Hedging Your Bets

Given the increasing number of opportunities for managing weather-related risk, Canadian markets have a vastly improved ability to use weather risk management contracts to protect against a myriad of weather-related risks that trigger earnings volatility.

The weather risk management market has experienced significant growth over the last decade. This is due in large part to increased awareness of the benefits of this form of risk mitigation. The Weather Risk Management Association (WRMA), the weather industry’s trade organization, last month reported the notional amount of weather risk contracts increased from US$4.5 billion five years ago to more than US$32 billion this past year.

A significant amount of the growth in the weather market can be attributed to the increased creditworthiness of dealers and their strong balance sheets. In addition, the clearing of contracts on the Chicago Mercantile Exchange has provided greater market transparency and liquidity.

The weather market in Canada has expanded over the last several years. Some players in the market have underwritten crop yield risk for a number of years in Canada’s grain producing regions. Grain processors and transporters are particularly vulnerable to adverse weather conditions. By creating a product tied to crop yield, companies absorb the basis risk that is inherent in a pure weather hedge tied to temperature and/or precipitation.

By creating weather indices specifically tailored to a client’s needs, companies that provide weather risk management can offer two types of customized solutions: 1) hedges for pure-volume risks based on weather measures and 2) hedges for volume and price risks based on a combination of weather and energy commodity price measures. Volume-related solutions are based on cumulative weather indices over a specified calculation period. The hedges can be structured as swaps, floors, caps or collars.

The strike is the index value at which payment occurs. The per-unit payment from the strike is specified by the tick amount (the value per unit of weather).The payout is the positive differential between the index and the strike amount multiplied by the tick. The maximum payout is defined by the limit.

WEATHER TRIGGERS FOR PURE VOLUME HEDGES

According to the National Oceanic and Atmospheric Administration, the top five warmest winters in the Northern Hemisphere, based on 125 years of records, have occurred since 1995. Due to the risks associated with climate change and warmer winters in recent years, weather risk management companies have received significant interest from energy and utility companies interested in hedging against a warmer than normal winter. Warm winters result in lackluster demand and lower-than-expected revenues.

One way for a company to hedge against a warm winter is through the purchase of a weather derivatives contract. Assume a utility company wants to hedge against a warm winter; it chooses Heating Degree Days (HDD) as its weather index for a put structure [a “put structure” refers to the computational formula for valuing a hedge portfolio]. An HDD is 65F (18C) less the average daily temperature (in Fahrenheit). Thus, 65F (18C) is used as a reference point because it has been shown that, if the temperature is this value, there is neither heating nor cooling demand.

The tick is set to the company’s incremental revenue per HDD, assuming temperature is the main variable driving power demand. The strike is chosen to reduce the company’s downside risk related to drop in energy sales volume during a warm winter to a level commensurate with its risk appetite and the costs it is willing to pay for the hedge. An example of a formula for determining the floor structure of a warm weather hedge is provided in Figure 1. Note in this example that if the actual HDD falls above the strike, no payment is made.

In addition to HDDs, weather structures can also be based on other indices such as wind, cumulative snowfall, rainfall or average temperature. Take, for example, the following cumulative snowfall structure.

SAMPLE SNOW REMOVAL HEDGE STRUCTURE

With the fall and winter seasons quickly approaching, local and city governments should be aware that winters with excessive snowfall strain snow removal resources. These events receive media coverage, causing not only political pressure but also budgetary pressures affecting speediness of event correction or a reduction in services in other government-managed sectors.

A recent example is the near-record, 2007-08 winter snowfall in Eastern Canada. A number of cities and their airports quickly exhausted their snow removal budgets. A weather derivative structure based on the cumulative seasonal snowfall could have covered the

increased snow removal costs for the city — i. e., automated melting, hauling and plowing. A payment trigger based on a predetermined seasonal snowfall amount exceeding a specific threshold is an objective way to hedge risk; it would also pay out without having to prove losses and file a claim.

The winter season snow removal example can also be extended to businesses interested in advertising sales promotions with rebates tied to weather events. A prime example occurred earlier this year when thousands of Quebec vacationers who booked a promotion on a major online travel retailer won a free vacation because snowfall exceeded a predefined threshold (12.7 centimeters) at Montreal Pierre Elliott Trudeau International Airport.

HEDGES FOR VOLUME AND PRICE RISKS

In addition to hedges based on pure weather triggers, structures exist for volume and price risks. These double-triggered hedges, known as quantos, can be structured as swaps, floors, caps, or collars. Under these structures, the payout formula is equal to the weather risk multiplied by the price risk. Quanto structures are based on both cumulated weather indices and commodity price risks over a specified calculation period. For example, in a Cooling Degree Day (CDD) structure, the fixed tick amount per CDD is substituted with a variable power price index, reflecting the actual value of the drop in energy sales volume during a cool summer. The structure of this superior — i. e. reduced basis risk — solution can be tailored to the specific needs of a company.

For example, a significant Canadian exposure is tied to hydro-electricity and power prices. Hydro-electricity is the dominant power source in Canada, representing close to 60% of the nation’s power supply. It is a low-cost and environmentally friendly (emissions-free) source of power. Lack of precipitation, both rainfall and snowfall, lead to reduced sources of hydro-electricity. This in turn drives the need for a replacement power supply, either through imports or through firing of thermal power capacity that has inherently higher levels of emissions.

Another kind of weather protection exists for hydro-electricity producers to help hedge their risks. The structure involves measuring a hydro-electricity producer’s tolerance level with respect to rainfall, stream-flow or lake-level amounts. Using rainfall as an example, the payout formula might translate into a payout by number of millimeters below this tolerance level, paid in megawatts of power. Because of the temporal diversification involved with multi-year structures, hydro-electric producers frequently consider three-or five-year structures. See Figure 2 for a sample floor calculation for a volume and commodity price hedge. In this example, if an aggregate rain falls above the weather strike, or if the power price falls below price strike, no payment is made.

TAMING THE WILD CARD

Using financial products to hedge risks has been widely recognized as an acceptable and efficient means to achieve a balanced portfolio and reduce volatility of an organization’s revenues and earnings. Environmental events have always been a ‘wild card’ affecting an organization’s financial plan, but sev erely adverse weather conditions can have a devastating impact upon an organization’s balance sheet. They should be properly managed using a hedging plan uniquely tailored to an organization’s needs.

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Figure 1

Sample Floor Structure

Objective: Limit revenue shortfall

Strike: 3,200 HDD

Actual HDD: 3,100

Tick: Cdn$50,000 per HDD

Payout Formula: Min {Max (Strike-Actual

HDD, 0) *Tick, Limit}

Period: Dec. 1 -Feb. 31

Limit: Cdn$10 million

Payout = Cdn$5 million

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A payment trigger based on a predetermined seasonal snowfall amount exceeding a specific threshold is an objective way to hedge risk. It would also pay out without having to prove losses and file a claim.

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Figure 2

Sample Floor Structure

Weather Strike: 76.2 cm rain

Aggregate Rain: 50.8 cm

Price Strike: Cdn$50/MWh

Power Price: Cdn$80/MWh

Notional: 709 MWh/cm

Limit: Cdn$10 million

Payout Formula: Min(Max (Weather

Strike -Agg Rain, 0

*Notional *Max

(Power Price -Price

Strike, 0), Limit)

Payout = Cdn$540,000