And in the green environment, renewable energy sources-hydropower, wind and solar, and even biofuels-carry weather risk. A $200 million wind farm in New Brunswick, Canada, with enough capacity to power 20,000 homes could suffer a loss if its turbines freeze one winter. With biofuels, companies face weather risk involving crops: The weather could be too hot, too cold, not rainy enough or so rainy it causes flooding.
More and more tsunamis, earthquakes, floods and hurricanes are damaging homes, mines and farmland. In Thailand recently, flooding closed down scores of factories and wreaked havoc with companies' supply lines. How much economic growth can be wiped away because of volatile weather?
It's one thing to see bad weather as an inconvenience. But in the business world, Mother Nature's impact is measured in dollars and cents, sometimes big dollars. Just look at what happened last winter when businesses were pummeled by weather.
Indeed, rising demand for protection from such events is propelling more businesses today to respond proactively by using weather risk-management tools-futures contracts, customized over-the-counter derivatives and reinsurance-to protect their bottom line against weather hazards. The insurance industry is embracing these derivatives, and other market players like hedge funds are climbing aboard.
The economic impact of weather is estimated to be $485 billion annually, according to a recent study in the Bulletin of the American Meteorological Society. According to Bill Windle, president of the Weather Risk Management Association (WRMA) and managing director of Woodlands, Texas-based RenRe Energy Advisors Ltd., weather risk is just as important a factor in business revenues and bottom lines as interest rates, exchange rates or other risks. And in some cases, more so, he says: Think Hurricane Katrina or Irene.
"Very few companies would fail to manage their interest rate or foreign-exchange risk," says Windle. "Why would they not focus on the weather?"
"Although it would be challenging for retail investors to buy these products themselves, financial advisors should be aware of their use because many companies that comprise the portfolios of their clients are exposed to the weather, and it's important to understand if and how they are managing this exposure," says Marty Malinow, the CEO of Galileo Weather Risk Management Advisors in New York and a former president of WRMA.
For advisors, the best way to be involved and protect clients is to evaluate companies for their exposure to weather risk and make sure they are doing enough to insure against it. You can determine how weather affects the bottom lines of these companies in their annual reports and other SEC documents.
"When you're evaluating companies, you want to take into consideration their full risk exposure, which may include their weather risk exposure, and what methods or products they're using to mitigate that risk," says Lauren Newberry, the WRMA's executive director.
Companies use such products when catastrophic insurance policies don't cover losses from certain kinds of weather, such as hurricanes, earthquakes, volcanic eruptions and fires caused by drought.
Some companies are even making weather risk part of their marketing. CelsiusPro AG, a weather risk management firm, and Switzerland camera maker Nikon recently hatched a promotion using rainfall data to offer camera buyers in Switzerland a refund for certain periods when the weather turns bad.
Weather risk management tools came into use in the late 1990s. Energy companies and utilities were early adopters and remain major users. Now, forward-looking companies in other sectors such as retail, construction, agriculture, transportation and leisure are also increasingly taking up the cudgel against Mother Nature's furies, using derivatives and recording the results for the shareholders' benefit.
For example, Washington Gas Energy, a subsidiary of WGL Holdings in Washington, D.C., derives a significant portion of its revenues from natural gas it delivers to residential and commercial heating customers during the winter heating season. According to its annual reports, the company received more in payments from weather derivatives than what it spent in premiums in two of the last three years. During fiscal 2008, it received a benefit of $4.6 million (pretax) from its weather insurance (against a cost of $3.4 million in premiums) after facing warmer-than-normal weather, and in fiscal 2010, Washington Gas made $1.3 million over and above what it paid out in premiums.
Meanwhile, Alliant Energy Corp., a public utility holding company based in Madison, Wis., showed in its fiscal 2010 annual report an estimated $1.38 per share of higher revenues "from changes in sales due to weather and impacts of 2009 hedges."
On some occasions, weather-risk protection can pay off in big, unexpected ways. Last winter, one fortunate client of Jeff Hodgson, president of the Chicago Weather Brokerage, reaped a whopping 261% gain on a snowfall trade.
Hodgson primarily deploys his strategies using the CME Group (formerly known as the Chicago Mercantile Exchange). "The trade protected the client from excessively high snowfall, which was the case last winter when Chicago experienced cumulative snowfall in excess of 57 inches, more than 50% over the ten-year average of approximately 38 inches," he says.
In only the third year of trading, volumes in snowfall and options at the CME Group have increased more than 400%, according to Hodgson.
The market works this way: Farmers, energy sellers, amusement parks and travel companies want to off-load weather risk inherent in their companies. Energy seller Con Ed, for example, is looking to protect itself against a cool summer. Weather brokers quantify the financial impact that cool or hot summer temperatures would have. They take on the risk and sell to counterparties who think it will be a sizzling summer.
Such financial products can smooth out the peaks and troughs of company revenues. For example, an energy supplier that would lose money in a cool summer can swap that risk with a company that would consume more electric power for cooling buildings when the weather is hot.
There are two main types of weather derivative contracts. Standardized, exchange-based contracts are executed by a broker through the CME Group on behalf of traders or hedgers having commodity accounts with futures brokerage firms. The accounts of the counterparties are credited or debited according to the fluctuating index values of the weather measurements specifically covered in the contracts.
The second type, the over-the-counter contract, is executed bilaterally between end users and/or reinsurers or hedge fund investors, and is subject to the creditworthiness of the parties. These products tend to be more customized, structured for a specific company's weather risk.
The market for customized weather derivatives grew by nearly 30% in the past year with the overall market increasing by 20%, according to the WRMA.
Weather derivatives are now enjoying significant market growth outside the U.S., particularly in Europe and Asia. Some 63% of last year's 228,000 OTC contracts were written in Europe while just 13% were in 2005, according to the WRMA.
"The international expansion has been very exciting for us," says Windle. "What we're finding in Europe are [brokerages] that pretty much focus on the larger industrial companies. We have other folks in the market who focus on the commercial and retail opportunities, and they've had some success."
For its part, the CME offers more than 71 contracts in 49 cities (26 cities in the United States and 23 outside) and in 13 countries (the U.S. and 12 others), according to Paul Peterson, the director of commodity research and product development at CME Group.
Contracts for wind, solar and hydroelectric energy producers are under consideration, Peterson says. A separate entity, the Green Exchange, focuses on carbon trading.
The weather derivatives allow individuals and companies to benefit when the weather doesn't behave as expected. The summer of 2009, for instance, was an unusually cool period with below-average temperatures during which many crops suffered in yield and quality. Utilities and merchant power generation companies, meanwhile, experienced lower sales during July 2009.
"Industries like energy, transportation, travel, entertainment, recreation, insurance, as well as institutions and municipalities that depend on certain weather conditions can diminish the uncertainty of temperature, rainfall, snowfall, windiness, sunshine or humidity and hurricanes by entering into weather derivative agreements," wrote Scott Mathews, the director of alternative investments at the Dow Corporation, in an autumn 2009 white paper, "Dog Days and Degree Days," that appeared on the CME Group's Web site. (http://www.cmegroup.com/trading/weather/files/WT133_Weather_White_Paper_Final.pdf). "Revenues and expenses can ebb and flow from changing weather, and these dollars can be protected, to an extent, with contracts that span the spectrum from insurance and reinsurance, to futures, options and over-the-counter transactions."
In an October 8, 2011 Wall Street Journal piece, Mathews described how the Minneapolis cooling degree day contract (which allows investors to hedge by adding up the number of additional degrees for a certain number of days of hotter weather) increased by 19.3% during the third quarter. In other words, the weather derivative vehicle, as an investment, outperformed gold, corn and the S&P 500 index, which fell 15.3% during that period.
"Weather futures and options products frequently stand out as one of the most noncorrelated asset classes in the entire spectrum of capital market investments," adds Mathews. "They have a mind of their own, and can't be swayed by fear, greed, legislation or central bank intervention."
These products are not without risk, of course. By some accounts, OTC products offer greater flexibility in specific weather triggers and payment plans, but carry greater risk for end users. Windle, however, thinks the risk is overblown. "The OTC products aren't as risky, per se, and they may not in some cases have as high a credit rating as the exchange, but they still have a quite high credit support," he says.
The other risk the investor has to be concerned about, according to futures broker Mathews, is the risk of the transaction itself apart from the counterparty credit risk.
Bruce W. Fraser, a financial writer in New York, is a frequent contributor to Financial Advisor.