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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

will remain the same. Since the WNA formula assumes that usage and hence earnings will increase, this results in over-refunding by the LDC. This leads to the rather ironic result that an LDC experiencing very cold weather has lower earnings than if the weather had been normal.

At the other end of the spectrum, an LDC may also suffer in very warm winters. If it gets warm enough, consumers may just switch off their heating equipment over a range of HDDs. This can also result in a downward discontinuity in the true consumption per HDD for very low HDDs. In this case a utility's volumes and hence earnings fall faster than the WNA formula anticipates, and so the LDC under-recovers (). 13

Even for an LDC whose WN rates correctly estimate the $/HDD relationship for a given range, the subsequent rate adjustments will not always exactly match lost (gained) revenues when the weather is warmer (colder) than normal. This is because of the phenomenon of declining usage on an absolute basis, and changes in consumption per HDD relationship over time.

Figure 4 shows revenue from residential consumption per HDD over a range of HDDs spanning three years. In this example, the average consumption per customer for a given HDD falls each year. The slope of the line, the heat load factor, represents the consumption per HDD. In our example the slope has flattened over time, corresponding to a reduced heat load factor.

The declining usage for a given HDD will lead the utility to under-recover during normal weather conditions. The utility would need to seek a rate case to recover this loss, something it may not want to do on an annual basis. The change in slope also leads to a change in the consumption per HDD. Figure 4 shows how this could impact earnings for an LDC. The difference between the dotted line and the solid line shows the earnings that would be unprotected if the consumption per HDD changed over time while the WNR structure remained unchanged. In this example, a cold winter results in the LDC refunding too much. 14

Weather derivatives therefore offer a potential complement as well as an alternative to the use of weather normalized rates. For example, an LDC with WN rates that failed at extreme weather conditions could buy a collar that only kicked in during extreme weather conditions, and gave no payout over the range of HDDs where the WN adjustment was effective.

In the current climate, managing earnings uncertainty increasingly is likely to be rewarded by investors. Utilities need to be aware of the different options available for managing weather risk. Weather derivatives could play an important role in managing this risk, provided they are priced reasonably.

  1. Current survey from April 1, 2001 to March 31, 2002. Joint survey by Weather Risk Management Association and PwC.
  2. The ability to pass through commodity costs is not without risks to earnings. When the price of gas rose abnormally in the winter 2000-01, LDCs' pass through of these costs led to a significant rise in