitative relationships.
Assume that, based on historical regressions, CoolCo finds that its sales are positively correlated with the CME Group Boston CDD Index with a sensitivity ratio of 0.65. I.e., a one percent change in CDD may drive a 0.65 percent change in CoolCo’s anticipated $52 million in revenues. Assuming futures are trading at 400, an effective hedge ratio may be calculated as follows:
∆Revenues ÷ ∆Value of Futures = ($52,000,000 x 0.65%) ÷ (400 x $20 x 1%)
Hedge ratio (HR) = 4,225 contracts
At the established hedging ratio, this might lead CoolCo to sell 4,225 futures to hedge the risks of lower-than-expected temperatures and reduced revenues in July.
July in Boston turns out to be slightly milder than average, with an average daily temperature of 77°, or 1° less than the forecasted daily average of 78°. The Boston CDD index for July thus settles at 372, or 7% less than the expected settlement of 400. This decline of 28 CDDs implies that sales may decline from 200 million kWh to 190.9 million kWh for sales of $49,634,000 ($0.26/kWh x 190,900,000 kWh). This implies a revenue shortfall of $2.37 million, but this shortfall is offset by a corresponding profit on the futures.
The use of derivative markets for hedging climate-related risk has existed for over 25 years. CME Group’s Weather derivatives contracts are used by a wide variety of commercial hedgers and liquidity providers from around the globe to help manage localized exposure to weather-related impact risk.
In 1999, CME Group received approval from the CFTC to list the very first standardized weather futures contracts based on weather indices of 10 U.S. cities. Since then, the number of cities listed has increased to span different unique geographic locations across the globe. The recent introduction of six more cities expands both domestic and international coverage. As climate risk compounds over time, so do the risk management needs of participants exposed to weather and climate volatility. Learn more at www.cmegroup.com/weather.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.