Other energy-related products – emissions and weather

Two other trading markets have been recently developing that complement energy
trading in the USA: emissions and weather derivatives. Emissions trading become
possible with the introduction of tradable tickets for Sulfur Dioxide (SO2) on a
national basis and Nitrous Oxide (NOx ) on a regional basis. Producers must have
enough allowances to cover production of SO2 and NOx (a by-product from fossil fuelburning
stations, particularly oil and coal stations) and can sell excess allowances to
those requiring additional allowances. The value of such allowances now represents a
significant proportion of production costs and as such have a direct impact on the
pricing in the fuel oil and coal markets. The emissions market is relatively active
through a brokered OTC market and a small number of options have been traded.
Weather derivatives also play an interesting role in the energy markets that are
particularly weather sensitive. A utility’s revenue is obviously dependent on its unit
sales, which are sensitive to the weather. Given this risk, weather derivatives are now
being used by a number of utilities to hedge their exposure to temperature and other
weather-related factors. In particular, swaps against heating degree-days are now
becoming common, and options against, snow fall, snow pack (a price driver for hydrobased
systems), river flow and other weather-related factors have been seen. A number
of energy traders now actively buy and sell weather derivatives which are also of
interest to insurance companies and have obvious applicability beyond energy players.

To date, the market is still at the early stages both in the USA and Europe and contracts
have tended to have a limited payoff structure (a limit on the maximum payout). 536