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They're Singin' in the Rain

Weather-related derivatives protect companies from Mother Nature's toll on earnings.

1Aug

You could call it a weather swap. This past winter in Rhode Island was extraordinarily warm, melting away revenues of Valley Resources Inc., a Cumberland, Rhode Island­ based public utility holding company. But Valley Resources, with $81.6 million in 1998 consolidated revenues, had prepared by purchasing a weather-related contract that reimbursed the company for lost earnings. "The No. 1 thing affecting our earnings over which we have no control is Mother Nature," says CFO and treasurer Sharon Partridge. "Our earnings can swing 20 percent up or down, depending on her whims."


Valley Resources hedged against a mild winter through a derivative whereby it swapped with a counterparty (whose identity, in this case, is confidential) both the upside in revenue generated by a very cold winter and the downside caused by a warmer-than-expected winter. "We retain the risk of temperatures getting either 2.5 percent colder or 2.5 percent hotter than a specific temperature level," Partridge explains.


If it gets colder than the 2.5 percent strike point, Valley Resources pays an energy company on the West Coast a fixed dollar amount. If it gets warmer than the 2.5 percent, the company pays Valley Resources. "This winter, they paid us $250,000, almost 10 percent of our annual $3.6 million in earnings, to make up for warmer-than-expected temperatures," says Partridge, who secured the weather contract through Marsh Inc., of New York. "Meteorologists had been expecting a La Niña year — a colder-than-expected winter — but it turned out to be 6 percent warmer than normal."


Valley Resources is one of about two dozen companies in a wide range of enterprises hedging against the effect of the weather on their earnings. These derivatives are not insurance for act-of-God events. Rather, they are a hedge against more-subtle weather-related problems. With Wall Street paying inordinate attention to earnings estimates and punishing those companies that don't meet projections, the companies are betting such weather-risk transfer strategies ultimately will enhance shareholder value. Some companies, however, prefer to manage their weather risk with internal strategies instead of paying premiums to hedge their exposure.


The U.S. Department of Energy estimates that roughly $1 trillion of the $7 trillion economy is subject to weather risk. A surprisingly wide range of companies are captive to the effect on earnings caused by cooler-than-expected summers, mild winters, above- or below-average rainfall or snowfall, and far more catastrophic events, such as a dry heat wave that decimates cornfields. The latter event can affect more than just farmers. When Universal Pictures selected the cornfield it wanted for the 1989 movie "Field of Dreams," it bought insurance to guarantee the field would grow to the appropriate height by the time of filming. "We wanted to hedge the cost of looking for another cornfield at the last minute," says Wayne Cramer, vice president of global risk management at Joseph E. Seagram & Sons Inc., the New York-based entertainment and beverage company that owns the film and television company.



Attendance Insurance

More recently, Seagram purchased a weather insurance policy on its Universal Studios theme park in Los Angeles to protect against the bad-weather impact on attendance. "The end of 1997 and the beginning of 1998 were predicted to be an El Niño event, meaning that rainfall would likely increase during the period," Cramer explains. "We bought a 'double trigger' insurance policy, in which two things had to happen for the insurance to kick in — an amount of rain above a certain aggregate threshold and a drop in attendance below a certain point."


Both strike points were triggered during the policy period (November 1997­April 1998). "Suffice it to say [the payout] was significantly more than the amount we paid in premiums," says Cramer. "Most important, the insurance hedged the budget coming from the theme park, which stabilized our earnings."



Hedging Mother Nature

Naturally, both the insurance- and capital-market investors are eager to provide a cushion for companies to absorb weather-induced earnings shocks. Major insurance markets include Swiss Re, American International Group, Lloyd's of London, and Zurich Insurance Group. Trading firms specializing in the deals include Enron, Aquila Energy, and Koch Industries. "The competition is driving down the price of transactions, and has increased the breadth of coverage available," says Tim Mahoney, senior vice president at Marsh, which can broker insurance deals and trade securities. "In the insurance markets alone, we can put together at least $100 million in coverage for a single transaction."


While the cost of coverage depends on a wide range of criteria, generally the premium falls between 5 and 10 percent of the limits of coverage purchased. "I've done deals for as low as $100,000 for $2 million in coverage, up to $1.5 million for $15 million in coverage," says Bob Schultz, president of Risk Strategies Corp., a privately held, Atlanta-based financial risk management firm.


Weather insurance not only protects a buyer's balance sheet from earnings gyrations, it can also offer similar solace to its customers. Schultz recently brokered a double-trigger weather program for Columbia Energy Services, the Houston-based marketing arm of Columbia Energy Group, a Dulles, Virginia-based utility that owns more than $7 billion in gas system assets. "Columbia wanted a way to transfer its customers' price volatility as a competitive weapon to retain market share or increase it," he says.


Columbia's customers operate gas platforms in the Gulf of Mexico that are subject to shutdown if a hurricane strikes. Employees manning the platforms have to be evacuated in such an event. When that happens, the producer has to buy gas on the spot market to service its customers, causing its prices to spike. Schultz put together a policy that requires two events to occur — a windstorm above 74 miles per hour within a specific radius of a platform and a rise in the price of natural gas above a certain threshold.



Weather Forecasts

Some companies are passing up weather derivatives and insurance policies, but are buying high-tech weather forecasting services that predict, with a fair degree of accuracy, long-range weather patterns. "If, for example, November is expected to be warmer than usual, we will want to adjust our cold-weather clothing lines," says Eric Specter, executive vice president and CFO of Charming Shoppes Inc., a Bensalem, Pennsylvania-based chain of 1,147 stores in 44 states. "By being able to predict the likely weather, we can plan our merchandising and inventory much more effectively."


Charming Shoppes, with $1 billion in 1998 revenues, hired Strategic Weather Services Inc. to be its in-house weather forecaster. The Wayne, Pennsylvania-based company correlates product sales and historical weather patterns to quantify the effect of weather on consumers and sales. It then forecasts the weather for a client and how that will affect demand for the company's products. Last year, for example, Strategic Weather told Charming Shoppes to expect a warmer winter in its key northeastern markets. "Based on their prediction, we changed our mix of coats to be more midweight, rather than heavyweight," says Sandie Gershenfeld, Charming Shoppes vice president of planning and allocation. "The prediction panned out."


Specter says Strategic Weather has been about 75 percent accurate over the course of the five years during which he has purchased its services. So far, he finds no need to buy weather insurance or derivatives. Says Specter: "Why get involved in hedging this risk when we can control it to some degree?"


Other companies also shy away from weather-risk transfer strategies. "We've examined these vehicles, but have found it more prudent to hedge weather risks naturally, via product and geographic diversification," says Jean Mordo, former CFO and currently group executive vice president, international, at The Scotts Co., a Marysville, Ohio-based manufacturer of lawn and garden consumer products.


Companies should try to develop such natural hedges internally before running out and buying a weather-risk transfer product, says Mitch Cole, a principal at risk-management consulting firm Tillinghast­Towers Perrin, in New York. "A utility concentrated in a particular geographic area may find that if it diversifies its operations in another part of the country, or in another country altogether, it will not be exposed to the same fluctuations in earnings it had previously [been exposed to]," Cole says.


Another voice critical of weather hedging is Felix Kloman, a retired risk management consultant who publishes a newsletter, Risk Management Reports. "I'm not critical of the attempt by finance officers to smooth earnings volatility, given the tremendous overattention paid to stock prices. But if the volatility is inherently natural, such as the expected deviations in the weather, wouldn't shareholders rather you invested their money on the basic business, instead of trying to hedge the weather?"

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