Weather Derivatives as Insurance Products in the Wind Industry

Travis Lowder's picture

The wind and solar industries are continuing to mature, stakeholders are getting savvier about the risks and rewards inherent to these markets, and more capital is being invested to deploy these technologies than ever before. So, it only natural that as more money becomes tied up in these industries, more investors, developers, and owners alike will be looking for advanced risk management techniques to protect their assets and secure revenue streams.

Photo of a utility-scale wind farm

Lately, these entities have been eyeing the financial markets for opportunities to hedge their resource-intermittency exposure, which is one of the thorniest problems looming over wind and solar industries. This has prompted a budding interest in the weather derivatives as a sort of performance insurance that could potentially boost project bankability, and even tamp down capital costs in the pre-financial close phase. Currently, there is little demand for these contract-based instruments in the wind and solar sectors, but several stakeholders see a market beginning to take shape. This post will review the basic structure of a weather derivative contract and explore how these products could be applied in the wind and solar industries.

On Derivatives

Generally, derivatives are bi- or multi-lateral contracts that specify a certain type of financial transaction to occur at a future date or upon a certain condition. The contract "derives" its value from one or more underlying assets, such as stock or bonds. Contract prices are typically valued according to today's cash market price and/or the probability of a future event(s) happening or not (for example, a drop in commodity prices, fluctuations in interest rates, or a change in the weather) [1].

Derivatives are risk transfer tools; they allow an entity to shift the risk of holding an asset or group of assets onto a counterparty that is willing to accept that risk in exchange for a premium. In this way, derivatives can function like an insurance policy, though there are some differences between the two (see below).

Weather derivatives are a special type of derivative contract that specify payouts in the event that certain weather conditions adversely affect the revenue streams of a business. That business will pay a premium to the contract offtaker in exchange for assuming the weather risk. The underlying asset of a weather derivative, and from which premiums and payouts are derived, is an index of weather variables that have been assigned dollar amounts. For example, one of the most used indices in the weather derivative market is the heating degree day (HDD), which provides a daily measurement of the heating demand in buildings based on the outdoor temperature in a given region. Weather derivatives are valued on the Chicago Mercantile Exchange by multiplying a monthly aggregate of HDD values by $20 [2, 3].

For the wind and solar industries, the weather variables of concern are the wind speed and the quantity of sunshine driving generation during a given timeframe (which means the variables are expressed in watt hours). Thus, wind and solar derivatives (as a subset of weather derivatives) would be used to hedge weather-related production risk—that is, the risk that the quantity of resource during the contract period will fall short of that needed to generate power, and thus revenues, sufficient to service debts. So, if your wind farm underperforms because of a streak of windless days, a derivative contract could potentially compensate you in the event that your production dips below the "strike," or the level at which coverage is triggered [4]. If the derivative is structured like a collar, the power producer will give up some of the upside revenues in exchange for downside protection. In this way, derivatives can not only mitigate project losses but also the threats posed by revenue volatility [5].

Weather Derivatives vs. Insurance

Though insurance-like in behavior, weather derivatives are fundamentally distinct from traditional insurance. Generally, both are avenues to transfer risk in exchange for premium payments; however, while weather derivatives anticipate high-probability low-risk events (i.e., weather fluctuations) and cover concentrated or singular risks, traditional insurance usually anticipates low-probability, high-risk events and is more comprehensive in coverage [2]. Moreover, derivative premiums and payouts are determined by the market value of the underlying asset(s) not by the probability of a loss event occurring (as is the case with insurance) [4].

One benefit of using derivatives in place of insurance is that the hedge is more protected from spatially correlated events such as adverse weather patterns. If, for example, a heat wave moving across the western United States halts production at wind farms in several states, project owners may have little recourse in the geographical diversity of their portfolio. Derivatives afford project owners access to the risk sharing forums of the financial markets, and this kind of diversification can trump that of geographical distribution [5].

Another benefit of derivatives is that the settlement process is typically quicker and less onerous than it is for insurance. Derivatives pay out instantly and are based on the movements of an index—something that is not open to contestation, given the proper functioning of the measurement apparatus. Insurance claims, on the other hand, can take considerable time and effort, and can produce a range of transaction costs because of the difficulties inherent in assessing claims [3].

Demand

Currently, the market for derivatives to hedge weather-related production risk in the renewable energy industry is quite small (one estimate pegs the percentage of wind producers globally that hold weather derivative contracts in the low double digits [6]). Pricing for these instruments can still be uneconomical for wind and solar projects, and industry players may still be generally unfamiliar with their function. Another issue may be in the scant secondary market for wind and solar derivatives; that is, it may prove tricky to find enough counterparties that are naturally short wind or sunlight and who can create a demand pull by buying up these contracts from the originators to hedge their own investments. One possible candidate for the wind industry could be natural gas generators whose capacity factors decrease when wind power comes on the grid.  But for now, it may be the speculators that make the market [6].

Despite the current limited market for wind and solar derivatives, many industry stakeholders believe this form of risk management will take off in the near-term [6, 7]. Companies continue to innovate products (for example, Galileo's WindLock and SolarLock products rolled out in 2011), and the demand for intermittency protection will, of course, persist. It is also likely that other risk management products such as catastrophe bonds, captive insurance companies, and even special insurance policies will play larger roles in protecting against intermittency risk in the near-term as well. As Torsten Musick, managing director at 8KU Renewables said, "products to deal with weather-related volume risk will be the next big thing in this business" [7].

References

[1] Moynihan, B. (2011). Financial Origami: How the Wall Street Model Broke. New Jersey: Bloomberg Press.

[2] Investopedia. (2010). Introduction to Weather Derivatives.
Investopedia. Heating Degree Day – HDD

[3] Mullins, R. (2008). "Derivatives for All Seasons." World Generation.

[4] Marsh Finances. (2008). Weather Derivative Solutions for Wind Farms Financing in Mexico: Feasibility Study. Marsh Finances and Paris Re.

[5] Personal communication with Michael Grundmeyer of 3TIER, April 13, 2012.

[6] Molloy, N. (Sept. 2011). Who Should Pay for Wind Power Risk? Risk.net.

[7] Economist Intelligence Unit. (2011). Managing the Risk in Renewable Energy. The Economist and Swiss Re.