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FAQs: Weather risk transfer as a risk management strategy for water utilities

Weather risk transfer can smooth the financial performance of a water utility and be a useful component of its risk management framework. In exchange for paying a risk premium, a utility receives a cash payment that could enhance its capital standing when weather adversely impacts water supply, customer demand, or water infrastructure.

1. Why is water risk important?

The volume of water in a region is always changing, which matters over a range of time scales. In the short term, water volume can vary on a daily or monthly basis based upon the amount of rainfall or snowpack that is available to recharge water extracted from a watershed. In the longer term, yearly or multi-year periods of drought or excess water can exacerbate shorter-term impacts. Such water variability across time and space can translate directly into financial risk for water-sensitive corporations and municipalities.

2. How does weather impact the financial performance of water utilities?

Day-to-day weather variability can accumulate over time and cause financial stress to water utilities. For example, reduced supply can create operational costs such as increased customer demand and water transport from alternative sources. Excess rainfall can reduce water consumption and sales or cause sewer overflow and damage infrastructure. As a by-product, bad weather can also impact credit ratings and capital expenditure decisions.

3. How do water utilities currently manage weather risk?

Water utilities typically retain weather risk and manage it indirectly. When drought reduces water supply, a utility may implement rate increases and water use restrictions. Capital reserves also play a role and may be drawn down during financially adverse weather and replenished during financially beneficial weather.

4. What is a weather risk transfer product?

Weather risk transfer is a financial product that an entity buys to protect itself against financial downside caused by a weather event. A contract defines the policy term, type and severity of weather, and amount of payment the entity receives when the defined event occurs. As such, the basic principles of weather risk transfer are no different from any other risk transfer product. Importantly, weather risk transfer is designed to protect the balance sheet and is focused on the drivers of financial performance rather than property damage alone.

5. When and how does a water utility receive a weather risk transfer payment?

An independent third party such as the US Government measures weather variables such as temperature and precipitation. When the measured weather exceeds the severity defined in the contract, the utility receives a secure cash payment from the creditworthy protection seller within days of contract expiry. Payment reaches the utility relatively quickly because there is no extensive claims process: the weather alone determines whether or not payment occurs.

Source: Nephila Capital Ltd

 

5. Who buys weather risk transfer products?

Such products are used by businesses and governments to smooth earnings in sectors such as energy, agriculture, and construction, among others. These entities choose to buy risk transfer products to increase the value of their operations by partially reducing the volatility of revenue, costs or budgets.

6. Why would a water utility add weather risk transfer to its risk management strategy?

Water utilities are turning to weather risk transfer to partially address the drawbacks of existing risk management tools. Rate increases can anger customers and expend political capital. Capital reserves have an opportunity cost and may not replenish at the same rate they are drawn. The cash flow injection from a weather risk transfer product during a time of distress can benefit utilities and their customers and demonstrate to stakeholders and rating agencies that management is proactively addressing the impact of bad weather on operations and financials.

Source: Nephila Capital Ltd

Case study: Quantifying water volume variability of hydroelectricity assets to facilitate risk transfer and debt financing discussions

A private equity investor wants to expand its energy portfolio by purchasing two hydroelectricity generation assets from a large industrial conglomerate. In order to estimate expected revenue produced by the assets, the investor has quantified power price variability (min: $35/MWh, average: $50/MWh, max: $60/MWh) and now must quantify power volume variability. The assets are located on a central California river where water storage available for power generation is highly correlated to winter snow pack in the Sierra Nevada Mountains that melts into the river watershed during the following spring. The investor wants to estimate the annual likelihood of physical water scenarios, especially drought, to support its risk transfer discussions with protection sellers and financing discussions with potential lenders. Lenders will assume a poor weather scenario in assessing the amount and cost of a potential loan. Ultimately, the investor desires a risk transfer product customized to its unique power volume and price exposure in order to avoid being subject to unnecessarily conservative assumptions of water volume available for power generation. The investor hopes to receive lending terms that are more favorable than those offered to competitors who have not quantified physical water risk in detail.

This case study was co-developed with sustainability non-profit Ceres. This adapted version is reproduced with permission from the Ceres Investor Water Hub.