Weather risk: Mother Nature is a hot commodity

Around a quarter of the annual economic output of the US, 37% of Germany and 45% of China is sensitive to the weather (see report). The profitability and revenues of virtually every business, from agriculture to energy and entertainment to construction, business survival and prosperity pivots to a greater of less extent on the vagaries of temperature, rainfall and wind. As climate change results in increasingly varied and extreme weather we explore what options are open to businesses (large and small) to manage this important and rising risk.

Why should businesses be concerned?

Weather extremes can have material impacts on a company’s operations, from reducing water reserves needed for production lines, to disrupting the supply chains, or destroying vital infrastructure. In 2011 droughts, floods, hurricanes and other extreme weather cost the U.S. economy at least $55 billion according to the NOAA, with 14 events each costing business in excess of $1 billion.

Extreme weather events can affect the production of commodities like cotton and oil. The devastating drought, and associated wildfires, in Texas and Oklahoma cost American crop farmers $7.6 billion, on top of $5.4 billion in losses to the cotton and cattle industries. Meanwhile hurricanes can disrupt the North American energy industry, since oil and gas production is concentrated in Gulf of Mexico and much of the country’s plants are on the US Gulf coast. Even the threat of a major storm can disrupt supplies, with companies having to evacuate platforms as a precaution.

Extreme weather events and other climatic changes can affect global supply chains. Disasters that hit manufacturing hubs, like the Bangkok floods in 2011, can affect the operations of businesses around the globe. Damage to facilities severely constricted the world’s supply of electronic hard drives. The resulting manufacturing slowdown led to companies such as Intel and Apple to warn of profit losses and industry-wide shortages.

Weather risks affecting business need not relate to specific one-off events but relative changes from the norm. An exceptionally warm winter, for example, can leave utility and energy companies with excess supplies of oil or natural gas. Or, an exceptionally cold summer can leave hotel and airline seats empty leading to a loss of revenue. Although prices may adjust as a consequence of unusually high or low demand, price adjustments don’t necessarily compensate for lost revenues resulting from unseasonable temperatures.

To illustrate the extent that the weather affects various industries the US National Center for Atmospheric Research (NCAR) analysed a range of different sectors in the US economy. It found mining to be the most affected industry (14% each year) with agriculture ranked second at 12%. Other sensitive sectors include manufacturing (8%), finance, insurance, and retail (8%) and utilities (7%). In contrast, wholesale trade (2%), retail trade (2%) and services (3%) were found to be least sensitive.

Why weather risk is on the rise.

Since 2000, the world has experienced 9 of the 10 warmest years since 1880. According to the IPCC (Intergovernmental Panel on Climate Change) climate change will almost certainly bring more record breaking temperatures. Hotter temperatures will likely affect, among other things, food and agriculture production, tourism and human health.

A warming world will heighten some natural variations in climate patterns. In many parts of the world, this will lead to changes in the variability of seasonal rainfall and temperatures, making forecasting and forward-planning more difficult and unpredictable. Climate change will have significant implications for many industries, including agriculture, water supply, forestry and urban planning. For example, India is projected to face heavier monsoon downpours but over fewer days, making the country susceptible to both more floods and more water shortages.

Weather as a commodity

Until recently, insurance has been the main tool used by companies to protect against unexpected weather conditions. But insurance only provides protection against catastrophic damage, covering high risk low probability events. Insurance does nothing to protect against the reduced demand that businesses experience as a result of weather variations.

Increasingly companies have been managing the impact that the weather has on their business through the use of various financial products, commonly referred to as derivatives. Weather derivatives began in 1996 and were used by US energy companies to hedge against the risk that unseasonal temperatures could have on gas demand. According to the Weather Risk Management Association (WRMA) the value of trades in 2010/11 totalled $11.8 billion (note this is down from $45 billion before the financial crisis).

Derivative contracts generally represent a contract to trade a specified quantity of an underlying asset, at an agreed price and time. The term “derivative” is used as they derive their value from movements in the price of an underlying asset. Weather derivatives derive their value from climatic conditions such as temperature, snowfall, hurricanes or rainfall and form the basis of a contract between businesses.

The most common of these contracts come in the form of either Heating Degree Day (HDD) or Cooling Degree Day (CDD) contracts. The payoff of these contracts is based on the cumulated difference in daily temperatures relative to a certain agreed temperature over a fixed period such as a month. The buyer of a HDD or CDD contract benefits from a positive payoff if cumulative temperature is below or above a specified level. For example a retailer who discovers that sales of hot meals declined by $50,000 each time the temperature rose by one degree over 20 °C may seek to hedge this lost revenue by being a buyer of an HDD contract above 20 °C.

While energy companies are still the biggest users of weather risk related products, construction companies and farmers are increasingly making use of them too. Recent start-ups such as CelsiusPro and eWeatherRisk have enabled even very small businesses to hedge their weather exposure. For example this may take the form of helping a tourist destination hedge the potential lost revenue of poor sunshine during the summer holidays by buying a contract that pays out when there is below average sunshine. As we highlight those businesses such as mining and agriculture are particularly sensitive to the weather and the relationship between weather conditions and revenue are relatively easy to ascertain. With other industries it is likely to be less clear.

The Chicago Mercantile Exchange took weather derivatives one step further and introduced exchange traded weather futures. These are standardised contracts traded publicly on an open market with continuous price negotiation and and transparency. Unlike the adhoc specialised contracts described so far the exchange allows those businesses seeking to hedge and those willing and able to offer a hedge to constantly monitor and change their position as they see fit.

As well as offering markets in HDD and CDD more exotic markets have developed in which businesses can manage business risk. For example if a business based in the US Gulf (say a hotel or a fishing fleet) wishes to hedge its exposure to hurricane damage and disruption they can buy Hurricane Season Maximum options at a specific price that would equate to what the market expects the largest category hurricane to make landfall will be.

Taking out a hedge on climate change

Companies are increasingly waking up to the need, not to just reduce the environmental impact of business but also to adapt to a rapidly changing climate. A 2011 survey of 72 major corporations, for the UN Global Compact found that 83% believed climate change impacts posed a risk to their products or services. The survey found that beyond the most obvious and immediate threats there is not a widespread understanding of what climate adaptation is and what it means for them and the markets they serve.

Uncertainties about the location, magnitude, potential timing and consequences of climate change impacts make it risky for businesses to tackle adaptation on their own, and few good tools exist to help businesses assess climate risks and opportunities.

One potential tool to help manage the longer term risks of climate change for businesses may be the Greenhouse Index developed by UBS. The index comprises a combination of weather and emissions asset classes and, as such, is the first integrated index that allows market participants to obtain an exposure or hedge against greenhouse gas emissions and their impact on the weather.

As businesses become increasingly reliant on supply chains that stretch across the globe, an increasingly volatile and unpredictable climate has the power to disrupt the ability of businesses to deliver. Meanwhile in an increasingly competitive market businesses have realised that even small variations in temperature, wind and other factors can have a significant impact on a firms revenue. Weather risk management products offer an innovative and rapidly evolving tool to help manage risk.

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