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By MATTHEW BRODSKY, senior editor/Web editor of Risk & Insurance®

When it comes to water, organizations in a green world have to worry about the efficiency of their water use. But some also worry about having enough water in the first place. Risk managers and financial executives have more at their disposal than just doing a rain dance. They can also hedge their scarcity-related risks with weather insurance.

"At the end of the day, the solution is pretty flexible," said Jürg Trüb, managing director, environmental and commodity markets, at Swiss Re, still one of the few major players in the weather market.

For power-generating operations, water contracts have been set up based on the flow of tributaries near a facility, on the amount of precipitation, or on a reservoir level, explained Trüb.

Hedges can even factor in energy prices, tying a lack of rainfall to the price of crude. That way, if a hydro plant finds itself short on water and needs to substitute in oil power to get energy to customers, it can get compensated for the added costs. Such a structure could be established by determining how much an inch less of precipitation would cost in terms of megawatts, which would then translate into a certain amount in replacement crude, based on a set price for the fuel. Such deals could be set up for five years, with the contract paying out five days after a loss is calculated, according to Trüb.

Rumor has it a big deal went down in Chile last year, with oil prices hedged against every millimeter of rainfall. Something along the lines of: If it rained less than 1200 millimeter and oil prices hit higher than $80, then the contract would pay out.

These contracts help out hydro companies in a number of ways including balance-sheet protection or budgetary certainty.

"The tightening credit market makes budget certainty more important," said Wilson Huynh, senior vice president with MMC Securities, the boutique investment banking arm of Marsh & McLennan Cos.

Water deals can also give "PML protection," he said, meaning a safety net should a water-related loss of catastrophic scale occur ... the probable maximum loss in insurance parlance. Most of these hedges, he explained, are structured to pay out once every five, even 10, years.

Coverage can even be engineered in the event aging and inadequate man-made infrastructure is the cause of water shortages.

"This could be a very large market," said Trüb.

For agriculture interests, coverage can be designed to compensate farmers for the cost of bringing in water should Mother Nature not do the trick, or to pay back the lost value of crops should yield suffer, according to David Friedberg, CEO of WeatherBill.

Or say farmers have to ration water and plant lower-valued but hardier crops. A contract could be established to pay the difference in income generated by the substitutes versus the crops the farmer originally wanted to plant.

Friedberg said his San Francisco-based company, which provides customized weather coverage to clients, predominantly through brokers, has already sold a fair bit of drought coverage to Midwest and Western farmers.

"Water levels being what they are, and precipitation levels being what they have been, a number of farmers are really concerned," he said.

Many seek protection from extreme events that appear to be occurring more frequently--an event that could cause a farmer to lose more crop than he could handle, or all of his year's revenue for that matter.

PARCHED DEMAND

Yet for all the promise these coverages offer, in a time when water seems to be getting more precious in many parts of our country and the world, demand just doesn't seem to match the enthusiasm of the insurance suppliers. Part of the problem in agriculture is that it's heavily subsidized the developed world over, including with traditional crop insurance.

Also, there's a bit of learning the hard way going on here. As Friedberg put it, people tend not to become sensitive to water risk until their business gets hit by bad weather and water levels drop, for a year, two or more.

"That's when we get the calls," he said.

Or maybe they don't get the calls at all. Even former weather insurance buyers hesitate to use the coverage today. Take the Sacramento Municipal Utility District (SMUD).

James Tracy, chief financial officer at SMUD, explained how the utility started using weather hedges back in the summer of 2001 for a hydroelectric power plant. After some analysis, Tracy and his team had realized that a nearby weather station possessed precipitation data closely related to the amount of water that ran in the streams and rivers through their dams.

"The amount of energy we can generate is proportional to the amount of water that flows through the dams," he said.

One form of water insurance they got involved in is more like traditional insurance, where they pay a premium for coverage against a catastrophic drought of the one-in-20-year (or worse) variety. If rainfall fell below this drastically low level, they would get paid so many dollars (say, $3 million to $4 million) per inch.

Starting out, SMUD also purchased collar hedges, coverages that would pay out in drier than normal years. But in wetter than normal seasons, SMUD would pay the carrier.

"That would level out our cash flow," Tracy said.

The problem with these collars for SMUD, however, is that they've always been complicated and now they've gotten expensive. As far as complexity, Tracy's team not only had to evaluate the expected losses/gains to be had should a season prove above/below average in wetness, but the collars are also expressed in terms of replacing energy, whose price fluctuates.

"And over time, we started seeing in our opinion a lot more risk premium being priced into these products," Tracy said.

So SMUD dropped the collars and went with an automatic rate adjustment that pushes some of the costs of the water risk onto customers.

The utility set up a reserve fund that they could tap should a dry season happen. If dry season followed dry season and the reserve fund evaporated, they would raise rates as much as 4 percent to cover expenses. If and when wetter seasons return, they could then refill the reserve, and then if possible rebate customers.

SMUD continues to use the catastrophic drought insurance, and Tracy said he would reconsider the collars or some other weather derivative (assuming rates become more reasonable).

But perhaps prices will never become reasonable again. Perhaps--and this is all supposition--the underwriters are sending a message in that pricing.

Trüb at Swiss Re spoke of the idea of awareness-raising through insurance pricing. The purpose of these contracts is to make the insured whole, but are cash payments enough when there isn't any water?

It must also be said that the weather insurance industry has had to deal with an image problem: its products as being expensive, even luxury, niche items.

Even for hydro and other renewable energy businesses?which are inherently tied to weather?weather insurance can be considered an option that's down on the list of financial priorities.

Another big potential user of weather contracts, water utilities, is also largely M.I.A. The industry could be setting up contracts, for instance, to get paid during a drought for losses from government-mandated water-use restrictions, or during a wet spring when no one needs to water their lawn and gardens.

But trying to get the water industry to buy into weather products has been like "pushing on a string," said Martin Malinow, CEO of Galileo Weather Risk Management Advisors. They have no interest, he said, because of the amount of regulation. Malinow is confident they'll come around. "It's coming. It's got to."

But listen to a spokesperson from one of the water authorities contacted for this piece, the Southern Nevada Water Authority. He said, "That (weather insurance) would be a very difficult thing for a government entity to get involved in."

"You'd be spending the public's money buying insurance to what end? What would be the return for it?" he said. "I don't know what insurance would do for us."

He wasn't sure even that anyone would sell them a water hedge considering they've been in a drought for the last 10 years.

The SNWA, as with other water utilities, instead focuses on managing what water it's got through conservation, differentiating water supply through new bodies, desalination and setting up water banks with other states.

"We're in business regardless of the drop in revenue," he said. "Money isn't the issue. It's the water."

September 1, 2009

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