Weather Risk: Staying Under Cover or Risk Getting Wet?
Evidence of global climate change has heightened interest in the relationship between the environment and the economy. In recent years, many countries have increasingly experienced extreme events, such as tornados, hurricanes, droughts or flooding. The unpredictability of weather is well known but the effect of that unpredictability on your business might not be as well understood.
What is the risk to your company’s bottom line if temperatures rise or fall? The answer is related to the nature of your company’s business. If you work for a corporation that is dependent on crop commodities, for example, then what happens if that crop fails, is delayed or is of poorer quality due to weather conditions, such as extreme rainfall or severe drought? In the final analysis, like other factors, weather poses a risk for many companies. But what, if anything, can you do about it? If you accept that weather is unpredictable and uncontrollable then, like many people, you might conclude there is nothing to be done.
Treasurers are used to managing risks such as foreign exchange (FX) volatility and interest rate change, etc. They do this by measuring their exposure to these variables and then hedging this exposure using financial products. Weather risk, in essence, is no different. The argument gaining ground among many corporates is that it is possible – and indeed necessary – to measure the risk that arises from weather variations.
Consider a beer manufacturer: weather can affect such companies in a number of ways. First, an uncharacteristically hot summer can greatly damage a barley crop (an ingredient of beer). This will result in reduced supply and therefore higher prices, possibly leading to lower demand and lower profits. On the positive side, a hot summer might be advantageous to a beer company in that consumption and, therefore, profits increase, whereas a rainy summer will have the opposite effect.
Both of these scenarios are not simply hypothetical. In 2006, a heatwave in Germany greatly damaged its barley crop. The supply of high-quality barley, which is used in traditional German beer, fell from 1.6 million tonnes to 1.2 million tonnes, resulting in a price rise of over 40%. Again in Germany this year, it has been reported that breweries there sold 4.5% less beer in the first six months of 2009 than in the same period last year due to adverse weather conditions.
So who should worry? Sectors that should concern themselves with weather risk include:
In 2008, WeatherBill published a research report that looked at weather sensitivity in 68 countries. Results showed that countries with extreme temperature variations, combined with high levels of mining and agricultural output, are the most sensitive to the weather. Brazil is found to be the most weather sensitive country and Pakistan the least.
The research also identified the total weather sensitivity in US dollar by country. Not surprisingly perhaps, the US was found to have the most exposure by this measurement, primarily driven by the size of its economy. The numbers, however, are striking: the US was found to have the largest total weather sensitivity, estimated at US$2.5 trillion, or 23% of the national economy. Europe (as measured by figures from Germany, UK, France, Italy, Spain and The Netherlands) came a close second at US$2.4 trillion and Japan third at US$1.2 trillion.
The WeatherBill research confirms that the numbers at stake are high and should not be ignored by corporates, rating agencies, banks or any other interested financial parties.
The traditional definition for the management of risk in companies requires the risk manager to mitigate, eliminate or transfer undesired and non-strategic risks. This process comes under close scrutiny by treasurers and chief financial officers (CFOs) who are used to having to manage such market risks and then to communicate to the banks and the investor community the full extent of the risks they are taking. Failure to hedge financial risks will lead to lower ratings and can seriously affect the value of a company’s share price. So the question that arises, given the above and other research, is why weather risk should be treated any differently to other risk or indeed more often be ignored?
The issue regarding weather is that, because investors and analysts are not aware that weather risks can be hedged, they do not penalise corporates for a risk type that they feel is out of their control.
The first step in the process is to understand how exposed your company is to the weather – in other words, measure the exposure as accurately as possible by establishing a link between the weather and your company’s cash flows. Studying weather patterns from previous years and correlating these against turnover will help form a picture. You will be surprised at just how much information is available to assist you with this process, with organisations, trade bodies, etc providing good information on rainfall, temperatures and wind speed.
It also might surprise you to discover that weather can be traded like any other financial instrument. There are a number of ways of doing this.
Weather derivatives are bilateral futures contracts that are accounted for based on atmospheric conditions, wind speed or rain. Typically, these instruments are used for managing non-catastrophic weather risk; by this is meant the financial exposure of a company to such weather conditions like heat, cold, wind, snow or rain. This definition can be expanded to mean the financial gain or loss arising from movements of daily weather. The cash flows resulting from weather derivatives are based on weather conditions specified in the contract. For instance, a company will receive a payment if the number of sunny days is less than 20. This might offset the loss that a brewing company will incur from a cold summer.
Companies can limit their exposure to weather risk by buying a weather derivative, thereby transferring the unwanted risk to the financial markets. The derivative transaction can be a forward, futures, swap or option contract. Such products have been around for at least 10 years and are offered by banks, insurance companies and specialist providers, such as SwissRe, RenaissanceRe and Galileo Weather Risk Management, to name but a few.
Large insurance companies also offer policies to businesses in the event of a financial loss due to adverse weather conditions. Similar to other insurance policies, a claimant must follow a claims procedure to receive compensation.
In the past couple of years, WeatherBill has begun to make a name for itself by selling coverage that pays out solely on the basis of weather measurements. Its customers can purchase this coverage solely as a commercial hedge against a weather event that, if it happens, would have a material and financial impact on their business operations. The difference between this and regular insurance is that there is no claims process and no proof of loss is required. What is unique about this service is that it allows businesses of any size to price weather risk online and instantly purchase weather coverage to reduce that risk. In the past, it was a very cumbersome process to hedge weather risk, and derivatives contracts were almost always only available for very large companies able and willing to hedge millions of dollars.
Although there are a number of cost-effective ways to hedge weather, the issue seems to be that many companies are just not aware of the available products and have not measured the potential size of the problem that exists within their company.
The other problem seems to be in the accounting for weather risks. The question here for treasurers of public companies is: how do they show that the purchase or sale of a derivative instrument is true and fair hedge and not speculation? The dilemma seems to be that despite economics dictating that weather needs to be hedged, accounting boards have not caught up with this by generating standards for the industry. The International Accounting Standards Board (IASB) urgently needs to provide a set of procedures to account for weather exposures and weather hedging products.