Weather events have a material impact on corporate earnings. How can this risk be managed?
Extreme weather is common around the world. Research from the European Academies’ Science Advisory Council (EASAC) shows the number of floods and other hydrological events have quadrupled since 1980 and doubled since 2014.
This rise comes at a large economic cost. EASAC’s research reveals that economic losses due to thunderstorms in the US doubled from US$10bn in 1980 to US$20bn in 2015, for example.
Elsewhere, 2013 flooding in Central Europe cost the countries impacted US$18bn in total. Moody’s expects that losses from the devastation caused by Hurricane Irma and Hurricane Harvey in 2017 will exceed US$150bn.
There is clear evidence that extreme weather negatively impacts corporates. In fact, new research by S&P; Global Ratings suggests that climate risk and severe weather have a meaningful impact on corporate earnings.
Material impact
S&P;’s research, conducted in partnership with Resilience Economies, found that 73 companies (15%) on the S&P; 500 publicly disclosed an effect on earnings from weather events in 2017. The large majority reported a negative impact.
However, only 18 quantified the effect. Those that did say weather had a significant negative impact on their earnings reported an average materiality of 6%.
Complexity is highlighted as the main reason so few companies quantify the risk. S&P; cites the airline industry as an example, where the cost of delays due to weather depends on location, time, class of aircraft, and the value of passenger time.
Investor interest
S&P; expects the number of companies reporting on and quantifying the impact of weather events to increase. This is because investors are increasingly interested in understanding what it means for their holdings.
Also, initiatives such as the Financial Stability Board’s Taskforce on Climate Related Financial Disclosures (TCFD) are looking to build a framework on climate-related risks to help increase understanding and to standardise disclosures. More than 250 companies have signed up to support the TCFD’s recommendations so far.
Reporting on and quantifying climate risk will have far-reaching consequences for companies. For instance, S&P; indicates that it may lead institutional investors to build climate risk factors into their portfolio selection processes, thereby placing greater emphasis on climate when directing investments.
Climate may also have implications on ratings. According to S&P;, 65% of the 43 rating actions it took between July 2015 to August 2017 where climate factor was a key driver were downgrades. Further contributory factors could be that more companies are becoming vulnerable to climate change and severe weather events, but few are proactively mitigating the effects on either earnings or credit ratings.
Weather risk checklist for treasury
- Make sure you have an understanding of the areas where weather may impact the business. This process may require an outside consultant to fully assess the level of exposure.
- Think about implementing a weather risk system. Many specialised vendors such as Metnext offer systems that can integrate with treasury and ERP systems.
- Consider learning how to calculate and understand the weather. This can be through the development of a meteorological team or through weather risk training provided by domestic treasury associations. L’Association Française des Trésoriers d’Entreprise (AFTE) offers its members training as part of a wider-reaching programme about alternative treasury risks.
Managing the risk
Whilst treasury cannot control the weather, it can help to ensure that it doesn’t have a negative impact on earnings and credit ratings. There are many products treasurers can use to counter weather risk.
One of the most common is the weather derivative. In a weather derivative trade, one party is paid if a specified weather event (a ‘strike’) occurs. The payment can be a one-off fixed payment or a specified amount (a ‘tick’) that is multiplied by the number of units (such as degrees or inches of rainfall) that exceed the strike level during the contracted period.
Structures of trade include:
Options
A cap or call option will protect the buyer if the weather variable exceeds a predetermined level. Conversely, a floor or put option would protect the buyer if the weather variable falls below a pre-determined level, for example, a cooler than average summer.
Collars
To minimise the cost of the premium, the protection buyer could agree on a collar. This combination of buying a cap and selling a floor (or vice versa) at different strike levels effectively protects against bad weather but limits the upside potential, thereby reducing the premium.
Swaps
With swaps, one party gets paid if the underlying weather data exceeds the strike level and the other party receives a payment if the weather variable falls below the strike level.
Corporates may also issue weather-linked bonds. An energy company, for example, could use a weather-linked bond to hedge its exposure against a warmer than average winter. Depending on how much the temperature deviates from the average temperature for a winter in the pre-defined region, the bond issuer will be allowed to reduce interest payments on the bonds or even to forego the repayment of principal.
A sustainable future
Prevention is always better than a cure, however. And the only way for businesses to mitigate the risk of weather events is to take steps that limit them happening. It is therefore encouraging to see many businesses focusing on sustainability and reducing their environmental impact.
Treasury has an important role to play in supporting the business. This could be by reducing the paper in the department or by issuing green bonds and taking advantage of other forms of green borrowing.
All this work is not just about protecting the business, it is about preserving the planet for future generations. As Sean Kidney, CEO and Co-Founder at the Climate Bonds Initiative told Treasury Today last year: “This is about survival.”
