Common objections to weather hedging products include:
- "We prefer a more conservative approach. Hedging with derivatives is too unorthodox for our company."
- "We use weather normalization to manage weather risk."
- "We tried it once, but the option didn't pay out."
- "We looked into using weather derivatives but found them too expensive."
- "The choice of available instruments isn't sufficient to cover our needs."
- "We simply don't have the expertise or capability in-house to effectively use weather derivatives."
Most if not all of these reasons would have been sufficient to dismiss the bottom-line benefits of weather derivatives a few years ago, when the market was in its infancy, but the current market has overcome the objections. How? Let's analyze each of these concerns.
We prefer a more conservative approach. Hedging with weather derivatives is too unorthodox for our company.
In fact, "derivative" is just another name for a future or option contract, trading concepts that have been around for a very long time. Futures and options are integral components to many markets, since they enhance market dynamics and provide a hedging mechanism to protect against setbacks.
To set the record straight; derivatives are simply a more general form of futures and options. Derivatives are not inherently bad, unsound, or unorthodox. Derivatives serve a vital role in many markets and have been widely used as effective hedging instruments for years.
Originally, futures and options were based on traded commodities, such as crops and other natural resources. Over the past decade, the concept of futures and options has been extended to other markets, such as credit, currency, and weather. In the course of applying the concepts to these new markets, "derivative" has become the term of choice.
So derivatives are not all that unorthodox. Many, however, perceive the term as involving high risk. Two events in recent market history might have been the cause for this common, yet false, impression: the failure of major hedge funds in the 1990s, and the failure of Enron, which traded in weather derivatives. In both cases, derivatives were associated with the unethical business practices of a limited number of corporate officers.
We use weather normalization to manage weather risk.
Most regulated utilities use weather normalization to stabilize consumer costs and utility revenues. But weather normalization falls short in protecting utilities and their shareholders from many weather risks, such as successive cold summers or warm winters, and short periods of extreme adverse weather.
At the recent Weather Risk Management Association conference, Bill Zorr of Alliant Energy in Wisconsin presented information showing how his company uses weather derivatives in conjunction with weather normalization to manage weather risks for customers and shareholders.
In Alliant's case, weather normalization is based on 20 years of weather data. Rates are set, in part, by the statistics on the weather during that 20-year period. As long as every season is near normal, weather normalization provides stability for Alliant Energy shareholders and consumers. When the weather takes a significant departure from normal, either in duration or magnitude, consumers are relatively insulated, but Alliant faces significantly increased weather risk. Alliant uses weather derivatives to hedge this risk, resulting in more stable profit margins.
Alliant first looked into using weather derivatives in the mid-1990s but found the set of options limited and expensive. However, as the weather derivative market grew, the cost of hedging was reduced and the range of products increased. Hedging with weather derivatives became a viable solution for Alliant.
We tried it once, but the option didn't pay out.
The primary function of weather derivatives is to hedge risk, not to extend profits. Bailing out of weather derivatives because they didn't pay out on the first try is like canceling life insurance because it has not paid out.
We looked into using weather derivatives but found them too expensive.
Take another look. In the early days, the cost of derivatives was quite high. Many companies came to the conclusion that is was better to bank the premium and keep the risk. Today, however, the weather market is more robust, more efficient, more liquid, and less expensive.
The choice of available instruments isn't sufficient to cover our needs.
As the weather market has grown over the years, so has the range of available products. Between the Chicago Mercantile Exchange and numerous over-the-counter products, utilities can almost always find a contract to serve their needs.
We simply don't have the expertise or capability in-house to effectively use weather derivatives.
With so many factors affecting the utility industry today, it is more difficult to maintain robust margins. In this light, utilities should be taking all reasonable steps to protect their margins. If your utility does not have the capability to implement a weather derivative risk management strategy, you may want to consider building this capability.
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