Many company financial directors are aware of the importance of managing their risks, whether it be fluctuations in interest rates or foreign exchange movements, all of which can affect a company’s performance. But how many are measuring the cost that variations in the weather have on their bottom lines?
The cold temperatures that hit Spain in early February have affected several of its growing regions in the south and east. In Valencia, 50,000 hectares of citrus groves were affected by the frost, damaging one million tonnes. Florida’s’ citrus sector also suffered severe damage from the weather in 2004, hit by three hurricanes. Given the recent climatic impact on the fresh produce sector, it may be time for weather to be measured as a serious business risk.
Producers and buyers are exposed to the vagaries of the weather, says managing director of WeatherXchange, Cindy Dawes. “Too often we hear, ‘you can’t change the weather’, or ‘there are swings and roundabouts to the weather’. Although you can’t do anything about it, you can solve exposure to weather by taking out risk management structures that hedge weather effects,” she says.
“As a finance director you could not blame adverse foreign exchange rates for lack of financial returns. Your shareholders would not let you get away with it. Likewise the future is the same for weather.”
WeatherXchange was set up in May 2001 to provide the weather risk management market with a central base of European data products and forecasts, as well as offer consultancy and brokerage services, so that a European weather derivative market could develop.
Dawes explains that the group’s largest shareholder is the Met Office, which makes it a unique venture. “WeatherXchange brings together people with years of experience in the financial derivative markets with the meteorological expertise of the Met Office, thereby providing unique weather risk management solutions for the weather derivative markets,” she says.
“However company directors and shareholders across industries are not fully aware of what can be done to mitigate weather risk - we are still educating them. Adverse weather such as extreme temperatures or unusual amounts of rain, can severely damage fruit and vegetable crops, or bring about plant disease or insect infestation. In addition, changeable weather patterns such as warm weather can promote early flowering, or a spell of cold weather can also cause damage,” adds Dawes.
For Emrah Mulayim, director of Turkish citrus marketing company Bamsped, the idea of managing weather risk is interesting. “Weather is a big factor and we take precautions against it at our Turkish operations Bamex by properly stocking and storing fruit to ensure we have supply. We produce 50,000-55,000 tonnes of citrus in a normal season of which 85 per cent is exported to the UK.
“We do our upmost to ensure we meet our supply agreements with retailers by managing our inventory to compensate for the loss of harvesting days,” he says. “It can be challenging because multiples expect programmes to be filled, so they source from several locations to fill their shelves. But in the case of a big weather disaster that affects several countries, then sourcing would be a major issue. But it hasn’t happened so far.”
Weather has made the Journal’s front page several times in the past six months, and one of the major weather events of late were the series of devastating hurricanes that hit Florida’s citrus growing region. “The hurricane damage to Florida’s citrus crops was extensive,” says Mike Yetter, director of international marketing from the Florida Citrus Department.
“Four hurricanes passed through with three hitting the citrus growing regions and two directly impacted the Indiana River district. As a result, this season’s crop is down by 60 per cent. In a non-hurricane year, 41 million boxes of grapefruit and 200m boxes of oranges are picked.”
Yetter says: “The current season’s grapefruit forecast is 13m boxes. However, on a per-box basis the impact on export revenues will be down by about 10 per cent, not as much as the box numbers, because prices have risen.”
So what options are available to the fresh produce sector?
In some industries weather risk management is beginning to become an everyday tool that companies use to hedge exposure to weather, says Dawes. “In constructing a hedge, a consultant needs to correlate the weather effects at that location, on the product in question and evaluate the crucial time periods for given weather events,” she says.
“Once this has been evaluated, and in order to structure the hedge, we need to determine the risk appetite of the client and what percentage of that risk the client would like to cover. For example, can the producer afford to loose a certain percentage of the ‘normal’ crop to weather?
“When this is determined, a hedge geared to the risk appetite of the producer/importer/retailer can be created, taking into account the various weather variables that affect the product, i.e. a hedge that is seasonally structured to take into account crucial time periods in order for the product to develop,” she says.
In recent years global banks, such as ABN AMRO, have entered into the weather market and have played a major role in the development of the financial weather market. Global head of weather and insurance derivatives, Alex Schippers, says managing weather risk forms part of the total risk management strategy for companies, which do not form part of their core competencies.
He says: “Put simply, weather risk hedging is taking out the adverse influences of weather on the core business of the company. Traditionally companies have managed their foreign exchange or interest rate risk by buying protection against adverse movements, and weather is very much part of that risk management approach.”
The weather-derivatives market was developed in response to the deregulation of the US power industry in 1996, where the first trade was done. The market in Europe grew rapidly in 2001 at an annual growth rate of 1,200 per cent.
Although the growth rate has declined, the market has expanded with new weather-effected industries outside the energy sector, such as agriculture, retailers and leisure, entering the market, as well as new regions including Australia and Japan.
“There are several ways of buying protection in what typically is available as insurance,” says Singapore-based ABN AMRO weather derivatives director, Valter Stoiani. “A typical insurance policy would offer protection on the crop itself and if the crop fails, then the claim would cover the actual losses suffered on the crop.
“However, it is different with financial products,” he says. “There is one index that drives the payment or settlement of the contract, in this case a weather index. Depending on where the index settles, there will or will not be a payment, and the size of that payment will depend on where that weather index settles, as well as on the other terms of the contract.
Stoiani adds: “This is a big distinction between weather derivatives and traditional crop insurance. But the biggest difference with weather risk management is that it is protection against volumetric risk and not price risk.”
So how does a company enter into a financial weather contract? Stoiani explains the steps involved: “It is important to be clear about what protection the client is looking for. For example, if a tomato grower is looking for price protection, then a financially traded derivative with tomatoes as the underlying product i.e. a tomato index, would be used.
“However, in the absence of such an index, the farmer could buy a weather contract as a best approximation for that exposure. These products are highly customised depending on the location, crop, volumes etc.
“For example, in 2004 a Mexican co-operative, which offered crop insurance protection to a number of farmers, wanted to pass on its risks to somebody else. The co-op had two choices; it could either go to the re-insurance market or buy a weather derivative. When it compared the two, the co-op decided the more efficient hedge would be to buy a weather derivative because it was exposed to several crops and regions,” he says.
“One of the crops was tobacco grown in Nayarit. Their crucial weather situation is when it gets too cold in the winter, between November and March, because the tobacco leaves start to burn. We defined this period as the critical season. The threshold temperature was 12°C, so at any temperature below 12°C, the tobacco is at risk of damage,” says Stoiani.
“Initially we needed to define the region the grower operates in and find a weather station there to be used as a reference point in the contract. In this case, we defined an index exclusively for the tobacco growers in Nayarit and we called it, damaging degree days (DDD).”
What does this mean? Stoiani explains: “For every day that the temperature drops below 12°C based on the reference weather station, it is a DDD. For example, if on a particular day the temperature is 8°C, then the DDD value is 12-8 = 4. However if it is 12 or above, it is not a DDD.”
At the end of the critical period, in this case winter, weather data is collected and the DDD values are summed. In the Mexican co-op example, a weather option was tailor made where the farmers paid a premium for the right to receive a payment if the DDD value throughout the winter season was above an agreed level, for example 40.
If the DDD value was above 40, the crop would likely be damaged and the farmer would receive a payout. However if the DDD value was less than 40, it is unlikely the crop has been damaged by the weather, and the option would not be exercised.
“The important point is that the co-op does not need to make a claim at the end of the winter because there is a pre-determined settlement date in the financial weather contract, just like any other financial instrument,” says Stoiani.
Schippers reinforces this point: “This is the major difference between an insurance policy and a derivative. With insurance, a claimant needs to prove the crop has been damaged in order to claim under the policy. With a derivative, an index is agreed. As in the case of the Mexican farmers, if the DDD total was 40 or higher, a payment is received even if there is no financial loss. This is why weather derivatives are ideal for the fresh produce sector.”
In another example, Schippers runs through the case of a UK importer who buys 70 per cent of its tomato volumes from Spain and 30 per cent from Israel. “If the tomato crop in one of these two regions fails, then it is likely the importer will have to pay more for tomatoes,” he says.
“To hedge this multi-region exposure, the importer could buy a weather derivative based on a tailor-made index. In the circumstance of one crop failing, for example Spain, they would be paid out on that derivative, which will offset the higher prices for Israeli produce. In this way the importer can deliver the volumes promised to its customers without the financial loss.”
Companies are not only using derivatives to hedge weather risk but also to influence demand. Several retailers have employed weather derivatives to try and influence sales of weather-sensitive items, such as fresh salads and ice cream. “In Japan, given the limited storage capacity in stores, these products are not only used to hedge weather risk, but to also help with planning orders on a just-in-time basis, based on weather forecasts, and to manage inventories,” says Stoiani.
Every country has its weather bureau, and in the UK it is the Met Office who provides the financial weather market with reliable, impartial information to create indices to use for contract settlements. However, the Met office also provides many companies, including supermarkets, with weather information usually on a daily basis.
“Most customers take a regular service from us and use the data as a tool in their routine business planning,” says Helen Tanner, sector-marketing manager for retail. The Met Office has been working with retailers for almost 10 years, providing services which include forecasting sunny or bad weather for fresh produce stocks, i.e. salads, fruit and vegetables, flowers, and seasonal promotions.
“This is very popular with supermarkets, convenience stores and fresh produce suppliers which account for most of our business,” says Tanner. Independent research by analysts Datamonitor has shown that the UK retail industry is potentially missing out on sales of £4.5 billion per year by ignoring the weather, representing more than five per cent of the total UK grocery and clothing retail market.
The Met Office services are designed to help retailers, and their supply chains, to maximise weather-driven trading opportunities, and minimise the impact of any negative effects. According to the Met Office, the benefits of using their services include optimising sales opportunities by meeting consumer demand; help to time promotions for maximum impact; control costs by diminishing waste and shrinkage; and enhance financial management.
One of the Met Office’s clients was the UK multiple Safeway, now owned by Morrisons. The retailer commissioned the Met Office to conduct a weather survey on the impact of weather on their sector, which found that being caught out by the weather costs UK retailers more than £2.7bn a year.
The Safeway case study findings state: “Safeway has discovered that, aside from seasonal trends and promotions, weather has undoubtedly been the biggest influence on their sales. The weather impacts on consumer behaviour and hence product demand... the challenge for Safeway and its suppliers is to consistently meet this demand 365 days a year. The Met Office’s challenge, in turn, is to provide Safeway with the information it needs to proactively manage the impact weather has on its business and thereby improve profitability.”
As a solution, the Met Office provided the supermarket with a web-based suite of services that includes regular daily updates of weather information which allowed Safeway’s supply chain weather team to plan, at all levels, the impacts of forecasted weather on consumer demand.
Safeway’s suppliers also received access to the same range of web services, to help them with planning for future orders. The forecasts, received through the web, ranged from a few hours ahead, for in-store tactical planning, to 10 days ahead, for supply chain planning, and as far out as 30 days to help with event and stock positioning.
A government conference on agriculture and climate change was held earlier this month, with the aim to change farming practices in the UK to suit changing weather patterns.
The conference attendees were warned that in the future, for example, crops grown in the south and east may no longer be irrigated from water taken from rivers and public supply, and that flooding and storms that destroy crops will become more frequent.
Environment minister Elliot Morley told the conference that farmers should rethink their farming practices to reduce soil erosion from flooding. However changing crop practices may be only one of the several solutions now on offer to the agriculture and horticulture industries.
Dawes from WeatherXchange sums it up: “Managing weather risk leads to stability of business performance, improved budgeting capability and may give you a competitive advantage over your peers. The business risk should not be about running the weather risk because that is not what any business model is built on.
“Any business that is weather dependant to determine its financial returns should cover its weather risk exposure. This is easily done and while, like any insurance policy, it will cost to get cover, the day-to-day business need not include worrying about lack of financial returns due to adverse weather events.”
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