Weather / Climate

Introduction to various uses

The Expansion of The Weather Derivatives Market Beyond Energy Companies

By Gautam Jain, Director and David Foster, Consultant, Weather Risk Advisory Ltd

At present, the vast majority of weather derivative deals involve energy companies. An estimated 70-80% of all deals struck have had an energy company on at least one side of the deal. This is no great surprise since the Heating Degree Day (HDD) and Cooling Degree Day (CDD) indices, upon which almost 95% of current deals are based, have been created with energy companies in mind. These indices are very closely correlated with the business performance of energy companies and so it is comparatively straightforward for them to enter the weather derivatives market.

The ever-increasing number of companies offering weather derivatives is driving down cost, and increasing liquidity in the market. This in turn means that corporates from other industries are realising that they need no longer be prey to the vagaries of the weather. However, since the weather exposures that impact upon their financial performance are often difficult to quantify and analyse, many are turning to external consultants to assist them before striking a deal

An estimated 70% of businesses face weather risk in some form, and below are some examples of industry types that can often be held to ransom by adverse weather conditions. It is from these sectors that the new wave of weather derivative hedgers will come.

Despite the wave of technological advances in the agricultural industry, such as using high-yield seed varieties of crops, the weather remains a major risk. From sowing through to harvest; sunshine hours, temperature, precipitation and wind can all affect the quality and quantity of a crop.

The relationship between weather and crop yield is often complex in nature; for example, drought impacts heavily upon water-dependent crops, but at the other end of the spectrum, excessive precipitation can result in flooding and ponding of the soil, leading to a restricted oxygen supply to the roots and a higher incidence of disease.

Fungicides play a vital role in guarding against damage to crops and for the agrochemical industry, wet years result in higher revenues. This is because spores find it easier to survive in wet or humid conditions, so greater quantities of fungicides are sold.

The use of pesticides also varies greatly with climatic conditions. One example of a weather sensitive pest is the cotton boll weevil, which costs cotton producers in the US $300 million a year. The numbers of weevils differs each year, largely due to the severity of the winter, and in extremely cold winters their numbers plummet, directly affecting the bottom line of an agrochemical company.

The viticultural industry is extremely sensitive to the weather. Lack of sunshine exposure and cool temperatures during the stages between pre-bloom and maturation can significantly affect the quality of grapes, and consequently the vintage of the resulting wine. In 1998 California’s production of wine grapes fell by almost 30% and this was attributed to a cool and rainy spring, followed by a very hot July and August. Higher than average rainfall during the summer months can also be very expensive for winemakers as this leads to the grapes rotting on the vines and delays the harvest

Sales of beer drop during cooler than normal summers, and although it is possible to estimate seasonal trading patterns, long-term forecasts are still notoriously unreliable. Apart from the reduced sales, brewers also suffer from cool summers because beer that they cannot sell must be stored at considerable expense. In extreme cases the beer must actually be disposed of, as there is no room to store any more.

Fashion may determine what clothing retailers stock in their stores, but the weather strongly influences what consumers actually buy. If a store is full of beachwear and summer shorts then a cool wet, summer can drastically reduce profits. The converse is true of a mild winter, when the shops are stocking overcoats and thick jumpers. There is no way to guarantee that the seasons arrive on time, but a weather derivative can be structured to offset this risk. However, companies must take care when structuring deals, as figures show that during extremely warm periods in the summer, consumers regard it as too hot to go shopping. Similarly, during very cold, snowy periods in winter, consumers do not want to venture outside. Hence the warm clothes that consumers require to enable them to go outside remain unsold. Clothes can be taken off the shelves and stored but, aside from the financial penalties associated with the cost of storage, it is unlikely that the same items will still be in fashion the following year

The construction industry is highly prone to weather risk. Heavy financial penalties can be imposed for work that runs over schedule, and delays can also cause projects to run over budget. Concrete needs to set at a certain rate to obtain its maximum strength, but if the temperature is too hot or too cold then it sets too quickly or too slowly respectively. High winds mean that labourers cannot work at heights and crane use is suspended due to safety regulations. But perhaps the biggest threat to the construction industry is rainfall followed by freezing temperatures. If water becomes trapped in materials and then freezes it can lead to cracking and the quality of the structure as a whole is greatly reduced. Ice can also result in the ground being too hard to dig.

Theme Parks
In many countries theme parks are open all year round, yet by far their busiest periods are the summer months. Attendance figures are closely correlated with fine weather, where even the lightest drizzle can deter some customers. Those traveling to the park from very long distances may still make their planned journey, but a large percentage of visitors coming from within a certain radius of the park will postpone their visit if the weather is deemed too inclement.

Retail Food and Drink
As supermarkets know, almost every type of food and drink has some sensitivity to the weather, and the UK Meteorological Office’s forthcoming internet service, Engage, has been created to take this concept to new levels of analysis. The system enables retailers to compare sales figures at the individual line level with UK Meteorological Office weather data, in order to make more informed decisions about how past weather has affected stock levels, reordering, promotions and product placement. Although supermarkets have a great deal of weather risk, they also have products with opposite exposures, so it takes detailed analysis to structure appropriate weather derivative deals. For companies specializing in certain types of food or drink, the sensitivity of their exposure to the weather is more obvious.

Roughly 35% of Europe’s leading ice cream manufacturer’s sales of ice cream are made in their third quarter. This equates to 50% of their annual profits from ice cream. Cool and wet summers can wipe out profits and have even been given as the reason why companies have gone into receivership.

The soft drinks industry has a history of sales predictions based on the weather. Some drinks are more dependent on the climate than others, but in general, hot summers mean increased sales. In the UK in 1998, sales of soft drinks fell compared to the previous year and this coincided with a summer that was a lot cooler than average. The poor weather was cited as the main contributory factor.

The retail industry can clearly benefit from weather derivatives by hedging their sales revenues. By removing volatility from sales, companies are able to undertake analysis of individual product performance with a far greater degree of confidence and accuracy. Shareholders and analysts in turn are better able to assess corporate performance, resulting in greater transparency and possibly lower costs of capital for the business.

Beyond hedging
Aside from being purely hedging instruments, weather derivatives can also be used to create marketing tools. The principle behind this is quite straightforward: suppliers add value to their products by taking weather risk away from the consumer. If marketed correctly, the product becomes more attractive to consumers and the supplier can then choose to either raise the sales price – in effect, creating a ‘premium’ product – for the same level of demand, or allow demand to rise whilst keeping the sales price constant. The supplier will then see an overall increase in earnings associated with the product. The increased risk that the supplier takes on is backed out using a weather derivative instrument. The cost of the weather derivative is recouped through the increase in sales revenues. Companies that lead the market in using these initiatives may also find that they obtain significant levels of press coverage, which will raise their profile as innovators and could have knock-on effects on sales.

A second benefit that suppliers may observe is a flattening of the sales profiles over the year. This applies to products that are ‘seasonal’ in nature, particularly where sales are closely tied to weather phenomena. A flattened sales profile brings a number of benefits; these include more consistent production over the year and improved stock holding levels. One of the first companies to adopt this strategy was Bombardier, a Canadian snowmobile manufacturer.

The Bombardier example
Bombardier was a pioneer in using weather derivatives as a means to increase revenues rather than merely stabilize them. Bombardier is a Montreal-based transportation-equipment giant who, in the winter of 1998, offered mid-western buyers a $1,000 rebate on its snowmobiles if a pre-set amount of snow did not fall that season. The company was able to make such a guarantee by buying a weather derivative based on a snowfall index. A standard amount of snow was agreed upon, and for every millimetre under this amount Bombardier received recompense. When the season ended the level of snowfall had been such that no payment was received on the weather derivative. However, Bombardier did not have to pay any rebates to their customers either. The 38% increase in sales generated by the offer easily compensated for the cost of the derivative.

In addition, historical buying patterns had shown high peaks during November and December, typically after snow had fallen during the winter season. Production and stock holding levels had to be geared to address this trend. However, when customers were offered the money-back deal, buying patterns changed with sales occurring between September and December. This change led to a reduction in working capital requirements (due to lower stock holding costs) and less strain on production capabilities. The company therefore benefited from lower costs as well as increased earnings.

There is significant potential for tour-operators to increase sales by offering holidays with a good-weather guarantee. Such a concept could be applied to both summer and winter holidays and in most cases would involve a partial rebate of the holiday cost should there be adverse weather conditions. The tour operator would then strike a weather derivative deal to offset the weather risk he had assumed. Examples would include partial rebates to holidaymakers if a set amount of rain occurred on a beach holiday, or to skiers who were unable to ski on a number of days due to insufficient snow.

The cost of the weather derivative deal could be met in a number of ways through increased sales, by raising the price of the holiday to reflect this novel feature, or offering the weather guarantee as an optional element of the insurance cover.

Market overviews
The US weather derivatives market continues to be dominated by energy companies, but as more and more of them enter, liquidity is increased, bid-offer spreadstighten, and companies from other industry sectors are being enticed into the market.

In contrast to the US market, where the main market-makers are the large energy companies themselves, the European market is being driven by banks and insurers. They already have close relationships with corporates across a wide range of industries and so it will be easier for them to attract a greater variety of counterparties to hedge with weather derivatives.

In Japan there have been a number of weather deals struck and these have almost all involved participants outside the energy sector. Retail companies and ski resorts have transacted the majority of these deals. Japan has embraced weather derivatives without the energy sector paving the way forward, as in the other major world markets. However, with 27% of the Japanese energy market having been deregulated in March of this year, and further liberalisation on the way, the energy companies will soon be entering the market. This is likely to increase liquidity in the market and result in more competitive pricing.

Energy companies play a significant role in the weather derivatives market, due to the high correlation between their exposures and the HDD / CDD
indices. As the market continues to develop however, corporates from a number of other industries that face weather risks will begin to participate in earnest. These companies will obtain financial benefits by using weather derivatives as hedging tools, through a reduction in the volatility of bottom-line performance. This will lead to a lower risk profile for the business overall and a greater capacity to leverage capital.

Innovative marketing approaches using weather derivatives as an effective means of transferring weather risk from customers to counterparty traders will lead to enhanced product value, and may also raise a company’s profile through press coverage, particularly in the early stages when such initiatives are seen as ‘trail-blazing’.

For many businesses outside of the energy industry, the question of ‘whether’ to hedge using weather derivatives is rapidly becoming ‘when’. Those that change their focus later rather than sooner may well end up feeling left out in the cold.

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