Massimiliano Zanetti believes that more European companies should be managing their weather risks

Following recent research by the Italian Academic Risk Management Association, Massimiliano Zanetti believes that more European companies should be managing their weather risks

Have you ever considered how much money a company can lose because of non-catastrophic weather changes? Research shows that more than 80% of economic activities are weather dependent. Indeed, the Chicago Mercantile Exchange estimates that the losses caused by weather volatility amount to 30% of the US GDP. Without a good weather risk management programme, losses can have a heavy impact on revenue and profit. Even if weather risks are strictly correlated to particular types of operation, many businesses can be affected by sudden, unforecast changes.

Sectors which show an interest in weather risk management include global industries, agriculture, transport and tourism, entertainment, food, drink, and energy. Many of them expect to benefit disproportionately in certain seasons, so weather can present a major risk.

For example, in the energy sector, (the first to be interested in weather risk management), electricity demand is highly correlated to temperature. A hot summer increases the use of air-conditioning, but if the temperature falls below a certain level, the demand for electricity falls.

In such circumstances, a risk manager has to consider the following:

  • Mathematical models are not able to forecast the weather accurately beyond five days.
  • It is difficult to create an adequate commercial plan without having a precise idea of this variable.
  • Price leverage will not stimulate the demand for energy if the weather is unfavourable.

    It is not, however, just the obviously weather-related businesses that can experience significant losses due to adverse climate. Many others can be affected to some extent by weather variability.

    The first step in measuring your exposure is to identify the correlation between your commercial activities and weather changes, by comparing, for example, the profit of several periods with temperature variability. This is not a sophisticated analysis but the results it produces could be very impressive.

    Covering non-catastrophic risks
    There is an appropriate risk management solution for virtually every kind of weather risk. Risk managers generally use two instruments – weather derivatives or insurance contracts. The difficulty of making the right choice between the two arises from several factors:

  • the capacity of the risk manager and his knowledge of the instruments available
  • the feasibility of establishing what the company really needs
  • the possible strategic use of weather risk management; – for example, some insurance contracts can be used not only to transfer weather risks, but also as a marketing tool.

    It is important to remember that both instruments have advantages and disadvantages. Insurance contracts can offer more flexible solutions, but a derivatives-based solution can be more useful, because of the possibility of hedging different positions in the same period of time. Weather insurance provides more tax benefits than weather derivatives, but it is also more expensive.

    Weather derivatives
    Weather derivatives are structured in the same way as options or future contracts, and are often quoted on a regulated market. The preferred underlying variable is temperature, because of the availability of historical data.

    Take the example of an energy company which can sell all the energy it produces only if the temperature is above 28ÞC. To transfer the risk created by a temperature below that level, the company can buy an option like this:

    Index - Temperature
    Type - Put
    Period - June- August
    Premiume - 120,000
    Strike - 28ÞC

    In a temperature higher than 28ÞC the option is not used and the premium is lost. But the company can sell the energy that it has budgeted for. With a lower temperature, the company does not sell its energy. It still pays the cost of production, but can exercise the option to produce a profit.

    A weather risk management programme can also be used as a marketing tool. A hotel in a ski resort can guarantee half price accommodation if the temperature fails to allow skiing. Having transferred the weather risk, the hotel uses this strategy to stimulate the demand for rooms.

    High potential
    According to a Pricewaterhouse Coopers survey, from 1997 to date more than $7.5bn of weather risks of this type have been transferred. Weather risk management is clearly a growth industry and has a huge potential market. 97% of contracts take place in the US, but there is increasing interest in Europe.

    One of the biggest problems in Europe is lack of knowledge of these instruments. It is time to create greater understanding and recognise the opportunities they offer.

    Massimiliano Zanetti is vice president, Academic Risk Management Association, Italy, E-mail: