Weather Risk Management for Regulated Utilities

Why hedging can make sense, even for companies covered by weather-normalized rates.

Weather risk management is growing, but utilities may be losing out.

A recent survey suggests that the number of transactions involving financial derivatives to hedge weather-related risks grew by 43 percent against the prior year for the twelve months ended March 31.¹ Yet regulated utilities continue to show reluctance to embrace weather derivatives.

For regulated utilities, the risk of volatility in commodity costs may be passed directly through to retail customers, using rate-making tools such as a purchased fuel adjustment clause.² That leaves sales volume as the most important weather-related risk factor for utilities. Nevertheless, some utilities believe they have a good alternative to weather derivatives. That alternative comes in the form of weather-normalized (WN) rates approved by the state public utility commission.³

Are the utilities right?

In this article we compare WN rates with various types of financial derivatives for hedging the weather, taking as an example a typical natural gas local distribution company (LDC). We show why WN rates fail to insure against some specific weather-related types of earnings risk. We also show why weather-related derivatives might in fact make sense in some cases for a regulated utility covered by WN rates.