A Composite Index-Based Instrument for Managing the Financial Risk of Variable Hydrometeorology for Electric Utilities

Electric utilities are particularly vulnerable to deviations from expected hydrometeorological conditions, including drought and heatwaves, which can influence peak electricity supply and demand, respectively. Utilities have long managed the financial impacts associated with these risks by using weather derivatives and index-based insurance products linked to temperature and hydrology. However, such tools often fail to account for the correlation between adverse conditions, thereby underestimating the risk posed by joint occurrence of droughts and heatwaves. For example, higher than normal temperatures can significantly and intermittently increase demand, forcing utilities to rely on more expensive energy sources. Meanwhile droughts can reduce available energy supply, particularly for sources such as hydropower, lowering electricity sales and utility revenues. When a heatwave coincides with drought, the risk of a severe budgetary shortfall rises, as increased demand must be met with reduced supply, often resulting in compensatory power purchases at exactly the time when prices are highest. Failure to address these financial risks can lead investors, lenders, and credit rating agencies to downgrade a utilities’ creditworthiness, resulting in increased borrowing costs (e.g., interest rates). This research utilizes a stochastic power system model (CAPOW) to explore economic dispatch, unit commitment, and hydrometeorological uncertainty, in order to characterize utility financial risks arising from weather variability. Pacific Gas and Electric (PG&E), a large California utility, serves as a case study where detailed weather, electric power system, and financial models are developed to simulate energy supply, demand, and net revenue variability under a variety of synthetic weather scenarios. Following the characterization of PG&E’s hydrometeorological financial risk, a novel financial contract is introduced to enhance its financial risk management. This contract is based on a composite index of measures including streamflow, temperature, and natural gas prices, and its cost-effectiveness is compared against a portfolio of three separate, and currently available, index insurance contracts, each based on a single index value. The composite index contract achieves the same reduction in the utility’s net revenue variance at roughly half the annual cost ($30 million versus $55 million). The savings is primarily attributed to the ability of the composite index to account for correlation between the three index values, which the portfolio of the three independent contracts does not, and which leads to lower basis risk. These findings have the potential to enhance the management of weather-related financial risks for electric utilities and contribute to the design of more effective insurance and reinsurance products.