27 April 2017
Transferring water risk can protect cash flows, balance sheets and ultimately increase the enterprise value of water utilities and hydroelectric producers, says D. Matthew Coleman at Nephila Advisors
Variability in the availability of water can impact the financial performance of many sectors of the economy, including municipal water services, energy, agriculture, and food and beverage producers. When making financial projections, organisations often assume that water volumes will be equal to the historical average. In reality, water volume is rarely average, which can have a direct impact on financial performance.
Proactive organisations are increasingly choosing to quantify and transfer the financial risk of variable water volume, rather than retain it in concentrated form. Some seek to smooth quarterly earnings or cash flows to receive improved terms on equity or debt financing. Others want to meet budget projections to decrease the likelihood of raising costs for customers, facing a downgrade in credit rating, or relying upon a cash reserve that has a high opportunity cost. Still others seek to protect physical assets exposed to water damage or fluctuations in asset utilisation.
Regardless of the motivation, the overarching objective is consistent: organisations desire access to contingent capital that provides financial relief during times of water stress. In this sense, water risk transfer could enhance enterprise value and flexibility like other types of risk transfer products that exist in commodity, interest rate, and currency markets.
Current applications of water risk transfer products
We highlight two applications of water risk transfer that are particularly topical right now: by municipal and investor-owned water utilities, and hydroelectricity providers. Both sectors face water supply and demand risk when water volume varies. When water supply is lacking, organisations can face increased operational costs in order to meet demand. Water utilities might purchase and transport water from a distant source, while hydroelectric utilities might face fuel-switching costs to generate electricity from non-hydro energy sources. Weather and water variability can also impact demand directly. For example, during cool and wet summers, water consumption typically decreases among residential water utility customers.
Below, we highlight frequent questions that water utilities ask when exploring risk transfer products. We also present a case study that outlines the risks and opportunities that a hydroelectricity utility might discover when exploring variability in water volume.
Questions to consider when assessing financial risk due to water volume variability
Organisations that are considering the financial exposures they face related to water availability should ask themselves the following questions:
- Have you located a multi-decadal time series of water volume measurements, like daily stream flow, rainfall, or snow pack?
- Is the water volume measured and quality controlled by an independent third party data provider, such as a U.S. federal agency, research institution, or other entity within the public-private weather-water data enterprise?
- Does the data provider produce live feeds of physical water data that extend the time series on a near real-time basis to facilitate ongoing assessments of water volume?
- Have your research and risk management teams quantified the statistical and physical relationships between water volume, power prices, and asset revenue in various wet-dry scenarios?
- Does your analysis connect with firm-wide financial risk management systems to assess whether it is more valuable to retain the water volume risk of the hydro assets or transfer the risk to an insurer, reinsurer, or similar risk capacity provider?
Data, data, and more data
Multiple decades of weather and water data enable the quantification of water supply and demand risk. Measures of river flow and snow pack are critical indicators of water supply downstream. Measures of rainfall and temperature enable better understanding of water consumption patterns. This allows organisations to establish:
- How often wet and dry weather occurs;
- Whether the variability of water is consistent or changing over time;
- The relationship between weather and water volume and business operations; and
- Based upon historical financial experience, at what level of water volume has negative impacts on financial performance.
Data are typically collected, quality controlled, and updated on a real-time basis by independent third parties such as government research entities and commercial weather data companies. The continuous ingestion and analysis of environmental data provides a dynamic foundation upon which an organisation can build risk management processes and scenario planning.
The water sector is exploring a natural extension of the established practice of financial risk transfer to the capital markets. As risk transfer awareness continues to spread throughout water-sensitive sectors, it is reasonable to expect that management teams and financial stakeholders will increasingly desire to quantify and manage water risk in a proactive manner that can be more cost effective than passive retention.
D. Matthew Coleman is Portfolio Analyst at Nephila Advisors in San Francisco. For more information, email firstname.lastname@example.org.