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Jean-Louis Bertrand : « Many companies have recognized the need to hedge against weather risk »

According to Jean-Louis Bertrand, an expert in weather risk management with METNEXT, this risk is likely over $ 400 billion per year, comparable to the foreign exchange risk. The business demand for hedging would be in the process of structuring the market ...

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What is weather risk for a company? Can you give an example of weather risk facing a French industrial?

Weather risk encompasses several concepts that should be clarified. It concerns firstly the impact of a company on the climate, that is to say essentially a legal risk and reputational risk arising from non-compliance with standards and environmental laws imposed on businesses by states to protect the environment and resources. In the other hand there is the impact of climate change on companies. So far, financial professionals have been limited to the physical risk assessment, meaning the destruction associated with extreme weather events. It was ignoring that climatic fluctuations, that is to say changes in weather (temperature, rainfall, etc..) Can have significant financial impact on sales volume or a company profitability. In the energy sector, for example, companies are starting to publish the impact of temperature anomalies (fluctuations relative to normal) on sales or the EBITA. In the case of EDF, the impact of weather in 2010 was 337 million Euros on sales and 215 million Euros in EBITDA. The energy sector is not the only sector involved: the distribution companies are very concerned because the weather conditions the number of customers moving to the point of sale, and influence customer choice in the amount and choice of the product consumed.

What is the part of weather risk throughout the financial risks of major French companies? how do you assess it effectively?

Weather risk is going up more than 400 billion dollars per year, affecting 2 companies out of 3 at different scales. Weather-sensitive sectors are, as we have seen, energy and distribution, which must be added food processing, agriculture, tourism, transport, construction, etc.. In sum, the weather risk is comparable to the foreign exchange risk, and for some companies, it is even more significant than all the usual financial risk in its ability to vary the financial performance from one period to another . To isolate the effect of weather, and produce climate change performance indicators, there should be a "study of weather sensitivity", which is to explain the contribution of all the economic and financial parameters and the weather regarding the company performance.

For Hedging solutions, you propose the use of weather derivatives. These products are they as simple to understand than interest rate or foreign exchange derivatives? Regarding the interest rate risk, a treasurer manages perfectly this risk: If he is indebted to € 10 million for three years on a variable rate E6M, he knows that for hedging he can buy a cap indexed on E6M with 10 years maturity for a nominal of € 10 million. Is it as simple for weather derivatives that appear to suffer from their lack of standardization? Is it not a major obstacle to development ?

The first hedging alternative , like other financial risks, is to reduce the position by considering better the influence of climatic variables, and researching "natural" hedges. When the optimization does not sufficiently reduce the risk of loss, you can actually make use of weather derivatives. In their format and their operation, they are very similar to foreign exchange and interest rate derivatives. Pricing models for weather derivatives are different (not Black and Scholes for the climate), because we obviously cannot buy, sell or store the underlying weather in a portfolio. The market is being restructured, and standards are being set up. The first standardized products were almost use exclusively for the energy sector. Companies outside the energy sector had not been aware of the importance of weather risks. With the magnitude of hazards, and 2010-2011 atypical seasons that we have just experienced, many companies have realized the need to hedge. This time, unlike what happened in the late 90s, it’s business demand that creates the market standard, and not vice versa.

Faced with the weather risk, what is the hedging horizon for companies? A few days? Three months? Six months? A year? The frequency should it match the company business cycles ?

Hedging periods are generally short, ranging from weeks to months. The periodicity is not necessarily the business cycle of the company. It all depends on what the company wants to hedge. In general, the hedging is for weather anomalies. A firm in the mineral water sector makes a greater proportion of its turnover in the summer, but the risk it wants to hedge is not the total volume of sales but the volume change associated with an abnormally low temperature. Same for an energy distributor in the winter that hedges against an abnormally high temperature.

Is there a market for futures on climatic variables? Who manages the risk in fine associated to weather derivatives sold to the company? Can you imagine the use of weather derivatives via securitization of a portfolio divided into slices and sold to investors likely to take risks?

Yes, there are futures on temperature or rainfalls, on strips of 1 to 4 or 5 months, quoted by the Chicago Mercantile Exchange (CME). There are also standards instruments that combine off events such as the number of days of frost or snowfall. The volumes that pass through the CME are quite low regarding the risks to hedge, and do not always meet the specific needs of counterparties. Therefore, in general, the risk in fine is ultimately borne by reinsurers or weather funds.

Critics of weather derivatives suggest that these products are more traditional insurance solutions than financial markets hedging instruments, do you agree?

fully agree with this view of things. If in the operation and size, weather derivatives are presented as conventional derivatives, they actually resemble insurance products. Moreover, the accounting constraints (IAS39 and soon IFRS9) that affect businesses are such that the derivatives do not always fulfill the conditions that allow the company to obtain hedge-accounting treatment sought. In fact, it is often preferable to package the hedge so that it can be accounted for as insurance and that it actually reduces earnings volatility.

Yann Olivier , November 2011

Article also available in : English EN | français FR

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