Hedging against Mother Nature: Weather risk and its effect on earnings

Roxane Richter

Energy Marketing Editor

Facing yet another nail-biting warm winter season, an East Coast power generator called upon Castlebridge Weather Markets, a weather derivatives “market maker,” to create a hedging transaction in order to protect its cash flow. The power generator purchased a “costless” collar transaction, spanning November 1999 through March 2000. The deal was based upon $5,000 dollar per-degree-day ticks, had a $2 million cap and used 30-year weather averages.

“Based upon the warm season, they`re very happy they did the hedge. Energy companies that have hedged in the past two to three warm winter seasons are all very happy that they`ve hedged their weather risk,” said Castlebridge Weather Portfolio Manager Ethan Kahn. “After this warm winter, everyone who requested quotes but failed to act on the deal and pull the trigger will be eager to do it next winter. They`ll have to in order to remain competitive.”

More and more, parties are seeking protection against weather risk-the uncer- tainty in earnings and cash flow due to weather volatility-by entering into weather-based hedges. And while the effect of weather is felt largely on volume, not price, and weather risk management does not manage the dynamics between price and volume-nonetheless, a single warmer-than-normal winter season can shave tens of millions off a utility`s earnings for the year. So the need to stabilize, not maximize, weather-sensitive revenue is key, as lenders require companies to better manage their cash flow and shareholders demand less volatility in earnings.

While weather`s profound impact on bottom-line dollars for utility companies, pipelines, traders and producers remains undeniable, it is really only in the past two years that the management of weather risk has begun wooing the attention of shareholders and industry executives.

Hedging strategies

According to economists, weather affects an estimated 20 percent (roughly $2 trillion) of the $9 trillion U.S. economy-with energy, agriculture, construction, financial and transportation as the most impacted arenas of the economy.

On average, a utility`s profit sensitivity per heating degree-day can range anywhere from $500 for small utilities, to between $5,000 and $25,000 for an average-size utility, and $150,000 and up for larger utilities. As for a residential customer, risk sensitivity can average about 10 cents per heating degree-day. Note that a heating degree-day (HDD) occurs when the average temperature is below 65 F. To be specific, HDD is 65 F minus the daily average temperature. Conversely, a cooling degree-day (CDD) occurs when the average temperature of the day is above 65 F. CDD is the average temperature minus 65 F.

To address relevant weather risk industry issues, in June 1999 the Weather Risk Management Association (WRMA) was formed and incorporated to serve the weather risk management industry. Created by four weather risk gurus from Castlebridge Partners LLC, Koch Industries, Enron Capital & Trade Resources Corp. and Southern Company Energy Marketing, the Washington, D.C.-based WRMA said it “felt a need for the industry to have one unified voice” to address standardized contracts, weather information back-up station, electronic trading, international opportunities and issues, brokerage, education and capital markets. “This market is still very new. Between 1997 and 1999, there were about 2,000 to 3,000 transactions, amounting to about $5 billion to $7 billion,” said WRMA Executive Director Valerie Cooper.

Charter members of the WRMA include Aquila, Castlebridge, Enron Capital & Trade, Koch Industries, Southern Company Energy Marketing and Swiss RE New Markets. Membership within the WRMA totals about 25 companies, including firms from France, England, the United States, Switzerland, Denmark and Sweden.

Even though you can`t change the weather, you can hedge against its fluctuations. One of the most alluring charac- teristics of weather-related products is the fact that weather is one of the last true spheres of scientific risk management; weather data is collected by neutral scientific organizations and is effortlessly available to the public at large. Unlike exchange prices, weather is not readily tainted by outside factors or forces, unlike the potential for market manipulations. Plus, weather hedging allows for the bartering of physical options for weather protection, holds a unique ability to isolate and manage volumetric risk and, in relation to other risk management tools, harbors a relatively low cost.

Generally speaking, weather products can be based on: temperature (minimum, maximum, average, CDD, HDD, etc.); precipitation (snowfall, snow pack, depth, stream flow/water level, rainfall); haze/pollution; wind or gust speed; sunshine; drought; misery (a heat and humidity index); growing degree-day; digital (lump sum once event/threshold is triggered); variable degree-day; energy degree-day (HDD + CDD), and other user-defined indices.

Products can include embedded weather agreements, collars, floors, HDD or CDD swaps, heating or cooling degree-day options, single-payment “knockouts,” as well as other custom-made configurations. Fundamentally, swaps (where floating price is exchanged for fixed price over a period of time) can stabilize volume-related revenues, and options (where purchaser has right to buy or sell at a strike price) can protect the downside, while preserving any upside potential. Collars (a blend of put and call options) can be “costless” or a minimal cost, and floors (the seller is assured of some minimum price) can protect earnings in mild weather scenarios.

Most of the current weather transactions use either cooling or heating degree-day tools, and run about $5,000 per unit, with a $2 million to $10 million maximum pay out. Sources stated that deals as small as $400 per unit in the secondary market have been transacted, and high-dollar deals and inquiries in the primary market have ranged from $10 million to $250 million in exposure coverage.

Stormy side of weather derivatives

Some of the current challenges flooding the weather derivatives market include:

– Bid-ask chasm: Ask prices can be two to three times the bid price, (often a $150,000 to $500,000 difference) these far-reaching numbers breed illiquidity.

– Transparency: Though neither completely opaque nor totally transparent, the over-the-counter (OTC) weather derivatives market could use a bit more sunshine in the darker corners of the market.

– Illiquid: Still a small number of players and a small number of market makers.

– A question of years: Aside from the question of whose data to use (the National Weather Service or other weather-gathering agency), hedgers are faced with using 10-, 15-, 20-, 30- or 50-year (or more) weather averages.

– Lack of acceptance: Utilities that are regulated often lack the incentive to hedge their risk. Utilities also may need to overcome the fear of “derivatives,” which have landed some rather well-known entities in both fiscal and legal distress.

– Inconsistent pricing methods: Still, no widely accepted pricing methodology.

– Fair valuation and location fragmentation: The inability of potential hedgers to easily evaluate prices at uncommon locations (without the use of complex pricing models), often leads to difficulty in assessing value, and often, locating potential counterparties.

– A nascent market: Weather derivatives still toil under the aches and pains of growing up and maturing as a market.

Key components to consider in a weather hedge are the strike (the predetermined point or number of instances to begin payout), option payout unit (unit of measure), weather data and weather gathering stations to be used or averaged (weighted), maximum and minimum possible payouts, period of time (option period), the amount at risk, and any available historical data, including the average, low and high of temperature, rainfall, etc.

The price of a weather derivative, explains Jeff Porter, Koch Energy Services director of weather derivatives, represents a value of the uncertainty in the future derivative outcome. This uncertainty is dependent upon the uncertainty in the future climate. In order to assess the value in a weather deal, Porter explained, potential hedgers could create their own model for pricing, use past information as a forecast, or ask the market directly.

On the whole, most pricing today is based on an actuarial methodology, guided by historical weather data, while factoring in components like forecast and trend. But before you rush out to price a U.S. weather derivative, explains Bob Dischel, a New York-based meteorologist and weather market consultant, follow these proven guidelines: First, get data directly from a U.S. government source. Second, plot data, look for trends and question any unusual events. Then use sound judgement for record length.

Dischel recommends his “Goldilocks Maxim” in estimating the probabilities of the future from the events of the past-whereas 10 to 20 years is “too short,”” a century is “too long,” but 50 years can be “just right.” Dischel also suggests using pricing models that are sensitive to changing record length and being cautious about using seasonal forecasts in your assessment. And finally, comparing your calculated fair value and market price against the cost to your business from not hedging.

But, thanks to the Chicago Mercantile Exchange, the business of buying and selling weather derivatives just became a little more transparent and a little easier this past September.

It`s not just OTC anymore

On Sept. 21, 1999, the world`s first exchange-traded, temperature-related weather derivatives began trading at the Chicago Mercantile Exchange (CME). The CME initially listed HDD index futures for four U.S. cities (Atlanta, Chicago, Cincinnati and New York), but is about to add Tucson, Las Vegas, Philadelphia, Portland, Dallas and Des Moines to the list, pending CFTC approval. Already, Atlanta is proving much more active than other cities-raking in the lion`s share (about 157) of the 293 contracts transacted between September and December of 1999.

“Now businesses have a new tool for protecting their revenues when weather depresses demand or results in increased costs,” said Scott Gordon, CME chairman. “From energy firms to insurance and reinsurance companies, those with weather-related financial risk can turn to CME weather futures for risk management.”

CME`s weather contracts are attracting new participants and increasing liquidity in the weather risk market for the following reasons: it allows a small transaction sizes ($100 per tick multiplier); it provides price discovery; it ensures low frictional and trading costs on the electronic system; and it eliminates credit risk for participants.

CME HDD futures are sized at $100 times the CME HDD Indexes (one for each city) and the exchange will initially list monthly contract expirations from October 1999 through March 2000. The minimum tick size of 1.00 HDD or CDD index point will equal $100. CME futures and options will trade electronically on the GLOBEX 2 system, virtually 24 hours a day, from 3:45 p.m. to 3:15 p.m. the following day. In addition to exchange-traded contracts, residential customers are now entering into some contracts of their own to alleviate their unique weather-related risks.

Weather risk in deregulated markets begs the question: Will residential and commercial customers-if given viable fixed-rate instruments-continue to accept price unpredictability in their energy bills?

As for the residential, commercial and institutional energy consumers in deregulated markets, WeatherWise USA, Inc., an underwriter of consumer weather risk, found that 23 to 32 percent of residential consumers who value certainty are willing to ante up four- to six-percent fees for the security of flat-fee, guaranteed energy bills. Already, about 100,000 residential and commercial customers use WeatherWise`s WeatherProof Bill. However, it`s a 9:1 ratio of residential to small commercial customers.

With first-year penetration rates of 7 to 16 percent, and third-year rates as high as 20 percent, guaranteed bills are gaining fast acceptance in Massachusetts, Wyoming, Nebraska, Pennsylvania, Illinois, Kansas, Maryland, Virginia, Washington D.C., Colorado, Indiana and Georgia, where the product is currently available. Plus, WeatherWise claims a 0.5 percent accuracy rate in assessing energy usage-a safe bet when weather-driven fluctuations in heating bills can run as high as 20 to 25 percent.

“Most people don`t want to take the risk in their electric bill or take the time to try and understand complicated billing components. They want to pay what they feel is reasonable and, unlike long-distance service, they`re unwilling to switch their provider every other month,” said WeatherWise Vice President David Zabetakis, “It`s not inconvenience when something happens to reliability, it`s a problem.”

So, when it comes to end-users hedging their own weather-related risk, it`s best to abide by the age-old adage: “Hope for the best; plan for the worst.”

Sunny skies ahead

Ravi Nathan, Aquila`s Weather Portfolio Manager, believes the future of weather markets will push out globally into the markets of Europe and India. Nathan points to a recent United Nations meeting concerning weather disasters, where delegates showed a great interest in the progression of weather markets in the states and elsewhere.

As for the future of weather derivatives, Nathan also sees a greater move toward Internet-based systems, using both standardized and exotic contracts. “This is not a commodity like wheat or corn. The Merc only trades a couple hundred a month. These are all electronically traded on the exchange. We`re breaking new ground here,” he explained.

In effect, as the weather risk management market matures and develops, there are fewer excuses available to companies who do not manage their weather risk. Much the same as the management of price risk today, weather risk is sure to form an integral link in a well-forged risk management program.

Plus, with the advent of exchange-traded contracts, increased liquidity and greater market transparency-it may just be sunny skies ahead for weather hedging, weather risk services and weather-related products.

CHIEF “RAINMAKERS” IN WEATHER RISK MANAGEMENT

Aquila Energy: (www.aquilaenergy.com) Aquila offers “shelter from the storm” with its Guaranteed Weather line of financial option products.

Castlebridge Weather Markets: (paul@castlebridge.com) Chicago-based Castlebridge Partners LLC takes counterparty positions in a variety of weather-based hedging transactions.

Chicago Mercantile Exchange: (www.cme.com/weather/) “The Merc” offered the world`s first exchange-traded weather derivative contract in September 1999.

Dynegy: (www.dynegy.com) Some products include Storage Investment Insurance and Gas Purchase Protection, which reduce exposure to unpredictable weather and volatile market conditions.

Enron Capital & Trade Resources Corp.: (www.enron.com) Offers numerous products based on min./max. temperature, rainfall, etc.

Financial Engineering Associates: (www.fea.com) Berkley-based FEA offers DerivaTool, spreadsheet add-ins and templates to value complex instruments such as weather derivatives (uses Monte Carlo simulation).

FSD International: (www.fsd.co.uk) London-based FSD offers weather derivative-specific software like FSDLib, a components library, whose routines include derivatives of gas, power, weather and interest rates.

Koch Energy Services: (www.kochweather.com) One of the prominent market makers, Koch offers financial products for swaps, collars, floors, etc. Also combines weather and price risk management tools, combines weather tools with physical transactions and barters unused physical options for weather protection.

Natsource: (www.natsource.com) A major New York-based OTC broker of energy products, Natsource puts together deals in natural gas, coal and electricity and their derivative financial products (swaps and options), as well as financial products derived from the weather and the environment.

Southern Company Energy Marketing: (www.southernco.com/site.scem.weather.asp) SCEM has developed hybrid products, which include a weather element embedded in a more traditional commodity instrument. Advanced weather-related products include Ensured Throughput (ensures that a provider meets minimum revenues in a period) and Ensured Energy (supply contracts whose volume or price is tied to the energy providers` physical need for the commodity).

Teknecon Energy Risk Advisors, Inc.: (www.teknecon.com) An Austin, Texas-based energy risk advisory firm specializing in client-focused solutions for risk management problems, including weather risk.

WeatherWise USA, Inc.: (www.weatherwise.com) A Pittsburgh-based underwriter of consumer risk, WeatherWise offers services and proprietary software products that reduce weather-related financial risks for energy consumers and others. Offered through partnering with energy retailers, the WeatherProof Bill tenders a pre-determined, guaranteed billing amount for heating and cooling.

Click here to enlarge image

Problem: An electric utility in the Hartford, Conn., area experiences large decreases in revenues during mild summers due to low cooling loads, significantly impacting earnings per share and putting downward pressure on its stock price. Each lost cooling degree day in the summer (below normal) decreases earnings by about $50,000. Solution: A guaranteed cooling degree day mild summer weather option which pays $50,000 per cooling degree-day below the strike for June through September.

Weather station & weights: Hartford, Conn. (HFD); Option period: June-September; Option payout unit: $/Per cooling DD below strike; Strike total CDD: 620; Number of options (@$1.3 million each): 1

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The Clarion Energy Content Team is made up of editors from various publications, including POWERGRID International, Power Engineering, Renewable Energy World, Hydro Review, Smart Energy International, and Power Engineering International. Contact the content lead for this publication at Jennifer.Runyon@ClarionEvents.com.

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