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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
  1. unpaid bills. As result, many LDC companies have subsequently considered hedging the price for some part of their supply portfolio.
  2. Weather Normalization Adjustments ("WNAs") provide the utility recovery of its fixed costs, regardless of volumetric throughput, through a surcharge mechanism. If the weather is warmer than normal, the utility assesses a surcharge for revenues that would otherwise be lost. If the weather is colder than normal, the utility refunds its excess collections.
  3. HDDs are particularly relevant for measuring how warm or cold the winter season is, while cooling degree days (CDDs) perform a similar function for energy companies whose earnings are susceptible to mild or hot summers.
  4. Estimating the correlation between volumes and/or earnings and some measure of the weather is the most common approach.
  5. The example shown in Figure 2 assumed that there was a perfect relationship between earnings and HDDs (corresponding 100 percent correlation). This does not need to be the case. Another company may have earnings that are only 85 percent correlated to HDDs. The company could still significantly benefit from hedging using the pay-off structure in Figure 2(b). In this case, however, it will not be fully hedged.
  6. HDDs are not the only measure of weather relevant to energy companies. For example, low rainfall or snowfall could limit the ability of a hydro plant to deliver energy for a sustained period, due to lack of water. If such a plant also had pre-existing contracts to supply energy it may be forced to buy power in the open market to meet its shortfall. To hedge against such an event, the firm could buy a weather instrument that paid out if the rainfall at a given location fell below a certain amount over a three-month period. While temperature-based contracts remain by far the most popular, the recent WRMA/PwC survey showed that the number of rain-based contracts increased roughly four-fold for 1.6 percent to 6.9 percent between 2000-01 and 2001-02.
  7. An easy way to get a feel for the premium is to estimate what the instrument would have paid out on average over the last 10 years; this is known as the "burn rate." This can be compared with the annual cost of buying the instrument. We have observed quotes for $10,000 to sell an instrument that has a historically expected payout of $5,000 or less. While the last 10 years is not necessarily fully representative of future weather, it is considered important information by the seller when setting the rate.
  8. The buyer is explicitly purchasing the derivative to eliminate or reduce risk. Sellers of such derivatives, on the other hand, do carry significant risk, unless they are properly diversified (e.g. through matching buyers with sellers).
  9. A fair return for a weather derivative is made up of three components: the risk free rate, a premium that reflects width of the HDD distribution, and an additional term that reflects uncertainty over the expected mean of future HDD distribution.
  10. Comment: This refers to six months prior to the winter season, when no meaningful predictions are available. Obviously closer to the winter season, weather