Figure 1. The bar chart displays the notional value of weather risk management contracts by the seasons they were utilized. 70% of those contracts traded on the Chicago Mercantile Exchange (CME) are utilized in the winter, making the overall split between those contracts utilized in the winter and summer similar to the previous year. The previous survey recorded 3,937 contracts with a notational value of $4.3 billion.

The winter of 2003-2004, one of brisk winds and heavy snowfalls, brought the Northeast’s major urban centers to a halt. A number of cities across the country suffered the largest snowfalls in recent history. As the snowfall and cold weather persisted, industrial facilities and businesses increased their energy consumption, leaving many companies financially unprepared to manage the costs of the unexpected energy demand.

High natural gas prices in the winter of 2004 underscore the vulnerability of business to weather-related energy costs. Energy managers need to prepare strategies for coping with the unpredictable fluctuations of weather. Resources to be found in the weather risk management industry can aid companies to effectively hedge their weather risks and stabilize their energy budgets.

Because of price swings in this era of deregulated energy markets, facility managers are now cautious about their financial exposure. Since they have used financial risk models—mainly natural gas and oil futures to hedge against their risks—facility operators are poised to take advantage of the weather risk management products available to stabilize revenue and protect profits.

According to the Energy Information Administration, energy expenditures account for about 7% of the U.S. gross domestic product (GDP) and constitute a large portion of industrial and commercial spending. On August 8, 2003, Reuters reported that analysts said, "Rising energy costs have long been a problem for U.S. manufacturers and will continue to drag on corporate profits …bucking expectations that falling oil and natural gas prices would provide some relief in the second half of the year."

Merely hedging against energy prices leaves a considerable amount of unmanaged risk. If an unusually cold winter demands twice the energy consumption of estimated levels, consumers face the challenge of paying twice the projected amount, even if the price has been hedged. The alternative to that loss of revenue is to secure a weather risk management tool.

While many factors affect the cost of energy, weather is very significant. And while increasing efficiency helps, any savings achieved can be completely wiped out if adverse weather strikes. As a result, it is no longer practical for companies to closely manage other costs and ignore the impact that weather has on corporate spending.

Energy restructuring in the 1990s prompted the creation of a new, market-based solution that would help firms hedge against the risks associated with weather. Once restructuring forced energy suppliers to compete, regulators no longer guaranteed suppliers fixed profits regardless of the cost of doing business. In an effort to stabilize revenues and protect profits, energy firms and utilities began using a class of risk management tools that hedged volume-related risks caused by variations in average temperatures. Combined with price risk management tools, the volume-related hedges allowed firms to provide superior risk management capabilities to manage their weather risks.

Since then, weather risk management has grown into a $16 billion industry. While many energy suppliers continue to take advantage of these tools, energy consumers have been slow to participate. The U.S. Department of Commerce reports that weather directly influences 40% of the nation’s GDP, or $4.1 trillion. Through the use of weather risk management tools in the form of customized derivatives or insurance, businesses are able to stabilize annual revenues that otherwise would be affected by changes in temperature, wind speed, snowfall, and rainfall.

The basic trade inherent in weather-related risk management products is indexed on heating degree days (HDDs), a widely used measure for the relative "coolness" of the weather in a given region during a specific time period. HDDs are calculated using temperature data provided by the National Weather Service. HDDs for any given day are calculated as the greater of two values: 65 degrees Fahrenheit less the average temperature for the day or zero.

Product Classes

Figure 2. While temperature-related protection (for heat and cold) continues to be the most prevalent, comprising more than 85% of all contracts compared to nearly 90% in the 2002 survey, there were substantial increases in the use of rain-related and wind-related contracts. In the 2003 survey, rain-related contracts account for 8.6% of the market compared with 6.9% in 2002, wind for 1.6% compared with 0.3%, and snow for 2.1% compared with 2.2%.

The weather risk management product classes include swaps, caps, floors, and collars. Payouts for these financial tools are defined as a specific dollar amount multiplied by differences specified in the contract (i.e. the strike) and the actual differences that occur during the contract period.

Swaps are privately negotiated financial contracts that allow two parties to exchange specific price risk exposures over a predetermined period of time. They are over-the-counter instruments that can be customized according to the parties’ needs. Swaps are designed to help protect against market price fluctuations. While energy producers can use swaps to lock in the specific price for the commodities they sell, energy commodities consumers can use them to ensure the specific price they will pay for the commodities. Locking in prices allows producers and consumers to gain greater control over the variable revenues and costs associated with their businesses.

There is no cost for a swap. When used in connection with floating energy price contracts, swaps offer end users protection from adverse price movements, which allows them to profit from beneficial price movements.

While there are no standardized swap transactions, most transactions involve an exchange of periodic payments between two parties in which one side pays a fixed price and the other side pays a variable price. The two parties involved establish the specific terms of swap agreements: the commodity’s fixed price and its floating price reference, the term of the contract, and the quantity to be hedged. Although there are standardized industry contracts, the details of the swap can vary according to both parties’ specific needs and objectives.

Caps and floors allow parties the right to enter into a long or short position at a specified price. Caps and floors are similar to swaps because they provide price protection at a predetermined level. However, caps and floors are different since they allow producers and end users to benefit from favorable price changes. The buyer of the cap or floor pays an up-front cash premium for this price protection. With cap and floor purchases, all risks are predefined; premiums for the options will always be the maximum loss or cost gained by the buyer.

Caps are usually bought by energy end users. Caps, sometimes referred to as call options, are arranged in conjunction with the physical purchase of a commodity in order to establish a maximum price (against an index price) the end user pays for that commodity. Caps provide full protection from rising prices, and they allow end users to fully benefit from decreases in the commodity price.

Energy producers usually buy floors. Sometimes referred to as put options, floors are arranged in conjunction with the physical sale of an energy commodity in order to establish a minimum price (against an index price) a producer receives for its commodity.

Collars provide energy producers and end users with price protection by limiting extreme market moves, which forces prices to move within a defined range. Costless collars are partially "paid for" by giving up a portion of a favorable price change. No cash premium is involved for costless collars.

For energy producers, collars offer floor protection on commodity sales prices. In exchange, the producer gives up some potential to benefit from favorable price moves by selling a cap. If index prices move within the specified collar or range of commodity prices, the producer will sell the commodity at prevailing market prices and will not make a payment. However, if the index price falls below the collar’s lower limit, then the producer will be reimbursed for the shortfall. Correspondingly, if the index price for the commodity exceeds the collar’s upper limit, the producer must pay the difference.

For energy end users, collars offer cap protection on commodity supply prices. In exchange, the end user gives up some potential to benefit from favorable price moves by selling a floor. If index prices move within the specified range created by the collar, no payments are made under the collar and the end user will buy the commodity at existing market prices. However, if the index price for the commodity exceeds the collar’s upper limit, the end user will be reimbursed for the difference. Likewise, if the index price for the commodity falls below the collar’s lower limit, the end user must pay this difference.

In many ways, collars are similar to swaps, but they allow for greater flexibility through some market responsiveness.

The Issue

For the past several years, Congress has consistently worked to implement energy legislation because a strong economy is linked to a sound energy policy.

The July 15, 2003 issue of the Seattle Times contained an article about a new Boeing manufacturing plant that read: "Site-selection consultants say energy is becoming more important because it has unpredictable swings."

These examples clearly indicate that weather and energy consumption are inevitably linked. However, the outlook of the commercial and industrial energy-consumer is typified by two statements: 1) energy is an essential input to any business and must be obtained and paid for, and 2) the only way to lower energy costs is to lower demand.

Statement one is a fact, but statement two is troubling, says John Polasek, president of the Weather Risk Management Association (WRMA).

"Lowering demand is clearly one way to lower energy costs. But circumstances are sure to exist where lowering demand just isn’t possible," Polasek explained. "The key is determining how to mitigate the effect those circumstances have on your energy budgets."

The typical volatility in energy bills frequently range from 10 to 75% of the commercial property’s average historical annual energy cost depending on the region and weather experienced. Even for the largest retailers, the requirement to keep the inside environment of their shopping spaces comfortable for customers can translate into a dip in earnings of up 5% of their annual earnings, if their facilities experience uncomfortable external temperatures. Smaller retailers, like jewelers, that depend heavily on short sales periods may see even a larger swing in earnings if weather becomes severe enough to prevent customers from visiting their stores.

In order to offset the potential swings in earnings for the large retailer, a commercial property manager may enter a temperature hedge. The structure of the hedge could be based on average daily temperature over the critical winter and/or summer months. In the event the average temperature in a region rises in the summer (for instance defined to be measured from June 1 to August 31) to a level that is above the contractual strike chosen, then the company buying the hedge can receive a payment commensurate with the modeled exposure. Such exposure, for example, may be defined as $50,000 per tenth of a degree above the strike level chosen by the commercial property manager. The contract may pay the buyer up to a limit or be purchased with no limit. The cost of the premium, although dependent on market conditions and specific contract terms, typically ranges from 10-25% of the limit.

Energy managers can pressure energy suppliers and utility regulators to participate in managing their weather risks. They can also work to prevent the implementation of a weather normalization adjustment (WNAs), a formula that allows utilities to adjust consumer energy bills based on weather fluctuations.

WNAs are instruments that compensate utilities for additional costs because of the adverse effects of irregular weather patterns. WNAs enable companies to pass these unexpected costs directly to consumers. As a result, utilities and their shareholders avoid the fiscal responsibility of managing the risks.

Weathering the Storm

It is the energy managers’ and facility managers’ jobs to operate a commercial facility and effectively lower its energy consumption to keep expenditures down.

When bad weather strikes and the need for energy increases, mitigating demand becomes extremely difficult. This is why it is incumbent upon commercial and industrial energy and facility managers to take advantage of and utilize weather risk management tools.

Companies stand to gain a significant financial advantage by hedging their weather risk and insisting that their supplier do so as well. One premium can guarantee predictable energy expenditures, revenue stability, and allow facilities to secure accuracy of annual budget forecasting.

Regulated Weather Futures

The Chicago Mercantile Exchange lists futures contracts that can be used in weather risk management programs for businesses having financial exposure to monthly temperatures in any of 15 US cities. (See Weather Hedging table, on page 24 of this issue.)

"These contracts are mini-sized," says Scott Mathews, president of WeatherEX LLC, a New York based commodity trading advisor. "Compared to the jumbo transactions that reinsurers and over-the-counter derivatives deals have been offering, the CME instruments are valued at $100 per HDD (or CDD)," Mathews explains. The seasonal hedges placed in OTC and insurance markets often cover millions of dollars in temperature risk. The regulated contracts traded on the CME’s electronic GLOBEX platform, allow even small businesses to hedge their temperature exposure.

"As long as a risk manager can articulate how many dollars in the company’s expense or revenue line are equated to a single degree day," continues Mathews, "he may be able to diminish the uncertainty that temperature often delivers to the bottom line by hedging with CME weather futures."