Weather forecasting.

I’ve been avoiding putting together a list of predictions for 2010 (more on that later) but just couldn’t resist suggesting that 2010 could well be a breakout year for weather risk management. All of the conditions necessary have finally started to come together and with the worst of the 2008/2009 hysteria behind us (without passing judgement on the future direction of markets), companies (and hopefully individuals) will start to wake up and respond to the risks and opportunities inherent in weather variability. I wouldn’t be surprised if weather risk was one of the top three risks faced by the vast majority of (non-financial) corporations, perhaps even the most important risk in some cases, and of the same order of magnitude as liquidity, foreign exchange, commodity and interest rate risk – all risk categories for which massive global markets in risk pricing and transfer exist. Weather in this regard remains significantly underdeveloped:

(via Ben Smith, First Enercast Financial) For example the Department of Commerce estimates that more than $1 trillion of U.S. economic activity is exposed to weather. Even if a small fraction of new risk is hedged through derivative contracts, 2010 will be a very good year for these markets.

The massive costs incurred in much of the northern hemisphere over the last few weeks due to heavy snowfalls and cold temperatures are just one more example of how important a factor in economic outcomes weather risk can be. For example, just take the exceptional – and uninsured – costs incurred by local authorities and airport operators across the UK for snow removal, sanding, salting, loss of revenues, etc. Previously, a manager of a company (or government entity) who suffered an exceptional weather-related loss could shrug their shoulders and plausibly say “it was out of my hands.” In a way that would be impossible if for example their organization suffered a massive loss because their buildings or equipment perished in a fire and they were not insured. In that scenario, shareholders or taxpayers would be incandescent with rage at the incompetent risk management of the managers. Not managing weather risks is no different in substance (now that appropriate weather insurance and derivatives are increasingly widely available), only remaining so in perception as awareness lags.

Of course I am biased, having invested in Weatherbill, which is at the vanguard of transforming weather risk markets:

(via J. Scott Mathews, WeatherEX LLC) The weather market was built upside down, which is quite a feat, even for financial engineers. What we mean is that it started on the wholesale level without any retail underpinnings. It started out like a castle in the air…The changes coming in 2010 for the weather derivative market will be keyed “from the bottom up.” Solutions companies such as Guaranteed Weather and Weatherbill who bring management choices to “ground level” risk holders are helping to complete a strong base to keep that castle from crashing on us.

The difference between weather derivatives (Weatherbill.com) (or any other new risk management tool) and say books (Amazon.com) is that risk management tools need to be ‘sold’ – there is a learning curve, however shallow; and while most people instinctively understand and can conceptualize their weather risks, their survival instincts – honed by decades of doing business with rapacious financial services firms – and fear of ‘getting their eyes ripped out’ means that they are understandably cautious when considering using weather risk management instruments for the first time.

This is where Weatherbill’s business model I think is particularly well adapted to the opportunity: on the one hand, they have a very modern (open) approach to pricing: anyone can go to their website and play around in their pricing ‘sandbox’. Try doing that ten years ago when you wanted to price up a complex FX or interest rate option. Basically it was build your own model or keep sending pricing request to your favorite sales person (who would then have to go beg the trader for a price, and in addition to the regular parameters, the client’s identity, the salesperson and the trader’s mood would also be imputed into the price. That is of course if he felt like making one.) On the other hand, (and this is something that has evolved over the past couple years) Weatherbill has aggressively sought out distribution partners – insurance brokers, industry platforms (eg travel sites), etc. – as trusted providers to their respective customer bases, they are ideally positioned to help their customers manage their weather risks by leveraging Weatherbill’s platform. I first wrote about this a few months ago, and since then they have signed up a number of new and significant partners.

I love skiing and my family take a season pass at Les Trois Vallees. Obviously weather risk is central to running or enjoying a ski resort. While there are many different types of risk you could look at in the context of a ski resort, in the interests of simplicity (ease of understanding/customer acceptance) and maximum pain relief, there are two risks that I would have loved to have had an embedded hedge for in our season ticket (and I suspect the same would go for someone buying a week-long pass for their holiday, in fact they would probably be even more sensitive/appreciative.)

1. Not enough snow to ski risk: ie not that the snow is great or this or that…the basic risk that the pistes are closed. For most modern ski resorts this is actually a function of temperature and not precipitation, as they use snow-making machine to lay down a base. Temperature risk is much easier to measure and price (than snowfall) and has much lower geographic variability ie you don’t need a weather station on every piste on the mountain.
2. Rain risk: ie the only time it is absolutely unpleasant to ski is when it is raining. Also, rain typically doesn’t help the existing snowpack, making skiing after rain often unpleasant as well.

Using Weatherbill to hedge their risk, Les Trois Vallees could offer a ski-pass that reimbursed me for every rainy day and for every day say less than 80% of their runs were open due to lack of snow. In an age of increasing climate uncertainty (or perception thereof) I am 100% certain this would help them market (and sell more) season tickets. And for week-long tickets, it would be a great marketing tool for advance sales (with significantly positive cashflow benefits), and great for improving the user experience. Imagine a vacationer whose week in the Alps is ruined by 5 days of torrential rain…getting their money back on the lift tickets (irrespective of whether or not they braved the elements) would go a very long way to having them consider giving it another try next year.

Of course this is but one example, I’m sure all of you can think of hundreds more. In fact it might be harder to think of services or businesses that are completely immune to the weather. So really, what are you waiting for? Start hedging!

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