Around the globe, utility companies have to anticipate a certain quantity of energy to be used in a given season, based on historical results and forecast data. However, the actual quantity they use can vary due to unanticipated weather events. These events could impact their profits or losses.

To help manage these risks, CME Group’s Weather complex offers futures and options contracts based on multiple temperature related indices. These include: Heating Degree Day (HDD), Cooling Degree Day (CDD),and Cumulative Average Temperature or (CAT) contracts.

These contracts are available across multiple cities in North America, Europe and Asia.

Consider a utility company selling electricity in Houston at a cost of $0.26 per kilowatt hour. Let’s assume in normal summer conditions, they would forecast sales of 200 million kilowatt hours with a projected revenue of $52 million in May.

However, they expect cooler than normal weather conditions and may face reduced revenues due to lower customer demand for cooling.

Assuming this utility company uses natural gas to produce energy, they will need to manage both their weather risk as well as their natural gas price risk. To mitigate both risks in this scenario, they could decide to sell Weather futures and buy Natural Gas futures (NG). 

To determine how many Weather futures contracts to sell, the utility company looks at the risk position and divides it by the contract size.

The utility company determines that their sales are positively correlated with the CME Group Houston CDD Index with a sensitivity ratio of 0.65, meaning a 1% change in cooling degree day may drive a 0.65% change in their anticipated revenues.

Assuming futures are trading at 400, they decide to sell 4,225 futures contracts expiring in May to manage their weather-related risk.

To get to 4,225 contracts, they would take their risk of ($52,000,000 x 0.65%) and divide it by the contract size (400 x $20 x 1°).

Let’s assume Houston has an average efficiency heat rate of 7,500 BTU per kilowatt hour.

To determine how many Natural Gas futures contracts they need to buy, they take the number of MMBTU they need to hedge and divide it by the natural gas contract size of 10,000. 

If the utility company is hedging 1,500,000 MMBTU, they will need to buy 150 contracts to hedge the natural gas price risk.

For example, let’s say that May in Houston ends up being slightly milder than average, with an average daily temperature of 77 degrees, or 1 degree less than the forecasted daily average of 78 degrees. 

The Houston CDD Index for May settles at 372, or 7% less than the expected settlement of 400. 

This decline of 28 CDDs implies that sales may decline, potentially resulting in a revenue shortfall of $2.37 million. 

However, this shortfall is offset by a corresponding profit on the 4,225 futures contracts – assuming the price of natural gas also fell to $3.45. Since the utility company bought 150 futures at a price of $3.50, the gain in the cash market was offset by the loss in the futures market.

Climate-related events continue to impact business operations on a global scale. CME Group’s Weather complex offers multiple solutions for managing risk. HDD, CDD and CAT products are also available to trade as a seasonal strip contract, providing the same type of risk exposure as the monthly contracts with the convenience of being able to trade a bundled package of months during the heating or cooling season.