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The Perils of Ignoring Mother Nature

Experts say utilities' inconsistent approach to weather risk is costing them dearly.
Fortnightly Magazine - May 15 2002

time to understand where their risks are, from an operational standpoint how the weather affects [them], then there would be no reason for them not to look at us as an industry and not to hedge those exposures," he asks.

Weather Risk Management: Real Market, or Marketing?

For the few years the weather risk market has existed, the growth of the market has been anywhere from 50 to 100 percent annually, which may sound far too reminiscent of dot-com growth rates for many.

Tobben says that the weather industry, and such growth rates, are not the latest fad. "I think if you look at the overall risk profile, even of the United States GDP, the U.S. government estimates that 10 to 15 percent of the GDP is directly impacted by weather. You put a 10 trillion GDP number up to that, there's actually a lot of opportunity." He says, "there is real value creation, it's not just a concept and getting people to click on your Web site." With weather risk, companies are able to hedge risk and manage their financial portfolios more efficiently.

The existence of an entire industry devoted to hedging risk related to weather struck many as absurd, initially. In 1996, the energy industry had just started to deregulate, and statements like "the company reported a fourth-quarter loss of $44.9 million, or 84 cents per share, because mild weather lowered the demand for electricity," were not only common, but palatable to public utility commissions and shareholders.

Weather risk management has definitely emerged from infancy. Players in weather risk now get questions like "What kinds of products does your company offer?" as often as they get "What is it again that you do?" Liquidity is increasing. Despite the demise of Enron, or perhaps even because of it, investment banks and other new players are entering the industry. And perhaps most surprisingly, Europe isn't just sticking a toe in the weather risk pool, it's diving in head first.

Which isn't to say that weather risk management is jogging along confidently. Some important players have exited the market. Liquidity may be growing, but it still has a ways to go. In 2000, the overall size of the industry shrank, and it's not clear that 2001 will be a significant improvement when those numbers become available in June. Likewise, the consequences of the exit of one of the founders of the weather risk industry, Enron, remain murky.

Two Steps Forward, One Step Back

Weather risk management sprang into existence in 1996, when Aquila signed a deal with Consolidated Edison Co. of New York in which pricing of the power bought from Aquila was indexed to the weather. Shortly thereafter in 1997, Enron arranged a weather swap with Koch, according to Tobben. "We can both claim to be first," he says.

The two companies were the leaders in the nascent weather risk industry. Aquila claims that it had a larger share of the business than did Enron-and of course, with Enron's demise, there's not going to be a lot of bickering on that point