Innogy, the UK’s largest electricity supplier, begun this week trading in weather derivatives. Active participation in this fledgling market is intended to reduce the company’s weather exposure and reduce volatility of earnings by buying or selling financial structures (weather derivatives) which pay out according to actual weather, compared to an agreed level.

Modest fluctuations in temperature and weather conditions are difficult to forecast and have to some extent been an unmanaged risk for Innogy. Its chief exposure arises from fluctuations in demand from its npower customers as the weather changes. For example, a one-degree celcius rise in winter temperature for a day can cause a decrease in power demand of almost two per cent, together with a five per cent change in gas demand. Conversely a decrease in temperature increases power station efficiency.

By trading the weather, Innogy has created the capability to manage exposure, rather than simply hoping that temperatures will be consistent with seasonal averages.

Brian Senior, Innogy’s Director of Trading and Asset Management, said, “This is an important step for us as we seek to ensure that Innogy’s exposure to risk is managed effectively. Although it may seem odd to be trading the sunshine in practice we can – and will – apply the same risk controls and processes to weather as we do to gas, power and other energy commodities”.

Innogy hope that by balancing weather exposure it will be able to protect earnings by better management of risks arising from uncertain energy prices and volumes.

Innogy have staffed its weather trading desk with recruits from both financial and meteorological backgrounds.

An active weather derivatives market is established in the US, with energy groups such as Enron being major players. According to a study by the accounting and consulting firm PriceWaterhouseCoopers, since the fall of 1997 there has been $7.5bn worth of transactions in weather derivatives.

The market works by traders offering a protection to companies whose business would be adversely affected by a change in temperature, such as a gas company whose sales will drop during an unseasonably warm spell. If it turns out that temperatures are high and sales fall, the derivative product will pay compensation thus removing the risk from the gas company. Conversely, cold weather could boost sales and generate enough extra revenue for the company to pay for the weather product.

Traders themselves seek to balance their books by finding matching trades – someone with the opposite problem to the gas company, in this example.

Weather derivatives differ from conventional insurance products, which tend to cover low frequency, high-risk events such as windstorms where an insured interest exists.