|What is Weather Risk?
by Jack Cogen
Weather Risk is the uncertainty in cash flow and earnings caused by weather volatility. Many energy companies have a natural position in weather which is their largest source of financial uncertainty.
In a survey of 200 top U.S. utility company annual reports, 80% cited weather as a major determinant of earnings performance. About 50% claimed weather was responsible for poorer than expected performance. These figures demand effective Weather Hedging and Risk Management programs. However, in comparison to other types of business risk, weather risk has been deficient in hedging and management alternatives.
Weather Risks Distinctive Aspects
Weather Risk is unique. It has special attributes that set it apart from commodity price risk and other sources of risk. First and foremost, weather affects the "volume" or unit quantity of energy transacted. In contrast, commodity prices affect the margin at which a single energy unit is transacted.
Both contribute to total risk as independent variables and as components of covariant risk (see chart, right). Experience and theory suggest that commodity prices and weather indices do not correlate well in a local area. This makes it virtually impossible to manage weather risk with a price hedge.
More Facets Of Weather Risk To Consider
Weather Hedging And Weather Risk Management
Everyone knows you cant change the weather.
One-hundred years of scientific research has proven that you cannot forecast the weather beyond a few days with enough accuracy to support sound commercial decisions. However, if you cannot forecast the weather beyond a few days with enough accuracy to support sound commercial decisions. However, if youre like many energy companies, you do experience operating results that correlate well with common weather statistics, such as cooling and heating degree-days. This makes it possible to derive financial products based on weather outcomes which can be used to transfer your weather risk to counterparties in a better position to manage it. Today we find insurance companies, commercial banks, investment banks, large energy companies and trading companies maintaining large portfolios of diverse risk investments. They are now ready and willing to underwrite weather hedges in the form of custom OTC contracts that settle on weather statistics.
When carefully constructed to meet your needs, these weather hedges provide protection against your performance volatility caused by weather.
Why Hedge Weather?
For years energy companies have been profitable in the midst of Weather Risk. Some regulated utilities have dealt with the problem by including weather normalization as an adjustment in their rate making process. However, our regulated energy industries are heading quickly towards free market enterprise where customers, rather than utility managers and rate boards, will make such decisions. With this change comes new opportunity...and new responsibility.
Upon the heels of deregulation, open market Weather Hedging will soon be a mainstream activity. Dozens of institutional level transactions have been concluded in the second half of 1997. If you havent seriously considered Weather Heading in your energy business, you may already be behind the competition. It may not be long before explanations of low revenues and volatile earnings caused by weather are viewed by investors as excuses.
Investors dont like excuses.
Additional Reasons To Consider Weather Hedging
Weather Hedging Strategies
The five examples that follow will give you a better idea of structures that producers, consumers, marketers, distributors and transporters of weather-based energy can use to modify their cash streams.
Cooling & Heating: Degree-Day Swaps
In the example below, an energy producer sells a swap and gets compensated pro rata per degree-day whenever degree-days settle below an agreed strike level. When degree-days settle above the strike, the producer pays the buyer of the swap. The combination of the swap and the producers revenue from operations is a more stable revenue stream. The buyer of the swap sees a mirror effect. This might be a consumer looking to stabilize his total cost of energy consumption.
Cooling & Heating - Degree-Day Options
If rainfall settles below the low strike, the producer receives pro rata payment per inch of rainfall from the seller of the put option.
If rainfall settles above the high strike, the producer pays the buyer of the call. When combined with the producers natural revenues from operations, the total revenue pattern is stabilized by the hedge outside of the strike range. Within the strike range, total revenue follows the unhedged trend.
In the example shown, a two-tier cost structure occurs from normal unhedged operations. The exposed party buys a digital hedge which mirrors this condition, thus compensating for the costs when they occur. The digital hedge ensures a fixed cost of operations regardless of the weather outcome.
Embedded Weather Agreements
The shaded area between the dashed lines shows the unhedged range of highly probable outcomes. After hedging (dark line), both price and volume risk are eliminated, guaranteeing a fixed energy cost to the consumer. This type of hedge can be useful for consumers who want to meet energy budgets.