[BETA] Fortnightly

Experts say utilities' inconsistent approach to weather risk is costing them dearly.

Energy companies know intimately that millions of dollars of their revenues depend on cold winters and hot summers. And while weather risk management tools-specifically, weather derivatives and weather insurance-have been available since the mid-1990s, some utilities do not seem convinced of their value.

Perhaps one of the most surprising examples is Duke Energy, whose first quarter profits fell 17 percent due to a mild winter and a weak economy that hurt demand for natural gas and electricity. Duke's regulated utility earnings before interest and taxes (EBIT) declined a whopping $189 million in 2001 from the previous year. According to the company's annual report, about one-third of that decline is attributable to "much milder weather" in the utility service territories during the last quarter of 2001.

But Duke is not alone in taking a hit in revenues due to a mild winter in 2001. In SEC filings, Aquila reported, "Key factors affecting lower first-quarter 2002 results were lower prices and volatility ... also impacting results were warmer-than-normal weather." Equitable Utilities, a subsidiary of Equitable Resources, had EBIT of $79.0 million for 2001, compared with $93.0 million for 2000. "Heating degree days were 5,059 for 2001, which is 10 percent warmer than the 5,596 degree days recorded in 2000 and 15 percent warmer than the 30-year normal of 5,968. The warmer weather had a negative year-over-year impact on net revenues of approximately $7.8 million," the company said in a February statement.

Similarly, Peoples Energy reported that operating and equity investment income was $60.8 million for its first quarter, compared to $73.5 million for the first quarter of fiscal 2001, as restated. "First quarter results were negatively affected by extreme weather that was 18 percent warmer than normal and 29 percent warmer than last year," the company said in a January statement.

To some companies, though, a mild winter is not a revenue disaster. While normally a gas company would expect to take a hit during a mild winter like the one Washington, D.C. just experienced, Washington Gas Light instead expects to take $8.8 million to the bank in 2002, after taxes. Weather insurance paid off big for the company, because temperatures in 2002 have been 14.7 percent higher than normal.

To his surprise, Glen Sweetnam, managing director of the weather risk management group at Reliant Energy, says he still sees clients who still come in and out of the market for weather risk management-without any consistent approach.

Dr. Jerry Skees, H.B. Price professor of agriculture policy and risk at the University of Kentucky, says the phenomenon can be explained in terms of the psychology of denial, seen often in another weather dependent industry-agriculture.

In a 1989 study with western Kentucky farmers, just after the worst year on record due to drought, Skees found that despite the financial loss, farmers were not willing to accept that things could get worse. Certainly, not disastrous enough to put them out of business, he says.

The psychology of focusing on the price of weather hedging distracts