A derivative to help firms weather the storm

Does your company's bottomline depend a lot on whether the monsoon arrives in India on June 2 or June 8 "" and pours on well and widespread through the season?

If so, an end to intermittent angst could be at hand: weather derivatives offered by banks are offsetting the adverse impact of the elements on cash flows.

How does it work? Simple. Let's say you are a fertiliser company whose fortunes for this year depends on the monsoons arriving by early June. If it comes too late, sowing will be affected, and so will fertiliser sales.

The bank offering the weather derivative will assess the risks and offer you a deal which will essentially say that if the rains arrive on June 1, you get nothing, but for every day's delay you will be compensated for an agreed amount. So rain or no rain, you get compensated.

RaboBank and ABN Amro have been the first off the block with such products in India.

Currently, they are talking to breweries, food industries, wind parks, sugar mills and processing companies for introducing weather derivatives.

Such products are gaining popularity in Europe, United States, Australia and New Zealand. But they are not that well-sought in Asia due to the continent's overall fair weather condition.

"There is, however, demand in Japan, which faces weather extremeties," said Greger Flodin, director (environmental financial products), Rabobank International.

"The weather risks in India are different. We are looking at the impact the monsoon has on the cash flows of corporate customers," he said.

In the US, Europe and Australia, temperature, especially snow and frost, and rainfall are the key conditions for which corporates buy weather derivatives.

Entities such as cold drink manufacturers, ice-cream dealers, breweries, wind farms, and a host of other corporates are exposed to weather risk. As long as the Met office says the rains are delayed, you get the compensation.

For example, a vineyard in New Zealand was able to tide over frost attack by flying a helicopter over the fields before the grapes could suffer from the cold.

"We did not wait for the company to approach us, but compensated them immediately as the temperature fell. This gives corporates an incentive to invest in their businesses," said Flodin.

"Weather derivatives ensure that corporates are in a position to meet investor expectation and deliver profits by meeting their cash flows even in the face of bad weather," said Peter Brewer, director (environmental financial products), Rabobank International.

The weather derivatives market is estimated at $12 billion by PricewaterhouseCoopers.

It is still at a nascent stage with a handful of large players. RaboBank has a significant share of the market, and has experienced growth rates of 500 per cent in the current year.

Other players include Guarantee Weather in the US, Entergy Koch, an energy trading company in the US, banks such as ABN Amro, Rabo and Credit Lyonnais.

Weather derivatives are different from weather insurance covers. In the latter case, a claim is paid on account of adverse weather, which needs to be proved, while in the derivative version, the payment is made the moment weather turns against you.

Weather derivatives are a cheaper alternative to insurance and can tide over the cyclical weather-related risks, said a senior corporate executive in the food industry.

The cost of a weather derivative depends upon the probability of adverse impact on account of the weather, and the duration of the contract signed between the bank and the corporate entity.

For instance, if a drought takes place once in 50 years, the cost of the derivative would be just 1.5 per cent of the amount that would be payable by the bank.

If the risk could take place once every 2-3 years, then the cost would be higher, say RaboBank officials.

"Our primary focus is the farmer, as opposed to weather derivatives meant for industrial clients dependent on weather vagaries," said Ritesh Kumar, head of risk & reinsurance, ICICI Lombard.

There is a fundamental difference between the two products, the insurance cover being linked to assets and infrastructure, while the derivative is more like taking a call on the weather conditions, he added.

Under the weather

• On 28th July this year, Coca-Cola Enterprises said cold weather in Europe hurt results, which led to an 18 per cent fall in the company's share price in a single day.
• UK-based Northern Foods, the microwave meals giant, ousted its chief executive in September 2003. This was perhaps the first case where an unhedged weather risk cost the CEO his job. Northern discovered that people do not eat microwave meals on a hot day "" but yet the company did not protect itself by despite weather derivatives.
• US giant Campbell's Soup found to its chagrin that international equity analysts recommended playing in its stock based on weather conditions "" because the company had not bought risk cover against inclement weather despite the fact that soup sells less in the hot season.