THE SUMMER OF 1996 OPENED COOLER THAN normal in June and July, cutting electric sales. When prices for natural gas did not fall as expected, as a counterbalance Consolidated Edison Co. of New York entered a combined gas-conversion and weather-heading transaction with power marketer Aquila Energy, giving Con Ed some measure of protection against further revenue shortfalls in August.
The deal was designed to run four days a week throughout the month (Tuesday through Friday) and to provide a guarantee of total cooling degree-days in New York City, with no apparent direct cash outlay from Aquila. If the variance between actual cooling degree-days and the forecast fell 10 percent below specified parameters, Con Ed would win a discount from Aquila, presumably on power the utility purchased from the marketer. Any returns due the utility from the marketer would come in increments of 50 cents per megawatt-hour; Aquila capped the utility's entitlement at $1.50 per megawatt-hour.
"It was a no-lose situation from my perspective," says Ken Bekman, Con Edison's wholesale power director. "It was an opportunity to generate some savings. The product ... was a good deal. It worked and we were happy with the results."
In the case in point, the parties took counter positions in weather. The utility sought protection against weather risk - the uncertainty in earnings and cash flow due to weather volatility - by entering into a weather-based hedge. The energy company took a weather position plus offered a client a desired weather risk management product.
Yet some question the strength of the link between temperature and prices. Weather hedging may prove useful, they acknowledge, but not as vital as some would have the industry believe. Earnings depend on many factors, including price and quantity, yet the effect of weather is felt largely on volume only, without integrating coverage against price risk.
Joe Petrowski, president of Consolidated Natural Gas Energy Services (an affiliate of the Pennsylvania utility, Consolidated Natural Gas), says the link between weather and underlying energy prices is growing more tenuous.
Although the weather remains the single largest variable in energy, Petrowski says, a "disconnect" in prices and weather now exists due to three distinct factors: 1) increasing speculative interest in crude oil, natural gas and power, which allows factors like the gross national product, currency spreads and production volumes to affect the market more; 2) more hedges (forward contracts sold), which means the spot market is no longer the market's sole calibrator, and 3) greater market efficiency, allowing for a closer match-up in timing between consumption and prices.
Bottom Line Impact:
According to Carl McCutcheon, Koch Industrial and Utility Services senior vice president, the weather-to-earnings correlation is very strong for utilities that have volumetric rate structures for a large share of their load, such as natural local distribution companies and some electric utilities. A study conducted by Koch Energy Services shows that from 1966-1995, the correlation of the price of New York natural gas as a function of heating degree-days (HDD) was 31 percent, yet the correlation of the use of New York natural gas as a function of HDD was 92 percent (see Chart 1).
Modeling of natural gas prices shows that 10-percent colder than normal temperatures in summer can decrease spot prices by 15 percent, or about 35 cents per Mcf (assuming no extraordinary storage and using normal temperatures for baseline assumptions), according to David Costello, senior economist in charge of short-term energy outlooks at the Energy Information Administration. Other research at EIA indicates that if average heating season temperatures rise 1.43 degrees Fahrenheit above normal, the drop in demand for natural gas will outweigh the increase in demand that occurs naturally each year to satisfy economic growth, thus forcing prices down overall.
Spot markets are not so well developed in electricity, with weather-related price effects more likely to be short-term and regional. Weather-related effects on demand naturally depend on the size of the distribution system and number of customers. Peter Nance, president of Teknecon Inc., notes that, depending upon the season, geographic location, fuel mix and size of the utility system, a movement up or down on the thermometer by one degree Fahrenheit can raise or lower electric demand for an electric utility by anywhere from 50 to 500 megawatts.
Moreover, while both power and gas utilities are affected by volatility in usage, electric utilities have a singularly unique position of further weather risk due to high costs involved in production and inter-day spikes in demand periods. Electric utilities are also affected by short-term extreme events, says Lee Branscome, president of Environmental Dynamics Research. He adds this is true especially when there are abnormally high temperatures for a few consecutive days.
In other words, if Houston has a week-long hot spell at 110 degrees, and the remaining three weeks are a temperate 65 degrees, the month's average is 71 degrees. Yet a utility's economic profile containing the severe peaks in Houston will be very different from a month of 65- to 70-degree weather. You can liken it to putting one foot in a bucket of ice water and another foot in a pail of boiling water - it may average out, but it's certainly not equal. Plus, unlike natural gas facilities, electric-only utilities may also suffer in utility load protection from large errors in temperature forecasts over a short period of days, Branscome explains.
Electric utilities also exhibit a heightened weather sensitivity in the summer, unlike natural gas utilities, which exhibit more exposure during winter weather months. Hydroelectric utilities are affected not only by temperature anomalies, Branscome notes, but also by snow and rain anomalies.
Given all these variables, it should come as no surprise that interviews with executives at gas companies reveal a wide range of estimates on the effect of weather on utility profits. Estimates of profit sensitivity per heating degree-day can range anywhere from $500 for a "small" gas utility; to $5,000 to $25,000 for an "average-sized" utility; and to $150,000 and up for a "large" utility. As for the typical residential gas customer, risk sensitivity appears to average about 10 cents per heating degree-day.
In Pennsylvania, Petrowski says last year's 21-percent warmer-than-normal weather in CNG's territories shaved off 33 cents a share, cutting almost $30 million out of the company's earnings. Having studied the industry's quarterly reports last year, Petrowski estimates some $500 million to $600 million in earnings was lost due to winter's warm weather and resulting low volumes. Since most regulated LDCs make money on volume alone, any increase or decrease in throughput flows straight to the bottom line, he notes.
"You can figure that if you have, say, 800 degree-days less in the Pittsburgh region, earnings could be affected, cumulatively, around $500 million, or about $700,000 per degree-day. Across the industry, that's as much as $700,000 to one million dollars per degree-day, on a cumulative basis," Petrowski says.
In addition, weather forecasts can affect how traders do business, says John Cochener, Gas Research Institute's principal analyst. Comparing temperature and prices in 1996, during which a harsh winter "blind-sided" gas markets, showed that, in the very short term, prices slightly lead changes in weather (see Chart 2).
Strengths and Weaknesses
Neither rain, nor snow, nor sleet, nor heat wave, nor ice storm, nor drought stops meteorologists from gathering objective historical and prediction data - forecast information imperative to weather derivative dealers.
A 1986 study conducted by the Gas Research Institute, entitled The Potential Value of Climate Forecasts to the Natural Gas Industry in the United States, reveals that five areas - gas storage, gas supply, service/sales to interruptible customers, maintenance and cash flow management - would most benefit from accurate forecasts. Quantitative estimates indicate that perfect climate forecasts could save companies as much as $8 million per year (imperfect forecasts could reduce operational costs around $3 million), thereby lowering gas prices to consumers.
Since understanding a weather forecast is critical for energy and weather derivative professionals, how can they differentiate between a low- or high-confidence forecast? According to Colin Marquis, a meteorologist for The Weather Channel, weather forecasting is a rapidly evolving science that should be approached with "cautious optimism."
Marquis identifies two factors as particularly important in forecasting: (1) volcanic activity and (2) conditions in the Eastern Pacific (like El Niño and La Niña). This coming winter, notes Marquis, is "very bullish," as La Niña presents a strong weather pattern.
The time of year also plays an important role. Winter forecasts tend to be the most accurate and most confident in long-range forecasts because winter weather patterns are better defined, depending more directly on peaks in big systems. By contrast, summer forecasts are more dependent on small-scale phenomenons and therefore are more apt to contain rapid changes. Spring and fall forecasts reflect transitional phenomena (manifesting lingering effects of winter) and are generally difficult to execute accurately, says Marquis.
As recently as June 1998, U.S. government forecasters confirmed that La Niña, a colder-than-normal South Pacific ocean temperature pattern that developed after El Niño, would likely influence weather conditions into 1999. Representatives from the National Oceanic and Atmospheric Administration had predicted that El Niño would bring warm and dry conditions to the Southwest during the summer, fall and winter this year, with normal summer precipitation in the Gulf states, plus fall and early winter wet conditions and a colder-than-normal winter season next year in the Pacific Northwest. The record heat seen in June and July in the Southwest appeared to prove at least a portion of that prediction.
Industry professionals can obtain predictions and reliable six-to 10-day forecasts, and 30-day and 90-day weather outlooks from the NOAA Web site at www.nnic.noaa.gov/cpc.
Hedging: Tools and Transactions
One of the most appealing aspects of weather-related financial products and weather hedging is the fact that weather remains one of the last bastions of purely scientific risk management. Objective organizations collect weather data from across the U.S. and make it readily available to everyone. While prices on the New York Mercantile Exchange typically reflect a mix of outside forces, including speculation, the weather does not. Other reasons to consider weather hedging are the ability to barter physical options for weather protection, its singular ability to manage volume risk and its relative low cost in comparison with other risk management products.
In the physical and financial energy markets, weather products can be based on: (1) temperature (average, cooling degree-days, heating degree-days, minimum and maximum five-day); (2) precipitation (snowfall, snow pack/depth, stream flow/water level, rainfall), or (3) more unusual factors such as haze/pollution, wind speed, gust speed, sunshine and misery, or accumulation of a heat and humidity index (see sidebar "Sunshine, For a Price").
Using common financial tools, weather hedging can include embedded weather agreements, collars, floors, heating or cooling degree-day swaps, heating or cooling degree-day options, single-payment "knockouts," and other tailor-made structures upon which a party and counterparty agree. Fundamentally, weather swaps (where floating price is exchanged for fixed price over a specified period) can stabilize volume-related cash streams, and options (where purchaser has the right to buy or sell at a strike price) can protect the downside while preserving upside potential. Collars (a combination of put and call options that form price range) can be "costless" or low cost and floors (the seller is assured of at least some minimum price) can protect earnings in mild weather circumstances.
Most of the current weather transactions use either cooling or heating degree-day tools, and run about $5,000 per unit, with a $2-million maximum pay out. Sources stated that deals as small as $400 per unit in the secondary market have been transacted, and high-dollar deals and inquiries in the primary market have ranged from $10 million to $250 million in exposure coverage.
Key components to consider in a weather hedge are: (1) the strike (a predetermined point or number of instances to begin payout); (2) option payout unit (unit of measure); (3) weather data and weather gathering stations to be used or averaged (weighted); (4) maximum and minimum possible payouts, (5) option period; 6) the amount at risk (total and per degree-day at-risk amounts); and 7) historical data, including the average, low and high of temperature, rainfall, etc.
While wholesale traders in financial and physical markets are becoming well-versed in the arena of weather risk, success is not assured.
GRI's Cochener advises caution: "Weather hedging may become more important in a deregulated market, but not as important as the promoters of hedging tools would lead you to believe. Seven or eight years ago, there were no natural gas futures, and we got along fine without it. But now people seem to be convinced that they need to hedge. Look at the winter of 1995-96, when basis differentials collapsed; hedging is not a sure thing. People tend to speculate in the name of hedging. They're tempted to chase a market."
A recent example of "speculating in the name of hedging," Cochener says, comes from Centra Gas Manitoba, a Canadian natural gas distribution company. Centra asked the Manitoba Public Utilities Board for permission to recover $31.4 million in trading losses last year, but the PUC ruled that the losses came from speculative gas trading, not hedging, and forced the utility's shareholders, not gas buyers, to bear the brunt of the losses.
From Ratemaking to
Utility deregulation promises an end to weather-driven ratemaking adjustments and perhaps the beginning of weather-related consumer products.
Under cost-of-service rate regulation, state utility regulators commonly approved revenue normalization adjustments to take account of unusual weather. Such adjustments did not directly affect the price the utility charged for energy. Instead, in the typical case, the commission would adjust the overall revenue requirement by modifying test-year income to reflect the level of expenses and revenues (including derivative items such as taxes and reserves for uncollectibles) that would have been earned had temperatures fallen with a "confidence interval" or a statistical range surrounding an arithmetic mean.
Depending upon how soon the utility would file its next rate case to allow it to adjust its tariffs, the typical weather normalization adjustment would tend to increase rates overall after a period of abnormally mild weather and reduce rates after a period of severe weather. A survey published in 1987 identified more than 20 states in which utility regulators had approved such adjustments during the 1970s and '80s, though some states, such as Ohio, Missouri and South Carolina had rejected the idea outright.
In a 1989 rate case, the Georgia Public Service Commission had approved a weather normalization adjustment for Atlanta Gas Light Co. that followed the typical pattern - it tended to raise or lower rates, respectively, after an abnormally mild or severe winter. That adjustment led to a higher authorized revenue requirement for the company in 1991 in its next rate case.
In June 1998, however, with the enactment in Georgia of the new legislation to deregulate natural gas (The Natural Gas Competition and Deregulation Act of 1997), the PSC told the company that beginning July 1, 1998, it could no longer factor in the weather adjustment.
"Now our rates are no longer based on how many times the wheel turns around on the meter, but how many noses [customers] we have," says an AGLC representative.
This loss of ratemaking guarantees by Atlanta Gas Light and other utilities, coupled with the onset of consumer choice, quite naturally begs the question: Will customers continue to accept energy bills that reflect volatility caused by weather?
WeatherWise, an underwriter of consumer weather risk, has found most residential customers are willing to pay up to 6 percent in fees for the security of a flat, guaranteed energy bill. In turn, of those customers seeking a flat or guaranteed bill, WeatherWise found that 6 to 15 percent were willing to pay for capped weather products, but the company expects that acceptance of its new Weatherproof Bill product offer will eventually hit as high as 30 to 40 percent.
Already, WeatherWise claims that residential energy customers (less than 10,000 total) are using the product under experimental programs or fully implemented arrangements in Massachusetts, Wyoming, Nebraska, Pennsylvania, Illinois and Kansas. Residential clients using Weatherproof Bill outnumber small commercial users by a ratio of nine to one.
"Since a multi-billion dollar market has grown up to cover consumer price risk, we'd expect the market to grow up and offer consumer weather risk,"says Rand Warsaw, WeatherWise operations vice president. "Now that the markets have developed there's no excuse not to manage weather risk, just like you manage price risk."
Considering that weather-driven fluctuations in heating bills can run as high as 20 to 25 percent, and price-driven factors can pump fluctuations up 40 to 50 percent, most consumers still don't understand that when their bill goes up in the winter time, it's weather related, explained Brad Beorn, another WeatherWise vice president. Unaware of what drives their energy bill, consumers embrace a natural tendency to accept protection against "unknown" forces. To illustrate this tendency, consider that some 80 to 90 percent of Americans hold fixed-rate mortgages, although adjustable rate mortgages can offer a better deal.
Although consumers may not understand what drives their energy bill, power and natural gas utilities make it their business to understand what drives their unique commodity-driven costs and their earnings.
A Sunny Forecast? Some Predictions
One argument you'll hear when weather risk management is mentioned is that it sounds almost too much like insurance. In fact, weather risk products are alternatives to traditional insurance products in that they are contracts based on a difference in terms.
"Weather risk is a contract of difference, not a contract of indemnity," says Tripp Dunman, Aquila Energy director of weather marketing. "There's no damages, harm or loss. It's merely the pay off in a discrepancy in weather, based on data provided by the National Weather Service, and the negotiated strike price. Unlike insurance, there's no messy claims dispute - it pays in five days. That's it."
There are also standardized documentation and a specified confirmation process governing the settlement process, Dunman adds.
Another criticism leveled against weather-risk management is its liquidity limitations (a "nascent" market) and unique, yet singular, influence on volumetric risk: "The biggest criticism I hear about weather risk is that it doesn't manage the dynamics between price and volume," says Lynda Clemmons, director of Enron Capital & Trade Resources. "Well, no, it doesn't. It's only a piece of the risk pie. It has to be used within a well-managed risk management program. I think what's made weather risk so popular is that it requires no new or special education or training. Utilities have always understood degree-days when they look at their loads and they already have the data."
A glance into the possible future of weather risk management could include: (1) involvement of end-users (residential and industrial, retail and wholesale), (2) an international market for weather derivatives, with participation by many industries (film, pipeline, manufacturer, etc.), (3) long-term transactions, and (4) broader and more custom-tailored terms.
"The next eight months is a critical time period," says Tom Kloza, editorial content director at Opis Energy Group, a Lakewood, N.J., energy information and consulting company. "If this is a humdrum, normal season, I think it will do a lot of damage to weather hedging. But if this winter features extremes like last year, it will galvanize the futures markets."
Roxane Richter is a freelance writer based in Seabrook, Texas. She writes frequently on energy issues.
Sunshine, for a Price Marketers offer a rainbow of weather-risk products.
n Aquila Energy (www.aquilaenergy.com), a UtiliCorp United Co., offers GuaranteedWeatherSM financial option products, including: guaranteed precipitation, snowfall, snow depth, average temperature, cooling degree-days, maximum temperature, heating degree-days, minimum temperature, unit contingent (generating unit operations) and forecast (five day). Products to be introduced in the future will include wind speed, gust speed and guaranteed sunshine.
n Dynegy (www.ngccorp.com), formerly NGC Corp., offers Storage Investment InsuranceSM (price protection against falling gas prices) and Gas Purchase ProtectionSM (protection against future gas price increases). Based on customer need, the company also offers other weather-based product solutions.
n Environmental Dynamics Research Inc. (www.endrinc.com), a Palm Beach Gardens, Fla., consultant group, provides option design and valuation, analysis, trading and hedging strategies, value-at-risk analysis and portfolio evaluation.
n Enron Capital & Trade Resources (www.enron.com) offers maximum and minimum temperature, rainfall, stream flow/water level, cooling and heating degree-day weather financial instruments. Also available are wind, haze/pollution, sunshine and misery (accumulation of heat and humidity index) products.
n Koch Industries Inc. (www.kochind.com) offers weather-related financial products for swaps, collars and floors involving heating degree-days and cooling degree-days. It also barters weather risk products for physical energy assets. Precipitation and weather risk management products will be available later this year.
n LG&E Energy Marketing (www.lgeenergy.com ) offers WeatherGuard swaps, options and collars.
n Natsource Inc. (www.natresgrp.com/) is a New York institutional energy broker involved in weather hedging markets and arranging weather transactions.
n Trade Winds (www.weathertrades.com ) provides weather forecasts and weather-related commodity reports (including "Weather Trading Made Easy") for the world's major crop and energy regions.
n Weather Derivatives (http://members.aol.com/petsm/derive.htm), based in Belton, Mo., tracks weather for energy markets.
n WeatherWise USA LLC (www.weatherwiseusa.com) is a Pittsburgh underwriter of consumer weather risk. It offers WeatherProof Bill, a product which caps commercial, institutional and residential heating and cooling costs and allows consumers to pay a predetermined, guaranteed amount for energy usage. - RR
1 John Herbert, James Thompson, and James Todaro, "Recent Trends in Natural Gas Spot Prices," Natural Gas Monthly, December 1997, p. vii, cited in "Gas Price Volatility: Of Winters Past and Futures Markets," Public Utilities Fortnightly, March 15, 1998, p. 38.
2 "Weather Normalization Adjustments in Recent Utility Rate Cases," Public Utilities Fortnightly, Nov. 26, 1987, p. 55.
3 See, Docket No. 3923-U, Jan. 15, 1991, 119 PUR4th 404, 408.
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