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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

Some companies use weather derivatives, (e.g., Washington Gas), some use WN rates (e.g., Piedmont Natural Gas), some use neither (e.g., Cascade Natural Gas), while some do both (e.g., Atmos Energy). To understand the relative merits of WN rates and weather derivatives, it is necessary to briefly review how LDCs recover rates and how WN rates work.

While most of a utility's operating and capital costs are typically fixed in nature, less than half of these fixed costs of providing service are recovered through fixed charges. A significant amount of these costs are recovered volumetrically in the utility's commodity rates. These volumetric unit rates ("commodity rates"), used to recover the balance of fixed costs, are usually designed based on "normal weather," using a 30-year average number of HDDs and calculating a heating-load use per HDD. As a result, when the weather is warmer (colder) than normal, the utility realizes less (more) revenues than it was designed to recover in its fixed costs, regardless of whether it utilizes flat commodity rates, or declining block commodity rates. 12

A WNA is one type of mechanism that may be employed by the utility to recover revenue under-collection or refund revenue over-collection. If the mechanism works perfectly, it is effectively a costless swap; the utility's variable weather-dependent earnings are replaced with fixed earnings. ()

WN rates have many of the characteristics that we have already discussed for weather derivatives, including more stable earnings, better debt ratings, and less need for short-term cash. The main advantage of WN rates compared to weather derivatives is that there is no premium required from shareholders. However, a potentially significant disadvantage is that WN rates do not provide a perfect earnings hedge, particularly in extreme weather conditions. Additionally, as swaps, WN rates do not allow the utility to choose to take upside risk. Table 1 outlines the pros and cons of using weather derivatives vs. weather normalized rates.

Discussions with clients suggest there are two distinct ways that WN rates can fail:

  • Simple linear WN rates formulas do not capture extreme conditions; and
  • WN rates formulas are not forward looking, so they do not reflect changing conditions over time.

Where WN Rates Breaks Down

The first way WN rates can fail reflects the tendency for regulators to seek simple rules. As a result, many LDCs have simple rate adjustment formulas that assume that the consumption and $/HDD relationship is linear (). This may work well for weather conditions that are 10 percent warmer or 10 percent colder than normal, but might not be true if the weather conditions are more extreme (e.g., 30 percent warmer or colder than normal). In extreme temperature conditions the consumption and hence $/HDD can become non-linear. This can result in LDCs under-recovering in very warm winters and over-refunding in very cold winters.

In the case of a really cold winter, the actual change in consumption per degree-day can fall. One reason for this is that when it is extremely cold, a consumer's heater may be operating at its maximum output. If it then gets colder, gas usage