Weather Derivatives -- Volume risk management tool

If changes in weather affect your business, this may help you.

Two years ago, the primary focus of risk managers was the price risk. They used financial derivatives to hedge risks arising from volatility in price, interest rates, and foreign exchange. 

Consider the following equation --  

Earnings = Price * Volume of Production 

There are many tools for managing the price risk. Risk managers however, largely concentrated on price and ignored risk due to the uncertainty in volume of production. This led producers and manufacturers, to instances where output did not follow the expected demand for the product. 

The need for a new instrument was felt in the US, where not only the price volatility but also the seasonal demand affected the energy industry. Many companies, which were affected by seasonal fluctuations, decided to hedge the risk by a new instrument. This led to the innovation of weather derivatives. Enron introduced the Weather Risk Management Products (WRMPS) in 1997 that resulted in significant cost savings and a more stable revenue flow. 

What are Weather Derivatives? 

You make every possible effort to run an efficient operation. Yet, an unusual winter or an extraordinary summer could ruin your careful planning, driving up costs or depressing demand. 

Businesses such as agriculture, power generation, oil exploration, tourism, insurance that are adversely affected by unanticipated changes in weather, use weather derivatives to hedge against the vagaries of Mother Nature. 

‘Futures’ and ‘options’ are used to hedge risk, arising from the volatility in price of equities, commodities, interest rates and foreign exchange. Similarly, weather derivatives are financial instruments that cater to stabilise volatility in revenue and expenses, caused by unpredictability of weather conditions.  

Who will benefit from WRMPS? 

Agricultural volumes are affected by rainfall, temperature, and other weather phenomenon. Consider a farmer who has sown a particular crop, but is not sure of the price his produce will fetch at the time of harvest. To hedge the price risk, he enters into a futures contract at a particular price. However, if he is not sure of the volume of the produce at the time of harvest, he can hedge using weather derivatives. Draught and floods may adversely affect the volume of production. In such a case, the farmer has to buy the shortfall in produce from the market at higher price to honour the forward contract.  

Enron’s weather risk management programme may also benefit the following organisations:

• Utility and energy companies can protect their volume-related revenues against unnatural weather phenomenon such as cooler than average summers or unusually warm winters. They will not be forced to raise rates in an increasingly competitive market.
• Distributors of crude oil, heating oil, and propane can make up for reduced business in the winter, when warm temperatures depress their demand.
• Agricultural companies can minimise the uncertainty in revenue due to flood, freeze or drought, adding stability to an inherently unpredictable business.
• Insurance companies can reduce their own exposure to weather-related claims. Risk products tied to rainfall, for example, can provide the funds to pay flooding claims.
• Financial institutions can incorporate WRMPS to broaden a client's portfolio.

Weather Risk Management Products (WRMPS) 

Weather Derivatives are similar to other traditional financial derivatives like futures, forwards and options except in terms of underlying variables. While other derivatives derive their value from underlying financial assets such as commodity or index, weather derivatives derive their value from certain measures of weather such as Temperature, Precipitation, Wind Speed, Rainfall, etc. 

The measure could be the number of Heating Degree Days (HDD) or Cooling Degree Days (CDD) based on the average temperature or maximum/minimum temperatures observed with respect to a particular location. On the other hand, it could refer to the amount of precipitation per day, week, month, or season.

The Business Standard, 19^th August 2000, reported that dry weather conditions prevailing in some coffee growing regions of Southern India during July-August 2000, would hit the country’s coffee output for 2000-01. The impact of the dry weather that lasted for nearly 25 days would certainly affect the vegetation.” Hence, It is likely that, revenue of coffee estate owners may be affected. In such situations, weather derivatives could prove a very useful tool.  

Conclusion 

Weather derivative products are becoming an integrated aspect of risk management for utilities, retailers, agriculture, municipalities, insurance companies, beverage companies and a variety of manufacturers. These industries have one common characteristic – correlation between earnings and the weather. Weather derivatives help to compensate financial losses in case weather adversely affects financial performance. 

Related reading
“Weather derivatives”, www.gtnews.com
“New Kid on the Block”, Chartered Financial Analyst
www.fenews.com