In response to frequent droughts, Uruguay buys insurance against the lack of rain
December 19, 2013
- An innovative insurance policy protects the energy industry from climatic changes and oil price volatility
The history of humanity is full of attempts to control rain: rituals, collective prayers and even pseudo-scientific experiments to make the clouds produce water. Recently, Uruguay took the innovative step of adopting a mechanism to effectively control rain or rather, the lack of it: climate insurance.
The policy insures against the frequent lack of rain, which in 2008 triggered one of the worst droughts in history, causing US$ 900 million in crop losses and negative consequences for the population. Not only did the crops suffer; the generation of electric power was also threatened by increasingly low reservoir levels.
Climate insurance for US$450 million protects the Uruguayan electric power company, Administración Nacional de Usinas y Transmisiones Eléctricas (UTE) against exposure to droughts and high oil prices. More than 80% of the country’s electric power is hydraulic, so when water levels drop, the company is forced to generate electricity using thermal methods, which consume fossil fuels.
The coverage compensates for financial losses originating from insufficient rain, which affects the reservoirs UTE uses to generate electric power. In the event of a drought, the company must purchase oil at high prices on international markets.
In 2012, the company was forced to import oil to cover demand for electricity, at a record cost of US$1.4 billion, 46% more than original estimates. This led the company to request stabilization funds from the government, and also to pass on some of the cost to consumers.
This strategic, innovative operation can be replicated in many countries that are susceptible to weather extremes, not only for the electric sector, but also for the agricultural sector, for example
Insurance with high technology
Until recently, climate insurance was only available in derivative financial markets of developed economies. However, technological advances in Uruguay have changed that reality. The southern nation is one of the few that has kept precipitation records for the past 100 years, which facilitates the assessment of rain variables and enables more accurate measurements.
Throughout the country’s main water basins, those of the Uruguay and Negro rivers, 39 stations measure precipitation and generate a daily index. When this indicator drops to the minimum levels established each semester, the insurance contract goes in effect, supplying the UTE with the necessary funds. The amount of money disbursed depends on the severity of the drought and oil prices on the date the insurance is activated.
Although there are no immediate antecedents of this type of coverage in the region, experts believe that the Uruguayan experience can serve as a model for areas that are experiencing droughts, such as northeast Brazil.
“This strategic, innovative operation can be replicated in many countries that are susceptible to weather extremes, not only for the electric sector, but also for the agricultural sector, for example” says Luis de la Plaza Bringas, World Bank financial expert.
In the short term, the objective of the insurance is to protect consumers from extraordinary increases in electric rates by ensuring the financial stability of the company. In the long term, the objective is to provide the conditions to enable Uruguay to continue develop alternative forms of renewable energy, according to the expert.