Outlook Cloudy but Improving - Managing Weather Risks
by Jean-Louis Bertrand, Chair, Banking and Finance Department, ESSCA
A recent survey conducted by the French business school ESSCA and AFTE, the French Association of Corporate Treasurers, showed that a vast majority of corporates have not put in place any policy to manage the financial impact of day to day changes in climate variables. Paradoxically, however, the study showed that the same corporates recognise that day-to-day weather changes have a significant financial impact on their turnover.
Weather risks are often associated with catastrophic events such as tornados, hurricanes, flooding or long-lasting drought. Global warming and greenhouse gas may cause these dramatic events which serve as brutal reminders of how climate can suddenly and violently affect economic activities in a given area. But weather changes do not have to be extreme to impact the activity of many companies and sectors. Many studies have proved it, yet very few finance managers seem to have integrated climate variables into their overall risk management policy.
Our study showed that 95% of respondents had not implemented any climate change hedging programme and 88% had no plans to do so in the near future. Yet 76% of them conceded that climate variables significantly impact the turnover and/or the results of their company. This is hard to justify in an environment where financial markets, analysts and investors have little tolerance of risks and uncertainties.
Surveyed companies explain the current situation by the fact that it is easy to identify, and quantify the financial impact of foreign exchange or interest rate changes using standard sensitivity analysis. The financial consequences of a change in temperature or rainfall are much harder to assess and often need a difficult preliminary study. Even if this is carried out hedging is still not straightforward. The only protections that exist for beginners in the field are insurances - mostly for catastrophic events: high risk but low probability. Weather risk management is about low risk, high probability events, and these are covered in some cases by weather derivatives.
The American market is ahead here, with exchange traded weather futures and options for a number of US cities available via the Chicago Mercantile Exchange. But in Europe one of the main problems is finding a weather derivative with the relevant underlying climate variable. Other problems cited by respondents to our survey included lack of internal resource and knowledge, lack of financial expertise or accounting treatment.
Who should have responsibility?
Someone has to bear the ultimate responsibility for a risk management programme, and 33% of respondents thought it should be the treasurer, 22% the finance director and 19% the risk manager where there is one. Twenty-six per cent did not consider that weather risk management belonged to any of these functions but made no other suggestions, demonstrating that weather risks are not clearly integrated in the overall management of the company. Companies allocate considerable resources to the management and hedging of traditional market risks, but almost none to weather risks, and certainly there is still a lack of efficient weather management risk programs, tending to be expensive, illiquid and often irrelevant.
However, the situation is improving. The CME now offers weather derivatives for nine European cities, and Metnext, a subsidiary from NYSE Euronext and Météo France launched in May 2007, is producing a range of weather indices to provide standardised and independent underlying references for derivative products and insurance contracts. The Weather Risk Management Association announced in June 2006 that the notional value of weather risk management contracts from March 2005 to March 2006 increased almost fivefold from $9.7bn to $45.2bn. The market has also been helped by the arrival of speculative hedge funds such as Tudor Investments, Centaurus, D.E.Shaw, Coriolis and Saracen. This increased volume and liquidity should help companies to hedge more in the future and spread from the US to Europe. Before this happens, it may take new extreme events or simply the decision by one or more leading companies to make the first move. Research reports, e.g. by UBS and Lehman Brothers, have also started to alert fund managers and analysts to the importance of weather in corporate strategic importance. Companies have no choice but to integrate weather risks in their strategy and to manage them. It’s only a matter of time.