Stuck into the lawn outside a home near Pollock Pines, California, is a small rain gauge that might be worth as much as US$50 million to Sacramento's municipal utility.
During droughts, Sacramento gets less of its electricity from hydroelectric dams and must pay higher prices for power on the open market. To ease the pain of high-cost droughts, the utility entered a five-year contract with Aquila Energy, a trading firm.
Sacramento gets cash when rainfall measured by the backyard gauge is low, and pays a fee when it's above normal.
The bets by Sacramento and Aquila are part of the US$2.5 billion market in weather derivatives, based on the nominal value of contracts. Demand for such transactions is expanding from the US into Europe and Asia as more companies seek to hedge their exposure to, or speculate on, rain, snow, wind and temperatures.
"Ignoring weather risk is becoming more of a problem for chief financial officers," said Scott Mathews, marketing director at United Weather in Jersey City, New Jersey, one of the two biggest US weather derivatives brokers. "From now on, there will always be a Wall Street analyst out there who will know that weather hedges could have prevented lower earnings."
The four-year-old market began when newly deregulated utilities could no longer rely on state rate-setting boards to cushion the impact of excess weather-related costs, said Lynda Clemmons, president of Element Re Capital Products.
At the outset, the contracts were based on degree-day readings, which measure the difference in temperatures from a mean, and that utilities use to gauge demand.
As the market grows internationally, "we're also seeing contracts based on simpler measurements of temperatures," said Clemmons, whose company is the weather-risk arm of Bermuda-based insurance firm XL Capital Ltd.
The potential impact on earnings from bad weather is a key reason why the derivatives market is growing, said Ravi Nathan, weather portfolio manager and head of weather derivatives group for Kansas City Missouri-based Aquila, a subsidiary of Utilicorp United Inc.
"Every winter we see more utilities involved," Nathan said.
"It gets into the chief financial officer's consciousness only when there's a big hit" on earnings.
Weather derivatives are slowly spreading outside of the US
Trading in North America accounted for 95 percent of the world weather derivatives market in the six-month period ended April 14, according to a survey by PricewaterhouseCoopers, down from 97 percent a year earlier. Contracts based on degree-days accounted for nine out of every 10 trades.
The London International Financial Futures and Options Exchange is betting that the weather derivatives market will become broader and simpler, and has started temperature indexes in London, Paris and Berlin in preparation for an eventual futures contract.
In Germany, Elektrizitatswerk Dahlenburg, a municipal utility, signed a contract in May that would protect its revenue at times of high summer rainfall, when local farmers require less power for pumps to irrigate fields. The contract was the third known weather derivatives contract in Germany and the first international transaction for Element Re, which acted as the counterparty.
"This product is still getting started in Germany," said Hans Esser, of FinanzTrainer.com in Dusseldorf, a consultant hired by Dahlenburg. "We don't tend to have hot or cold summers here in Germany but we do have wet and dry summers. Rain had an 80 percent correlation to electricity sales while temperature was 40 percent."
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