Changing climate conditions present a huge risk for everyone, including the quant finance sector. It is time to protect our profitability under the upcoming adverse changes in climatic conditions, and Laura Ballotta, Reader in Financial Mathematics at Cass Business School, presents a study analysing the performance of hedging strategies based on snow and temperature options developed by ski operators.
In a time of increasing awareness of the challenges that climate change poses to society, we discuss the potential of weather derivatives in developing risk management strategies aimed at protecting profitability under adverse changes in climatic conditions.
In this work, we focus on the case of the tourism industry, and specifically on the winter sports tourism sector. Given the high degree of adaptive capacity and flexibility of tourists, and the strong dependence of the winter tourism on the level and reliability of snow cover, this sector is at high risk due to climate change. However, for some areas such as the Alpine region, winter tourism represents one of the main sources of income for local population across several industries, including accommodation, food services, transportation, arts and entertainment, and retail trade. In Austria and Switzerland, for example, the winter tourism industry is estimated to account for up to 49% of the countries' annual overnight stays to which a multiplier effect applies to account for income employment, government revenues and other inter-industrial relations. Consequently, reducing the resort exposure to weather-induced risk is a relevant problem; further, due to the close links between these operators and their local communities, suitable management of this risk would contribute to stabilising the economies of such communities and protecting their investments.
Adaptation strategies aimed at supporting ski tourism operators in managing the impact of weather variability and climate change have been developed over the years; the most common one being artificial snowmaking. Other potential strategies include revenue diversification beyond traditional ski activities which, in many instances, leads to all-season facilities, and sharing of risks of financial impacts by either adopting a conglomerate business model or accessing the financial market for products such as weather derivatives. Although snowmaking is the most popular adaptation strategy, it raises important questions about its sustainability in certain locations, its environmental impact, and consequent potential government restrictions on, for example, the use of additives to help artificial snow last longer in above-average temperature conditions and on water access rights in certain regions. Further, snowmaking and other technical strategies as well as strategies based on revenue diversification do involve high investment costs for infrastructure and operating costs, especially in higher-than-average temperature conditions.
We argue that, in this context, weather derivatives can represent a useful support to the other adaptation strategies, by providing flexible means for stabilising business profitability year-on-year, and facilitating the implementation and maintenance of strategies such as snowmaking, whose economic profitability is threatened, too, by climate change.
We illustrate the case of a hypothetical ski resort in Austria which employs hedging strategies involving portfolios of options on snow and temperature levels. This procedure requires addressing satisfactorily three key issues: firstly, the development of a mechanism for scenario generations of the revenues at risk if the weather conditions are not sufficiently reliable to run the resort; secondly, the choice of a hedging criterion which is robust under basis risk; finally, a transparent valuation procedure for weather derivatives.
The quantification of the revenues at risk requires a generation process of the weather variables which is sufficiently general to be adaptable to different geographical areas, and easy to implement. Our empirical study based on data from the European Climate Assessment and Dataset does not find significant evidence in support of a parametric model for this process; consequently, data generation is performed by moving-block bootstrap with block’s length optimally selected.
The main challenge in forming a robust hedging portfolio is basis risk, which in this context emerges primarily in two ways. In first place, we observe a natural mismatch between the revenues at risk and the underlying asset of the hedging instrument: due to the uncertainty and discretionary nature of the information regarding resorts seasonal revenues, the hedging instrument is chosen to be a derivative on weather variables, as information on their seasonal level is provided by independent bodies and weather stations. Secondly, the so-called spatial basis risk plays an important role due to the difference between the weather conditions at the location of interest and the reporting station. To meet this challenge, our construction relies on the so-called minimum variance principle, according to which the optimal hedge ratio is given by the coefficient of regressing the revenues cash flows on the net payoff of the weather derivative, i.e. the covariance between these two quantities, which is the key to immunisation against basis risk.
The problem of determining a market-consistent price for weather derivatives is not trivial either, as standard arbitrage-free pricing approaches are questionable in this context due to the lack of a replicating portfolio of ‘tradeable’ securities. Our empirical analysis though shows no significant dependence between the revenues of the ski resort and the financial market as summarised by world, regional and sectoral stock indices. This allows us to consider this type of risk as diversifiable, and therefore we suggest to carry out pricing directly under the ‘real world’ probability measure, up to a mark-up capturing the profit margin asked by a financial institution offering the contract.
An ancillary aspect of the problem of setting up a suitable hedging strategy is represented by the actual design of the contract payoff. Our simulation study shows the superior performance of hedging strategies based on portfolios of options written on snow with periodic reset, either as standalone or in combination with options on temperature. This performance proves to be robust under stress testing of the dependence between the number of visitors (i.e. the revenues) and the weather conditions at the resort. Thus, the choice of the weather station becomes less critical.
It is noted in the literature that features of weather derivatives, such as transparency and settlements' promptness, might justify the interest and attention they attract from ski operators; however, their applicability is hindered by a number of factors such as product and practice knowledge, related high fixed costs, counterparty risk due to the over-the-counter nature of these contracts, and indeed basis risk. The approach advocated in our study though is relatively parsimonious, simple to implement and maintain; further, it provides a pricing rule and a number of possible hedging portfolios which prove to be robust against basis risk. This makes the case for further developments in the weather derivatives market.
Laura Ballotta; Gianluca Fusai; Ioannis Kyriakou; Nikos C Papapostolou; Panos K Pouliasis (2018). Risk management of climate impact for tourism operators: An empirical analysis on ski resorts. Cass Business School, City, University of London