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Temperature, Price and Profit: Managing Weather Risk

Fortnightly Magazine - September 1 1998

natural gas as a function of HDD was 92 percent (see Chart 1).

Modeling of natural gas prices shows that 10-percent colder than normal temperatures in summer can decrease spot prices by 15 percent, or about 35 cents per Mcf (assuming no extraordinary storage and using normal temperatures for baseline assumptions), according to David Costello, senior economist in charge of short-term energy outlooks at the Energy Information Administration. Other research at EIA indicates that if average heating season temperatures rise 1.43 degrees Fahrenheit above normal, the drop in demand for natural gas will outweigh the increase in demand that occurs naturally each year to satisfy economic growth, thus forcing prices down overall.

Spot markets are not so well developed in electricity, with weather-related price effects more likely to be short-term and regional. Weather-related effects on demand naturally depend on the size of the distribution system and number of customers. Peter Nance, president of Teknecon Inc., notes that, depending upon the season, geographic location, fuel mix and size of the utility system, a movement up or down on the thermometer by one degree Fahrenheit can raise or lower electric demand for an electric utility by anywhere from 50 to 500 megawatts.

Moreover, while both power and gas utilities are affected by volatility in usage, electric utilities have a singularly unique position of further weather risk due to high costs involved in production and inter-day spikes in demand periods. Electric utilities are also affected by short-term extreme events, says Lee Branscome, president of Environmental Dynamics Research. He adds this is true especially when there are abnormally high temperatures for a few consecutive days.

In other words, if Houston has a week-long hot spell at 110 degrees, and the remaining three weeks are a temperate 65 degrees, the month's average is 71 degrees. Yet a utility's economic profile containing the severe peaks in Houston will be very different from a month of 65- to 70-degree weather. You can liken it to putting one foot in a bucket of ice water and another foot in a pail of boiling water - it may average out, but it's certainly not equal. Plus, unlike natural gas facilities, electric-only utilities may also suffer in utility load protection from large errors in temperature forecasts over a short period of days, Branscome explains.

Electric utilities also exhibit a heightened weather sensitivity in the summer, unlike natural gas utilities, which exhibit more exposure during winter weather months. Hydroelectric utilities are affected not only by temperature anomalies, Branscome notes, but also by snow and rain anomalies.

Given all these variables, it should come as no surprise that interviews with executives at gas companies reveal a wide range of estimates on the effect of weather on utility profits. Estimates of profit sensitivity per heating degree-day can range anywhere from $500 for a "small" gas utility; to $5,000 to $25,000 for an "average-sized" utility; and to $150,000 and up for a "large" utility. As for the typical residential gas customer, risk sensitivity appears to average about 10 cents per heating degree-day.

In Pennsylvania, Petrowski says