Using Customized Weather Derivatives to Hedge Earnings Volatilities in Energy Markets

Electricity production and consumption depend, to a large extent, on weather. Energy demand for space heating and cooling varies directly with temperature. The volume of wind, solar and hydroelectric energy sources are all a function of weather variables. Since the introduction of vanilla HDD and CDD weather derivatives over a decade ago, weather-linked hedging products have evolved to meet in a more customized way the needs of not only the energy industry but several other sectors where earnings are driven by weather volatility. The objective of this talk is to examine how weather-linked derivatives can be customized to stabilize cash flows for energy producers and retail utilities. We examine case studies including hedging the cash flows of: (i) a wind farm using a wind speed-linked contract (ii) an hydroelectric power plant using river flow and rainfall-linked contracts (iii) a utility retailer using temperature-linked contracts The results will show the advantages of using customized weather hedges over vanilla electricity contracts in terms of ability to mitigate earnings risk due to both volume and price volatility.