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Weather Risk Management for Regulated Utilities

Why hedging can make sense, even for companies covered by weather-normalized rates.
Fortnightly Magazine - October 1 2002

being charged by the seller.

Figure 3 shows how to estimate properly the intrinsic value of various types of weather derivatives. The figure shows that valuing a weather derivative is relatively straightforward in principle. The payoff-function ($/HDD) is simply multiplied by the probability that the HDD occurs, summed over the relevant HDD range. This is not rocket science. The main difficulty, and it can be a real problem, is in estimating the mean and the shape of the true HDD distribution on a going-forward basis.

Sellers of weather derivatives do so expecting to make at least a fair return. 10 The use of multiple bids for the same payout structure is probably the best way for a potential buyer to ensure receiving a fair premium, although at a minimum the buyer should also do a burn rate analysis to check for reasonableness. Ideally, if companies want to be protected, they need to buy early, rather than try to bet on the weather. Multi-year contracts should also be considered, since they ought to result in a lower premium (because for a given expected annual payout, the distribution will be narrower for a multi-year period). However, the recent warm weather may make multi-year deals expensive in the short-term.

Three bids is a useful rule of thumb. Too few bids obviously can lead to a non-competitive price, while too many bids can reduce the interest of potential sellers and move the price against the buyer in the secondary markets. In some cases potential buyers work directly with brokers, such as Aon, Marsh, and Willis, that handle weather contracts. In other cases potential buyers may work directly with one of the potential sellers.

In the end, pricing is a combination of art, science, and what the market will bear. A fair price depends on your view of what the "normal" weather is, since this determines the expected payout. 11 Stung by a succession of recent warm summers, there has been a move by some sellers to try to convince buyers that the last five-year time horizon is more representative of "normal" than the last 10 years. The statistical validity of such a claim is doubtful, and leads to the risk that some sellers may-at least in the near-term-price themselves out of the market.

Understanding Weather-Normalized Rates

For regulated energy companies that are interested in mitigating the impact of weather, the decision on using weather derivatives is more complex than for their unregulated counterparts. This is because, in many areas of the United States, regulated companies also have the option of implementing WN rates.

A recent survey showed that 40 gas companies in 19 states have a weather normalization adjustment (WNA) clause in their rates. This also suggests, however, that a large number of states do not have WNAs. Moreover, some LDCs' applications for WN rates have been rejected, and so for these firms, weather insurance may be the only available alternative.

When a choice is available, the relative merits of using weather derivatives versus weather-normalized rates are not universally understood or agreed upon in the industry.