[BETA] Fortnightly

Why hedging can make sense, even for companies covered by weather-normalized rates.

Weather risk management is growing, but utilities may be losing out.

A recent survey suggests that the number of transactions involving financial derivatives to hedge weather-related risks grew by 43 percent against the prior year for the twelve months ended March 31. ¹ Yet regulated utilities continue to show reluctance to embrace weather derivatives.

For regulated utilities, the risk of volatility in commodity costs may be passed directly through to retail customers, using rate-making tools such as a purchased fuel adjustment clause. ² That leaves sales volume as the most important weather-related risk factor for utilities. Nevertheless, some utilities believe they have a good alternative to weather derivatives. That alternative comes in the form of weather-normalized (WN) rates approved by the state public utility commission. ³

Are the utilities right?

In this article we compare WN rates with various types of financial derivatives for hedging the weather, taking as an example a typical natural gas local distribution company (LDC). We show why WN rates fail to insure against some specific weather-related types of earnings risk. We also show why weather-related derivatives might in fact make sense in some cases for a regulated utility covered by WN rates.

Of course, recent market failures in the energy industry have spawned a tightening of credit that has led a number of energy trading and marketing companies, such as Reliant and Aquila, either to exit or sharply curtail their activities. Their place is being taken by financial institutions, primarily (re)insurers such Element Re and Swiss Re, expanding from insurance into the derivative market, and by banks like Société Générale.

But these events should not color our analysis of WN rates and weather hedging. That analysis begins with some general principles to help energy companies quantify weather risk and calculate the value of a weather-hedging derivative. After that, we examine how WN rates protect utilities from weather risks in some cases, but not in others.

Quantifying Weather Risk

The Heating Degree Day ("HDD") ⁴ is commonly used in the utility industry to quantify weather and measure how earnings are related to weather. ⁵

Correctly estimated, HDDs often show a remarkably linear and tight relationship to volumes and earnings over a significant range of HDDs. Although linearity is not crucial, the tightness of the fit (i.e., the standard deviation of volumes consumed for a given HDD) is important. Since weather varies widely by location, it is important to determine the company's volume to HDD relationship by aggregating on a location- and business segment-weighted basis. Figure 1(a) shows the volume to HDD relationship for residential customers at a variety of locations. Figure 1(b) shows the load-weighted volume to HDD relationship. The load-adjusted $/HDD relationship is what should be used when considering weather protection.

An energy company wishing to protect itself from this weather variability can buy a weather contract that provides a pay-off in the event of unfavorable weather. This type of weather derivative is commonly called a "floor," and requires a premium. In the alternative, a