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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

upbeat. "I've been really pleased with the development of [the industry]. We've seen happenings that I think mark a positive turn of events, such as a number of banks coming into the market, like J. Aron & Co., which is the commodity division of Goldman Sachs, and Deutsche Bank."

Clemmons says that now, she talks to a large number of utilities that are saying to her, "My boss has just told me that I need to learn how to put some weather coverage on." As she points out, "[t]hat's a very different conversation than we were having two or four years ago, which was, 'Hey, can we talk to you a second and tell you about what weather coverage is?' So, we've progressed along the learning curve, to where people are asking how can you structure coverage of this risk that is most economically viable for me, instead of asking, 'What are you talking about?' "

The exit of Enron is a prime example of one of those steps back that the market has taken, according to Sweetnam. But Enron is not the only one to leave. Sempra has also exited. Many of the insurance companies have also either exited, or scaled back their participation, due to what Sweetnam calls "disenchantment" with weather risk.

The departure of insurance companies is a problem for the industry, because they provide the "other side" of weather hedges. It's not all gloom-and-doom, though. As Sweetnam points out, other insurance companies are entering the market. For example, in 2000, XL Capital started its Element Re subsidiary, which is now a very active participant in the market. Also, Swiss Re, which had scaled back its weather desk, has refocused and reentered the market.

Liquidity-Is the Glass Half Full or Empty?

One consistent problem that has dogged the industry is liquidity, or lack of it. According to Caifa, concerns about liquidity get voiced in one of two ways: "These are comments I've heard from some of the end-users-'Well if I buy something I can't get out of it,' or 'I might not be able to get a good price.'"

"Lack of liquidity and lack of education seem to be keeping some people from transacting," Caifa says. And now, after scaling back, Swiss Re believes that the weather risk market is "at a point now that we see it has potential again, the market is growing, and we think that we can add tremendous value." He hopes that such value-and increased liquidity-will come from Swiss Re's new auction offerings. Through such auctions, Swiss Re will offer new derivatives based on measures of temperature and precipitation. "By hosting these type of auctions, we're hoping to drive liquidity by offering in effect 'market based pricing,'" he says. In addition, the entry of investment banks into the weather risk space should diversify the industry further, as well as bring in a different client base, "and that's going to help grow liquidity."

Clemmons agrees that expanding the sectors involved will bring more liquidity to the market, though more so for larger transactions. "Where you