New financial umbrellas keep companies dry when it rains on their earnings

Weather: a convenient scapegoat for poor financial performance

Matt Coleman's entire article can be found on the Quartz news website. You can read it here

By D. Matthew Coleman September 17, 2013 (PSU 2005 M.S.)
D. Matthew Coleman is a portfolio analyst at Nephila Advisors LLC in July 2011. Previously, he was a senior weather risk analyst at Citadel LLC.

Matt Coleman

It has become more widely accepted that volatile weather is having an increased impact on corporate performance in a variety of global industries from retail and entertainment to agriculture and energy.  For example, recent retail and beverage earnings reports from Zara, Target,  and Coca-Cola highlight cold and rainy weather as two key factors that contributed to decreased customer demand for springtime goods. More broadly, a study from the National Center of Atmospheric Research estimates that in the US alone, economic activity can swing plus or minus $240 billion annually due to routine (as opposed to catastrophic) weather variability, depending upon whether or not the observed weather was favorable for business operations.  However, despite the clear relationship between weather and profits, the majority of weather-exposed businesses continue to retain weather risk rather than mitigate it.

Evolution of the weather risk transfer marketplace
The natural catastrophe risk transfer industry (for events like hurricanes and tornadoes) is well developed with over $500 billion in risk transferred each year. In contrast, the risk transfer market for day-to-day weather variability (like fluctuations in temperature and precipitation) is relatively smaller at $15 billion, although it continues to mature, according to a 2011 survey Nephila Capital did with PriceWaterhouseCoopers. The weather market has evolved considerably since its founding on energy trading desks in the late 1990s.  During those early years, the desire to transact only standardized products—within the context of turning weather risk into a tradable commodity—led to infrequent transactions on financial exchanges for limited geographies.  However, by necessity weather risk transfer today is evolving from a trading mindset to an insurance one.  This has spawned a rapidly growing over-the-counter market where risk transfer contracts are customized to the specific needs of an enterprise and offer sizable protection with coverage amounts reaching the hundreds of millions of dollars.

How does it actually work?
A number of investment and reinsurance firms like Nephila Capital provide insurance against weather risk.  Effectively, Nephila extracts weather risk from businesses and municipalities in exchange for a premium, and warehouses that risk on behalf of institutional investors who seek investment returns that are unrelated to the broader financial markets. Investment performance is dictated by the weather alone: fluctuations in traditional investments like equities and fixed income have no bearing on whether the United Kingdom experiences a frigid winter or Brazil observes a dry growing season.

Some industries quantify the correlation of weather and their business performance on a daily basis. For example, utilities constantly monitor the weather to balance the demand and supply of energy and when possible, transfer unmanageable weather risk. Other industries are currently less apt to do so. A large retailer may intuitively sense that the weather impacts sales of seasonal goods, but may not proactively measure or try to mitigate that risk.  Thankfully risk takers, insurance brokers, and weather consulting firms are educating weather-exposed entities about the efficacy of weather risk transfer. For example, these educators may help a retailer gather historical weather and sales data to demonstrate that when springtime temperatures fall below 10°C, sales drop by 10%. Now that the retailer has quantified its risk, it can: define the amount of euros per degree Celsius it wants to be paid when temperatures fall below 10°C; estimate the fair value of a risk transfer product; and approach the weather risk market for a quote.

Weather: from fall guy to capital source
As more industries learn that it is possible to transfer weather risk, it is reasonable to expect that equity analysts and rating agencies will too.  A few decades ago, businesses did not transfer the risk of fluctuations in currency, interest rates, and commodity prices. Once those risks were identified as being material to the bottom line and applicable risk transfer markets developed, stakeholders demanded that businesses mitigate those risks and allocated their capital accordingly. Interestingly, unlike other financial risk transfer products whose valuation depends upon a variety of economic factors and investor sentiment that may or may not pertain to the product in question, the value of a weather risk transfer product is derived directly from a physical weather measurement that is transparent to all parties and aids in rapid valuation and settlement of contracts.

It is clear that the weather is a chaotic phenomenon that varies annually, seasonally, and daily. And of course the elephant in the room is climate change and its effect on the frequency of temperature and precipitation events, particularly extreme ones. Atmospheric scientists analogize this to the use of performance enhancing drugs in baseball: although it may not be possible to attribute any single event (home run) to climate change (PEDs), it can increase the overall likelihood for them to occur over the course of multiple years and decades (games and seasons).

Given all of these physical and financial factors, transferring weather risk is becoming a more attractive alternative for capital providers than passively retaining it.  How much longer will investors accept poor financial performance due to weather?  Only time (and capital flows) will tell.