Climate Variables and Weather Derivatives: Gas Demand, Temperature and Seasonality Effects in the Italian Case

Abstract

Weather derivatives are financial instrument that allow to hedge weather risk that is the financial gain or loss due to variability in climatic conditions. The market originated in 1998 when the US power community realised that the high volatility of revenues due to weather variability could be controlled and, since then, has grown rapidly both in terms of number of contracts concluded and notional value and in terms of variety of industry applications. The purpose of this study is to analyse the real hedging capabilities of weather derivatives on the Italian energy sector. This is achieved through the investigation of the existence of a robust statistically significant relation between energy, more specifically, gas consumption, and climate parameters. We investigate such a relation applying different models. The first is a simple regression where we estimate gas consumption, as the dependent variable, and temperature, rain, humidity and pressure as explicative variables. In the second model we introduce a derived temperature variable, the heating degree day function, in order to better capture the non linearity behaviour of gas consumption. In the third model we implement lagged, other than present, weather variables. In the fourth model we apply dummy variables in order to consider, daily, monthly and holiday patterns in gas consumption. In the fifth model, finally, we introduce an autoregressive structure in the error term. The paper is organised in five session. The first one summarises methodology and results of previous studies on this topic. Session three describes data. Session four presents methodology and results and session five reports our main conclusions.

Keywords: weather, derivatives, energy

JEL Classification: G19, C32, C51