Historic wind drought sends utilities scrambling for new kind of cover

Global warming is making wind less reliable and, after a historic wind drought this year blew a hole in the balance sheets of major utilities including RWE, interest is spiking in a lesser-known tool to help protect power producers.

EDP Renewables CEO Miguel Stilwell d'Andrade also lamented the weakest quarter for wind in Europe for “86 years” in the Iberian developer’s own earnings call.

Rob Hutchinson, team lead for energy and utilities at Swiss weather modelling firm Meteomatics, concurs with the EDPR chief. Analysis of data dating back to 1940 reveals that March to May was the least windy three-month period on record for parts of Europe. There was an exceptionally low amount of wind in February too.

Those parts include much of northern Germany, the North Sea and the Benelux region, all areas that he notes have significant installed wind capacity – not least for RWE.

Wind droughts typically occur due to quasi-stationary high-pressure systems influenced by a “complex interplay” of large-scale climate patterns, said Hutchinson, including El Niño and the North Atlantic Oscillation.

“There is significant annual and inter-annual variability in wind,” said Hutchinson. And if this was not tricky enough to manage for power producers, there is “growing evidence to suggest that this variability is increasing.”

There is now a tendency for large-scale weather patterns to “become ‘locked’ in place for longer,” said Hutchinson. For example, El Niño’s sister cycle, La Niña saw a highly abnormal three year ‘triple dip’ event from 2020-2023.

What do we have to thank for this increasing volatility? Climate change.

It seems likely that wind droughts will become “increasingly common,” said Hutchinson. “Some climate models indicate that much of Europe will on average become less windy as climate change unfolds.”

Weather derivatives can help ‘smooth out’ wind droughts

So how are power producers protecting themselves as the wind, already a fickle friend, gets less trustworthy? Increasingly through weather derivatives.

These derivatives aim to “smooth-out revenues for companies exposed to fluctuations in the weather,” said Robert Bates, partner and head of claims at Nardac Insurance Services.

A wind power producer “might choose to buy a ‘put’ policy” that fills any gap between actual revenue and a specified higher level, he said.

The crucial difference between such derivatives and regular insurance is that they don’t require proof of loss. Payouts can be triggered by reference to agreed third party data, said Bates, making the process quicker than traditional indemnity insurance.

Much of insurance the wind power producers buy is mandatory, said Bates, such as cover for property damage. For optional policies like weather derivatives, “people don’t tend to buy them until they perceive risk in not buying, or inherent value in, the product.”

Following the recent wind drought, “I think we’re starting to enter a period where companies now perceive the risk of not purchasing these products as worth the cost of buying them.”

Bates puts the potential losses stemming from a major wind drought across all major utilities in Europe, as a conservative estimate, in the “hundreds of millions”.

Pierre Buisson, senior structurer for weather and agro at German insurer Munich Re, agrees. Many utilities have been using weather derivatives for some time, he said, but the “spectacular” wind drought this year “made others realise” they also need to hedge against such eventualities.

“Consequently, we saw a significant uptick in the demand for wind hedges” after the drought, he said.

This year, he said Munich Re had “four or five large scale summer wind hedges in our portfolio while, historically, most of the activity was around winter months.”

‘Some may say this all washes out over time. Who lives in a world like that?’

Weather derivatives have been around for decades but it is only in the last five or six years they have “really taken off” for wind power, said Ralph Renner, head of distribution at Parameter Climate, a New York-based advisory and analytics firm focused on protecting companies from weather risk.

Historically, it was gas retailers that wanted to hedge not against a lack of wind but mild winters, he said. “In a really mild winter, gas demand is typically very low.” And that’s bad for a gas retailer who may be forced to sell gas back to the market at a loss.

The recent growth in wind industry interest is down to a few things, said Renner. “The first is that you just have, in general, such a large contribution from wind to overall generation that it has a market impact on prices.”

The second is that utilities are becoming bigger players in the wind industry. When wind farms originally took off, it was smaller and specialised investors that were building them, said Renner. “But the bigger these wind exposures became within utility companies, the more they sought to de-risk the annual volatility to their earnings”.

“Wind volatility is extremely difficult to manage,” he said. Put another way: “It is very, very hard to predict wind.”

This January was a case in point. Utilities and trading houses hire meteorologists to predict wind production, said Renner. “And January was just incredibly challenging because the forecast kept changing.” At one moment the short to medium range forecast looked “very windy,” and the next day it would “flip and suddenly it's not windy.”

Then came the drought, which redefined what the “worst case” scenario was for such an event, said Renner. “Those months were just awful.”

That will make people “reconsider how they go about hedging,” he said, given the “huge hole” that it can tear in a power producer’s finances.

“Some people may say over time this all washes out. And if you can take that approach in your business, that over time, the next three, five, ten years, it's going to all average out, maybe. But who lives in a world like that? Ultimately, you've got an investor, you've got a shareholder, you've got a boss.”

Utilities take different approach to same problem

What sort of weather derivative policy might a power producer take out to protect against a future drought?

Well, if you’re a major utility with wind farms across Germany, then you might buy a derivative based on an index that replicates wind power prices across the whole country. If you just own one wind farm, you might have it tailored to wind speeds and turbines at that particular site.

What’s interesting, said Renner, is that utilities that hedge with wind derivatives all take a different approach. “Even though the exposure is really similar, the way they manage it differs greatly.”

Some are happy taking an index for the whole of Germany, said Renner. Others might have hundreds of PPAs and want to model “every single one of them precisely.” Or they may just be happy with the wind speed at the nearest weather station.

Of course, one of the best forms of insurance is a diversified portfolio, both in geography and technology.

It does not currently use weather derivatives, “but remains attentive to developments in this market”.

The second point, diverse technologies, is neatly summed up by Hutchinson at Meteomatics. Because this year wasn’t just the least windy since 1940 for large parts of Europe. It was the sunniest too.