CONSUS S.A.

WEATHER RISK

Definition of weather risk

The Weather Risk Management Association (WRMA) defines weather risk as financial profit or loss caused by the variability of daily weather conditions. Another definition was presented by E. Banks, who states that weather risk is a () financial risk to which every business can be exposed, exposure is related to weather conditions like: snow, rain, wind, temperature. For companies representing the energy sector, non-catastrophic risk may occur generally in the form of unstable temperature variation. This risk is illustrated on the chart below.
C HART 1 C ORRELATION BETWEEN
MONTHLY

A VERAGE TEMPERATURE

AND AMOUNT OF CONSUM PTION OF HEAT ENERGY IN XYZ CITY .

Source: Consus S.A.

Chart 1 shows the typical link between heat energy consumption [GJ] and average monthly temperature. Practically the same correlation exists between average temperature and consumption of electric energy [MWh], or even gas consumption [m3]. During the heating season, temperature deviations in plus (from historic values) always result in lower sales the warmer it is, the lower the sales are. This causes lower annual income, hence most of companys income is generated during the heating season. Furthermore, a warm winter may contribute to not only the loss of money, but also the loss of the liquidity that is necessary for financing current and future investments or modernizations of the companys facility.

Consus S.A.; Dominikanska 9; 87-100 Torun Poland; District Cort in Torun - VII Economic Departament, Register of companies - KRS 0000329119; NIP: 879-22-48-150; Stock capital: 500 000 PLN; +48 56 653 97 13 +48 56 475 41 93

How big is your company exposure to the weather risk?

The possibility of financial loss caused by non-catastrophic weather risk will be a problem for a company only if both the amount of loss and the probability are high. In other words, risk of relatively low losses together with low probability will be considered unimportant. Unfortunately, weather risk in the energy sector must factor in relatively big losses with high probability, mostly at the level of 40/50%. To define how big the weather risk is for a company (in money units), it is important to introduce the Heating Degree Day index, which is commonly used in the market to measure risk of that nature. Heating Degree Day is an index which summarizes (in certain period of time) deviation in plus of average temperature from base temperature, which usually equals 16 C. An example of HDD calculation for one week with base temperature at 16 C
T ABLE 1 M ETHOD
OF CALCULATING

H EATING D EGREE D AY I NDEX

Day
March 1 March 2 March 3 March 4 March 5 March 6 March 7

Average temperature
10 C 13 C 16 C 18 C 15 C 14 C 13 C

HDD [16]
Max(0;16-10)=6 6+Max(0;16-13)=9 9+Max(0;16-16)=9 9+Max(0;16-18)=9 9+Max(0;16-15)=10 10+Max(0;16-14)=12 12+Max(0;16-13)=15

Source: Consus S.A. This method for calculating the Heating Degree Day index is determined by the human nature to heat up rooms when outdoor temperatures drop below a certain point, commonly below 16 C. If the outside temperature is higher than 16 C there is no need to use heating systems. In conclusion, such an index explains the instability of energy sales better and simpler than average monthly temperature (chart 2).

Consus S.A.; Dominikanska 9; 87-100 Torun Poland; District Cort in Torun - VII Economic Departament, Register of companies - KRS 0000329119; NIP: 879-22-48-150; Stock capital: 500 000 PLN; +48 56 653 97 13 +48 56 475 41 93

C HART 2 C ORRELATION BETWEEN H EATING D EGREE D AY I NDEX [16] AND MONTHLY SALE OF

HEAT ENERGY

1,800,000 1,600,000

Heat energy sale [GJ]

R2 = 0.9705
1,400,000 1,200,000 1,000,000 800,000 600,000 400,000 100 200 300 400 500 600 700 800

Heating Degree Day Index [16]

Source: Consus S.A. According to chart 2, the degree of weather risk exposure is based on sale instability as a result of an increase/decrease of the degree day index by one point in a certain period. An outcome of weather risk analysis is information about the scale of exposure, for example: 2400 GJ for each point on the HDD index. However, the expected level of HDD and its volatility in whole year enables to estimate with certain accuracy chance to obtain financial outcome higher than planned. For example, each point on the degree day index can change a companys income by 20 000 EUR. That means that if the index decreases/increases by one point, the companys revenue declines/rises by that amount. Therefore, during heating season, if the expected value of the HDD index was estimated to be 2400 points and the actual value turned out to be 2350 points, the company bears a possible loss of one million EUR. [(2400-2350)x20 000 EUR = 1 000 000 EUR.

Consus S.A.; Dominikanska 9; 87-100 Torun Poland; District Cort in Torun - VII Economic Departament, Register of companies - KRS 0000329119; NIP: 879-22-48-150; Stock capital: 500 000 PLN; +48 56 653 97 13 +48 56 475 41 93

How can weather risk be managed?

Risk management is a continuous process designed to stabilize cash flow and consequently enlarge the value of a company. The energy industry should protect total revenues and through the hedging strategy stabilize the profit level set out in the business plan. Risk management can be defined in two different forms: a) physical control risk reduction or avoidance, b) financial control risk retention or transfer.

C HART 3 F ORMS OF R ISK M ANAGEMENT

Source: Tarczyski W. Mojsiewicz M. Zarzdzanie ryzykiem, PWE 2000. Humans are not able to prepare a high accuracy long term weather forecast. Business activity in the energy sector is a yearlong activity, hence weather risk avoidance using weather forecasts is not possible. Furthermore, weather risk reduction is also not possible since humans cannot affect (or change) weather conditions. Therefore, in practice, a company can only retain or transfer its risk. Financial risk control risk retention is a reasonable solution for the energy sector only when a company is able to diversify its business and alongside its core business (negatively correlated with weather) run another business (at the same scale) but with positive correlation. In that case, risk is eliminated and financial outcome for the company is not exposed to weather risk. Nevertheless, it is very hard to find such business profiles, which would enable in certain and natural ways to cover losses caused by a warm winter. Another way for a company to retain risk is to bear all costs from the companys capital.
Consus S.A.; Dominikanska 9; 87-100 Torun Poland; District Cort in Torun - VII Economic Departament, Register of companies - KRS 0000329119; NIP: 879-22-48-150; Stock capital: 500 000 PLN; +48 56 653 97 13 +48 56 475 41 93

This solution is also not economically justified, hence it needs to prepare high money reserves for eventual losses, even for a few years in a row. With positive ROE (Return on Equity), making such a reserve means essential decrease in project profitability. Moreover, a company which decides to retain risk inside will be perceived by owners or creditors as a high risk investment. This can cause reluctance to develop such types of business. The next risk management application is to transfer that risk directly onto the customer (contracting, normalization, etc). Such an approach can diminish a companys competitiveness. It also brings out market regulators objections during price acceptance. It should be noted that customers have a lower ability to absorb that kind of risk than capital market entities. Thus, in cases of bigger variations in weather conditions (from average level), such events can cause difficulty in making regular payments. Furthermore, the European Commission states that such practices discourage customer energy savings and equipment modernization, which is inconsistent with the emission reduction policy. Solution for problems caused by the risk of non-catastrophic weather is to transfer it on capital markets using weather derivatives or by establishing insurance contracts.

What are the advantages of weather risk management?

The main advantage of risk management is increasing the opportunity for finance plan realization. Eliminating weather risk with weather derivatives allows: a) an increase in the economic value of a company because a small reduction of profits (cover premium) significantly decreases weather exposure. Hence, such an investment will be more attractive for many shareholders b) for the stabilization of cash flow within the company, c) for the improvement of financial indicators, what allows for the negotiation of credit conditions.

Consus S.A.; Dominikanska 9; 87-100 Torun Poland; District Cort in Torun - VII Economic Departament, Register of companies - KRS 0000329119; NIP: 879-22-48-150; Stock capital: 500 000 PLN; +48 56 653 97 13 +48 56 475 41 93

Case study: Weather derivative at ABC Company

Sale results for ABC company are highly correlated with temperature level. The board of this company is aware that the outcome of heating energy sales depends on weather conditions. In connection with the important investments, the board is afraid that a warm winter could thwart its financing plans, which could result in a rise of total costs. In order to prevent such a situation, the company asks Consus for help with introducing a weather hedge. According to the analysis prepared by Consus, ABC received information about weather exposure (table 2) and observed temperature tendency (HDD index) in its geographical location (chart 3).
T ABLE 2 W EATHER EXPOSURE FOR ABC COMPANY

Scenario Expected value in season 2010 Expected value standard deviation Expected value 2*standard deviation Expected value + standard deviation Index value from year 2001 Expected value - 1 pt Expected value - 80 pts

Seasonal HDD [16] (Oct-Apr) 2480 2240 2000 2960 2209 2479 2400

Complete probability Deviation from that index value will be planned sales equal or lower 0 EUR -3,600,000 EUR -7,200,000 EUR 7,200,000 EUR -4,065,000 EUR -15,000 EUR -1,200,000 EUR 50.00% 15.87% 2.28% 97.72% 12.94% 49.83% 36.94%

Source: Consus S.A.

C HART 4 L EVEL OF HDD INDEX IN YEARS 1979-2009 IN THE AREA OF ABC COMPANY

3,200 3,100 3,000 2,900 2,800 2,700 2,600 2,500 2,400 2,300 2,200 2,100

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

Source: Consus S.A.

Consus S.A.; Dominikanska 9; 87-100 Torun Poland; District Cort in Torun - VII Economic Departament, Register of companies - KRS 0000329119; NIP: 879-22-48-150; Stock capital: 500 000 PLN; +48 56 653 97 13 +48 56 475 41 93

2009

On the basis of data from table 2 and chart 3, it has been established that the company would like to hedge against a decrease of HDD index below 2400 points. Furthermore, the company is willing to pay only 400,000 EUR, and in case of a strong winter (index level over 2640 points), ABC company shares its profits with the weather hedge provider. Bearing in mind those conditions, Consus prepared a hedge offer called collar, details of which are in tables 3 and 4 and on chart 4.
T ABLE 3 E FFECTS OF WEATHER COVER CALLED " COLLAR "
Payout New Sales from weather (hedged, including hedge hedge costs)

HDD index level [16]

Sales (without weather cover)

1760 1840 1920 2000 2080 2160 2240 2320 2400 2480 2560 2640 2720 2800 2880 2960 3040 3120 3200

29,200,000 30,400,000 31,600,000 32,800,000 34,000,000 35,200,000 36,400,000 37,600,000 38,800,000 40,000,000 41,200,000 42,400,000 43,600,000 44,800,000 46,000,000 47,200,000 48,400,000 49,600,000 50,800,000

9,600,000 8,400,000 7,200,000 6,000,000 4,800,000 3,600,000 2,400,000 1,200,000 0 0 0 0 -1,200,000 -2,400,000 -3,600,000 -4,800,000 -6,000,000 -7,200,000 -8,400,000

38,400,000 38,400,000 38,400,000 38,400,000 38,400,000 38,400,000 38,400,000 38,400,000 38,400,000 39,600,000 40,800,000 42,000,000 42,000,000 42,000,000 42,000,000 42,000,000 42,000,000 42,000,000 42,000,000

Source: Consus S.A.

Consus S.A.; Dominikanska 9; 87-100 Torun Poland; District Cort in Torun - VII Economic Departament, Register of companies - KRS 0000329119; NIP: 879-22-48-150; Stock capital: 500 000 PLN; +48 56 653 97 13 +48 56 475 41 93

T ABLE 4 W EATHER HEDGE OFFER - C OLLAR

Hedge period Payout strike [HDD pts] Tick value of payout Maximum payout Strike of extra payment [HDD pts] Tick value of extra payment Limit of extra payment Total hedge cost

Year 2010 2400 15,000 EUR 9,600,000 EUR 2640 15,000 EUR 8,400,000 EUR 400,000 EUR

Source: Consus S.A. The company which bought this hedge (as a derivative or insurance) is sure that regardless of the weather, it will have a total revenue (from energy sales and hedge payout in total) of at least 38,400,000 EUR (cost of hedge already included).

C HART 5 S ALES PROFILE WITHOUT AND WITH WEATHER HEDGE

52,000,000 50,000,000 48,000,000

Total revenue [EUR ]

46,000,000 44,000,000 42,000,000 40,000,000 38,000,000 36,000,000 34,000,000 32,000,000 30,000,000 28,000,000 1760 1920 2080 2240 2400 2560 2720 2880 3040 3200

Total revenues (without hedge) Total revenues (with hedge)

HDD[16] index

Source: Consus S.A.

Consus S.A.; Dominikanska 9; 87-100 Torun Poland; District Cort in Torun - VII Economic Departament, Register of companies - KRS 0000329119; NIP: 879-22-48-150; Stock capital: 500 000 PLN; +48 56 653 97 13 +48 56 475 41 93

Role of Consus
Our company is always first on the market with cutting edge innovative financial instruments. We prepare comprehensive expert reports on the identification and measurement of weather exposure (rainfall, snowfall, temperature, and wind) and organize transactions of weather derivatives in Poland and other EU member states. Consus is also a market leader for emissions trading in Europe. Our strong position in this market results from many years of experience we have been an active player on the carbon market since 2000. Headquartered in Torun (Poland), Consus S.A. created Consus France S.A.R.L based on the French law, which enabled us to take full advantage of rules for trading with European Union Allowances (EUAs) and other Kyoto emissions units in the aspect of the Polish tax law. Consus Romania was created in 2009, which solidifies Consus Group as a reliable European player. We are the only company in Poland to be a member of the Weather Risk Management Association. It is the worlds largest association of professional institutions that deal with the weather derivative market. Thanks to the WRMA we receive actual information about any changes in the financial or insurance markets, which could influence price and method of risk transfer. Consus a pioneer in the Polish weather derivative market offers you cooperation in the area of preparation and introducing weather protection, which effectively covers all financial losses caused by weather instability. Pre-calculations and training in the field of weather risk are treated as promotion of Consus. Our services provide: the data essential to weather exposure analysis and conducting out analysis; measurement of weather risk exposure based on companys financial data and weather data for at least last two years; presentation of risk transfer methods (as well as derivative or insurance) adjusted to your companys needs, considering your companys budget on hedging; supervision of the transaction.
Consus S.A.; Dominikanska 9; 87-100 Torun Poland; District Cort in Torun - VII Economic Departament, Register of companies - KRS 0000329119; NIP: 879-22-48-150; Stock capital: 500 000 PLN; +48 56 653 97 13 +48 56 475 41 93

Prepared analysis is based on highly advanced statistical methods supported by expert computer software. Thanks to these factors, the available hedge is highly effective. To receive a payment from weather hedge does not require any liquidation process. The only condition to receiving payment is the occurrence of conditions included in the weather contract e.g. specified level of weather index. Its value is quantified and delivered from National Weather Station (no possibilities of speculation with data or with market).

Contact info:

Director of Weather Risk Management Department

Weather Derivatives Specialist

Dr Juliusz Pres Tel. +48 606 676 804 Email: juliusz.pres@consus.eu

Pawel Piejak Tel. +48 601 317 506 Email: pawel.piejak@consus.eu

Consus S.A.; Dominikanska 9; 87-100 Torun Poland; District Cort in Torun - VII Economic Departament, Register of companies - KRS 0000329119; NIP: 879-22-48-150; Stock capital: 500 000 PLN; +48 56 653 97 13 +48 56 475 41 93

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