Managing Weather Risk: The Rise of Weather Derivatives

Helen: Hello, and welcome to the "Power Dispatch," an Argus Media podcast from the "European Electricity Report." I'm Helen Senior, the editor of Argus's "European Power Report." On the "Power Dispatch," we attempt to step back from the day-to-day fluctuations and fundamentals and take a longer view of the issues, ambitions, and policies shaping the market.

As renewable generation continues to expand and extreme weather phenomena are becoming more frequent, managing weather risk is becoming increasingly important for energy companies. Conventional hedging strategies can help manage price exposure, but they do not always address the financial impact of unexpected weather patterns on demand, generation, or trading positions. As a result, weather derivatives are attracting growing attention. To discuss this and understand more about these products, I'm joined by Deputy Editor, Apostolos Tsarikas.

Apostolos: Hello.

Helen: And by two special guests from German reinsurance firm, Munich Re, Pierre Buisson, Senior Weather and Energy Structurer, and Theresa Kammel, Weather Trader and Originator. Thanks very much for joining us. Would you like to give a brief introduction to yourselves and Munich Re?

Pierre: Yeah, I can start. So, I'm Pierre Buisson, very happy to be here and very happy for your invitation. Yes, my current role is really more kind of head of weather and commodity risk for Europe and kind of my team is basically taking care of kind of any risk transfers position related to weather risks. So it can be... We will cover that a bit later, any kind of, let's say, deviations for the norms in terms of temperature, wind, precipitations, etc.

And I'm actually coming from the energy world because I did all my career in energy trading or energy consulting. So I really kind of move from the utilities side and the energy trading side to the reinsurance world. Actually, we deploy capacity to help companies to mitigate those weather risks.

Theresa: And also, thanks from my side for the invitation to be on your podcast. I am Theresa Kammel. I work in Pierre's team as an originator and support all our clients across Europe in finding the right weather hedge.

Helen: Thanks very much. Perhaps it's a good idea to get started with the basics because weather derivatives are a relatively well-established market, but obviously still unfamiliar to many people in the energy industry. How would you explain what weather derivatives are, how they work in practice, and also the role that they play in helping companies to manage weather-related risk?

Pierre: Weather derivatives are indeed a very common tool, but somehow a bit unknown there. And maybe let me just step back a bit. Just thinking of energy systems, they're massively and heavily weather-dependent. We all know that from the demand side, we all heat...all houses or apartments more when the winter is cold. So, therefore, the energy demand is higher then. And of course, we heat less when temperatures are pretty mild or warm, which has an impact for the energy companies in the amount of energy dissolved.

But also, more now around the supply side with renewables, they are very, very dependent on weather conditions and how healthy is the wind blowing or the sun shining, etc. And the weather derivative market, starting about two decades ago in the U.S., and people were trading temperatures then. Why temperatures? Because, at that point in time, the uncertainty was mostly on the demand side, less than the supply side.

And in the U.S., you have two obvious, let's say, weather seasons. You have the summer and the winter, because in the winter, they need some...weather is impacting heating demand, while actually, in summer, it's now impacting more and more cooling demand with the development of AC. And the market starting there with actually having energy companies who were looking for kind of...buy some weather protections there against temperature. And so, this is where the market started.

Then progressively, the market move also to Europe, where it's actually became also very dynamic there, also starting on temperatures. And then since about kind of 5 to 10 years ago, there was a massive ramp up around renewables following also the development of renewables with a lot of the risk transfer solutions around kind of wind, solar, and a bit more so on precipitation and hydro conditions.

How those solutions are working, it's relatively simple. So people attempt to trade kind of simple derivatives, so coal options, put options, swaps, etc., so very common kind of option trading. And it means that people, for example, they want to get protections against warm temperatures because they will sell less energy.

So utility will go to the markets, OTC, or kind of on some exchanges, and they will actually try to buy temperatures protection. So they will say, "I want to get kind of being paid when temperatures goes below..." Sorry, in that case, above a certain threshold because they want to get the warm protections. And they want to be paid X euros or U.S.D per degree.

And the weather station where the temperature is measured is defined. How much they will get paid per degree is defined. So all of that is defined in a contract. And then once the transaction is done, kind of at the end of the risk period, just only a few days after that, settlement is made, calculation is being run, and one counterparty may have to pay the other one for this kind of coverage. So it's a very efficient and simple hedging tool.

Apostolos: Pierre mentioned already earlier that there's been...this market has been on for 20 years, and it has evolved from its beginning. But we notice that extreme weather events appear to becoming more and more frequent and more impactful. How has demand for weather risk management evolved in recent years? And are traditional weather patterns becoming less reliable as a basis for risk modelling?

Pierre: It's a bit sad, to be honest, to have to wait necessarily for extreme events to suddenly kind of see the market realizing the risk and the magnitude of the risk. But, of course, it's something that we see in day-to-day life that when people have experienced kind of extreme weather events, they tend to think really about the hedging kind of strategies. However, I still think the energy market is very aware of its weather sensitivity. So it's maybe one of the most advanced business segment where kind of...very aware of the impact of the weather, and it needs less of those extreme events to start thinking about kind of the hedging protections.

I'm thinking, for example, around kind of hydro hedging. We have seen companies hedging their weather-related risk in the sense of reservoir content on stream flows for their hydropower productions since decades. So we are seeing that. It's not necessarily the most common weather risk that is being hedged, but we are seeing that type of activities.

While, for example, in terms of good transportation on some rivers, we see that as a bit of an emerging trend because people start realizing after the last summer that it can be extremely critical for the business. However, what we tend to see is that for some specific perils, like as I mentioned, kind of hydro and maybe wind also, we have seen kind of very extreme situations over the last few years.

The last two Q1s have been kind of terrible in terms of wind outputs. We really have seen kind of 20% to 30% below the norm in terms of wind generation in Europe in Q1-24, for example, which had a crazy impact on the European power system at that point in time. We have seen some players that, of course, before that point in time, were thinking that wind was not that uncertain, for example, because they did not think that actually wind drought can go to that extreme, for example. And it is the case.

So we really tend to see kind of, of course, more demand coming from after those events just because the awareness is increasing. But as I said, I think the energy sector is maybe kind of well above the rest of the other markets because there is weather risk enough in everywhere in our daily life, which is still a bit kind of not necessarily managed there.

Apostolos: If we focus on the market as it is at the moment, who would you say are the main participants of the market? And is there a balanced mix between buyers and sellers?

Theresa: Yes. I think the mix is really getting in a quite nice balance. When we go back to what Pierre already mentioned, 30 years ago, 25 years ago, it was all just the utilities on the demand side. Now you have the demand and the supply side. I think there is a much better awareness of the weather risks. Of course, still not everybody is perfect there, but there is so much more knowledge already today in the market and that people are getting these risk transfers so that there is buyers and sellers, different structures you can buy at OTC and on the exchanges. So I think that's really a great development that we are observing.

Apostolos: And obviously, utilities, as you mentioned, have been a big part. Are there any other industries that seem to be moving towards adopting weather derivatives more rapidly recently?

Theresa: So I would say the most obvious case are the asset owners because they are generating the electricity. Think of a wind farm, think of them when there is no wind like we had last year, and they can't fulfill their contractual obligations, then they have a problem. The same for hydropower producers. They are a little bit less talked-about category, but I mean, often these companies just focus on hydropower, that's their main business area.

So their entire P&L depends on the rain raining or not, and they carry a huge risk. It's just a few companies, but they have massive risks laying on their balance sheets. And then, much more recently, we see the more short-term oriented prop traders adopting weather derivatives into their trading toolkit, using them as, like, a hatch in their strategies. And over the past three, four years, we've seen a massive uptick in them using that tool.

Pierre: I think what Theresa is mentioning is extremely interesting and kind of that trend that we are seeing with more pure traders actually leveraging weather derivative is a very interesting development there. And not only because it's a new market and it's growing and it's, of course, interesting for us, just because it reflects a bit the changes and the impact and the weight of weather in actually kind of setting up prices for the energy market.

So we are now end of September 2026, and if you're, let's say, a power trader is looking at German-based prices for November, you will see something being in a range of 170 euros per megawatt-hour right now. So, if you are in that situation and you're a pure trader, you may have a view there. Is it kind of overvalued? Is it undervalued? You may want to make your decision there. So, you have a fundamental kind of belief there.

So let's assume you want to go long power there because you think prices will increase there. Now with the massive penetrations of renewables, you will just kind of roll a big dice on the weather if you just do that position, because in case of very high wind, you know that prices can collapse. Even if you're right and prices should increase because you're writing your assessment on the market that maybe it's currently a bit undervalued, you still kind of, you know, have to carry a huge risk on what will be the weather in delivery.

And that's something that we see a lot of players, those who are, let's say, open positions on the power trading market, they tend to, on a rolling basis, for shorter term, kind of basically hedge that position to say, I stick to my view, I want to be long or I want to be short power, for example, but then you neutralize the counter effect of the weather in delivery. And that's something kind of that is a very, very interesting trend from my perspective because it also shows that kind of the nature of the price formation has changed progressively with the weather components being the dominant driver.

Helen: Yeah, that's a very interesting dynamic that's coming through. And obviously, with the increase of lots of different players in the market, I can imagine there's been quite a lot of shifts in the past couple of years. One thing that I'm quite interested to know is where currently you see the greatest sort of concentration of liquidity, whether that's particular regions or particular sort of weather variables that you said that are kind of dominating trading activity.

Theresa: So, on the regional level, I think it's always very closely linked to how free our energy market is. So, like, the more liberalized, the more trading and hedging activity there is generally be observed. So, in Europe, the focus would be, like, Germany, UK, France, the Netherlands, the obvious use cases. And then there is a traditional seasonality, depending on what kind of firm we're looking at. So, of course, the retailers, they would look at, like, the winter exposure, and they would come every year as they build up their portfolio.

Whereas, on the power markets, depending on whether it's an asset owner who thinks a little bit more long term versus just a trader who thinks more in the near term, like, the front month, the front quarter, we really see activity around the year nowadays. And I think just in this current year, I think we've been busy every single week.

Apostolos: We've already, within a couple of minutes in the discussion, we've discussed quite a lot of transformations in this very interesting market, the weather derivatives market. And Theresa already mentioned that there's been another form of transformation, a change in the nature of the OTC and exchange-based level of the market.

So I wanted to ask if you see that the exchange-traded weather products are gaining more traction, more and more traction, and how do you see the balance between OTC and exchange markets evolving further in the future?

Theresa: So maybe I can start first to tackle that question. So, yes, I confirm there is this two-split market exchange and OTC, and there has been a visible uptick in the exchange activity. And this is also the part that is visible to the public because, generally, let's say the weather market is a little bit more niche because it's often done just bilaterally.

This growth is also reflected in the OTC market 100%, and I think this just reflects the general trend in the energy trading area of more activity. We welcome that there is more activity on the exchange because I think that just attracts more people, it provides transparency, and it's a great development.

Long-term, I think the really big complex structures, they are always being placed directly. OTC, because they're so bespoke, really matching a client's portfolio, specific risk periods, specific weather stations, that'll be really difficult to translate into OTC contracts. But I think it's really good to have this two-fold dynamic that is complementing. So, very great development.

Pierre: Maybe just to add on what Theresa said and to comment on that coexistence of two different systems there. So, weather derivative, as the name indicates, it's about derivatives with structured product, and always kind of it's always a bit more complex for structured product to trade on an exchange rather than on OTC, because you need to find good standardizations for the product.

Maybe thinking there, depending a bit on the perils, as Theresa mentioned, if you're an hydro producer, you want to hedge yourself against the inflows of your reservoirs, for example, it depends very much on the topology of your assets and things you may have the know-how. So how do you want to measure those precipitations, etc. So you have to... How do you create the indexes, a lot of customization there.

So that type of the market will always remain, I believe, OTC because it will be very complex to find, let's say, kind of one formula that satisfies everybody. However, for, let's say, those energy traders, kind of who wants to go long and short, for example, German wind or Spanish solar in summer and things, it's relatively easy to find standardized product now in the market. And I think there will be a very interesting development.

So things which are kind of, let's say, good proxy directly for prices, the big weather impact, I fully believe that on the mid to long term, they will be fully standardized and on exchanges. Things which are more related to specific portfolios, assets, or have to want to, as we are seeing this year in a very highly critical energy supply situation, kind of trying to kind of be very customized solutions to be able to handle very particular situations, I think those ones will remain a bit more OTC. But that's also the nature of those...of structured trading.

Helen: Yeah, that makes sense. It's certainly a very interesting time to be looking at these, I think, as we've discussed, you know, a lot of changes in the past couple of years. And the energy markets, the wider energy markets have obviously also been in quite an interesting position over the past couple of years.

Obviously, you know, we had the energy crisis, and now, you know, leading into the war this year. Have you seen any increased interest in weather hedging from particularly, you know, power and gas market participants? And has the nature of these conversations sort of shifted in the past couple of years as we've had these more extreme events?

Pierre: It's very easy to think that was a derivative could be kind of, you know, directly that the right tool when you're in a very scarce supply situation, because, of course, then kind of, that's very important to hedge that. However, with a derivative, I think goes really beyond that.

And we have kind of, we're seeing kind of traded volume on the weather market, regardless of the geopolitical context all the time. However, it's true that, indeed, that there's a bit of an extreme sensitivity for the coming month to what will be the weather, how the weather will turn for this winter, because we are in a very high price and very scarce cost supply situation. So when you have those things, you tend to see higher demand. That's very true.

We had the situation when the war between Russia and Ukraine started a few years ago, and it was kind of in that different point in time, during the winter, but we saw kind of a big surge there because people were really fearing cold situation. Now, kind of with the current situation in Iran, and also the very complex situation between Russia and Ukraine, we're still kind of, let's say, in a...people really fear, let's say, low supply situation or high demand situation.

So demand for coal protections has increased, as you can imagine, and people start thinking also, which have been kind of a bit ignored so far, surprisingly, but they start thinking more and more at kind of, for example, low wind, because it can be extremely dramatic. If we have, again, a low-wind winter, this winter it will be particularly difficult for the European power system.

So we see kind of, let's say, with the recent high volatility and the recent tensions between Iran and the U.S., that kind of...it directly translates into higher volume there. It's also something that I find a bit interesting this year, is that kind of, up to a few weeks ago, there was a lot of, let's say, almost a wait-and-see approach.

So people still hoping that we will enter the winter in a different situation, which doesn't seem to be the case as of today. So kind of there's a bit of, let's say, last-minute buy for, let's say, temperature protection, because kind of, indeed, people were simply kind of not knowing what to do, what would be the sizing of the structures. And this is something maybe we can elaborate with to think with our clients, how we can...I combine them in that kind of this high volatility and these high fluctuations where they didn't know if actually...what they fear the most.

Is it, let's say, warm temperatures, because then, in that case, they will sell less energy, or is it cold situation because they would have to be...they will be short energy, and they would have to buy at a crazy price the missing energy. And we had to find solutions to accompany them in that big uncertainty, even if since, let's say, a couple of weeks we are thinking of now clear directions with people, at least for Q4. Really, people fear cold temperatures, they tend to fear low wind, low precipitations, etc.

Apostolos: If you were advising an energy company that is not yet actively hedging weather risk, what would be the key reasons for considering weather derivatives as part of its risk management strategy today?

Theresa: I think that's very easy, because your P&L in the end is volumes times price. How much energy do you sell at what price? Volumes times price. How much energy do you sell at what price? And everybody is active in the price hedging. I mean, do you know a single energy company that doesn't? It's like a no-brainer. But not all of them are active on the volume hedging, even though it's so obvious once you start thinking about it.

So if you really want to be in control of your P&L, you better think of both of these areas, or those complementing elements. And I think this is where the more sophisticated firms have now really integrated the weather desk with weather trading specialists into their risk management and trading strategies. Like, the weather desk sits on the trading floor with them and supports. And I think this is a trend that we'll see across all the firms active in that space. Just because weather has, as we've already covered a bit, become such a fundamental driver.

Helen: And obviously, Munich Re has been active in this space for quite a long time and worked on a very wide range of solutions across the board. Without revealing anything confidential, obviously, could you share an example of a particularly innovative or interesting weather risk solution that you've developed and explained the challenge that it was designed to solve?

Pierre: You're perfectly right in saying we do not want to necessarily disclose our innovative products with the clients and things. However, sometimes when the client is fine with that, we can actually publicly mention that. So the case I will describe is one that we presented last year to the Energy Trading Week, and we even worked more on the product. And it worked very well, and we did that jointly. And I can mention their name because it was public then, with EON, where we tried to find solutions, particularly, as I mentioned, to adapt in very high-volatility times.

And you don't know where actually energy prices will be, if energy prices will increase or if energy prices will come down there, what is the direction of your protections? Do you fear warm temperatures, or do you fear cold temperatures? And how these things can evolve in the season.

So you can say, right now, maybe you fear for the next few months, for example, cold temperatures. But then in Q1, which we all hope is some kind of geopolitical relaxations and then there will be more business as usual, and as a utility, you tend to fear more warm conditions.

And in order to address that, it can be extremely complex because you need to actually kind of basically almost say, "Okay, I want to change my mind basically during the season. I don't know exactly what I want in terms of directions and things." And the beauty of using kind of companies like Munich Re, which are, let's say, we are neutral, in that sense. We just want to kind of offer a contemporary capital for those utilities.

What we thought about is actually kind of a bit, compared to the traditional structures where people buy, for example, the coal options or put options, depending if they want to have high temperatures or low temperatures protections, here, we would actually offer them some flexibility in saying, along the season, you can basically decide on the directions and on the scaling of the protections. So you can really adapt a bit to the price fluctuations within the season.

So to really kind of increase your protection, reduce it or even kind of flip the directions. That's particularly kind of... It was something relatively new for the market. So, again, based on this simple traditional instrument, but then applying that kind of new flexibility there to really a combine kind of utilities. And we did that with many counterparties now to really a combine them kind of in those particularly highly volatile point in time.

So really, to help them to say, "Look, we will be helping you in the right directions all over the winter." So even if suddenly, there is a massive change in the geopolitical situations and things, you have already at pre-degree terms to support of mini-grid to help you to basically kind of go through that period of time.

And it is something that is kind of, let's say, we are very proud of because it's a way to really help kind of also those companies in navigating those times where they really need support because, as I mentioned, with the current energy prices, indeed, if you have a cold winter this winter, or if you have a low wind situations with the current gas storage levels and the current very dramatic hydro situations, the impact will be dramatic. So you want to be able to help them in those cases. But if, of course, things would improve in the next few months, maybe kind of going back to a more normal hedging behavior, we want to be there for them too.

Theresa: And if I may add to that, I think it's a perfect illustration of, for one, these very spoke, very tailor-made structures. Like, they rely on really a collaborative approach with the client, or rather the counterparty on how to structure them, how to come up with a solution that really fits to them, and also to allow them to go from a very static hedging approach to be more adaptive in their risk transfer. And they can respond more dynamically to a changing situation. And this, I think, is really what we are now seeing more and more in the market.

Apostolos: Yeah, it's definitely very interesting. We are in volatile times, and predicting the future can be very, very tricky. But if we attempt to look, perhaps, to the end of this decade, what do you think the European weather derivatives market will look like?

Pierre: I really like that question because I think it's a very interesting exercise. And I mentioned earlier that, for me, weather is becoming more and more the dominant driver of energy system. And if you're trying to project yourself, and if you read a bit of the political ambitions or the ambitions of our societies, particularly in Europe, we still have a strong commitment at the end to be in a CO2 neutral, have high penetrations of renewables, and things like that.

So meaning that you will engage in energy systems, which will be mainly about zero marginal cost. So what will make the price of electricity by 2030 or even after that? It will be the weather. So I will be extremely provocative, but I think the weather markets will converge with the electricity market, to some extent, because that's the same.

Because what people right now do, and if you think about development of batteries, they really think about the opportunity cost. But the opportunity cost will no longer be how much the gas costs for the CCGTs on the long run? It will be how much wind, how much solar do you have in the energy system? What's a bit your...the water temperatures from the river for the cooling of some critical power stations in summer, for example? What will be the total demand with the temperature?

So all will be about the weather, and the weather scarcity will be the kind of the draw value of the electricity prices. So if I project myself, and this is why personally I also move from the power trading to the weather trading, because I'm fully convinced that in a zero marginal cost energy system, the biggest driver will be the weather, and weather trading will become the dominant traded market for energy.

Apostolos: Definitely. And I think, throughout our discussion, we've understood... You've helped us set the lights and understand quite a lot of the importance, how critical weather can be for the power markets and for risk management.

So I would like to thank you, Theresa and Pierre, for joining us and sharing your insights. And I would like to thank you too for tuning in this podcast. "Power Dispatch" will be back in the future with further episodes. But, in the meantime, you can look for the range of podcasts on argusmedia.com.