Sunny skies ahead

09 August 2004 Angelo Coppola

(9.8.04) The prudent management of weather risk is thus likely to become a corporate governance hot-topic, and also a major issue for government, according to Charles Nortje, a director of risk finance at Alexander Forbes Risk Services.

On circuit at the moment is a movie about a time in the near future in which a global weather storm changes the world as we know it.

Is this pure science fiction? Perhaps, but Charles Nortje believes that for corporations the management of weather risk is fast becoming a central issue

In July and August 2002, major floods in Europe caused more than $16 billion in losses.  In 2003 the hottest summer ever recorded in Europe led to deaths and crop failure.

Heat waves in France were followed by flash floods. Swiss Re reports that these summer heatwaves can be expected to occur on a two year basis toward the end of the century. Closer to home, Cyclone Delfina in early 2003 left 54 dead and over 200,000 homeless in Malawi and Mozambique.

Scientists like Professor Tim Partridge of Wits ascribe this to the effects of high levels of greenhouse gases in the atmosphere - so-called global warming.

Partridge says that Carbon dioxide levels are at their highest for 420,000 years and that the amount of energy in the system will lead to more frequent and more extreme weather events in the years ahead.

Nortje started collaborating with Partridge in 2001.

In southern Africa, the main weather problem is either too little rain or too much rain.

In the absence of long-term reliable rainfall figures for many areas in the country, Partridge came up with an ingenious proxy for rainfall which avoids the need for monitoring individual weather stations. 

Maize is grown all over the country. According to Partridge the annual declared maize yield in tons per hectare correlates very highly with weather conditions, particularly rainfall.

A weather hedge was constructed for an agri-business company based on the SA maize yield as a trigger.

"Investors have always recognised that certain businesses are more exposed to weather risks than others, for example, energy companies, clothing manufacturers and ski resorts do well in cold weather, conversely agri-businesses, island holiday resorts and beer producers do well in warm weather.

“It came as no surprise that energy companies launched the weather derivatives market as a way of balancing their revenues between winter and summer.

"What did come as a surprise has been the fast rate of take-up by corporations eager to hedge the impact of weather on their bottom line," says Nortje.

It all started back in 1997.

A chain of wine bars in London found that on sunny Thursdays and Fridays, people stayed longer than if the weather was poor. A product was structured to compensate them for each degree by which temperature fell below a certain level.

From these bacchanalian beginnings, the weather derivative market was worth more than $3 billion by 2000, and growing substantially.

"Insurance companies have always offered products such as crop insurance which respond to events like a hailstorm," says Nortje, "but more often companies face risk to their revenues from unseasonal weather changes which are not a one-time event."

Nortje explains that weather derivatives use an index as their base rather than a single insurable event. For example, the trigger might be precipitation, temperature or hours of sunshine over a period.

The major practical issue with such products is whether clients understand the impact of weather changes on the bottom line. Many businesses have an intuitive sense that bad weather impacts on their business, but few have modelled the correlation.

"If the weather derivative triggers, and the risk hasn't been modelled properly you could end up with a payoff that may or may not hedge your loss. This can also lead to accounting problems.

"If the correlation can be shown, the product tends to be regarded as akin to insurance, with tax and accounting benefits.

A purely speculative product falls under AC133 as a financial instrument, which may not be as beneficial," Nortje explains.

Insurance companies in South Africa generally regard weather-related events as their single largest claims exposure. Corporations too are becoming sensitive to the effects on profits.

"The prudent management of weather risk is likely to become a corporate governance hot-topic, and also a major issue for government," says Nortje.

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