Construction Business Owner, November 2007

Several days of relentless rain were starting to cost real money. Like all construction companies, this excavation specialist had built weather delays into the contract for its work on a major new office building project. But the company’s own estimates of potential weather delays—not to mention historical rainfall averages for the time of year in this city—were already under water. Now, the ground was saturated, and the forecast was for more of the same. Expensive equipment sat idle. Schedules were out the window (this was supposed to be the dry season). Penalties couldn’t be ruled out. Cash would be getting tight.

Fortunately for this company, it had a financial hedging contract that stipulated payment of $100,000 a day—to a maximum of $1 million—for each subsequent day after five days when precipitation totaled one-half inch or more.  They won the bid—and profited later because the contract terms were weather-protected.

This mini-case history is hypothetical, but very real world at the same time. Recall the rain-induced floods that hit the upper Midwest last August and Texas for much of last summer. Just a year before, most parts of the state had been in a drought. One year later—deluge. (We could also cite a non-weather factor—the pervasive tightening of credit that roiled financial markets this year. When the credit window is closing, a little bad weather can mean some construction companies catch financial pneumonia.)

New Tools to Manage Weather Risk

Construction is one of those industries that is at the mercy of the whims and caprice of mother nature. No news there. The availability of new weather risk management solutions specifically geared to the construction industry is news. These new tools are easy to implement, and they control weather-related financial risk far more effectively than ever before.

For example, the industry now has access to a set of indexes specific to the construction business that enable companies to analyze the financial impact of weather on a project schedule and to quantify the benefits of protection designed to mitigate that impact. This means that for the first time a wide variety of construction companies are able to analyze the financial implications of weather based on project type and geography and then act on the results.

Contractors benefit because the ability to meet bid price and live to guaranteed numbers is central to profitability. In competitive bidding situations, contractors are able to reduce the number of necessary weather days to be captured in a contract, thereby providing competitive differentiation. They are also able to manage debt more effectively, improve liquidity and invest for growth. And there’s the peace of mind factor: In an industry in which there is plenty to worry about these tools take weather risks off the plate for the construction business owner. 

Financial solutions to mitigate weather risk are not entirely new, but they have been underutilized in the construction industry because they can be costly and complex. Today’s solution simplifies the process. How? First by providing the buyer with an understanding of their specific risks through benchmark indices, data and individual company analysis. If the analysis shows a risk that can be effectively hedged, then the next step is the implementation of financial contracts to transfer the identified risk in a cost-efficient manner. The price of a weather risk hedging contract to protect against financial loss depends on the likelihood of a payout—if the probability of certain weather conditions occurring is low, so will the cost of the contract.

How It Works

As an example of how these tools work, start with the bid process. The contractor  estimates the number of days it will take to complete a project. Using an index, the contractor can figure out what the historical mean is for precipitation, temperature and wind in a specific geographic location over a specific period of time. That leads to an understanding of the impact for loss for specific types of industry functions—heavy and civil engineering, poured concrete and materials, building construction and site preparation—and then projecting cash flow requirements in the event that weather patterns significantly exceed norms. Indices are available based on long-term meteorological averages for more than 500 specific locations. For instance, a 2007 Rain Delay Index might tell us that in the city of Atlanta in the month of June over the past ten years there has been an average of 2.67 days in which it has rained more than one-half of an inch, excluding weekends and holidays. Without access to reliable data based on historic weather averages, such as the Rain Delay Index, a contractor may build some delays for abnormally bad weather conditions into its schedule, but it’s more likely to be a “guesstimate” than a scientific calculation. And if extreme rains similar to those that hit Texas this past summer were to inundate Atlanta during the construction period, then what?

 

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