Death, taxes and weather are universal factors that we cannot escape or control. For years, society has unsuccessfully tried to manipulate these forces that regulate our lives. Though we have not managed to control the weather, we can control its effect on our finances. In the past, companies in most industries accepted the impact of weather as an inevitable element of nature and simply absorbed the financial burden of volatile climate patterns. However, in 1997, utility companies in the US, whose revenues are intimately tied to the weather, began to purchase derivative contracts to protect their profits from the effects of warmer than normal winters. This was driven by the deregulation of the utility industry, which forced utilities to focus on profits and shareholder value more than ever. Now, four years later, weather risk management has gone from a little-known industry to a $7.5bn international industry of brokers, traders, banks, consultants, insurers, reinsurers and government agencies that are driving one of the most innovative segments of risk management. This global industry has provided financial stability for end-users not only in the utility and energy sectors, but also in the fields of entertainment, agriculture, retail, transportation, and food and beverage.
In June 2001, the Weather Risk Management Association (WRMA) released a comprehensive survey of the industry in conjunction with PricewaterhouseCoopers, measuring contracts from winter 1997 through winter 2000. This was an important achievement, as the industry's growth and current size had never been accurately measured. A key development tracked in the survey was the tremendous growth in the number of contracts executed. In the winter of 1997, 82 contracts were executed with a total notional value of $169,410, while in the winter of 2000, 1,633 contracts were completed with a total value of $1.8m.
The survey also revealed that the industry has begun to diversify. Over 70% of businesses are exposed to financial weather risk. In the US alone, the Department of Commerce estimated corporate weather exposure at $1trn - approximately one eighth of the gross domestic product. In the winter of 1997, 100% of the transactions took place in North America and protected against warmer than normal winters. While temperature-related contracts continue to make up the majority of the market, there has been encouraging progress in other areas. In the US, weather risk financial tools have been used to cover risk related to stream flow, crop yield, excess inventory and even ice cream sales. In the European, Asian and Australian markets, there has been an increased number of utility contracts and weather deals to protect against temperature and precipitation. While consisting of only a small part of the total weather risk management industry, the over $184m in notional values that have been written in these markets demonstrate the remarkable - and rapid - development.
The rapid growth of the industry is attributed to companies realising that their revenue and profits are no longer at the mercy of the weather. As they have hedged against interest rates and currency fluctuations, they are able to protect themselves from the risks associated with fluctuations in the weather. Equity analysts and the general financial community, who cite the purchase of weather products as a significant factor in their ratings of companies, increasingly support this decision.
In November 2000, Goldman Sachs named Washington Gas Light's purchase of weather insurance as a positive for its shareholders. Likewise, Atmos Energy Corp, a US natural gas distributor, received a higher earnings-per-share estimate in January 2001 from Salomon Smith Barney because of its weather hedging. In addition, analysts at Goldman Sachs, Standard & Poor's and CIBC World Markets have cited a company's decision to mitigate its weather risk as a choice that will enhance its value as well as its credit rating. The consensus is that hedging weather allows a company to continue to focus on the growth and stability of its core business and to enhance the value of its products, services and capital development.
Weather risk management products come in the form of derivatives or insurance, and both products are widely used in the marketplace. Both can be customised and easily structured to suit the need of any company. Generally speaking, derivatives are often purchased by companies with experience in hedging, such as utility and energy companies which have traditionally purchased index-based derivatives. Those which historically have never hedged their risk, such as the agricultural and entertainment industries, often prefer insurance. A derivative can be structured so that there is no up-front payment while insurance requires that a premium is paid. There are also differences in the way each must be reported and taxed.
Before 1997, purchasing weather derivatives was virtually unheard of in industries other than utility and energy. However, the insurance industry is beginning to play an important role in bringing weather risk management to companies outside the utility/energy realm. In the past, insurance has simply provided coverage for catastrophic weather events like storms, hurricanes, floods and tornadoes. The non-catastrophic weather market, which protects against precipitation, snowfall and temperatures, is giving re/insurers the opportunity to greatly expand the protection they provide to customers. It is not only an exciting convergence of insurance and the larger financial markets, but a natural extension of coverage that the industry has already been providing. The challenge for re/insurers is educating their customers, which are often unaware of non-catastrophic weather hedging and how these new products can help them. The success of this endeavour will not only strengthen the weather risk industry, but the insurance industry as well, which has long been viewed as a mature market with little room for innovation.
table x:str border=0 cellpadding=0 cellspacing=0 width=575 style='border-collapse: collapse;table-layout:fixed;width:432pt'> Contracts executed per season Coverage Period Contracts Executed Year-Over-Year Growth Rate Winter 1997 82 - Summer 1998 209 - Winter 1998 486 492.70% Summer 1999 362 73.20% Winter 1999 923 89.90% Summer 2000 1,126 211.00% Winter 2000 1,633 76.90%
|Frequency of contract types|
|Percentage distribution for number of contracts by type of contract, by coverage period, all regions|
|Coverage period||Exclusively temperature contracts||Other contract types||Total|
|Notional value of executed weather structures|
|Notional value by contract coverage period and region, all contract types (Thousands of US dollars)|
|Coverage Period||North America||Rest of the world|
While the US weather market is primarily driven by market-makers of weather risk management products, the European market is driven by end-users. A number of these end-users have been brought to the market by banks. Banks are actually developing a strong presence in the industry. With access to a broad segment of the European market, the addition of more banks will likely result in greater liquidity. In recent months, Dresdner Bank, Deutsche Bank, HypoVereinsbank, IntesaBci and Royal Bank of Scotland have announced their involvement in the industry and as knowledge of weather risk financial tools increases, more are expected in the near future. As they increase their participation, banks will also develop more sophisticated and customised products to meet the demand of industry participants.
Though the European market has grown, the largest obstacle to continued growth is access to weather data. Weather contracts are structured and based on historical climate data gathered at specific locations, therefore availability and accuracy is imperative to creating effective weather products. In the US, this information is available quickly and inexpensively from a number of regulated government stations across the country. In Europe, the system is less consistent. Since there is no centralised European agency to gather weather data, its availability varies by country. It is also difficult to determine data reliability due to the lack of regulation and a standard format. This creates a daunting conversion process for any company using information from multiple sources. The WRMA is currently lobbying the European Union and individual governments in an attempt to lower prices for weather data and make its availability more consistent. In addition, a standardised protocol for cataloguing weather data, which will be introduced later this year, is near completion.
According to the WRMA/PwC survey, Asia saw $46.1m in weather contracts in 2000, compared to $4.4m in 1999. This growth is partially attributed to the deregulation of the Japanese electricity industry, which will continue for the next few years. Asia also has a number of participants outside the energy sector that hedge in areas other than temperature, creating a more diverse market than the US and Europe. In fact, approximately 50% of weather contracts in Japan focus on elements other than temperature, such as rain, snow and wind. The end-users include golf courses, resorts, and equipment and beverage manufacturers. Although the majority of these companies are domestic, smaller end-users, the diversity indicates the development of a strong and liquid market. In Japan, the majority of the Asian market, banks and insurance companies are the dominant players. However, Japanese utilities are becoming market-makers in their own right.
Although only six trades were recorded in Australia as of March 2001 (according to the WRMA/PwC survey), the market holds great promise.
The deregulation of the electricity industry and the establishment of a trading market prove that Australia seeks to mirror the success of the Asian, European and American markets. Though the contracts traded in Australia have all been temperature-related, as the market grows the diversification of contracts will occur.
In recent months, the number of weather transactions completed through online and futures exchanges has increased considerably.
The major exchanges include the Chicago Mercantile Exchange (CME), which began listing contracts in 1999, the IntercontinentalExchange (ICE), beginning in November 2001, and the latest, the London International Financial Futures Exchange (LIFFE), which started trading weather derivatives in December 2001. Each has noted an increase in activity this winter, partially due to milder than normal weather throughout much of the US and Europe.
Using weather products
The intimate relationship between temperature and revenue made utility and energy a natural sector to embrace the concept of hedging weather risk. Gas utilities in the US have reported as much as a 15% drop in first-quarter earnings when winter temperatures are milder than normal. A gas utility can structure a weather contract to protect against these diminished earnings while taking advantage of the revenue that arises during a profitable winter season, lending stability to the balance sheet and allowing a utility to avoid raising rates. Similarly, a power provider could purchase an indexed swap to stabilise revenues during the cooling season whether conditions are warmer or cooler than normal.
Farmers depend on a favourable climate during the entire crop cycle. According to Major World Crop Areas and Climate Profiles report, 1997: "Climate and weather are significant factors affecting agriculture production around the world. Both seasonal and regional variability in weather directly influence crop yield potential." In addition, rising production costs and stringent environmental regulations leave farmers with fewer margins for error. Consequently, purchasing risk management tools that offer weather protection and reduce the financial effects of harsh climate conditions is an important safeguard.
According to a case study performed by Enron in June 2001, fashion may influence the styles of the season, but the weather will determine what is purchased in stores.
While profits resulting from retail sales of clothing are affected by taxes, costs of labour, unemployment rates and the state of the national economy, the weather is recognised as a major influence on sales figures.
In recent months, companies around the world such as Toys `R' Us, J Sainsbury, Ted Baker and House of Fraser, have cited unseasonably warm fall and winter weather as a key factor in lower sales. To counteract this financial effect, weather risk tools can be structured to cover the risk of unfavourable weather conditions, providing compensation that will guarantee minimum earnings and reduce cash-flow instability.
Recreational and entertainment entities use weather risk tools as other industries, to stabilise revenues and gross margins. Ski resorts and theme parks, in particular, use weather products to offset the effects of a mild winter or rainy season. From a promotional standpoint, a ski resort may use a weather risk tool to cover the cost of offering rebates on lift tickets if weekly snowfall is less than expected. However, theme parks may use a weather risk tool for protection against successive rainy days or extreme temperatures.
The transportation industry faces a range of threats from weather including heavy snowfall that makes roads, railroad tracks and runways impassable; freezing temperatures that cause ice to accumulate; and too little rainfall, which creates hardships for businesses that utilise barges. The State Departments of Transportation face increased road repairs from harsh winter weather.
An unusually tough winter can force them to spend funds allocated for other programs. Likewise, municipalities face a similar issue with the costs associated with clearing excess snowfall. If snowfall occurs outside of contracted time periods, cities, too, are forced to spend funds allocated for other programs.
Though the weather risk management industry has grown rapidly over the last few years, its continuing success depends on the ability of providers and end-users to operate with increased precision in terms of analysing their exposure to weather and designing the best solutions to resist its effects.
Our industry requires professionals who are equipped to interpret weather data, understand the dynamics of weather and take an active role in developing deals that are customised to the needs of end-users. WRMA's goal is to facilitate this process and ensure that providers, end-users, and market players are properly educated on developments in the industry and have access to the tools needed to help it grow.
The Weather Risk Management Association
Formed in 1999, the WRMA is the only trade association dedicated to serving and promoting this industry. Our internationally-based membership, which covers Europe, North America and Asia, comprises over 70 member companies, many of which are the leading producers in this market.
Our principal goal is to demonstrate that financial weather products are marketable and economically productive assets that will enhance the financial portfolio of any business.
The WRMA is devoted to developing industry standards of methodology and contracts, addressing critical issues that affect the industry (such as easy and inexpensive access to historic weather data, which is a key factor in developing effective financial weather products), and facilitating the growth of a strong and vibrant weather trading market.
By Valerie Cooper
Valerie Cooper is executive director of the Weather Risk Management Association.
For more information on the weather risk management industry, visit www.wrma.org .