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.”
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Gritit, a British gritting company, offers clients “frost day” certificates, weather derivatives arranged with Zurich specialist Celsius Pro. For a premium, customers receive an automatic payout if predefined weather criteria, in this case a certain number of frost days, are exceeded.
The product is primarily aimed at local councils but is also used by construction companies and retailers that have to cover winter service costs. Jason Petsch, Gritit’s commercial director, says weather risk management is the next logical step for any organisation making contingency plans.
“There is huge potential given the state of public finances and any business, whether public or private, that does not have a serious look at this… well, I won’t say I told you so,” he says.
The ultimate aim of hedging out the risk is to know that the contract will compensate for at least some of weather-related losses. Kenny Tang, chief executive of Oxbridge Weather Capital, says there is a clear need for businesses directly affected by weather to consider hedging the financial impact. Research by PwC for the Weather Risk Management Association, a trade body, found that retailers made up only three percent of all weather-hedging contracts set up in 2009 compared with 59 percent for energy companies – who have been hiking their prices this winter using the excuse of the risk in spot energy prices, which is in turn affected by the weather.
Stephen Doherty, chief executive of Speedwell Weather, which provides data and forecasts for insurers and corporates, believes weather risk is a growth market. “We have been involved in this market for 10 years and it has grown steadily, but I suspect that it has further to go. It is clear that it could be more widely used,” he says.
Tomlinson says that while energy businesses are heavy users, the agricultural and construction sectors are less aware of the potential for weather risk management. Petsch adds that government spending cuts will make it more important that councils act to reduce the risk of overspending because of poor weather and, after the past couple of winters, manage the expectation that more roads will be gritted if it snows.
Doherty explains that many of the difficulties impeding the early growth of the market, such as having accessible data on weather trends, have been removed, so there are enough participants offering types of product to make competitive pricing. But the biggest impetus behind future uptake of weather-risk products may be climate change, evidence of which can already be seen in the glut of severe weather events such as heavy snow in the UK, devastating floods in Pakistan and crop-devastating fires in Russia due to unprecedented drought.
Tang, author of the book Weather Risk Management, says that climate change and its impacts will unfold over the next few decades. “What is very clear is that severe weather events of the sort we have just seen in the UK, Brazil, Pakistan, Australia and elsewhere are likely to happen on a more frequent basis,” he says.
Some of this is apparent in the impact the Australian floods had on coal prices. Spot coking coal prices rose as high as $300 (£186) a tonne after January’s floods, a rise of 33 percent which also affected British companies such as mining giant Rio Tinto.
Poor weather has also contributed to a surge in food prices, which have risen to their highest average level on record, outstripping the previous peak in 2008, according to the United Nations Food and Agricultural Organisation.
Abah Ofon, commodities analyst at Standard Chartered, says the recent commodities price rally is mainly due to supply shocks, “in particular adverse global weather conditions. In the short term, price volatility will be significant and supply shocks will amplify price volatility”.
Kona Haque, commodities analyst at Macquarie, expects wheat prices to rise again this year. “A continuation of adverse weather hampering any production recovery would cause prices to surge further to the upside,” she says.
Tang adds that businesses must realise that weather risk is just as important as interest rate and exchange rate risk in its effect on business revenue.
“Next time a severe weather event affects your business operations somewhere around the world with significant financial implications for your company, you have been warned,” he says. “The weather can no longer be used as an excuse.”