Wind derivatives: is hedging the risk the next step for wind energy?

Weather derivatives are not a new product. The first contract were traded over the counter in the ‘90s, with the Chicago Mercantile Exchange (CME) introducing from 1999 a broad set of products like futures and options that are widely traded today.

They are a financial product that can help hedging the risk associated with the inherent variability of weather.

They are not like an insurance. With an insurance, you know that one or more events (for instance, a hurricane damaging your wind farm) will trigger a payment if certain contractual conditions are met.

Derivatives are more “continuatives”. Simplifying a lot, you can get money if a certain index is above (or below) a certain threshold in a given time frame.

For instance, a common contract traded in the CME is linked to the (cumulated) difference between the actual temperature and 18⁰C. Basically, if the weather is warmer than usual you will have a payoff: this will lower the business risk of companies whose activity is linked to cold weather (for instance, selling products to household heating).

In the previous example the index underlying the derivative is the temperature. In the case of wind energy, derivatives can be built around 2 different concept – wind speed (as measured at the met mast or in a meteorological station) or wind power (that is, hedging the actual production of the wind farm).

A second categorization would be the typology of contract built around the chosen index. At least theoretically, all the standard structures are possible – e.g. futures, options, floors and other types of cash settlements.

I’m writing this post because I’ve noticed that, in countries where the wind energy has a high penetrations, wind derivatives are not a mental experiment – they are already a reality: for instance in Spain there is a specific market for them, and this second product cover the highly developed German market.

My first impression is that wind conditions are very local – therefore it can be hard to find an off the shelf financial product considering a wind index that match the conditions of the area where the wind farm is operation. Possibly these products are more useful for an utility (trying to hedge the risk on a nationwide level) than for a small energy producer.