What is Weather Risk Management?

What is Weather Risk Management?

The business of weather has two facets:

  1. The management of the financial consequences that adverse weather has on those entities with natural exposure to weather.
  2. 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 whose revenues, costs and financial performance are sensitive to 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 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.

Actual structures may have more features, and some can become quite complicated Also, there are a myriad of sophisticated ways of discussing the benefits of weather risk management, such as establishing a floor for adverse variances or outsourcing contingent capital required to meet the weather risk. However complexly structured and 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. 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.

Example:

Beyond this level of trading is the identification of anomalies within the weather space itself (for example, 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. 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. Example:

  • Risk takers may develop exposures in the upper Midwest to low precipitation (drought insurance)

This 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.Managing Weather Risk

Structuring Basics:

There are a few fundamental steps common to every weather risk management process for buyers with natural exposures to weather:

  • Identify the critical weather variable or variables
  • Identify the impact of the weather variables on revenues, margins, profits and/or costs.
  • Identify a reliable, neutral source of historical data and current recordings of the weather variables (usually a government agency such as the National Weather Service in the U. S., MeteoFrance or the Japan Meteorological Agency)
  • Identify the date period during which the weather variables’ influence is operative (e.g. hot weather influences air conditioning use primarily in the summer).
  • Quantify the relationship between changes in the weather variables and changes in the financial parameter affected by weather.
  • Establish sensitivity to the changes in the financial parameter and translate the sensitivity into terms of the weather variable.

This process is not always straightforward, and it is normally an iterative process. Data quality and availability often are major issues, and the weather exposures of each business segment – e.g. utilities, retail, transportation or municipalities – may have its own idiosyncrasies. Nonetheless, in virtually all cases, these steps are fundamental to assessing the weather risk and structuring a weather risk management solution to manage a concern’s natural exposure to weather. There are three types of weather risk programs, based on:

  1. Aggregate measures of weather variables over a defined period, such as average temperatures, cumulative degree days total snowfall, total rainfall. Aggregate based programs respond to the total of the values of the weather variable – e.g. 40 inches of total snowfall in a season.

The analysis of weather variables and their relationship to financial parameters will identify the type of program which corresponds to the risk.

Aggregate Measures of Weather: Cool Summer and Ice Cream Sales

Aggregate measures of weather, precipitation and temperature affect the supply and demand of a variety of products. Much attention has been devoted to the role of temperature. Utilities, for instance, have been the main purchasers of aggregate temperature structures. Cool summers imply less electricity consumption for air conditioning. For utilities, aggregate temperature is usually determined by the number of Degree Days: Heating or Cooling Degree Days being the difference, respectively, between 65°F and the day’s average temperature. The result of this daily computation can be summed over a defined period to establish whether a season is unusually warm or cool. Utilities are not the only sector for which demand is sensitive to weather. Food, beverages, apparel, chemicals, agriculture and leisure/sport are sensitive to seasonal aggregate measures of weather such as precipitation or temperature.

As an example, let us consider the business of ice cream. Assume that a dairy in the Chicago area reviews its annual sales and sees that peak season sales in the summer are affected by weather. In cool summers, sales drop off; in hot summers, sales peak. Further analysis relates the consumption of ice cream to Cooling Degree Days (CDDs). The more CDDs, the warmer the summer and the greater the sales; conversely the fewer the CDDs, the cooler the summer and the less the sales.

If the dairy pegs its production to summer temperatures, it may find that its sales in cool summers become critically short if the summer is 10% cooler than average during the critical ice cream consumption period (taken to be June 1 – September 15). At this level of temperature, revenues become insufficient to support the business and inventory costs become burdensome.

Further analysis determines that the dairy’s loss of revenues and increased costs are approximated by a lineal relationship between summer coolness (fewer CDDs), expressed in terms of $ddd/CDD. The dairy elects to take to market a structure, based on this analysis, which begins to pay the dairy when the seasonal CDD total is less than 680 CDDs (10% less than the 20 year average) and will pay at the rate of $ddd/CDD less than 680 CDDs until the seasonal CDD total amounts to 375 CDDs, beyond which point it no longer will respond. The 375 CDDs represent the coolest recent summer (1992). Under this structure, for each seasonal aggregate CDD less than 680 CDDs, the dairy would receive $ddd. The maximum payment would be (680 CDDs – 375 CDDs = 305 CDDs) x $ddd/CDD. In this way, the dairy would receive a payment which offsets its loss of revenues and its increased costs due to adverse summer weather. If the aggregate total of CDDs during the summer exceeded 680 CDDs, the dairy would receive no payment. This reflects the conclusion of its analysis that if the summer was warm enough to result in 680 CDDs during the critical ice cream consumption period, the dairy would be able to meet its basic financial targets.

Aggregate Measures of Weather: Precipitation – Agriculture

Farmers in certain parts of the southern United States desire to plant crops as early as possible in the season. If they are unable to plant early in the season, they have to switch their planting strategies and they lose the opportunity to plant two crops. The critical factor is rainfall. If there is excessive rainfall early in the season, farmers cannot work the soil and may not be able to move equipment onto their fields because of the soft ground. Excessive rainfall creates additional expense and lost income.

A farm cooperative offered a program to its members backed by a weather risk structure. If rainfall exceeded 9.5 inches in total in the months of February and March, the farmer would receive a single payment based on lost income and extra expense due to the inability to till and plant in the early spring.
Based on this structure, the program would have paid to the farmers nine times in the last 50+ years.

From the two examples above, it is clear that the logic of aggregate structures translates well to temperature and to precipitation exposures. Aggregate measures of weather risk apply to many other enterprises:

  • Insufficient rainfall requires increased sprinkling of golf courses and other recreational facilities.
  • Snowfall totals affect the cost of maintaining highways in the winter.
  • Combinations of snowfall and temperature are critical to ski resort revenues and the sale of ski-related apparel and equipment.
  • Average wind speeds relate to the general efficiency of wind turbine generated electrical power.
  • The combination of rain and temperature play a meaningful role in determining the demand for lawn fertilizer and swimming pool treatment chemicals.

Adverse Day Count: Agriculture – Corn (Maize) Yields

Temperature is one of the weather variables to which corn (maize) yields are sensitive. Excessive cold at germination and excessive heat in the phases before harvest reduce yields. Any party dependent on the volumes of corn harvested – farmer, grain elevator operator, agricultural credit bank – may look to manage a significant portion of the yield risk by managing the temperature risk through a weather risk management structure.

Taking the various elements into account, such as local climate, farming practices and seed varieties, the buyer brought together the following critical information:

  • Season: April 15 – October 31, in which cold temperature risk prevailed up to the middle of June and hot temperature risk commenced towards the middle of June.
  • Expected (Average) Cold Days: 5 days with average temperature < 32ºF.
  • Expected (Average) Hot Days: 3 days with average temperature > 95ºF.
  • Impact of early season cold: loss of x bushels of grain equivalent to $20,000 revenue iro harvested corn for each Cold Day.
  • Impact of mid-late season heat: loss of y bushels of grain equivalent to $30,000 revenue iro harvested corn for each Hot Day.
  • Historical maximum number cold days: 15.
  • Historical maximum number hot days: 13.

Possible Structure  Type: Count of Adverse Days Adverse Days: Section A: Cold Days: Days with average temperature < 32ºF  Section B: Hot Days: Days with average temperature > 95ºF Risk Period: April 15 – October 31 Section A: April 15 – June 14 Section B: June 15 – October 31 Attachment (Deductible/Priority): Section A: 5 Cold Days Section B: 3 Hot Days Limit: Section A: 10 Cold Days Section B: 10 Hot Days Amounts Payable, in total up to a maxim of $500,000 subject to the limitations below: Section A: $20,000 per Cold Day after the fifth Cold Day in the Section A Risk Period, up to a maximum of $200,000 with respect to Section A. Section B: $30,000 per Hot Day after the third Hot Day in the Section B Risk Period, up to a maximum of $300,000 with respect to Section B. Measurement of Temperature as recorded by the NWS at the Weather Station ___ during the Risk Period and reported by the National Climatic Data Center. Premium: t b d Performance:  The example structure would pay out as illustrated below.    In a hypothetical season the payments might take place as follows:

Section A: 8 Cold Days recorded+

Section B: 4 Hot Days recorded

Recovery:

Section A: 8 Cold Days – 5 Cold Day Attachment = 3 Cold Days x $20,000 = $ 60,000

Section B: 9 Hot Days – 3 Hot Day Attachment = 6 Hot Days x $30,000 = $180,000 Total Recovery $240,000

This payment of $240,000 corresponds to the reduced volume of corn and related loss of expected revenue due to weather factors occurring during periods critical to the growth of the corn plant. This revenue could represent the reasonably expected loss of revenue to the farmer (reduced harvest), or to the elevator operator (reduced volume of grain shipped), or to the processor (less volume of grain available for milling, etc.) or to the bank (unpaid loan installments).

Adverse Day structures have a wide range of applications beyond agriculture, including:

  • Construction: increased costs and penalties incurred due to weather related construction delays: e.g. number of days in which the average temperature is less than 32°F, number of days in which precipitation exceeds ¼ inch.
  • Insurance Companies: weather conditions which result in losses but which are not picked up under traditional property catastrophe excess of loss covers (e.g. days in which the maximum temperature is less than 32°F and there is more than ½ inch of precipitation).
  • Transportation: inclement weather increases operating costs, maintenance costs and costs of delay, or increases revenues (e.g. if rainfall in the Upper Mississippi basin exceeds or is less than a given amount agricultural goods otherwise carried by barge will be carried by rail).
  • Utilities: heat waves or cold spells which require utility to purchase energy on the spot market at times of high demand (e.g. successive days in which the daily average temperature exceeds or falls below a given threshold).
  • Entertainment and Sports: cancellations and delays during a playing season or concert tour (e.g. more than y evenings on concert days in which there is significant rainfall).

o   Sales Promotions: weather risk programs can finance salespromotions for weather sensitive products, such as air conditioners, ski mobiles, or snow tires. The promotions can be constructed around a weather variable, such as: If there are fewer than z days with a maximum temperature greater than 85°F before July 4, customers who have purchased air conditioners before June 7 will receive a rebate of $mmm.If snowfall totals less than 12 inches by December 31, snowmobile buyers – or snow tire buyers – who purchased their vehicles before October 30 will receive a rebate of $mmm.

Adverse Events

The concepts of Adverse Events and Adverse Days are closely related.

Adverse Days operate on the assumption that a certain number of days with weather conditions defined as adverse will take place during a given period. The risk management practice is to make reasonable allowance for the occurrence of such Adverse Days and to secure protection from an unusual number of Adverse Days occurrences. The reasonable allowance usually is the deductible, and the purchase of protection against the excessive condition relieves the buyer from making physical or financial allowance for the contingency.

Adverse Events in the strictest sense imply that the buyer cannot tolerate the presence of the adverse condition at all. Examples:

  • Rainout of a day in a test cricket match, of a World Series game or of a semi-final Grand Slam tennis match means rescheduling with increased costs for the promoter and venue and loss of audience and advertising efficacy for advertisers.
  • High winds during a week in which a contractor is dependent on cranes to complete a work process.
  • Adverse temperatures and/or precipitation on the day when there is to be spraying of fertilizers, herbicides or insecticides.

Adverse Event programs are structured to respond by paying the reasonably established amount of the increased costs and/or revenue loss associated with the Adverse Event taking place.

The logic of Adverse Events brings some participants in the weather risk market to offer capacity for Extreme Weather Events. The thought process is similar to other adverse events, in that programs are structured with respect to storms of a given strength afflicting a pre-defined area. Payments may be in relation to the strength of the storm (e.g. wind speed or category), or they may be digital on the event itself.