The Weather affects consumers’ behavior in terms of what products they buy, where they buy them, and in what quantity. Even if a business knows how normal weather affects its earnings, unexpected abnormal weather events present their own risks. Research shows that abnormal weather disrupts the operating and financial performance of 70% of businesses worldwide. When weather conditions are on average adverse over days, weeks, or entire seasons, shortfalls in sales cause reduced cash flows and can lead to financial distress and business failure.
These disruptions add up. Every year, weather variability is estimated to cost $630 billion for the U.S. alone, or 3.5% of GDP. And yet, this aggregate number adds up positive and negative weather impacts, and masks the true extent to which abnormal weather harms individual businesses operating in utilities, retail, food processing, transportation, and construction, among other industries. In the apparel sector, for instance, the unusually warm winter temperatures across Europe and the U.S. last year triggered shortfalls in sales, store closures, and job cuts. In the UK, no less than 18 weather-related profit warnings were issued by industry leaders. Small businesses are even more vulnerable. Two-thirds of small business managers declare to have been negatively affected by weather over the last three years.
Abnormal weather is the difference between observed weather and its “normal value,” which is typically calculated using the 30-year average. With climate change, the frequency and the intensity of abnormal weather patterns have dramatically increased, and the shift to warmer temperatures will only further this phenomenon. Financial losses caused by adverse weather that did not seem material enough even a decade ago now must be closely monitored and managed with weather-based financial instruments. These instruments are not new. They were introduced in 1997 in the energy sector, to automatically compensate investors for financial losses when the weather index exceeds a predefined level. They work like any other traditional hedging instruments except that the index on which they are settled is a weather index. The index can be average temperature thresholds, rainfall levels, wind speeds or any combination of variables that represent the risk to which the business is exposed. The payment is triggered by and linked to the weather index, not the actual financial loss incurred by the business.
However, efficient risk management can only take place on the condition that the risks are defined. This boils down to writing a relationship between a financial variable (sales, volume, profits or margins) and a weather index (temperature, precipitation, wind speed, etc. or any combination).
Existing research has been inadequate to provide managers with a clear and actionable understanding of their exposure to weather variability. One reason has been a lack of access to the sort of reliable historical weather data needed to model individual business’ exposure to weather risk. This is no longer the case. Big data and cloud computing have made it possible to store and manage the enormous amounts of weather data required to evaluate weather risks anywhere in the world, price and deliver tailor-made hedging products through internet platforms in a timeframe acceptable to customers and cover sellers.
Our research has focused on how businesses can manage weather-related risks, including estimating potential losses and their probability, and potentially using financial instruments to hedge against that risk. Drawing upon the UK’s retail sectors for empirical evidence, we developed a methodology to assess and hedge the exposure of sales to weather risks. In the process, we found that weather has a greater impact on sales than previously estimated. And, perhaps unsurprisingly, the risks vary considerably between industries. Finally, our estimates suggest that hedging against weather risk could help businesses avoid the very real possibility of weather-related financial distress.
Today, weather risk management is still in its early days. The majority of businesses do not hedge against weather risks, nor do they have an accurate view on how much is at risk. Accounting standards on disclosures do not help as weather is not explicitly listed in the risks for which a sensitivity analysis must be provided to investors. The Task Force on Climate related Disclosures (TFCD) chaired by Michael Bloomberg has just released recommendations to overcome this issue.
Disclosing climate change risks is not just about reporting on your energy usage and carbon emissions. Climate change is making severe weather more common, and reporting to investors about how climate affects the business will require companies to estimate and report on the risks they face from the weather.
Source: Harward Business
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Original article: Severe Weather Threatens Businesses. It’s Time to Measure and Disclose the Risks.