A mild or cold winter — how much will gas cost?
It is September. Data from the tropical Pacific help assess whether El Niño or La Niña will develop during winter. This forecast can matter financially to a city: it changes the estimated likelihood of a mild or cold winter, and therefore expected gas consumption and heating costs. It can help the city plan its budget and decide whether to buy protection against the costs of a cold winter.
Below we show how this decision would have affected a gas buyer’s spending during two actual Chicago winters: the mild El Niño winter of 1997/98 and the cold La Niña winter of 2010/11. We compare costs without protection and with protection against cold weather.
Three temperature curves
— Average 1991–2020 · — El Niño 1997/98 · — La Niña 2010/11
Daily temperatures smoothed with a 7-day average. Consumption calculations use the unsmoothed daily observations.
First, the assumptions: how does the company buy gas?
The supplier bills the energy in the gas in MWh. We assume a fixed price per MWh, so the bill rises with the quantity of gas purchased.
HDD, or heating degree days, measure heating demand. Each day we calculate the difference between 18.33°C and the daily mean temperature (zero if it is warmer), then add these values over the winter. A day averaging 8.33°C gives 10 °C·days.
10,000 MWh is the assumed consumption for uses such as hot water: about 111 MWh per day for 90 days. Set this to zero to include only space heating.
100 MWh/(°C·day) describes the scale of the heated building stock. A day that is 1°C colder increases gas purchases by 100 MWh when heating is needed.
The company pays this amount to the option seller before winter in exchange for the right to receive a payout during a cold winter.
Now calculate the bill for an average winter
What we buy: a contract protecting against a cold winter
A contract is an agreement. Here the company buys a weather call option on HDD from a financial institution, such as a bank or a firm active in weather risk markets. The protection resembles insurance, but the payout depends on the agreed temperature index rather than proof of an actual loss.
An option is a right that we buy: the company has the right to receive money when the contractual condition is met, and the option seller must pay it. The price of this right is called the premium. Here, a call pays when HDD rises above the agreed threshold.
Without protection
The company pays its supplier for the gas consumed. A colder winter means a larger bill.
With call protection
Before winter, the company pays the premium to the option seller. After winter, the seller pays the company if HDD is higher than the threshold — meaning more accumulated cold. If HDD is equal to or below the threshold, the payout is zero. In both cases, the company separately pays its gas supplier.
The key result: total spending in both winters
Each table compares the same winter without protection and with a call option. The gas bill is the same in both columns. With protection, we add the premium paid before winter and subtract the payout received afterwards. The last row shows the company’s final expenditure.
Total spending = gas bill + price of protection − payout received.