Published: June 15, 2009
Wall Street has put a lot of pressure on corporates to meet the numbers and forced treasurers to tackle sales and earnings volatility through the use of rigorous hedging programmes. Most companies have dedicated resources to implement and manage IFRS compliant programmes to cover foreign exchange, interest rate and sometimes commodity exposures. To date, weather risks have not been on the radar screen, yet many studies confirm they can have financial consequences on the business and profits that can be far in excess of what currencies or interest rates can generate.
Treasurers have foreign exchange, interest rates or commodity risks under control, but is this the case for their most significant risk?
We all know that extreme weather events can cost companies a lot of money, but they might just be the tip of the iceberg. Day to day changes in temperature, precipitation or sun hours too can considerably affect business activity and more importantly the bottom line. The recent consequences of the high snowfall in London would be a good illustration.
Over the last thirty years, corporate treasurers have learnt to successfully deal with all sorts of financial risks using derivative instruments. However, their ability to do so is not simply about the availability of financial products. They are able to manage their risk because they are able to identify and understand the risks they are facing and the consequences for the business. In addition, the International Accounting Standards Board (IASB) provides a structured framework to report and evaluate these risks and their associated hedging programmes. Finance professionals and investors know where to look in annual reports if they wonder what FX, interest rate or commodity price movements could do to EBITDA. The same cannot be said about weather risks. Yet weather may well be the next crisis companies have to deal with, especially if they are completely unprepared.
Weather risks are defined as non-catastrophic weather events which have a financial impact on company sales or profit. They relate to any measurable and tradable variation to a definable benchmark such as changes in temperature, rainfall, snowfall or even wind speed, but exclude extreme events such as tornadoes, hurricanes, flooding or long lasting droughts. Evaluating globally, the financial impact of weather risks on the economy, is not an easy task because methods differ from one study to another.
In August 2008, WeatherBill published the weather-sensitivity rating of 68 countries (Table 1). The higher the rating, the higher the exposure to weather risks. Brazil may be the most weather-sensitive country in the world, but in dollar terms, the US ranks top of the list. Their weather sensitivity amounts to $2.6tr or 23% of their GDP. The total world exposure is estimated to be $5.8tr. In 2005, ABN AMRO published a study showing that weather risks affect between 20 and 30% of industrial production in Europe and 35% in the US, a fact confirmed by the US Department of Commerce, which also stated that the weather impacts 80% of US companies. [[[PAGE]]]
Some industry sectors are more sensitive to weather than others (Table 2). Météo France showed that, in some cases, weather variables can in fact be the most significant risk factor: up to 90% of electricity consumption, 80% of beer consumption, 70% of textile sales and 60% of selected consumption products such as coffee and tea, are explained by changes in weather conditions, particularly weather. This places in doubt risk management programmes currently in place in these sectors. No doubt treasurers have foreign exchange, interest rates or commodity risks under control, but is this the case for their most significant risk?
It is estimated that the cumulative turnover of companies exposed to the weather is in excess of $1,000bn in the US, $1,250bn in Europe and $700bn in Japan. These studies all confirm that the amounts at stake are considerable and therefore cannot be ignored or undermined by investors, rating agencies, regulators, banks and other financial partners and companies themselves indefinitely.
When the weather has an impact on the level of sales and net profits, it must have an impact, positive or negative, on the value created by the company, and ultimately on its stock return. The influence of the weather may not show on the weekly returns, but since companies publish results on a quarterly basis, the economic reality must eventually catch up.
The study highlighted a number of companies for which the weather has a significant influence on the return of the stock.
Behavioural Finance has tried several ways to establish a relationship between stock returns and the weather. Some studies, for instance, took the view that the weather influences traders’ mood and determines trading behaviour (cloudy days are said to be negatively correlated to stock returns), but while such evidence is still being challenged, we will stick to economics.
Stock returns can be explained by the well-known CAPM (capital asset pricing) model (1964) which defines the return of a given stock as a linear relationship between two variables: the market return and the risk-free rate. Each stock is characterised by its sensitivity to the market return (the famous Beta). In 1976, Stephen Ross extended this model to add more explanatory variables than just these two (Arbitrage Pricing Theory or APT). Under the APT, the expected return of a stock is a linear function of various economic and financial factors (such as the return of the overall stock market, changes in the interest rate yield curve, currencies, changes in commodity prices, etc) and the sensitivity to changes in each factor is characterised by factor-specific Beta coefficients.
French business school ESSCA (Ecole Supérieure des Sciences Commerciales d’Angers) and Metnext analysed the stock performance of 37 companies which all belong to supposedly weather-sensitive sectors (Beverage, Food products, Retail, Energy, Tourism Hotels and Leisure, Textile, Construction, Home Improvement and Utilities) all listed on the Paris stock exchange. They analysed weekly returns over a 9-year period using explanatory models that included traditional finance variables (SBF120 (Société des Bourses Françaises 120 Index), OAT (Obligations Assimilables du Trésor), BTAN (Bon à Taux Annuel Normalisé), inflation, currencies and energy) to which they added weather variables such as changes in temperature, temperature versus seasonal averages, changes in humidity levels, and changes in sun hours. An additional feature was introduced in order to evaluate how long it takes for economics to catch up with the potential effects of weather changes on the business. Four different sets of weather explanatory variables were prepared: average and cumulative weather data from the previous week; the previous month; the previous 2 months; and the previous quarter, resulting in four different explanatory models. [[[PAGE]]]
For each stock, each factor-related Beta was tested for statistical significance, and only the ones which met the required significance level were kept as relevant explanatory variables. Each selected variable was assigned a REP (Relative Explanatory Power) as a percentage contribution in the global explanation of the weekly return, and aggregated by category - finance and weather. This was done for each model with the objective being to answer two questions: is the weather a significant explanatory variable in stock returns and, if the weather has an influence on company’s profit, how long does it take to the market to reflect it in the stock price? The study highlighted a number of companies for which the weather has a significant influence on stock returns. It also showed that the previous quarter’s weather is much more influential in explaining the return of a stock than the previous week’s weather. This can easily be explained by the fact that traders and analysts may not immediately (if at all) consider weather as a key determinant to stock value.
When testing the explanatory power of the previous week’s weather on the 37 stocks, 28 showed a very low exposure to weather (REP < 10%), of which 14 showed no exposure at all, whilst 11 companies had a moderate to high level of exposure to weather variables (REP between 25% and 50%). When considering the previous quarter’s weather however, 29 stocks had a moderate to high level of dependency on weather and only 8 stocks showed no sensitivity to weather.
In most cases, the SBF120 return was the most important explanatory variable (on average, the SBF120 return explained 34% of the stock return) but weather came second, ahead of changes in currencies or interest rate yield curve, which sheds some interesting light on where the volatility of these stock returns really comes from. This also clarified where the true risks and exposures of these companies lie and where hedging efforts should be focused. It is also worth adding that in some cases, weather was the most influential factor in explaining stock returns. Energy, home improvement, beverage and retail sectors were amongst those most exposed to weather conditions.
Managing risks in companies means mitigating, eliminating or transferring undesired non-strategic risks for which shareholders are not expecting additional return. Non-strategic risks under management traditionally include financial risks (foreign exchange, interest rates, commodities, energy, liquidity, credit, etc.) and operational risks (compliance, controls, continuity, reporting, etc.). These risks are closely monitored, not just by treasurers and CFOs but also by auditors, rating agencies and investors. International accounting standards (FAS 133, IAS 32 and 39, IFRS 7) require companies to explicitly publish their risk management policy, with particular emphasis on identification, quantification and hedging procedures. Failure to manage market risks or communicate appropriately to the financial community can have a serious adverse effect on the share value of a company. Investors need to understand the full extent of the risks they are taking to determine the appropriate level of return.
Since weather risks too can affect company performance, and sometimes to a greater degree than other market risks, why should they be treated any differently or worse still, ignored?
Like currency movements, weather conditions are out of the company’s control, but the management of their financial consequences clearly is not. So long as investors and analysts are unaware that weather risks can be hedged, they do not penalise companies for risks they believe to be out of management’s control, but global warming and the surge in the number of catastrophic events is changing this situation rapidly and companies need to be prepared. [[[PAGE]]]
Identifying and understanding the exposure is always the first step of risk management. When dealing with Foreign exchange risks, linking changes in FX rates and P&L is relatively straightforward. Weather risks are different simply because it takes more than sensitivity analysis to establish the relationship between weather and a company’s cash flows. It can be done, provided both weather and financial expertise are combined.
Wealth can be traded like other financial instruments despite the fact that weather has no physical underlying.
Metnext, a joint venture between Météo France and NYSE Euronext launched in April 2007 brings these two skills together. Metnext delivers consulting services to identify, measure, rank, analyse, understand and anticipate weather impacts on company performance. Many supply chain and marketing managers are already benefiting from such work to quantify the impact of the weather on past and future sales, control production volumes, optimise inventory levels, anticipate and meet demand, optimise the launch of an advertising campaign etc. Once the relevant weather variables have been identified, it is possible to create sector-specific or company-specific weather indices. Such indices are used by corporates to manage and plan the business and by insurers, brokers or banks to create, structure, and value weather risk management instruments. Metnext acts as an independent third party by storing and providing historical and real-time data on weather indices. Such indices can be found on the Bloomberg Professional® service or directly on Metnext web platform.
As always, the risk starts at business unit level, and in weather-sensitive sectors, business managers now have a way to rationalise and quantify what good or bad weather can do to their performance. What is an acceptable risk at individual business unit level, may well be unacceptable at group level and this is where treasury needs to get involved. Treasury has the ability to aggregate risks and integrate this information with existing cash flow and profit forecasting systems. In a constrained credit environment with a global shortage of cash, treasurers cannot afford to expose their cash to the mercy of the weather.
Although it may come as a surprise, weather can be traded like other financial instruments despite the fact that weather has no physical underlying. The spot market is the value of the weather index. Forwards, options and swaps are also available. Weather volatility is comparable to most financial markets, although it has become more volatile in recent years. Pricing methodologies are consistent with general trading market practices for pricing options and other derivative instruments, although the traditional Black-Scholes methods can at times be replaced by other stochastic pricing techniques. Weather risks can be managed using the same approach as other portfolios of risks, including value at risk measures, efficiency tests and other Greek parameters.
Weather futures and option contracts have been around for a decade although most hedges are customised bilateral over-the-counter (OTC) transactions. According to the Weather Risk Management Association, more than half of weather transactions are currently done by the energy sector, followed by the construction and agriculture sectors. The most commonly traded contracts are based on temperature indices such as HDD, CDD, CAT or other sector-specific indices (see Box 3). In practice how does this work? Let us consider an example. Météo France analysed the impact of temperature on beer consumption in France. For simplicity, let us say that in the summer a deviation of 1°C from the normal temperature implies a linear change in consumption of 5%. Assuming a normal average temperature of 25°C in July, consider a business which forecasts £10m of revenues during that month. If the average temperature dropped from 25°C to 20°C the financial impact would be a loss in revenues of (20°C – 25°C) x 5% x £10m = - £2.5m. Assuming a 20% profit margin, the loss would reach £0.5m. To hedge this potential loss, a treasurer can use the relevant CAT future contract. If the expected average temperature in July is 25°C, the price of the CAT contract is 775 (25°C x 31 days). Since the value of a tick is £20, the treasurer needs to sell 161 contracts: (£10m x 5% x 20%)/ (£20 x 31 days). As a result, a drop of 1°C in temperature, which would cause profits to drop by £100k would be compensated by the profit made on the hedge (31 x £20 x 161 contracts = £99.8k).
The slow adoption of weather hedging among companies which operate in weather-sensitive sectors is largely due to unfamiliarity with the weather risk market. In fact, a large proportion of senior executives still believe that there are no cost-effective ways to manage weather risks. Furthermore, another major issue is the issue of IFRS or FAS and hedge accounting. Where is the underlying weather risk in corporate accounting books, and what are the accounting rules which apply?
6. Accounting for weather risksCompanies that are subject to public disclosure, either to regulators or their shareholders must demonstrate that the purchase or a sale of a derivative instrument is a true and fair hedge, not speculation. FASB and IASB both provide guidelines on the steps that are required. Under FAS in the US, OTC weather derivative transactions can generally be exempted under derivatives and hedging disclosure rules of FAS 133 section 10 for non-exchange contracts settled on climatic variables, although specific structures and applications have to be assessed for each company situation. All written non–exchange–traded option–based weather derivatives contracts should be carried at fair value with subsequent changes in fair value reported in current earnings. When they are standardised and traded on exchanges, weather derivatives fall within the scope of FAS 133.
IFRS, however, makes a distinction between an insurance contract in which a payment takes place only if a underlying weather index reaches a particular level that has an adverse effect on the policy holder and is a contractual precondition for payment, and other instruments, such as weather derivatives, in which an adverse effect is not a contractual precondition for payment, and the payment based on a specified weather index takes place regardless of whether there is an adverse effect on the contract holder, although the holder may in fact use the instrument to hedge an existing exposure. [[[PAGE]]]
The distinction between insurance and financial instrument is not always clear cut, as some derivative instruments are structured in a way that resembles the use of an insurance contract. For instance, some may argue that a derivative instrument which provides the holder with a maximum payout which only partly offsets the loss on the underlying risk is effectively an insurance contract. One should be aware that the choice of the accounting treatment is dictated by the nature of the instrument rather than the holder’s motives to hedge an existing underlying risk. This view was confirmed by the Basel Committee on Banking Supervision which stated that weather derivatives should be brought under IAS 39 unless the weather derivative meets the definition of an insurance contract.
IAS 39 allows hedge accounting under certain circumstances provided the hedging relationship is formally designated and documented and expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk. It also requires the effectiveness to be reliably measured. IAS 39.78 lists hedged items but does not make references to weather risks.
Additionally, IFRS 7 requires companies to disclose the sensitivity of their results to movements in market risks as a consequence of their financial instruments. This means presenting a sensitivity analysis for each type of market risk (currency, interest rate and other price risk) to which the reporting company is exposed at reporting date. This analysis should show and illustrate how profit or loss and equity are affected by “reasonably possible” changes in the relevant risk variable, as well as the methods and assumptions used to provide this sensitivity analysis.
The weather is a risk to financial performance and companies must prepare themselves to face this reality.
Weather risks and weather derivatives are currently not displayed in IFRS 7 and yet, as we have seen earlier, the volatility in earnings caused by the weather can be considerable. Unfortunately, weather variables are not recorded in companies’ books, unlike currencies or interest rates, and therefore there has to be some way to materialise them as an underlying risk. The emergence of standardised weather indices and risk assessment methods (i.e. Metnext) make it possible to obtain reliable ways of quantifying past and future impacts of ordinary changes to climate variables. Additionally, since the weather market has grown rapidly software companies have started to offer valuation models which are available to corporate customers.
Companies which operate in weather-sensitive sectors need to be able to manage these risks and achieve hedge accounting treatment, and thus need to be provided with a methodology by the IASB to materialise and value weather risks in their financial reports. When the weather has a direct impact on a company’s earnings and its share price, it is only fair to shareholders and stakeholders more generally to be made aware of the financial consequences of adverse (or favourable) changes in weather conditions. At a time when regulators and investors are demanding transparency and sound enterprise risk management, it is no longer acceptable to leave weather risks out.
Investors and shareholders are becoming more aware of weather risks and are increasingly requiring companies to provide detailed information about the risks they are taking and the way these are managed. Hedging products exist, as do risk identification and quantification methods.
The weather is a risk to financial performance and companies must prepare themselves to face this reality. The IASB urgently needs to provide risk managers, auditors and investors with a set of rules to account for weather exposures and weather hedging instruments.
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