New Tools Hedge Weather-Related Financial Risk

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?

That’s where the financial hedging contract comes into play. It allows construction companies to enter into simple contracts that hedge the risk of revenue and costs being hurt by adverse weather conditions. These contracts function much like typical options contracts. Agricultural and materials companies have long entered into futures contracts to hedge swings in pricing. Today’s construction industry weather-related contracts function in much the same way.To demonstrate more clearly how the indices and contracts work, let’s look in more detail at two case histories that, while also hypothetical, will give readers a better sense of how financial risk hedges work. The first is the case of New Jersey Crane & Steel. The owner, Bob Shays, noticed that Spring 2007 was starting off very wet and was straining the company’s project schedules. Shays had just won a contract with a ten-month completion window when he learned about the existence of new weather indexes for the construction industry. He purchased the relevant benchmarks and data and ran an analysis based off his projects over the past five years using the data and analytics from one of the leading weather risk providers. While rain does not directly impact his company’s ability to work and use equipment, it often causes conditions that are too risky for safe operations. After the analysis, it became evident to Shays that the cost of retaining labor, equipment, material scheduling and back office expenses would result in a net loss. So, he decided to price a weather contract paying up to $2 million and limiting his company’s exposure to a maximum of nineteen days with rainfall greater than one-half inch per day within the ten-month contract period.

Elsewhere, in a major metropolitan area in the Northeast construction is underway on a new professional sports stadium. This past spring, Daedalus Concrete was expected to pour the first part of the foundation by April 3. But a cold front hit on January 21 and turned a warm, optimistic  winter schedule into cause for concern and delayed many of the contingent project components. As of March 8, snow was still in the forecast and Daedalus was running out of time. The company had to make a decision to either invest in heating equipment or end up facing damages due to inexcusable weather delays.Daedalus performed a weather analysis and considered its financial alternatives. The company found that an unusually cold period for that time of year is highly unlikely; the average temperature range at the stadium is 12 degrees Fahrenheit to 43 degrees Fahrenheit. However, based on the magnitude of potential damages and increased costs, a weather contract was deemed to be advantageous. Armed with intelligence from the relevant weather indexes, Daedalus priced a weather-indexed financial contract for the critical last month that would pay out $50,000 a day for each day after the first four in which the temperature is less than 40 degrees Fahrenheit.

These are good examples because they illustrate a key point: Everyone in the construction industry cycle has some degree of exposure. In these cases we cited a crane company and a concrete company. But, every subcontractor is at risk—from site clearing to masonry to landscaping—as is the general contractor if a project isn’t finished on time. The owner is liable, too, if occupancy is delayed.

Weather financial risk management is not about forecasting. It is about finding business relevance in a forecast—in a world of increasing weather uncertainty—and taking the right action at the right time.

Construction Business Owner, November 2007