SR/SSD 98-14

Technical Attachment

New York, March 12, 1998

NOAA and ESA staff met with representatives of the weather derivatives industry to discuss data and economic issues. A copy of the participants list is attached. Highlights of the discussions are summarized in this note.

A weather derivative is a financial instrument that allows a firm to partially or fully hedge weather-related revenue/profit risk. For example, a firm whose business is based on the expectation of cold weather, such as a ski resort operator, retailer, or energy firm, might purchase an instrument that would pay off if the weather were warmer than expected.

Last fall, Willis Faber, Enron, Transatlantic Re, Goldman Sachs, and Koch Industries started offering weather derivatives. Companies, cities, and any other interested entities could purchase customized contracts (options) that pay off if the cumulative degree days varied up or down from an agreed threshold level (strike price) by X dollars for each degree day of difference. The firms act either as the agent or as the agent and principal (holder of the other side of the contract).

According to the participants, this newly emerging industry wrote "several hundred" contracts covering the heating season (Nov 1, 1997- March 31, 1998). The "exposure" of each contract, that is, the maximum payoff, ranged from $100,000 on the low end to $100 million on the high end.

Data issues, both short and long-term, pertaining to these contracts were the immediate reason for this meeting. On their own initiative, industry participants have chosen to use daily temperature data from the National Weather Service to calculate their cumulative degree day indices upon which the contracts are based and which will be used to settle the contracts.

One concern they had was regarding the difference between preliminary and official data. NOAA indicated that the preliminary data are usually quite close to the official historical data, which are published with a lag of two to three months. With this understanding, the firms said they felt more comfortable using the preliminary data for initial settlement of the contracts, subject to a "true-up" to the official data several months later.

A second interest was that there be one set of tailored data for common reference. This could reduce disputes that might arise from different sources for the weather data. Industry representatives agreed that they would submit to the National Climatic Data Center (NCDC) a list of critical cities or regions. NCDC will try to assemble the weather data series for these cities as a package.

The industry representatives indicated that they would be willing to pay for a tailored, "official" set of historical and concurrently released data that they could all use as a common reference, for both analytic and contract settlement purposes. It was also agreed that the industry representatives would develop more detailed specifications for this request and submit it to NOAA/NCDC.

Industry representatives indicated that they will explore hiring an expert third party, such as a university, to assemble and analyze such data.

Weather forecasts influence pricing. One firm asked whether NOAA could offer its forecasts in terms of probability distributions. NOAA indicated that this was a long-term objective.

NOAA scientists discussed in some detail anomalies that exist in historical data series. For example, temperatures recorded at a specific site may vary because of instrumentation or locational shifts. Data on river flows may vary because of administrative waterflow decisions, as well as a result of changes in precipitation. It was agreed that a desirable, long-term objective would be to assemble a metadata set describing the details of each series. It was agreed to explore this further.

At this point, the weather derivatives market is newly emerging and structured as over-the-counter, customized transactions. One participant indicated that public commodity exchanges, including the New York Mercantile Exchange and the Chicago Board of Trade had indicated some interest in public trading of a standardized weather contract.

Next steps: It was agreed that industry would work on its list of selected cities to be sent to NCDC shortly. A conference call, as well as a possible Washington visit by industry representatives, may follow. NOAA will participate in two industry conferences during April and May, where it will describe its data resources, and the potential issues with these series, in more detail.

--Provided by Aln Eustis NWSH Industrial Meteorology Staff