Understanding the drivers behind climate and weather risk transfer as an investable asset

Apr 10, 2019

Noel Hillmann: Why do Nephila Climate’s investors choose to invest in weather risk?

Matt Coleman: Usually when we talk about investing in weather risk and the overall strategy that Nephila Climate employs, we often compare it with catastrophe risk with which many ILS investors are quite familiar.

One reason investors invest in Nephila Climate’s weather risk strategy is non-correlation. Generally, the ways in which weather varies day to day – temperature, rainfall, snow, wind – has no bearing on financial markets and vice versa. This means that there is a clear beta play on investing in weather risk because it is non-correlated to broader investment classes. It is also not correlated to catastrophe risk so it can add another diversifying strategy into an investor’s portfolio.

Another reason why investors consider this strategy is because of the general growth of the weather market in sophistication, volume of transactions and increased awareness by companies and governments of the value in hedging weather-linked risk. Awareness is also increasing amongst investors who directly or indirectly hold weather risk through their investments in traditional asset classes like equities and debt, the value of which can be influenced by weather.

This latter point is underscored by the push from large institutional investors for climate and weather-related risk disclosure.

All of this feeds back into the general growth of the weather market, which can provide opportunities to deploy investor capital from investors to support the growing universe of transactions that we underwrite.

Noel: How does an investment in weather risk compare to an investment in natural catastrophe risk?

Matt: One distinction is that generally investing in a risk such as day to day weather risk can be more volatile relative to investing in catastrophe risk. Catastrophes are binary events that may or may not occur. Usually there is a very low probability that these events will occur and cause economic loss that impacts exposures held by an investor.

On the other hand, weather risk consists of a spectrum of exposures that occur more frequently. Weather exposures can range from occurrences of extremes (e.g. very hot or very cold) to departures from expectation (e.g. variance around average temperature). The relatively higher frequency of weather exposures, combined with the ability to be short or long weather risk, can lead to attritional or outsized gains and losses which distinguishes weather risk from catastrophe risk.

Another key difference to mention is that weather exposures can be diversified by exposure direction, in addition to diversification by exposure type and geography. In a particular geographic region, it is possible to sell protection against opposite weather exposures (e.g. hot and cold) during a similar period of time.

Noel: What are some examples of financial risks that are linked to weather and held by corporates and governments?

Matt: There are several financial risks that are linked to common elements of our day to day lives, including energy, food, and water amongst others.

A conventional energy utility might be concerned about a warm winter when revenue is depressed due to less demand for interior heating. A renewable energy project such as a wind farm or solar park, can experience variations in the underlying weather resource (i.e. did the wind blow or the sun shine) that link directly to variations in project cash flows.

In agriculture, there are a variety of participants in the sector that hold weather risk that is linked to crop production due to drought or a surplus of rainfall. They range from individual farmers, to the government programs and banks that insure or lend to farmers, to agribusinesses that operate within the agriculture supply chain.

Within the water sector, examples include hydroelectricity generators and public and private water services companies. Drought can depress revenues of a hydroelectricity project owner, or a cool, wet summer can depress water use and sales of a water utility.

Other sectors that consider hedging weather risks include outdoor entertainment businesses, like theme parks and golf courses, construction and mining companies, and municipal governments.

The common theme is that weather risk transfer products enable corporates and governments to enhance value by stabilising earnings and budgets that vary due to weather.

Noel: What are the types of risk transfer products that Nephila Climate creates and sells to holders of weather risk?

Matt: Nephila Climate and the broader weather market commonly execute parametric weather index products. These risk transfer products pay the protection buyer when the weather measured at a location by an independent source—such as a government owned weather station or satellite measurement—exceeds a contractually defined threshold.

Other risk transfer products pay based upon measurement of an index chosen by the protection buyer that is linked to weather but might not be weather directly. For example, a drought-exposed water utility might prefer a water use index rather than a rainfall index. Such an index is understood and routinely tracked by the water utility because it could relate strongly to revenue that varies significantly when water conservation programs are implemented during periods of drought.

We also develop innovative products that address a core need within a market or sector. For example, a growing number of players within the renewable energy sector utilise our Proxy Revenue Swap (“PRS”) product. The product effectively fixes the revenue of a renewable energy project, such as a wind or solar project, for a period of multiple years. A PRS protects a project and its financial stakeholders against intermittent resource risk (i.e. variable wind speed and sunshine), electricity price risk, and the risk of a variable relationship between resource and price, which is called shape risk.

Regardless of how simple or complex a weather risk transfer product is, a weather or weather-linked index is measured over a period of time and payment is made to the protection buyer when the index threshold is breached.

Noel: How are these underlying weather risks managed in a portfolio on behalf of Nephila Climate’s investors?

Matt: Generally, it can be more efficient for Nephila Climate to accept and warehouse weather exposures, relative to any specific or subset of weather exposures being concentrated within a balance sheet or income statement of an individual corporate or government.

The reason is because we aggregate weather exposures into a portfolio that is diversified across multiple continents, exposure types, and exposure directions. Managing weather exposures in this way allows us to offer better risk-adjusted pricing to protection buyers and returns to our investors.

Noel: How does weather risk impact traditional equity and debt investments held by investors?

Matt: Due to both voluntary and investor – or regulatorily – mandated climate risk disclosures, investors are increasingly assessing the weather and climate exposures within their portfolios of traditional investments, such as equities, fixed income, and commodities, amongst others.

An example could include an investor who holds shares of an energy company or agribusiness. Holding shares of these companies can lead to investment performance that fluctuates due to weather.

Or a bank might extend financing to weather-exposed assets such as renewable energy projects. The project’s ability to service its debt can be linked strongly to the presence or absence of the underlying weather resource.

These are just a couple of examples that highlight how weather can impact the value of traditional investments held by investors.

Noel: How do investors currently manage the weather risk embedded within their existing investments?

Matt: As mentioned previously, investors are increasingly requesting information from companies that describes how weather and climate impacts their operations.

This request for information on weather risk is one way that investors have begun to proactively manage weather risk.

The next step that an investor might take is to screen investments based upon their exposure to weather and climate risk. An investor usually devises a screening process that can be applied consistently across its investment portfolio and inform investment and divestment decisions.

The next step we see beginning to emerge is for investors to quantify the dollar amount of weather and climate risk that they hold. Investors are increasingly asking questions about how and where to find weather and climate data and analysis techniques they might use to quantify the linkage between weather and the historical and future operations and earnings of a particular investment.

Noel: Thank you for sharing your thoughts on this topic.