Seasonal power, gas demand, and wholesale prices fluctuate with weather conditions.
Contrastingly the winter of 2015-16 saw wholesale prices crash. We have seen similar price fluctuations in the United States during the “Polar Vortex” and times outside of “seasonal” or “normal” temperatures.
These demand and price fluctuations can create very large financial exposures for energy retailers who sell power and gas for domestic or industrial heating and cooling.
In an instance where demand comes in below expectations and temperatures are warmer than normal in winters, and cooler than normal in summers, firms could correspondingly see less than anticipated revenues. In many cases, demand and seasonal temperatures can have a nearly linear relationship that provides an opportunity for these firms to quantify their risk exposure and hedge against adverse revenue impacts to their organization.
If a firm anticipates a revenue decline of a certain amount in a warmer than normal winter, a short HDD instrument could provide an offset to this particular risk, as the firm could collect on the payout from the HDD instrument to offset the revenue decline as a result of the decreased demand.
A degree day is a measure of how much a day’s average temperature deviates from 65 degrees Fahrenheit (or 18 degrees Celsius outside the United States). Average daily temperature is defined as the average of a day’s maximum and minimum temperature. Index values are multiplied by a cash amount for settlement.
The above daily values would be summed up during the tenor to arrive at the monthly or seasonal hedge.
These hedges assume seasonal normal weather. As the demand position changes due to the weather, retailers have to balance their energy positions by buying more gas/power on colder days and selling excess gas/power on warmer days.
Long warm spells drive down gas demand and reduce retail margins/volumes as well as producing realized losses on hedges due to falling gas prices. Extreme cold can cause price spikes above the effective retail energy price and again retailers can suffer considerable losses.
Daily Payout: [Realised Weather Variable – Seasonal Normal Weather Level] * [Retail Value of Commodity – Daily Value of Commodity] * Notional
In this case, the Weather Variable is specifically designed to be highly correlated to demand, in effect it is based mostly off of temperature.