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<td width="75%" valign="top"><font face="Arial"><big><b>What is Weather Risk?<br>
</b><strong>by Jack Cogen</strong></big></font><p><font face="Arial"><strong><big>President,
Natsource Inc.</big><br>
</strong>(<em>originally published by PMA OnLine Magazine: 05/98</em>)</font></p>
<p><font face="Arial">Weather Risk is the uncertainty in cash flow and earnings caused by
weather volatility. Many energy companies have a natural position in weather which is
their largest source of financial uncertainty.</font><ul>
<li><font face="Arial">Colder than normal summers reduce electric power sales for
residential and commercial space cooling. These cooler temperatures idle capacity, raise
the average cost of power production, and reduce demand for natural gas and coal energy
feedstocks. <br>
</font></li>
<li><font face="Arial">Above average winter temperatures reduce natural gas and electric
power sales for space heating.<br>
</font></li>
<li><font face="Arial">Lower than normal precipitation upstream of hydropower facilities
reduces power production. This reduces revenues to the facility and diverts buyers of
hydropower to higher cost power alternatives.<br>
</font></li>
<li><font face="Arial">Independent power producers often have weather adjustments built into
their fuel supply contracts. When weather events trigger these adjustments, fuel supply
costs can skyrocket. In extreme cases, fuel supply and business operations are temporarily
interrupted.</font></li>
</ul>
<p><font face="Arial">In a survey of 200 top U.S. utility company annual reports, 80%
cited weather as a major determinant of earnings performance. About 50% claimed weather
was responsible for poorer than expected performance. These figures demand effective
Weather Hedging and Risk Management programs. However, in comparison to other types of
business risk, weather risk has been deficient in hedging and management alternatives. </font></p>
<p><strong><font face="Arial">Weather Risk’s Distinctive Aspects</font></strong></p>
<p><font face="Arial">Weather Risk is unique. It has special attributes that set it apart
from commodity price risk and other sources of risk. First and foremost, weather affects
the "volume" or unit quantity of energy transacted. In contrast, commodity
prices affect the margin at which a single energy unit is transacted. </font></p>
<p><font face="Arial">Both contribute to total risk as independent variables and as
components of covariant risk (see chart, right). Experience and theory suggest that
commodity prices and weather indices do not correlate well in a local area. This makes it
virtually impossible to manage weather risk with a price hedge. </font></p>
<p><font face="Arial"><strong>More Facets Of Weather Risk To Consider</strong></font><ul>
<li><font face="Arial">There are no physical markets in weather. Try as you might, you
can’t store a hot July day until December. You can’t transport a Houston
rainstorm to the Pacific Northwest either.<br>
</font></li>
<li><font face="Arial">Weather Risk is localized. There are few, if any, benchmark indices
in weather that have commercial meaning to broad markets. There is no analogy in weather
to natural gas at the Henry Hub or electric power at the COB Interchange.<br>
</font></li>
<li><font face="Arial">Physical weather is completely beyond human control. It can’t be
influenced, modified or manipulated by regulation, speculation, cartels, major market
players or mass market dynamics. Everyone gets the same raw deal in weather, because
Mother Nature doesn’t bargain.</font></li>
</ul>
<p><font face="Arial"><strong>Weather Hedging And Weather Risk Management</strong></font></p>
<p><font face="Arial">Everyone knows you can’t change the weather. </font></p>
<p><font face="Arial">One-hundred years of scientific research has proven that you cannot
forecast the weather beyond a few days with enough accuracy to support sound commercial
decisions. However, if you cannot forecast the weather beyond a few days with enough
accuracy to support sound commercial decisions. However, if you’re like many energy
companies, you do experience operating results that correlate well with common weather
statistics, such as cooling and heating degree-days. This makes it possible to derive
financial products based on weather outcomes which can be used to transfer your weather
risk to counterparties in a better position to manage it. Today we find insurance
companies, commercial banks, investment banks, large energy companies and trading
companies maintaining large portfolios of diverse risk investments. They are now ready and
willing to underwrite weather hedges in the form of custom OTC contracts that settle on
weather statistics. </font></p>
<p align="center"><img src="../images/weather1.gif" alt="weather1.gif (5694 bytes)" WIDTH="400" HEIGHT="300"></p>
<p><font face="Arial">When carefully constructed to meet your needs, these weather hedges
provide protection against your performance volatility caused by weather.</font></p>
<p><font face="Arial"><strong>Why Hedge Weather? </strong></font></p>
<p><font face="Arial">For years energy companies have been profitable in the midst of
Weather Risk. Some regulated utilities have dealt with the problem by including weather
normalization as an adjustment in their rate making process. However, our regulated energy
industries are heading quickly towards free market enterprise where customers, rather than
utility managers and rate boards, will make such decisions. With this change comes new
opportunity...and new responsibility.</font></p>
<p><font face="Arial">Upon the heels of deregulation, open market Weather Hedging will
soon be a mainstream activity. Dozens of institutional level transactions have been
concluded in the second half of 1997. If you haven’t seriously considered Weather
Heading in your energy business, you may already be behind the competition. It may not be
long before explanations of low revenues and volatile earnings caused by weather are
viewed by investors as excuses. </font></p>
<p><font face="Arial">Investors don’t like excuses. </font></p>
<p><font face="Arial"><strong>Additional Reasons To Consider Weather Hedging</strong></font><ul>
<li><font face="Arial">The cost of Weather Hedging can be lower than other risk management
products. This is particularly true for long-term agreements reaching out 5-10 years.<br>
</font></li>
<li><font face="Arial">Retail demand is here! One new partnership has already experienced
explosive growth marketing fixed cost heating and cooling contracts to residential and
commercial end users. The program allows customers to lock in energy budgets, regardless
of weather outcomes. <br>
</font></li>
<li><font face="Arial">Weather Hedging provides customized solutions by using weather
indices specifically tailored to an individual client’s needs. Basis risk is
dramatically lower, providing a better hedge and adding greater value to the hedger’s
enterprise.<br>
</font></li>
<li><font face="Arial">Weather Hedging brings an entirely new dimension to risk management.
It is the only known vehicle for managing volume risk in the energy industry. This allows
end users greater flexibility in developing multi-faceted risk management programs. <br>
</font></li>
<li><font face="Arial">Weather Hedging is reliable, safe and fair. Weather data is accurate
and more objectively collected than any other major commodity or financial index. At least
50 years of official weather data is on record for most major cities in North America, and
readily available from government sources. </font></li>
</ul>
<p><font face="Arial"><big><strong>Weather Hedging Strategies</strong></big></font></p>
<p><font face="Arial">The five examples that follow will give you a better idea of
structures that producers, consumers, marketers, distributors and transporters of
weather-based energy can use to modify their cash streams.</font></p>
<p><font face="Arial"><strong>Cooling & Heating: Degree-Day Swaps</strong><br>
Swaps can be used to stabilize cash streams associated with cooling and heating energy. </font></p>
<p><font face="Arial">In the example below, an energy producer sells a swap and gets
compensated pro rata per degree-day whenever degree-days settle below an agreed strike
level. When degree-days settle above the strike, the producer pays the buyer of the swap.
The combination of the swap and the producer’s revenue from operations is a more
stable revenue stream. The buyer of the swap sees a mirror effect. This might be a
consumer looking to stabilize his total cost of energy consumption.</font></p>
<p><img src="../images/weather2.gif" alt="weather2.gif (4820 bytes)" WIDTH="400" HEIGHT="300"></p>
<p><font face="Arial"><strong>Cooling & Heating - Degree-Day Options</strong><br>
In their simplest form, options provide a one-sided hedge towards the downside, while
preserving upside potential. This sounds better than a swap on the surface, but it comes
at the expense of a premium the buyer must pay up front for the hedge. In the example
shown, a producer buys a put option and gets paid pro rata per degree-day whenever
degree-days settle below an agreed strike level. This offsets lower revenue from
operations, and sets a minimum floor on total revenues. If degree-days exceed the strike
level, the producer pays nothing more than the option premium, and enjoys full upside
operating revenues.</font></p>
<p><img src="../images/weather3.gif" alt="weather3.gif (5376 bytes)" WIDTH="445" HEIGHT="281"></p>
<p><font face="Arial"><strong>Collars</strong><br>
Collars put boundaries on natural outcomes, limiting them to a desired range. Collars are
constructed using a combination of put and call options. In the example shown, a producer
buys a rainfall put option with a low strike level and sells a call option with a high
strike level. If rainfall settles between the two strike levels (the strike range), there
is no payout to either the buyer or the seller of the hedge. </font></p>
<p><font face="Arial">If rainfall settles below the low strike, the producer receives pro
rata payment per inch of rainfall from the seller of the put option. </font></p>
<p><font face="Arial">If rainfall settles above the high strike, the producer pays the
buyer of the call. When combined with the producer’s natural revenues from
operations, the total revenue pattern is stabilized by the hedge outside of the strike
range. Within the strike range, total revenue follows the unhedged trend.</font></p>
<p><img src="../images/weather4.gif" alt="weather4.gif (5437 bytes)" WIDTH="441" HEIGHT="277"></p>
<p><font face="Arial"><strong>Digital Structures</strong><br>
Digital structures are used to cause lump sum cash transfers between contract parties
whenever specified conditions are met. These structures are useful in situations where
risk and associated costs come in discreet amounts instead of a variable scale. An example
would be a power producer who incurs a fixed cost of bringing a peaking facility on line
whenever temperatures exceed a threshold level. </font></p>
<p><font face="Arial">In the example shown, a two-tier cost structure occurs from normal
unhedged operations. The exposed party buys a digital hedge which mirrors this condition,
thus compensating for the costs when they occur. The digital hedge ensures a fixed cost of
operations regardless of the weather outcome.</font></p>
<p><img src="../images/weather5.gif" alt="weather5.gif (4602 bytes)" WIDTH="427" HEIGHT="283"></p>
<p><font face="Arial"><strong>Embedded Weather Agreements</strong><br>
These types of agreements can be used to combine weather hedges and physical energy
delivery in a single transaction. The payout of the weather hedge is embedded in the
energy supply cost. This can be useful as a matter of convenience, or when policy
restricts the use of naked hedge agreements. Embedded agreements sometimes make it easier
to see the result of combining weather hedges with operating results. Weather hedges can
also be combined with price hedges and physical energy supply. For example, the diagram at
right shows a total cost hedge for an energy consumer who is sensitive to both degree-days
and price volatility. </font></p>
<p><font face="Arial">The shaded area between the dashed lines shows the unhedged range of
highly probable outcomes. After hedging (dark line), both price and volume risk are
eliminated, guaranteeing a fixed energy cost to the consumer. This type of hedge can be
useful for consumers who want to meet energy budgets.</font></p>
<p><img src="../images/weather6.gif" alt="weather6.gif (4639 bytes)" WIDTH="401" HEIGHT="287"></p>
<blockquote>
<hr width="98%" color="#FFFF00" size="1">
<font FACE="Palatino" SIZE="1" COLOR="#000000"><p></font><small><strong>Jack Cogen</strong>
is President of Natsource, Inc. Natsource has concluded weather transactions with every
active market participant, and are the leading specialists committed full-time to weather
hedging products and services. </small></p>
<blockquote>
<p><small>Jack Cogen</small><br>
<small>President</small><br>
<small>Natsource, Inc.</small><br>
<small>Weather Hedging Services</small><br>
<small>140 Broadway</small><br>
<small>30th Floor</small><br>
<small>New York, NY 10005</small></p>
<p><small>(212) 232-5305 Tel</small> | <small>(212) 232-5353 Fax</small></p>
<p><a href="mailto:[email protected]"><font face="Arial" color="#0000FF"><small>[email protected]</small></font></a>
<font color="#000080">|</font> <font face="Arial" color="#0000FF"><a href="http://www.natsource.com"><small>http://www.natsource.com</small></a></font></p>
</blockquote>
</blockquote>
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