Whirlwind growth

Weather derivatives trading in Japan will see very rapid growth in 2001, with volumes tripling or quadrupling compared with activity over the past 18 months.
According to Jonathan Whitehead, vice-president for trading and origination at Enron Japan, a subsidiary of the Houston-based Enron energy group, the market in these products, although still in its infancy, is “moving very fast. We are starting to see the Japanese energy companies taking a lot of interest”.
Until now, the leading participants in this market have been financial institutions, such as reinsurance companies and banks. Although there have only been about 30 or 40 transactions since the market got going in the latter part of 1999, half of those have come in the last three months, says the Tokyo-based Whitehead. He predicts liquidity in the market will increase significantly in the coming months.

Jonathan Whitehead, Enron: “We are likely to begin getting linked deals”
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Big deals
At the moment, individual transactions are much bigger in Japan than in either the US or Europe, where a typical deal would mean having $1 million at risk. Japanese deals tend to be 10 or 20 times bigger, according to Whitehead. The reason is that many of these are undertaken by insurance companies, “which tend to be aggregators of much smaller risks. They then lay these risks off in one large transaction”, he says.
The chief forms of weather derivatives are heating or cooling degree-day swaps, which commonly use a reference temperature of 18°C (people tend to turn their heating on at temperatures below that level and the air conditioning on at temperatures above that level). The fixed leg of the swap is an agreed value, while the payout on the floating leg is determined, in the summer months for example, by the number of cooling degree-days during a specified period. However, in Japan, options on swaps are the most popular, partly because they are preferred by financial institutions.
Deregulation of the Japanese energy markets is set to give a big push to the expansion of weather derivatives. “As in the US and Europe, deregulation is the catalyst,” says Whitehead. Electricity deregulation is just getting underway, and foreign energy companies are now allowed to compete. The first phase came a year ago, when transmission grids were opened up to all electricity generators over a certain size.
“As we get a more liquid electricity market, and a greater acceptance of weather derivatives among other energy companies, such as the oil firms, we are likely to begin getting linked deals,” predicts Whitehead. This could mean, say, having weather derivatives embedded into electricity supply deals, where the amount provided is determined – on a sliding scale and at a pre-set price – according to the number of days the temperature is above or below a specified temperature. Such linked deals would be particularly applicable to the market in kerosene, which is widely used for heating in Japan. That would be an ideal commodity to link to weather derivatives, says Whitehead.