Whilst this month’s mild temperatures across Europe have been pleasant to many of us, they represent a very real financial risk for energy providers, who sell much less electricity and gas than during a cold year due to a reduction in use of heating appliances. In fact, during the first 3 weeks of January, temperatures reached their highest levels since 2010, with a significant impact on energy consumption. The average power consumption in France is more than 12GW lower than at the same period last year, or the equivalent of the production of 12 nuclear power plants!
This chart illustrating the average annual power consumption in France versus the average annual temperature reveals the inverse relationship between the two: the warmer the temperatures, the less energy we consume, and vice-versa. Therefore, energy providers see their turn-over vary with this temperature, because their sales volumes are directly linked to it.
And yet, contingency plans can be made for the weather, ensuring the stabilization of energy firms’ turn-overs. Hedging solutions, or “weather insurance”, is available for large energy consumers, energy companies and portfolio managers to transfer their risk to specialized counterparties.
Weather insurance is easy to set up: the weather risk hedging structure is quoted for the weather station of interest, the period to be covered and the desired maximum level of indemnification. In the case of energy producers, the warmer the winter period, the larger the received indemnification. If the winter period turns out to be cold, though, the company will not require nor receive any compensation. In this way, the company will have a stabilized turnover in any weather.
Price fluctuations on energy markets compound energy producers’ risks
In 2017, prices on the European energy markets were extremely high in early January, due to a combination of cold temperatures and problems with French nuclear power plants. This year, the situation is the opposite: prices on the European energy markets have been on average more than half lower. For example, in France, the average “day ahead” price for delivery between 1st and 22nd of January was approximately €35/MWh, whereas last year, for the same period, it was €75/MWh!
As a result, energy companies have been faced with reduced energy demand from consumers due to warm temperatures, as well as low market prices. In other words, they have had to sell the extra energy that consumers didn’t use at a discounted price.
In order to hedge against both volume risks (which are linked to the temperature) and price risks (which are linked to production and consumption levels amongst other factors), energy companies can utilize bespoke hedging products called quantos to stabilize their revenues. A quanto is a weather-contingent energy derivative; its payoff is triggered if a weather variable (eg. temperature or precipitation) crosses a specified threshold, at the same time as the price passes a certain strike value.
Unseasonal weather expected to continue
With temperatures expected to continue to be mild in coming weeks, electricity prices continue to fall. As the following chart illustrates, today, the monthly futures contract for February in France is trading € 10 /MWh lower than a few weeks ago.
Price evolution (€/MWh) of the monthly Future contract February base France / Source : EEX
Gabriel Gross, CEO of Meteo Protect, an underwriting and brokerage firm specializing in weather risk management explains: “Hedging solutions are effective and essential for energy companies to remain competitive in today’s climate. In France, for example, temperature variations account for 85% of the energy consumption variations in winter and 63% in summer. For distributors, the net sales variation can exceed 30% in case of particularly adverse conditions : a warm winter for a gas distributor or a cool summer for urban cooling networks. At the same time, long-term trends show that unseasonal weather and extreme weather events are on the rise.”
CFOs and portfolio managers at energy firms are likely discussing this concern and how the onus is now on them to assign weather risks higher than ever on the risk matrix and to ensure that a fulsome range of hedging solutions are in place.