Weather Derivatives

A utility's biggest business risk isn't always the price of gas or power, it's the weather itself, since a mild winter cuts heating demand regardless of what fuel costs. Weather derivatives let a company hedge that risk directly by paying off based on an actual measured weather outcome rather than a price. The most common structure uses heating degree days (HDD) and cooling degree days (CDD), each day's deviation of average temperature from 65°F, summed over a season, as the underlying "price" the contract settles against.

A buyer might purchase a contract that pays out if a winter's cumulative HDD count falls below a threshold, protecting against the mild-winter, low-heating-demand scenario that would otherwise hurt a gas utility's revenue, while an energy trading desk on the other side takes the opposite view as a bet, not a hedge.

Worked example. A utility buys an HDD floor at 4,000 degree-days, paying $20 per degree-day below the floor. If the season sums to only 3,700 HDDs, the contract pays $(4000 - 3700) \times 20 = \textdollar 6,000$, offsetting the shortfall in heating-driven gas sales.