Features, November 1999 Bond buyers look to the skies Investors are now paying closer attention to the early morning weather forecast. In October, Koch Energy Trading issued the first weather-linked bond. Mark Nicholls reports on the development - and future - of this new asset class The close of the first ever weather-linked bond on October 28 was greeted with more of a sigh of relief than the popping of champagne corks at Koch Energy Trading and Goldman Sachs. After an intensive process of number-crunching, financial engineering, and exhaustive marketing, the US investment bank was finally able to place $50 million worth of the bonds - which are linked to a portfolio of weather derivative trades transacted by the trading arm of Koch Industries - compared to the original goal of $200 million. "We were maybe a little ambitious to begin with. We aimed for the stars," says Jeff Porter, Koch Energy Trading's vice president of marketing. But Porter says that the deal generated considerable investor interest, despite being a "more complex deal than I would have liked". And Koch managed to pip rival US energy major Enron to the post. Sources say that the Enron deal, which is being structured by Merrill Lynch, is proving to be an easier sell to investors than the Koch bonds, largely because the structure is less complex. But that said, Merrill Lynch had hoped to have closed the deal some time in October. Many are not surprised that the investment banks have faced an uphill struggle marketing the bonds. Any new asset class is always a difficult sell to investors. A fund manager at a major asset management company in New York says that he is currently evaluating the deals. "We're not sure yet how much risk we'd be taking with these instruments - it's something that hasn't been adequately explained to us yet." And the timing is not great. In the run up to Y2K, many investors are chary of any investment that doesn't offer a deep and liquid secondary market. If the turn of the century does, as some fear, confuse computers and cause economic chaos, investors want to be able to sell investments quickly. Some investors have also expressed nervousness in dealing with Enron and Koch, concerned about the sophistication of the two energy companies. One New York-based potential investor complained of "information asymmetry", fearing that he would be taking risk that he didn't fully understand. Porter adds that having two competing deals vying for investors' attention didn't help. "People have only so many resources, and the two deals are quite different. That may have been to their detriment." Nonetheless, the bond issue marks an important milestone in the development of the weather derivatives market. In a classic application of financial markets theory, an esoteric, little understood financial risk has been repackaged and sold into the wider investment community. A similar process took place with catastrophe bonds, and a weather-linked bond market looks set to mirror its development, say analysts. Indeed, the teams at Merrills and Goldman Sachs responsible for catastrophe bonds structured the Enron and Koch weather issues. Launched in 1995, the catastrophe bond market has grown to be worth about $1 billion in 1998, with similar issuance expected this year. In exchange for a higher return than would be normal with a bond from a similar company, the investor loses some, or even all, of its investment if the specified catastrophe takes place. The introduction of catastrophe bonds has allowed the reinsurance sector - with its exposure to huge insurance claims in the wake of a major earthquake or hurricane - to pass on unpalatable levels of risk to the capital markets. As with catastrophe bonds, so too with weather. Porter says that the amount of "weather exposure" in the US economy could very quickly swamp the balance-sheets of those companies - such as the reinsurance sector and the large energy companies - prepared to take it. A key problem is that most companies looking to hedge have similar exposures, making it difficult to match natural buyers and sellers of risk. "We're starting to see liquidity constraints," he says. "If three of the big energy companies attempted to lay off all of their weather exposure, it would overwhelm the capacity of the market to absorb it." But by passing this risk on to capital markets investors, Koch will be able to transact more weather derivatives deals going forward. Koch and Enron can also take heart from the early days of the catastrophe bond market. "The first cat bonds took at awfully long time to get out," says a structurer at a New York-based investment bank. "There were a few false starts." However, the experience of that market is likely to speed the growth of weather bonds. Initially, it is likely that the new weather bonds will go to the same buyers of catastrophe risk. Those investors are familiar with many of the underlying principles of these new instruments, says Christopher McGhee, managing director of Marsh & McLennan Securities in New York. "It will take less time for the market to develop than with catastrophe bonds - much of the analysis is very similar." Marsh & McLennan Securities is the investment banking arm of Marsh & McLennan Companies, the financial services group. As with all new markets, a vital precondition for the success of weather bonds is the ability of investors to assess the risks of the new instruments. "The capital markets will take on any risk that they can accurately quantify," says the structurer. Fortunately, the weather is something about which governments have been collecting and collating data for, in some cases, several hundred years. In the US particularly, reliable, largely consistent and freely available government data stretches back over a century. However, although the data is largely consistent, there are idiosyncracies that structurers and investors have to address. For example, some weather stations (where the data is collected) have been moved, or have had their immediate environment subtly changed. Also, there are occasional interruptions in the data, caused by equipment breaking down, for example. In fact, the Koch deal relies on weather stations that were explicitly chosen for the consistency of their data to avoid some of these problems. A thornier issue is that of 'trending'. Throughout most of this century, mean global temperatures have been gradually rising. The causes of this remain controversial: while most scientists would argue this is probably caused by greenhouse gases produced in increasing volumes since the industrial revolution, some would suggest that this is at least partly caused by the 'heat island' effect, where temperatures recorded at weather stations are marginally raised by the growth of cities around them, and the waste heat they produce. In an attempt to overcome this problem, Enron and Koch have taken a similar approach to that taken in the catastrophe bond market. An independent and well-respected company - Risk Management Solutions (RMS), a California-based risk-modelling and software company - has 'cleaned up' the raw data, and has performed a 'de-trending' exercise. "To make the market work, we need to ensure that no-one is at an advantage - that there's a level playing field," says Robert Muir-Wood, technical director at RMS in London. "That's what this clean data can offer." The large energy trading companies and reinsurers - who have been active in the underlying weather derivatives markets - have been cleaning the data to allow them to perform their own weather risk analyses. However, potential weather bond investors may not have been through the process. Also, different companies have chosen to deal with the problems with the data in different ways, which means that they would price the bonds' risk differently. So the banks behind the two bonds have chosen to disseminate RMS's analysis widely. "A novel feature of this market is that the data has been handed out to potential investors," says Muir-Wood. Each of the offering documents comes with a CD rom containing the data, and RMS's methodology, allowing them to perform their own risk analysis. "This offers the market a new level of transparency," says Muir-Wood, adding that the ability of issuers to place 'exotic' risks such as weather derivative exposure depends on the confidence of investors in the underlying information. FOR THE FULL STORY EVERY MONTH, SUBSCRIBE TO ENVIRONMENTAL FINANCE, OR CONTACT info@environmental-finance.com FOR OUR BACK ISSUES SERVICE