When weather hedging may not be enough to protect the bottom line

The increasingly changeable and unpredictable climate is exactly what weather hedging, using instruments such as weather derivatives, was designed to protect companies against. Weather risk management can hep you protect your bottom line if you’re a business who stands to lose if the weather varies from historical norms. Most of the time it works very efficiently, but sometimes the weather can be so unusual that hedging just isn’t enough to protect you from the downside.

Take the example of Centrica, owner of UK gas and power provider British Gas, who today released an interim management statement saying that they expect their profits to be lower than market expectations due to unusually warm weather across the UK.

The first ten months of 2011 saw demand for residential gas and electricity fall year on year. Average residential gas consumption was 17% lower than a year before and average residential electricity consumption was down 3%. Business usage declined by 15% for gas and 13% for electricity over 2011 to date versus the year before.

Centrica put this decline down to the warmer than average weather experienced in the UK this year. Now November is so far heading towards being one of the warmest in the UK on record which, unless the weather patterns change, could add to the downside for Centrica.

Centrica are a regular user of weather derivatives to help them hedge exactly this type of weather anomaly and they are a member of the Weather Risk Management Association. In 2010 Centrica benefitted from a payout on a cold weather hedge when temperatures were lower than expected, we’ll have to wait until their 2011 annual report is published to see whether they had the reverse in place for this year.

So, despite being a sophisticated user of weather risk management tools you can’t always predict the weather and hope to offset any variation from the norm. Sometimes the variation may be more than your weather hedge can provide protection for or the weather may swing the opposite way to that which forecasters had expected. Of course the important lesson here is that weather risk management tools like weather derivatives can help you to minimise any loss due to weather variation no matter how extreme it may be. It’s better to have protection in place (as we’re certain Centrica will have had) than no weather risk management strategy at all, just that protection will not always be enough to fully protect you from downside risk.