Bad weather around the world hits UK companies

It has been a winter of discontent for British companies. Not only have many of them had to deal with an onslaught of strikes or demonstrations at their shop fronts, but they have suffered losses from the impact of bad weather, at home and abroad. From freak snowfalls shutting Heathrow and bringing Britain’s transport system to a halt, to floods in Australia sending commodity prices through the roof, it has been a rocky start to 2011.

The weather even took the blame for a 0.5 percent slump in economic growth in the final quarter of 2010 that left the UK on the cusp of the much-feared double-dip recession. And the flurry of post-Christmas profit warnings following the coldest British December on record reads like a Who’s Who of the high street: Mothercare, Clinton Cards, Alexon, Theo Fennell and Next. Building companies, transport businesses and racecourse owners were hit by a real and metaphorical snowball.

While companies often cite unusual weather as a reason for lower profits in all seasons, the sheer scale and regularity of the weather events in recent years have burned a hole in many bottom lines, indicating the trend may be starting to become a normality for British businesses used to little more than a few snow flurries. The Federation of Small Businesses (FSB) has estimated that each day of snow chaos in 2010 cost the British economy between £600m and £1bn: airports operator BAA ran up losses into the millions when it shut down for four days in December. Among small businesses the average loss was about £5,000, according to the FSB.

For most businesses in Britain’s consumer-driven economy, the real risk used to be a slightly unusual stretch of heavy snow or rain that kept shoppers off the high street. So what to do about weather risk if it is becoming the norm?

Companies have long been able to buy insurance against catastrophic weather such as an annual hurricane that destroys an oil rig or a flood that wrecks a grain harvest. But the past decade has seen the arrival of financial products - futures and options - that help companies with large exposure to weather events hedge that risk. Unlike insurance policies that require proof of loss, these contracts pay out when the strike criteria - the change in the weather around which they are written - are met.

The weather future

CME Group, which owns the Chicago Mercantile Exchange (CME) that introduced the first exchange-traded weather futures in 1999, thinks weather risk is a blind spot for businesses of all sizes. A study it undertook shows that while 60 percent of US companies have a high exposure to weather volatility, only 10 percent do anything to hedge that risk. Similar research in Europe by Deutsche Bank suggests that three quarters of companies believe themselves vulnerable to weather, but only a quarter of them take action to manage the risk. And for smaller businesses, the cost of these often bespoke, complex products has been out of reach.

The challenge is to find a product that will protect against a particular risk. The CME offers dozens of products linked to indices for temperature, rainfall and snowfall, based on weather conditions in 47 cities across the US, Europe and Asia. But most companies are likely to want something tailored to the impact a weather event will have on their revenue.

The cost depends on how much revenue they want to protect and how severe a weather change they want to protect against. According to Dan Tomlinson, managing director at Galileo Weather Risk Management, a company that writes tailored products for various businesses, it is essential to identify three key issues. What is the weather that causes the problems? What is the financial impact of adverse weather? And how much pain can the company afford to bear before it wants protection? For a wind farm, it could be loss of revenue from a fall in wind speeds below a certain level, while for an antifreeze manufacturer it could be linked to the number of days in winter above freezing temperatures. For retailers the analysis becomes more complex: the weather may be only one of the factors affecting footfall, along with economic growth and changes in tastes and fashion.

“When it is more difficult to quantify, I would suggest that a general hedge executed quickly is much more effective than getting a comprehensive level of knowledge of where the risk is, but failing to execute it in time,” says Tomlinson. “You can over-analyse the risk to a point where additional research will only refine your hedge to a minimal degree.”