Weather risk management

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Weather risk management is a tool that companies use to offset the risks they can incur from unexpected weather conditions. Weather risk is the potential impact on a business, both with respect to overall profitability or simply success/failure, that relates directly or indirectly to the weather. The U.S. Department of Commerce estimates that nearly one-third of the U.S. economy, or $3.5 trillion, is modulated by the weather. Financial statements are awash with comments such as “income decreased $7.2 million as a result of wetter than normal conditions” or “shipments were down 5.5 percent due the cooler temperatures during the summer months.” In the past, statements such as these were accepted as part of doing business, however, blaming poor results on weather is no longer an excuse accepted by stakeholders.

The most commonly used weather risk management tool are weather derivatives. Weather derivatives are one of the fastest-growing segments of the commodities market. [1] These financial instruments are used by companies to hedge against the risk of weather-related losses. Another type of weather derivatives product is a Global warming index, created by UBS in 2007. [2]

Weather risk can be defined as financial gain or loss due to a change in weather conditions over a period of time. That period of time can be hours, days, months, or even years. For instance, an outdoor concert has a period of weather risk over the course of several hours, the time of the concert, whereas a wind-generated power facility may have a period of risk spanning several years.

Managing Weather Risk

Once a company has made the decision to hedge their weather risk, there are several techniques that can be used to managed the risk. The first alternative is to buy an option - a call option protects the buyer in the case of an “excess” amount of weather, such as too much rain, while a put option protects the buyer in the case of a “deficit” of weather, such as not enough snow. Weather options, unlike traditional equity options, have a strike level based on the relevant measure of weather (actual measures such as temperature, precipitation amounts or indexes like heating or cooling degree days).

If the simple purchase of an option does not provide the exact type of protection desired, more complicated structures, such as a collar, can be implemented. A collar is the equivalent of buying a put option and selling a call option with different strike levels, or selling a put option and buying a call option. The advantage of a collar is that the amount of premium is reduced by sharing potential profits, in effect receiving downside protection and giving up some upside potential.

A third alternative strategy is a swap, which is the equivalent of buying a put option and selling a call option (or vice-versa) with the same strike level and premium. With a swap, one party gets paid if the weather is greater than the strike level, and the other party gets paid if the weather is less than the strike level.

References

  1. Weather Derivatives Becoming Hot Commodities. USA Today.
  2. UBS Launches Global Warming Index. Financial Times.

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