Weather risk hedging

VERSION FRANÇAISE

hedging

Why Hedge ?

Protecting business margins and prevent unfavorable weather conditions to jeopardize the financial equilibrium has become a no-brainer. Climate variability has stayed within a narrow range until the late 80s and progressively temperature anomalies started to rise. This is when meteorologists and everybody else started to talk about climate change. Initially, the concern was about how far the average world temperature would rise. Between 1980 and 2010, global temperature rose 0.6°C. Naturally, climate specialists from the Intergovernmental Panel on Climate Change have evaluated the extent of temperature rise the world should expect and prepare for. Their latest estimate is that temperature should rise by +2°C by 2050 and +4°C by 2100.

The financial community has very quickly tried to estimate what the impact of climate change might me on the return and the value of many companies potentially exposed to weather risks. Their methodology relied a lot on the exposure of companies to carbon and to their reliance on natural resources. But it turned out to be very complicated if not impossible to value and discount long term cash flows which were very difficult to evaluate and assess what the financial impact was in the short term, which is the traditional investment horizon of most funds and individual portfolio managers.

In the 2012 State of the Climate, the World Meteorological Organization with its statement on climate variability opened new perspectives as the financial community realized that it did not have to wait until 2050 to start feeling the pain of climate change. It has already happened and the financial impact of climate variability can be measured on companies’ results every quarter. If institutional investors keep an eye on 2050, they now know that climate variability in Europe has almost doubled in the last 10 years and is on the rise in the rest of the world. This variability has a direct impact on quarterly results of weather-sensitive companies. Corporate value and resilience depend on stable and more importantly foreseeable quarterly results. Weather-sensitive companies which experience volatile weather-related results will undoubtedly be penalized by investors if they fail to rapidly have a risk-mitigating or hedging plan and an appropriate communication strategy.

World temperature anomaly 1951-1980

World temperature anomaly
1951-1980

Operational management

Companies for which sales or supplies are weather-sensitive can integrate weather forecasts in their existing management systems. The idea is to enhance the ability of the company to bring the right product at the right time at the right place. For instance, if coming summer days are expected to be cooler than normal, a supermarket manager can decide to reduce its orders in beverage and increase them in chocolate if it has integrated weather forecasts in its order system. For those companies which are flexible enough to adjust their business within a few days, the use of weather forecast can improve sales or margins by a couple of percentage points.

Yet, operational management is far from being the not the ultimate response to weather risks. Reliable forecasts do not exceed 2 weeks and practical experience shows that companies which tried to use weather forecast beyond 2 weeks have actually deteriorated their performance versus using a system with no weather information at all. The truth is, in case of long-lasting unfavorable weather conditions, the company might know in advance that it will lose sales, but the bottom line at the end of the year is that is has lost business and profits.

Operational management can be a way to reduce the consequences of unfavorable weather conditions but it doesn’t prevent from losing sales or to suffer from increased costs when the weather is durably unfavorable.

Strategic management

More and more companies are trying to improve their weather resilience by diversifying either their product-mix or their geographical activity both in terms of supply or sales. They use weather risk management specialists to help them select the optimal diversification strategy which best reduces the net impact of natural climate variability

Each product range reacts differently to weather anomalies. By mixing complementary weather-sensitive products it is possible to reduce the overall sensitivity of a company to weather the same way it is possible to reduce the volatility of return on portfolio of shares. If we take the example of two global companies which both produce and sell chocolate such as Lindt & Sprüngli and Nestlé. Lindt & Sprüngli has 100% of its sales in chocolate. Nestlé is more diversified in terms of products since it also sells ice-creams and mineral water. If spring or summer is cooler than normal, Lindt & Sprüngli wil suffer a lot more than Nestlé.

Geographical diversification is another way to reduce the global exposure of a company to changes in weather conditions. In the textile sector for instance, Next concentrates more than 90 per cent of its sales in the UK. Inditex, which owns Zara, has 60 per cent of its sales spread evenly across Europe. If spring is cooler than normal in the UK, which happens quite regularly, Next’s financial results will necessarily be more affected than Inditex’s.

Having said that, geographical diversification is not the ultimate solution against weather risk either. A lot of people wrongly assume that because a company is “global”, its exposure to unfavorable weather conditions is small as it is likely that “bad” weather somewhere is offset by “good” weather somewhere else. It is myth. Just use Coca-Cola Q2 results as an illustration. The group announced that sales results were down in the US because of unusually cold temperatures, and down in Europe because of cooler-than –normal temperatures and down in China again because of unfavorable weather conditions. Kepler Cheuvreux and Meteo Protect analyzed how likely it was that weather anomalies were in the same direction at the same time. They showed that in the last 30 years, the impact of weather on a quarterly basis between the US and Europe adds up 60% of the time and that there is compensation only 16% of the time, which means that geographical diversification leads to true risk reduction only 1 every 6 years.

To conclude, when both product and geographical diversification have been pushed to the limits, the only remaining solution to manage efficiently the residual weather exposure is to use weather financial hedging instruments.

Hedging weather risks

Weather-sensitive companies which hedge against unfavorable weather conditions used index-based financial instruments know as weather derivatives or weather insurance products. These products work exactly like foreign exchange or commodity hedging instruments. The only difference is that the index on which the payout is calculated is a weather variable. Most of the time, the weather variable is temperature-related. It is often an average temperature or a cumulative weather anomaly. Other contracts can be based on rain, wind speed, sun hours or cloud cover. Again, for each of these variables, it is common to use average indices or cumulative anomalies. In agriculture, the index is often a combination of several weather variables.

Options are the most commonly used weather hedging instruments. Thanks to the weather-sensitivity analysis, a company has the ability to know which weather variable to use as an index and financial losses related to a change in the index value. The company can choose the level at which the cover should trigger (the “strike”), the payout per unit of change of the index (known as the “tick”), the maximum payout, the time period and the geographical area which applies to the cover. The price of the cover depends on the choices made by the company and the probability that the risk materializes.

If the weather was unfavorable during the cover period, the final value of the index exceeds the strike and the company is automatically paid. The payout depends solely on the value of the weather index. If the weather was favorable, there is no payout as there is no weather-related loss to the business.

When there is some symmetry between weather and financial performance, it is possible to decrease the price of the cover by giving up some of the weather-related upside additional profit. These hedging instruments are known as “collars” or “swaps”.

Index-based weather hedging instruments can either be derivative products or insurance contracts. The choice depends on local accounting and tax rules. In the case of insurance contracts, the payout is traditionally integrated to the operational result. This is particularly relevant for a listed company as it is a way to reduce EBITDA volatility and avoid being penalized by financial markets. When using weather derivatives, the potential payout is integrated to financial results unless the company has obtained hedging accounting treatment.

In all cases and for all companies operating in weather-sensitive sectors, weather index-based hedging instruments are the only way to efficiently handle the financial consequences of unfavorable climate conditions.