Thinking about the weather (markets.)
The color of the sky as far as I can see is coal grey.
Lift my head from the pillow and then fall again.
With a shiver in my bones just thinking about the weather. -10,000 Maniacs (video)
Assiduous readers will know that some of the key themes that I try to discuss here include the application of technology to markets, the application of markets to economies, and the resulting emergence of new tradeable markets as a consequence thereof. Tangentially, like a growing number of people in the developed world, over the past two years I have become increasingly interested in climate change, especially the potential economic impact of changing and volatile weather patterns and how markets and derivatives in weather could be used to improve risk management and economic growth in the years ahead. (for readers in a rush wanting some background check out Weather (Risk) Report, Axa Bets On Weather and Hurricane.)
And so when I met David Friedberg last summer and he showed me his idea for launching a new technology-driven business for hedging weather risk, I was obviously keenly interested. After many conversations, due diligence and negotiations I am very happy to be on board as one of Weatherbill’s founding investors. Weatherbill, as reported on TechCrunch, will offer highly customized weather insurance to businesses across the US using the best of modern internet and financial technology to price and distribute its risk-management products.
Weather is in my opinion likely to be one of the fastest growing financial derivatives markets over the next decade, and perhaps 2006 will be seen in hindsight as the inflection point for market growth after a decade long incubation (an incubation that was probably somewhat artificially extended by the fallout from the Enron debacle…) In terms of high-visibility, listed, weather markets, the CME has been leading the way and offers a wealth of information and links on it’s website which I would recommend to anyone wanting to learn more about weather risk management which is also neatly explained on the Weather Risk Manangement Association’s site:
Weather challenges a wide spectrum of businesses: utilities, transportation, construction, municipalities, school districts, food processors, retail sales and real estate are simply a start to a long list of sectors whose revenues, costs and financial performance are sensitive to weather. Cold winters result in high heating bills which pressure the budgets of school districts and erode the margins of real estate property operators. Adverse financial impacts result from adverse weather. The weather risk market makes it possible to manage the adverse financial impact of weather through risk transfer instruments based on the weather element – temperature, rain, snow, wind, etc. – which affects revenues, costs or margins. In its simplest form an enterprise affected by weather pays a premium to a risk taker who assumes the risk, defined in terms of a weather element, posed by adverse weather. In exchange for the premium the risk taker, under certain pre-defined circumstances, will pay the buyer an amount of money which corresponds to the loss or cost increase caused by the weather.
It is often quoted that between 20 and 30% of the US economy is directly affected by weather conditions. For SMEs I suspect this number might even be higher (as they would tend not to have internal diversification of weather risk as compared to large national or international groups), indeed I suspect for many SME’s – in terms of management of exogenous financial risk – managing weather risk would be more important than managing interest rate or foreign exchange risk.
I am also highly confident that increasing risk capital will be made available to these developing weather risk markets. One key reason is that the underlying – weather – is actually not subject to liquidity constraints, and the outcome is always independent of the market. ie It doesn’t matter if I buy a hundred billion HDD’s on Chicago in June, the temperature in Chicago – ie the settlement value – will remain unaffected…this is clearly not true with financial instruments, and liquidity and open interest is a key factor in pricing most securities and futures. Also weather is a diversifying (uncorrelated) asset in many portfolios and as such should be an attractive additional asset for most existing financial portfolios (see modern portfolio theory for further information.) Finally, in general, there is good natural diversity (opposing risk positions) in the market (rain is good for some, bad for others…), allowing risk wholesaler’s to construct better portfolio’s of risk that can more easily be managed and hedged (using a variety of very well established financial engineering techniques and models.)
Ok, ok, weather is a great opportunity, we get it…but why Weatherbill? Well in a nutshell, if I were building a derivatives structuring and trading business – in any asset class – at an investment bank today, I’d build it like Weatherbill. (Probably much to the chagrin of many people working in said investment banks today…) What does that mean? Firstly it means using technology to empower the customer; giving the customer as much information as possible and the tools to easily and quickly determine and manage her risk. This might seem obvious to the denizens of Web2.0 land, but is pretty unusual and in some cases antithetical to the traditional investment banking mindset (which clings to the fabulously successful pre-internet paradigm of limited disclosure and scarce information arbitrage.) Secondly, it means using technology – and especially the abundance of computing cycles and bandwidth – to run complex continuous real-time pricing algorithms at very low cost. Investment banks are actually generally extremely good at this sort of thing, except for the last bit: their legacy infrastructure and more importantly culture and politics mean that their costs are often very high. This means they either need to generate enormous volumes (on more commoditized instruments) or charge high margins (on illiquid bespoke instruments.) Obviously this is an over-simplification, over-generalization, nonetheless the infrastructural and technological barriers to entry into the financial derivatives and risk management business that existed and were significant as recently as a few years ago, are melting like snow in the sun, and in some instances, new entrants might even have an advantage.
In any event, I’m very excited to be on board with David and his team at Weatherbill both as an investor and an advisor. Furthermore I look forward to participating actively in the discussion of the emerging market of weather risk – perhaps with a bit more insight than before – as it develops over the coming months and years. So please feel free to add ‘weather’ or ‘weather markets’ to your tags for the Park Paradigm.
They call it stormy monday, yes but tuesday’s just as bad.
They call it stormy monday, yes but tuesday’s just as bad.
Wednesday’s even worse; thursday’s awful sad.Weatherbill hedge on Friday, saturday I go out to play.
- adapted (with apologies) from T-bone Walker, as performed by Eric Clapton
