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What is Weather Risk?
by Jack Cogen

President, Natsource Inc.
(originally published by PMA OnLine Magazine: 05/98)

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.

  • Colder than normal summers reduce electric power sales for residential and commercial space cooling. These cooler temperatures idle capacity, raise the average cost of power production, and reduce demand for natural gas and coal energy feedstocks.
  • Above average winter temperatures reduce natural gas and electric power sales for space heating.
  • Lower than normal precipitation upstream of hydropower facilities reduces power production. This reduces revenues to the facility and diverts buyers of hydropower to higher cost power alternatives.
  • Independent power producers often have weather adjustments built into their fuel supply contracts. When weather events trigger these adjustments, fuel supply costs can skyrocket. In extreme cases, fuel supply and business operations are temporarily interrupted.

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 Risk’s 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

  • There are no physical markets in weather. Try as you might, you can’t store a hot July day until December. You can’t transport a Houston rainstorm to the Pacific Northwest either.
  • Weather Risk is localized. There are few, if any, benchmark indices in weather that have commercial meaning to broad markets. There is no analogy in weather to natural gas at the Henry Hub or electric power at the COB Interchange.
  • Physical weather is completely beyond human control. It can’t be influenced, modified or manipulated by regulation, speculation, cartels, major market players or mass market dynamics. Everyone gets the same raw deal in weather, because Mother Nature doesn’t bargain.

Weather Hedging And Weather Risk Management

Everyone knows you can’t 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 you’re 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.

weather1.gif (5694 bytes)

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 haven’t 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 don’t like excuses.  

Additional Reasons To Consider Weather Hedging

  • The cost of Weather Hedging can be lower than other risk management products. This is particularly true for long-term agreements reaching out 5-10 years.
  • Retail demand is here! One new partnership has already experienced explosive growth marketing fixed cost heating and cooling contracts to residential and commercial end users. The program allows customers to lock in energy budgets, regardless of weather outcomes.
  • Weather Hedging provides customized solutions by using weather indices specifically tailored to an individual client’s needs. Basis risk is dramatically lower, providing a better hedge and adding greater value to the hedger’s enterprise.
  • Weather Hedging brings an entirely new dimension to risk management. It is the only known vehicle for managing volume risk in the energy industry. This allows end users greater flexibility in developing multi-faceted risk management programs.
  • Weather Hedging is reliable, safe and fair. Weather data is accurate and more objectively collected than any other major commodity or financial index. At least 50 years of official weather data is on record for most major cities in North America, and readily available from government sources.

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
Swaps can be used to stabilize cash streams associated with cooling and heating energy.

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 producer’s 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.

weather2.gif (4820 bytes)

Cooling & Heating - Degree-Day Options
In their simplest form, options provide a one-sided hedge towards the downside, while preserving upside potential. This sounds better than a swap on the surface, but it comes at the expense of a premium the buyer must pay up front for the hedge. In the example shown, a producer buys a put option and gets paid pro rata per degree-day whenever degree-days settle below an agreed strike level. This offsets lower revenue from operations, and sets a minimum floor on total revenues. If degree-days exceed the strike level, the producer pays nothing more than the option premium, and enjoys full upside operating revenues.

weather3.gif (5376 bytes)

Collars put boundaries on natural outcomes, limiting them to a desired range. Collars are constructed using a combination of put and call options. In the example shown, a producer buys a rainfall put option with a low strike level and sells a call option with a high strike level. If rainfall settles between the two strike levels (the strike range), there is no payout to either the buyer or the seller of the hedge.

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 producer’s 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.

weather4.gif (5437 bytes)

Digital Structures
Digital structures are used to cause lump sum cash transfers between contract parties whenever specified conditions are met. These structures are useful in situations where risk and associated costs come in discreet amounts instead of a variable scale. An example would be a power producer who incurs a fixed cost of bringing a peaking facility on line whenever temperatures exceed a threshold level.

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.

weather5.gif (4602 bytes)

Embedded Weather Agreements
These types of agreements can be used to combine weather hedges and physical energy delivery in a single transaction. The payout of the weather hedge is embedded in the energy supply cost. This can be useful as a matter of convenience, or when policy restricts the use of naked hedge agreements. Embedded agreements sometimes make it easier to see the result of combining weather hedges with operating results. Weather hedges can also be combined with price hedges and physical energy supply. For example, the diagram at right shows a total cost hedge for an energy consumer who is sensitive to both degree-days and price volatility.

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.

weather6.gif (4639 bytes)

Jack Cogen is President of Natsource, Inc. Natsource has concluded weather transactions with every active market participant, and are the leading specialists committed full-time to weather hedging products and services.

Jack Cogen
Natsource, Inc.
Weather Hedging Services
140 Broadway
30th Floor
New York, NY  10005

(212) 232-5305 Tel(212) 232-5353 Fax |

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