Understanding Heating Degree Days
Let me explain what a heating degree day (HDD) is—it's a measure of how many degrees a day's average temperature drops below 65 degrees Fahrenheit (18 degrees Celsius), the point where buildings typically require heating.
You should know that HDD quantifies the energy demand for heating buildings. It's simply the degrees below 65°F for the day's average temperature. In the world of weather derivatives traded during winter, prices rely on an index of monthly HDD values. To get the settlement price for a weather futures contract, you sum the month's HDD and multiply by $20.
Basics of Heating Degree Days - HDD
While HDD helps describe overall heating needs for planning in residential or commercial buildings, it's essential for pricing weather futures. This creates a risk management tool that companies in utilities, agriculture, construction, and similar fields use to hedge against weather-dependent activities—like energy requirements, growing seasons, or outdoor work schedules. The first HDD-based weather futures contracts appeared in September 1999 on the Chicago Mercantile Exchange (CME).
How to Calculate Heating Degree Days (HDD)
There are multiple ways to calculate HDD, and the accuracy improves with more detailed temperature data. One method is to subtract the average of a day's high and low temperatures from 65. For instance, if the average is 50°F, the HDD is 15. If it's above 65, set it to zero. For a 30-day month with every day at 50°F average, the monthly HDD would be 450 (15 x 30), making the weather derivative's nominal settlement $9,000 (450 x $20).
Another approach: Subtract each half-hourly temperature from 65, set negatives to zero, sum them, and divide by 48 (for the half-hours in a day). Then sum that over 30 days and multiply by $20. In all methods, if a day's value is zero or less, it counts as zero HDD; if positive, that's the day's HDD.
There's a related metric called cooling degree day (CDD), which measures energy for cooling homes or businesses. Keep in mind that HDD is very localized—heating needs differ by region, and even adjacent buildings can vary due to construction, orientation, insulation, sun exposure, and usage.
Key Takeaways
A Heating Degree Day (HDD) tracks the average days where temperature drops below 65°F, prompting buildings to heat to maintain around 70°F. HDD gets set to zero if negative. It's key in weather futures contracts, acting as a risk management tool for weather-impacted sectors like construction and agriculture.
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