Experts say utilities' inconsistent approach to weather risk is costing them dearly.
Energy companies know intimately that millions of dollars of their revenues depend on cold winters and hot summers. And while weather risk management tools-specifically, weather derivatives and weather insurance-have been available since the mid-1990s, some utilities do not seem convinced of their value.
Perhaps one of the most surprising examples is Duke Energy, whose first quarter profits fell 17 percent due to a mild winter and a weak economy that hurt demand for natural gas and electricity. Duke's regulated utility earnings before interest and taxes (EBIT) declined a whopping $189 million in 2001 from the previous year. According to the company's annual report, about one-third of that decline is attributable to "much milder weather" in the utility service territories during the last quarter of 2001.
But Duke is not alone in taking a hit in revenues due to a mild winter in 2001. In SEC filings, Aquila reported, "Key factors affecting lower first-quarter 2002 results were lower prices and volatility ... also impacting results were warmer-than-normal weather." Equitable Utilities, a subsidiary of Equitable Resources, had EBIT of $79.0 million for 2001, compared with $93.0 million for 2000. "Heating degree days were 5,059 for 2001, which is 10 percent warmer than the 5,596 degree days recorded in 2000 and 15 percent warmer than the 30-year normal of 5,968. The warmer weather had a negative year-over-year impact on net revenues of approximately $7.8 million," the company said in a February statement.
Similarly, Peoples Energy reported that operating and equity investment income was $60.8 million for its first quarter, compared to $73.5 million for the first quarter of fiscal 2001, as restated. "First quarter results were negatively affected by extreme weather that was 18 percent warmer than normal and 29 percent warmer than last year," the company said in a January statement.
To some companies, though, a mild winter is not a revenue disaster. While normally a gas company would expect to take a hit during a mild winter like the one Washington, D.C. just experienced, Washington Gas Light instead expects to take $8.8 million to the bank in 2002, after taxes. Weather insurance paid off big for the company, because temperatures in 2002 have been 14.7 percent higher than normal.
To his surprise, Glen Sweetnam, managing director of the weather risk management group at Reliant Energy, says he still sees clients who still come in and out of the market for weather risk management-without any consistent approach.
Dr. Jerry Skees, H.B. Price professor of agriculture policy and risk at the University of Kentucky, says the phenomenon can be explained in terms of the psychology of denial, seen often in another weather dependent industry-agriculture.
In a 1989 study with western Kentucky farmers, just after the worst year on record due to drought, Skees found that despite the financial loss, farmers were not willing to accept that things could get worse. Certainly, not disastrous enough to put them out of business, he says.
The psychology of focusing on the price of weather hedging distracts people from the ultimate question of what can you stand as an industry, he says. The real question for the farmers and for the energy industry is how much risk can you stand, and what kinds of events will lead to bankruptcy, according to Skees.
Some companies that offer weather risk products, such as Element Re and Swiss Re, say they have not seen the so-called in-and-out of the market phenomenon displayed by utilities. Yet in addition to Sweetnam, Aquila's Brian Tobben, vice president for weather products, says that his company also has clients who hedge one year and decide not to hedge the next.
Of course, Mother Nature may provide the necessary education about hedging weather risk, though the lesson may be harsh. "[I]f you look at the utilities, and you look at the last five years, there have been some utilities that have suffered tremendously due to mild winters. This winter is a perfect example. I think if anything, just climatic volatility is going to move them to hedge more and more," Tobben says. He points out that for a utility, throughput of commodity, whether power or natural gas, is the heart of how they make money. "The funny thing about weather is over time it normalizes, but one year to the next it can be quite volatile, and certainly, five or six years ago, no one looking at the historical data up to that point probably figured the next four to five years were going to be warm, and if you had a couple [of warm winters], you'd figure the next year is going to be cold, we don't need to worry about it. Then, boom, another warm winter, it's definitely going to start affecting your operations."
Many companies are currently dealing with the fact that four out of the last five winters were mild, so that they really have no margin for error in the next year. Companies are forced to do something to re-evaluate how they manage their company, and their operations, and that will force them to take a strong look at putting some hedging in place. "We're seeing more and more utilities desiring to take a comprehensive approach to risk management, not only commodity price, but also their volumetric risk," Tobben says.
Frank Caifa, associate director at Swiss Re, says he has started "getting the requests we were hoping to see two to three years ago, and the end-users are starting to come in." He says that trend started in the Midwest a few years ago, when a handful of companies did some hedging. "Now, four or five have done hedging, simply because no one wants to be left exposed to an unhedged balance sheet simply because their competition is hedged. And that's the thing that as an industry we're striving to continue to educate the marketplace."
In part, Caifa says, the issue is critical mass. Another big piece of the puzzle is educating the marketplace. He said that eventually there will be no reason for this risk class to be any different than from how people view currency hedging or interest rate hedging today. "No bank or financial company would be caught without doing some interest rate managing, or currency fluctuation management, if they're in international countries," he observes. Caifa also points out that even the interest rate market is relatively young, about 20 years old. Weather is possibly an even bigger risk than the interest rate environment.
Lynda Clemmons, president and chief operating officer of Element Re, a subsidiary of XL Capital, says she still regularly has the "Weather risk? What are you talking about?" kinds of conversations with potential clients. "There's a whole world out there that needs to be educated, and you can't hit them all in the first few years. It's just not going to happen, especially at the rate of change that you've seen going on in the energy business," she observes.
Retail deregulation may help push that educational process along. As companies move to deregulate, Clemmons says, it doesn't make sense to pass along unhedged risk costs. "Typically, you're passing that on in a 12-month lag, so it's the weather that happened last year. So you'd be passing that on-if you had retail customers, who had the ability to switch from you to someone else, you would be passing on potentially to a new customer a charge from the previous year, based on weather. That might not make you competitive," she says wryly.
Meanwhile, to keep customers consistently in the market, Sweetnam says that liquidity and transparency must improve. "People have a sense that [hedging is] expensive-and it's not-but you can't really know that until you have the liquidity and transparency," he points out. While there is plenty of healthy competition to ensure weather products are not expensive, "the perception when you're talking to one seller after another, is that it can be [expensive]. When people get comfortable about the value of what a hedge is bringing them, then we'll see more industry activity."
Interestingly, businesses outside the United States often seem to have a finer grasp of the value of weather hedging. Clemmons says, "When I spent some time in Sydney, there were already a lot of people that had the education about the marketplace, and were just looking for somebody to fill their needs."
Tobben, too, says that markets such as Asia seem to have a more sophisticated knowledge of weather risk. In particular, he says, Japan seems to have a very clear understanding of how weather affects their business.
"I'm not just talking utilities-retail companies, department stores, theme parks, restaurants-they know how weather impacts their business," he says. Such knowledge gives those companies a strong base from which to help go purchase products to protect their risk. "We here in the states have not had that knowledge so widely understood nor researched as much," Tobben says.
Another reason, he says, for the lack of education, has been Wall Street's failure to hold companies accountable for weather-related downturns in revenues. And he questions that stance. "Why is that? If they [utilities] can structure a program, or take the time to understand where their risks are, from an operational standpoint how the weather affects [them], then there would be no reason for them not to look at us as an industry and not to hedge those exposures," he asks.
Weather Risk Management: Real Market, or Marketing?
For the few years the weather risk market has existed, the growth of the market has been anywhere from 50 to 100 percent annually, which may sound far too reminiscent of dot-com growth rates for many.
Tobben says that the weather industry, and such growth rates, are not the latest fad. "I think if you look at the overall risk profile, even of the United States GDP, the U.S. government estimates that 10 to 15 percent of the GDP is directly impacted by weather. You put a 10 trillion GDP number up to that, there's actually a lot of opportunity." He says, "there is real value creation, it's not just a concept and getting people to click on your Web site." With weather risk, companies are able to hedge risk and manage their financial portfolios more efficiently.
The existence of an entire industry devoted to hedging risk related to weather struck many as absurd, initially. In 1996, the energy industry had just started to deregulate, and statements like "the company reported a fourth-quarter loss of $44.9 million, or 84 cents per share, because mild weather lowered the demand for electricity," were not only common, but palatable to public utility commissions and shareholders.
Weather risk management has definitely emerged from infancy. Players in weather risk now get questions like "What kinds of products does your company offer?" as often as they get "What is it again that you do?" Liquidity is increasing. Despite the demise of Enron, or perhaps even because of it, investment banks and other new players are entering the industry. And perhaps most surprisingly, Europe isn't just sticking a toe in the weather risk pool, it's diving in head first.
Which isn't to say that weather risk management is jogging along confidently. Some important players have exited the market. Liquidity may be growing, but it still has a ways to go. In 2000, the overall size of the industry shrank, and it's not clear that 2001 will be a significant improvement when those numbers become available in June. Likewise, the consequences of the exit of one of the founders of the weather risk industry, Enron, remain murky.
Two Steps Forward, One Step Back
Weather risk management sprang into existence in 1996, when Aquila signed a deal with Consolidated Edison Co. of New York in which pricing of the power bought from Aquila was indexed to the weather. Shortly thereafter in 1997, Enron arranged a weather swap with Koch, according to Tobben. "We can both claim to be first," he says.
The two companies were the leaders in the nascent weather risk industry. Aquila claims that it had a larger share of the business than did Enron-and of course, with Enron's demise, there's not going to be a lot of bickering on that point now. Times have certainly changed since 1996 and 1997, when there was one deal and 82 deals, respectively, according to a survey released by the Weather Risk Management Association (WRMA) in June 2001, and conducted by PriceWaterhouseCoopers (the PWC survey). By the end of the 2000 season, the total number of weather risk contracts had shot up to an amazing 1,663. ()
The trajectory of notional value-the maximum payout under a weather risk contract-has not been quite as steady an upward rise. While the October to April 1998 notional value grew at rate of 550 percent from 1997, and at a rate of 110 percent for the same period in 1999, the notional value fell for the October to April 2000 period by 19 percent. ()
Sweetnam might best sum up the current state of weather risk management when he says, "The weather market has continued to develop in positive directions on whole, but it is a market that takes two steps forward and one step back all the time it seems." Growth has not been as large as sector participants would like, nor has the growth been as spectacular as some of the hype. Still, Sweetnam says, what growth there has been is solid. He says he is still looking for this market to grow.
Others in the industry take a similar view. Tobben says the fits and starts the market is seeing is just part of the natural growth of a marketplace. "Certainly, there are ebbs and flows in the acceleration of a marketplace. I don't attribute that to an overall slow-down." The growth that the United States has seen has been primarily in terms of players and trading volume, he says. "We were hoping when we got into the market that there would be a lot more larger, structured end-user type deals coming in, non-energy related. The big utilities have this massive amount of weather risk, but they just basically take [it] as part of their doing business every day. We would have hoped, over time, that they would have been more active in looking to hedge that."
Tobben predicts that the next PWC study, expected to be released in June, will document substantial growth for the past October to April season, particularly in Europe.
Caifa, who has been in the weather risk business since 1998, when there were only six or eight players in the market, says, "[A]s someone who has been in it since then, as well as other players, our overall perspective and hope is that we would have been further along by now than we are as an industry," he says. He goes on to note that the industry has made some great strides over the last couple years. In particular, he points to the presence of over 20 active players in the market right now, an amount he says is growing.
Clemmons, who has been in the weather risk market about as long as anyone, came to Element Re in 2000 from the Enron desk, which she started. Clemmons' assessment of the industry is upbeat. "I've been really pleased with the development of [the industry]. We've seen happenings that I think mark a positive turn of events, such as a number of banks coming into the market, like J. Aron & Co., which is the commodity division of Goldman Sachs, and Deutsche Bank."
Clemmons says that now, she talks to a large number of utilities that are saying to her, "My boss has just told me that I need to learn how to put some weather coverage on." As she points out, "[t]hat's a very different conversation than we were having two or four years ago, which was, 'Hey, can we talk to you a second and tell you about what weather coverage is?' So, we've progressed along the learning curve, to where people are asking how can you structure coverage of this risk that is most economically viable for me, instead of asking, 'What are you talking about?' "
The exit of Enron is a prime example of one of those steps back that the market has taken, according to Sweetnam. But Enron is not the only one to leave. Sempra has also exited. Many of the insurance companies have also either exited, or scaled back their participation, due to what Sweetnam calls "disenchantment" with weather risk.
The departure of insurance companies is a problem for the industry, because they provide the "other side" of weather hedges. It's not all gloom-and-doom, though. As Sweetnam points out, other insurance companies are entering the market. For example, in 2000, XL Capital started its Element Re subsidiary, which is now a very active participant in the market. Also, Swiss Re, which had scaled back its weather desk, has refocused and reentered the market.
Liquidity-Is the Glass Half Full or Empty?
One consistent problem that has dogged the industry is liquidity, or lack of it. According to Caifa, concerns about liquidity get voiced in one of two ways: "These are comments I've heard from some of the end-users-'Well if I buy something I can't get out of it,' or 'I might not be able to get a good price.'"
"Lack of liquidity and lack of education seem to be keeping some people from transacting," Caifa says. And now, after scaling back, Swiss Re believes that the weather risk market is "at a point now that we see it has potential again, the market is growing, and we think that we can add tremendous value." He hopes that such value-and increased liquidity-will come from Swiss Re's new auction offerings. Through such auctions, Swiss Re will offer new derivatives based on measures of temperature and precipitation. "By hosting these type of auctions, we're hoping to drive liquidity by offering in effect 'market based pricing,'" he says. In addition, the entry of investment banks into the weather risk space should diversify the industry further, as well as bring in a different client base, "and that's going to help grow liquidity."
Clemmons agrees that expanding the sectors involved will bring more liquidity to the market, though more so for larger transactions. "Where you may not have significant liquidity is a highly structured transaction that is over $20-30 million, that kind of transaction takes a little more care." Having a bigger mix of players, she says, is certainly going to help liquidity. "It's going to attract an even different kind of service provider to the marketplace."
Sweetnam agrees that liquidity remains a barrier to growth. "Our real challenge is to get liquidity up, to have the market be more liquid and more transparent, so that companies that aren't currently using weather instruments become comfortable doing that," he says. Sweetnam sees the lack of a single benchmark for weather products as the chief obstacle to liquidity and transparency. In other words, he explains, weather is very localized, so you don't have a standard like a Henry Hub gas price. That localization means that weather exposure varies significantly.
Whereas energy companies may be primarily concerned about temperature over a broad area, agricultural companies may be primarily concerned about precipitation-and even that concern may vary, either over a wide or fairly specific area. Construction may be concerned about precipitation in a very specific area. As a result, "everything gets very customized," Sweetnam says. "It's all very do-able, so it's not a fundamental problem, but it's definitely a problem to increasing liquidity and transparency. The deals that get crafted, many are one-offs."
To improve that situation, Sweetnam says Reliant's approach is to design products that will be used by gas and power traders, to optimize their trading activities. He says Reliant, along with several other market players, began to make markets in six U.S. cities for weekly average temperature swaps, on the Intercontinental Exchange (ICE). They are weeklong swaps, Monday through Friday, average temperature, traded for the current week and the next week. Sweetnam says that these derivatives are traded and designed to match up with exactly how power traders trade power.
"For example, if you had access to the ICE, which power traders do, you could get on and look at what power is trading forward in PJM, then click over to the weather page, then look what weather is trading for in Philadelphia. Then you can buy your power, and sell your weather, and hedge your bets. It's very slick," Sweetnam says. He fully expects that such trading activities will give the industry the liquidity it is looking for.
Others, like Clemmons, are more optimistic about the current level of liquidity in the market. "U.S. liquidity is fairly strong on smaller transactions that are within a season. I think we have very strong liquidity within that arena." She acknowledges that liquidity is a hurdle that the industry faces, but is not terribly worried about it. "I've been in the market longer than almost anyone else, so I remember when there really was no liquidity. Maybe it's just a relative sense of how many trades we're able to see, how many deals we see, now versus two to three years ago, and the numbers are just so much larger," she points out. "At least to my mind, I think people forget where the market came from. There's certainly been an increase in liquidity. Does it still have room to grow? Absolutely, there's no question about that. But I do think a lot of people would like to say there's a problem, rather than looking to see what the positives are."
Smaller is Better?
One of the positives of current market liquidity is, oddly enough, the fact that there were many more small deals in 2000, rather than more of the blockbuster marquee deals. The fact that there were so many more total deals (2,759 in 2000, compared to 2,049 in 1999) points to increasing liquidity. Overall, people are trading significantly higher volumes, but smaller size. Clemmons points out that it is a lot easier to hedge something traded in a smaller size. "It's a lot more palatable for those firms that don't want to take on large amounts of risk, but want to participate in the market. And I think part of it also, when you look at products like ICE and the CME, they're trading in very small lots. If you're interested in those markets, and you want to participate in those markets, you scale your size down to make it appropriate for those [players]," she says.
Sweetnam says the fact of smaller deals, but more of them, is not necessarily a bad thing. "In fact, with these weekly deals, we'll see a lot more smaller deals, and a commensurate increase in the financial size, because these will only be weeklong trades, as opposed to seasonal trades," he says. What is driving more, yet smaller, deals is a drive to create a product that's of value to the customer, which will allow the market to grow. "I think it will also have the side effect of greatly increasing the liquidity and transparency, which will also allow the market to grow," Sweetnam says.
Exit Stage Left
As the weather risk industry was trying to cope with fairly normal business problems, the business problem of the decade came along: the collapse of industry founder Enron. One immediate question was how the precipitous exit of one of the industry's largest players would affect liquidity.
Clemmons says, "With the decline of Enron, we were a little nervous, because they were such a big player in the European market, and they really provided a lot of the liquidity for the trades that were going on in Europe." She noted that Enron had some of the marquee deals, such as signing up the wine bars in London to hedge their weather risk. Initially, Clemmons says, "everyone was in shock ... suddenly, there was no Enron to trade with." But after a short period, she says, people stepped up to the plate and started trading.
Tobben says that there have not been any problems with the market absorbing the risk after Enron's departure. "I think there's adequate risk capital in the market," he says. "I think that's evidenced by the fact that I don't see any end-user deals not being done because of capital constraints." Unlike the reinsurance market, which is hardening appreciably in the wake of Sept. 11, the same thing is not happening in the weather market after Enron's departure. Tobben says, "I think it is a signal that the players that are in the marketplace are there, and are strong, and are able to support the increased deal flow due to Enron's departure." He did note that one impact has been a lower level of activity in the secondary market, in certain places where Enron was very active such as counterparty to counterparty.
Like Clemmons, Tobben saw some slowdown in the European weather markets after Enron collapsed. But overall, Enron's loss has been Aquila's gain. "We've seen a tremendous uptick in the amount of end-user business and trading business that we've done since [Enron's] departure," he says.
Caifa says that he is hearing that much of the substantial, and now former, Enron desk is starting to disperse not only to existing players in the market, but also to other companies that are looking to get into weather risk.
Indeed, at press time, Duke Energy had just opened its weather derivative desk and executed its first transactions on the ICE, according to sources.
Sweetnam echoes the point, rattling off a list of new players that includes Constellation Energy Group. Perhaps the most significant new entry to the weather risk industry is Goldman Sachs, which in the fourth quarter of last year became the first Wall Street firm to offer weather hedges. "That was a very significant development, in terms of the investment banks coming in and also trading in this market," Sweetnam says. In addition to Swiss Re, several companies that had either downsized their weather operations or had never been highly active are currently increasing their activity, including Renaissance Re, El Paso, and Dynegy.
Weather Risk Crosses the Pond
Perhaps the real story about weather risk last year wasn't in the United States at all, despite the disappearance of Enron. Tobben says that there was a tremendous amount of activity in Europe in 2001. This is good news to Tobben. "We're seeing additional geographical regions come into the marketplace, which is prompting a tremendous amount of growth," he says. He attributes the growth in Europe to a few different factors. "There were a number of shops that just began to get off the ground in Europe over the last couple years. And the sales cycle-it takes some time to educate consumers about these products and get them to a point where they're ready to transact."
Also, Europe is opening up to electricity competition. Tobben says, "[t]hat's certainly a big driver in the energy space. We see, in addition to the energy players like ourselves, some of the other major players over there originating business. We also see the banks becoming very active in Europe as well, suggesting weather as a risk management."
"The European market is where we would have liked to have seen the United States go, in terms of the larger structured deals," Caifa says. Large European companies are looking at their gross weather risk, he says, and are looking for some sizeable transactions to help them ameliorate that. On the whole, Caifa says that Europeans are not into trading. Instead, they are looking to hedge large blocks of risk.
For Clemmons, one of the key factors to the growth of the European weather risk market is the entry of banks. In addition to the usual players such as Aquila, Element Re, and Entergy/Koch, she noted that Deutsche Bank trades in London. "I think it's an increase in the number of banks taking a look at these products as something else they can offer their customers. And there are insurance companies that are doing the same thing." In Clemmons' opinion, Europe, as well as Japan, tends to have more non-energy customer-focused deals than in the U.S., relative to the size of energy deals. "So for instance in the United Kingdom, you might see a number of restaurant transactions, or theme park transactions, that you might not see in the United States, because the U.S. market is so focused on energy."
Finding the Other Side
One of the things that could help the weather risk industry the most, ironically, is to get away from such an energy-focused clientele. It's a change that would ultimately help those energy clients, too.
Clemmons says that people in the industry are actively trying to expand beyond the energy market. These efforts are an attempt by players to provide themselves with a larger customer mix. In addition, it is also about getting a better mix of risks, she says, so that everyone isn't trying to protect themselves from warm winters. "I think the next big step for the weather market in the United States is going to be agriculture." She points to a very large agricultural rainfall deal done in Alberta recently, and some other crop coverage type of transactions put together recently in the United States, as evidence of that trend.
Skees is pushing for the weather risk industry to expand into agriculture. He says, "[t]he more that the weather traders can create a global market, the more that they will be able to find offsets, and the more liquidity that will be in the market." According to Skees, there are some specific attributes to weather risk products for agriculture that make the offsets quite interesting for the energy industry. For example, in a hot, dry summer, agriculture is a loser, while the energy industry is a winner. "That's the vision," he says, "getting two big markets together that depend on weather, but different types of weather, will improve opportunities for both. And improve pricing, liquidity, and price discovery-all the things that happen in a wonderful market."
Caifa applauds the move to diversify the industry client base. "I think now the shareholders, and possibly even the analysts, are going to be pushing for another alternative to help mitigate some of this volatility," he says. He, too, says the industry is starting to diversify amongst non-energy users, to clients like municipalities, entertainment companies, and construction companies. Construction is in many ways to perfect "other side" for hedging weather, since a warm winter that is disastrous for energy company revenues is a boon for the construction industry.
Tobben agrees that weather risk is seeing a move beyond the energy industry. "It's nothing new," he says, "but we've seen large transactions come in from the construction sector, from the agriculture sector, and through our partnership with International Finance Corp., we've seen a tremendous amount of interest for weather coverage in emerging markets." In emerging markets, he says, it is very difficult to obtain insurance, with the recent hardening of the insurance market, so companies are turning to coverage through the weather market for alternate sources of capital and risk management products.
Tobben even predicts that past growth trends could speed up in the next three to four years. "If anything, I might envision a bit of acceleration, because of all the business we're beginning to see in Europe, in Asia, in Australia, even Africa and South America." He acknowledges that "yes, they are significant growth rates, but you've got to realize just as the numbers are going up, probably the participants are going up at a similar rate as well."
Perhaps Caifa said it best: "Unless the weather just turns out to be normal for the next 10 to 15 years, and everyone is just content with it, I see no reason why you wouldn't want to hedge that risk, because it's there and it's volatile."
Although there are many positives in the industry at the moment, it is still fundamentally a very young industry. Tobben says that he wouldn't necessarily characterize the industry as still being in its infancy, but "I'd say we're starting to walk."
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