An empirical study of electricity price and temperature : hedging against the weather-related risks on the Nordic market

Abstract

Unfavorable weather raises cost of doing business around the world. According to the CME Group, around 30 percent of gross domestic product (GDP) of the United States (US) is affected by the weather. Only in the US total exposure to meteorological conditions accounts for nearly USD 5.3 billion. In order to address those risks, a market for weather derivatives emerged in 1996 which allows companies and individuals to use this financial instrument to hedge against losses associated with volatile weather. In this thesis, I examine the impact of unanticipated fluctuations in air temperature on electricity prices to explore the relevance of weather derivatives for Norwegian companies. I conduct a time series analysis on historical observations for air temperatures in Oslo, Norway, along with the respective historical prices for electricity in the same area in order to either prove or dismiss the causality between the two variables. The data for electricity prices is from Nord Pool, while the series for air temperatures is from the Norwegian Meteorological Institute (MET Norway). In case the causal relation exists, it would provide local enterprises that are sensitive to air temperature fluctuations with a strong argument for using derivatives issued on temperature-based indices to mitigate their weather-related risks. My study proves the causality between the two variables: air temperatures and electricity prices. In particular, it finds that warmer-than-expected winters cause the decline in electricity prices presumably due to their effect on demand for power. This adversely affects utilities which end up with selling less power. In addition, there is the lack of academic works discussing the fast-growing market for weather derivatives. This is explained by the fact that this market is just recently developed. This thesis therefore aims at adding to the knowledge of weather-indexed instruments, and explicitly underlines the importance of further research on this topic.