Risk Management Through Weather Derivative in Indian Power Sector : Perspective of an Indian Power Firm

Weather-based financial instruments have gained huge popularity in the recent past for hedging weather or climate-related risk across sectors in many economies. Among developing countries, India was one of the pioneers to apply the concept of weather hedging through financial instruments in agriculture. However, although advocated by many, India is yet to explore the use and efficiency of similar instruments in any other sector, including power, whose financial performance is also highly exposed to weather fluctuations. This paper aims to assess the efficiency of temperature derivative at micro level from the perspective of an Indian power distributor. The responsiveness of power demand towards temperature fluctuation is estimated and a suitable temperature derivative product is developed for mitigation purpose. This instrument is priced using discrete time series modeling of daily temperature incorporating a trend in the mean, a lower order Fourier series with autoregressive (AR) component in the presence of Generalized Autoregressive Conditional Heteroskedasticity (GARCH). The efficiency of the instrument is judged through simulating the performance of the power trader with and without the weather derivative. The study reveals that even under current semi administrative pricing structure that exists in Indian power sector, the volumetric risk arising from temperature fluctuation can be successfully hedged using weather derivative