What is Weather Risk Management?
The business of weather has two facets:
The management of the financial consequences adverse weather for those with natural exposure to weather.
Commercial trading of weather risk, both in its own right and in conjunction with a variety of commodities.
1. Management of Weather Risk:
Weather challenges a wide spectrum of businesses: utilities, transportation, construction, municipalities, school districts, food processors, retail sales and real estate are simply a start to a long list of sectors whose revenues, costs and financial performance are sensitive to weather. Cold winters result in high heating bills which pressure the budgets of school districts and erode the margins of real estate property operators. Adverse financial impacts result from adverse weather. The weather risk market makes it possible to manage the adverse financial impact of weather through risk transfer instruments based on the weather element – temperature, rain, snow, wind, etc. – which affects revenues, costs or margins. In its simplest form an enterprise affected by weather pays a premium to a risk taker who assumes the risk, defined in terms of a weather element, posed by adverse weather. In exchange for the premium the risk taker, under certain pre-defined circumstances, will pay the buyer an amount of money which corresponds to the loss or cost increase caused by the weather.
Example:
Extremely cold weather increases heating costs for a university.
University budgets heating costs to conform to a winter with a daily average temperature of 40 ºF. University also maintains a modest contingency fund for unforeseen expenses.
University reviews its use of heat and gas consumption and, on the basis of the review, negotiates with a weather risk taker to pay a set amount of $XX,000 per degree should the coming winter’s average temperature fall below 37.5 ºF.
The winter’s actual average temperature was 34.2 ºF.
The risk taker pays the buyer an amount equal to $XX,000 * (37.5 ºF-34.2 ºF).
The university uses this payment to defray the unexpectedly high heating costs, thereby limiting the impact of the extra heating costs on the contingency fund in the budget.
If the winter’s average daily temperature is above 37.5 ºF the risk taker retains the premium. The University’s expenditure for heat has been less than the amount which critically affected its budget.
Actual structures may have more features, as you will see from the case studies to be found elsewhere in this section of the website. Some structures can become quite complicated: multiyear with variegated payout schemes and financially engineered premium provisions. There also are a myriad of sophisticated ways of discussing the benefits of weather risk management, e.g. establishing a floor for adverse variances or outsourcing contingent capital required to meet the weather risk. In essence, however complexly structured and however sophisticatedly evaluated, all weather risk management structures perform in the same way as the example above of the university seeking to limit the downside consequences of cold weather to its operating expenses.
In summary, adverse weather creates adverse financial conditions, which can be managed by financial instruments or insurance policies built around the weather element to which the buyer is exposed. The outcome of purchasing the risk transfer instrument is to limit the adverse impact of weather on the buyer’s economics and to finance the consequences of adverse weather conditions when and if they take place. Insurers, banks, financial houses, specialist companies and exchanges make their business in assuming weather risks from those with natural exposures, often through brokers and other intermediaries.
2. Trading of Weather Risk
A wide range of capital providers make markets in weather risk per se. The existence of this market makes it possible for risk takers in the risk management market to manage their portfolios of weather risk business and for market participants to find value in the dynamics of the market itself. A risk taker who has, for example, accumulated weather exposures around Chicago, may be able to sell a portion of these exposures to a counterparty who is looking for Chicago exposures or to exchange a portion of these exposures for weather exposures in South Africa, Belgium or Japan in order to diversify its business. Beyond this level of trading is the identification of anomalies within the weather space itself – e.g. aberrant behavior of climatological regions which normally are statistically correlated – which provide the opportunity to create value from the trading of weather risk. This trading activity creates value, increases diversity, restructures weather risk as it exists in the market and facilitates market efficiency within the realm of the weather risk business generally.
Over the last two years the cross trading of weather and commodities has grown significantly, adding a new component to the trading of weather. The two markets compliment and supplement each other in a variety of circumstances. For example, risk takers may develop exposures in the upper mid west to low precipitation (e.g. drought insurance) which may be managed in part by the purchase of calls on wheat prices given that drought usually results in lower than expected supply which usually drives up prices. Commodity traders can stand this thought process on its head to manage their price positions. There are a variety of such combinations in which the two markets interact. Additionally, it is possible to combine weather risk and weather-related commodity risk in bundled or triggered structures which will respond, for example, if winter weather is both exceptionally cold and the spot price of natural gas is unusually high. The combination of weather and related commodity risk adds depth and breadth to the weather market and is the source of innovative products being offered in the native risk management arena. The scope of this trading extends to areas beyond energy and agricultural commodities into stocks and also into new risk areas, particularly environmental risks such as emissions and carbon.
Source:
www.wrma.org