Rain check
June 12th 2007 Weather derivatives are the latest financial instrument being incorporated into risk management strategies to reduce the risk associated with adverse or unexpected weather conditions.
Does your company have weather exposure? The chances are it does: around 70% of businesses are said to suffer weather–related losses. So how can businesses protect themselves? The answer for many companies could be weather derivatives – which can offer a cost-effective way of reducing or eliminating the effect of the weather on income. They can also give companies a real competitive advantage.
While most people have now heard of weather derivatives, those who are not involved in the energy markets are still under the misconception that the market literally involves the buying and selling of weather. The word “derivatives” has also scared others off, even though they are essentially very simple financial instruments.
Most companies have insurance policies in place to cover for the effects extreme, low probability weather conditions can have on their business – for example storm and flood damage. Weather derivatives offer protection against much higher probability, less severe weather conditions and their impact on company finances.
Fixing costs
Consider an example in the property sector. While managers of large property portfolios work hard to negotiate the optimum combination of contractual flexibility and low costs in their energy supply contracts, they generally are unable to eliminate one area of uncertainty – the effect of temperature changes. Normal variations in temperature can result in swings in total energy consumption in excess of 10%, with a consequent impact on costs. Volatile energy prices have made this even more significant.
One solution is a weather swap, which allows a company to synthetically fix its energy costs. A company has to first understand its exposure. For instance, a firm may project its electricity costs over an average winter (with temperatures at a seasonal norm of, say, 7°C) will be £1,000,000. For every 1°C drop in average air temperature, heating costs increase by £100,000 and for every 1°C increase they fall by £100,000.
The firm could provision funds against adverse weather or it could choose to accept the risk of poor financial performance. Alternatively, it could enter into a swap agreement, whereby it will pay out £100,000 for every 1°C the winter temperature is above the expected average, in return for receiving £100,000 for every 1°C it is below.
This is as long as it can find someone to take on the opposite side of the deal (which in this case could be an energy supplier seeking to reduce its earnings volatility). The net effect of the weather on its energy costs would thus be zero.
This is an extract from Energy Procurement, The Essential Guide to Excellence, a new guide available for £195, with all proceeds going to the publication sponsor, EDF's chosen charity MENCAP. To order your guide now, please provide your full name and address details and a cheque for £195 (made payable to progressive media) to Shawn Coles. Progressive Media, 33/35 Cantelupe Road, East Grinstead, West Sussex, RH19 3BE
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