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Temperature, Price and Profit: Managing Weather Risk

Fortnightly Magazine - September 1 1998

naturally begs the question: Will customers continue to accept energy bills that reflect volatility caused by weather?

WeatherWise, an underwriter of consumer weather risk, has found most residential customers are willing to pay up to 6 percent in fees for the security of a flat, guaranteed energy bill. In turn, of those customers seeking a flat or guaranteed bill, WeatherWise found that 6 to 15 percent were willing to pay for capped weather products, but the company expects that acceptance of its new Weatherproof Bill product offer will eventually hit as high as 30 to 40 percent.

Already, WeatherWise claims that residential energy customers (less than 10,000 total) are using the product under experimental programs or fully implemented arrangements in Massachusetts, Wyoming, Nebraska, Pennsylvania, Illinois and Kansas. Residential clients using Weatherproof Bill outnumber small commercial users by a ratio of nine to one.

"Since a multi-billion dollar market has grown up to cover consumer price risk, we'd expect the market to grow up and offer consumer weather risk,"says Rand Warsaw, WeatherWise operations vice president. "Now that the markets have developed there's no excuse not to manage weather risk, just like you manage price risk."

Considering that weather-driven fluctuations in heating bills can run as high as 20 to 25 percent, and price-driven factors can pump fluctuations up 40 to 50 percent, most consumers still don't understand that when their bill goes up in the winter time, it's weather related, explained Brad Beorn, another WeatherWise vice president. Unaware of what drives their energy bill, consumers embrace a natural tendency to accept protection against "unknown" forces. To illustrate this tendency, consider that some 80 to 90 percent of Americans hold fixed-rate mortgages, although adjustable rate mortgages can offer a better deal.

Although consumers may not understand what drives their energy bill, power and natural gas utilities make it their business to understand what drives their unique commodity-driven costs and their earnings.

A Sunny Forecast? Some Predictions

One argument you'll hear when weather risk management is mentioned is that it sounds almost too much like insurance. In fact, weather risk products are alternatives to traditional insurance products in that they are contracts based on a difference in terms.

"Weather risk is a contract of difference, not a contract of indemnity," says Tripp Dunman, Aquila Energy director of weather marketing. "There's no damages, harm or loss. It's merely the pay off in a discrepancy in weather, based on data provided by the National Weather Service, and the negotiated strike price. Unlike insurance, there's no messy claims dispute - it pays in five days. That's it."

There are also standardized documentation and a specified confirmation process governing the settlement process, Dunman adds.

Another criticism leveled against weather-risk management is its liquidity limitations (a "nascent" market) and unique, yet singular, influence on volumetric risk: "The biggest criticism I hear about weather risk is that it doesn't manage the dynamics between price and volume," says Lynda Clemmons, director of Enron Capital & Trade Resources. "Well, no, it doesn't. It's only a piece of the risk pie. It has to