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Enron Weather Derivatives

Pacific Northwest Electric is facing a difficult winter season with lower than average temperatures recently, hurting revenues. Weather derivatives that pay out based on heating degree days could help smooth revenues and reduce borrowing costs by increasing its bond rating. The proposed contract pays PNW $20,000 for each heating degree day below 400, with a maximum payout of $800,000. While only partially covering extreme outcomes, it reduces downside risk and stock price volatility for PNW. Black-Scholes cannot accurately price this contract due to its cumulative payout structure tied to weather, requiring a simulation approach instead.

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Jordi Aranda Bautista
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172 views9 pages

Enron Weather Derivatives

Pacific Northwest Electric is facing a difficult winter season with lower than average temperatures recently, hurting revenues. Weather derivatives that pay out based on heating degree days could help smooth revenues and reduce borrowing costs by increasing its bond rating. The proposed contract pays PNW $20,000 for each heating degree day below 400, with a maximum payout of $800,000. While only partially covering extreme outcomes, it reduces downside risk and stock price volatility for PNW. Black-Scholes cannot accurately price this contract due to its cumulative payout structure tied to weather, requiring a simulation approach instead.

Uploaded by

Jordi Aranda Bautista
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Enron Corporation’s Weather

Derivatives
Who is PNW and what problem is it facing?

• Pacific Northwest Electric


• Facing the 2000-2001 winter season
• Recent warmer-than-average winters
• Hurts revenues
• Deregulation doesn’t allow them to pass costs
on to customers
• PNW’s stock has lagged benchmarks
• Borrowing costs increasing because lower
rating
Example of how weather can affect a
business adversely
• Too warm of winters reducing a utility’s revenues from less
heating usage
• Too mild of summer reducing a utility’s revenues from less air
conditioning usage
• Storms keeping shoppers indoors
• Lack of snow affecting ski resorts
• Too rainy / too cool summer affecting beach destinations
• Too hot of a summer might lead to too much demand of a
product and stockouts might occur (turn people away)
How could weather insurance help?
• Smooth Revenues

• Cover Excess Costs

• Reimburse lost-opportunity costs

• Stimulate Sales

• Diversify investment portfolios


Some Utility lingo…
• Heating Degree Days (HDD)

• Cooling Degree Days (CDD)

• Based on deviations from 65 degrees Fahrenheit


Possible weather-protection products
• Floor (too warm of winter and HDDs fall)

• Ceiling Cap (too much snow – city expenses)

• Collar (long one contract, short another)

• Swap (receive fixed revenue stream; pay floating payments


based on HDD/CDD)

• Futures Contract (cash settlement based on several airport


temps)
The contract at hand… (Exhibit 1)
• Draw its payoff diagram (to PNW)
$ Payoff
800,000 Max Payout
$20,000 notional
800,000
amount per HDD

800,000 / 20,000 = 40

400 – 40 = 360 is the


HDD where they
would cap out at.

360 400 HDDs


Pros and Cons of this contract
Pros Cons

Reduce Downside Risk Truly serious outcomes only partially


covered

Keep Stock Price Less Volatile Premium has to be paid

Contribute to Better Bond Rating

Reduce the cost of financing


Can Black-Scholes be used to price?
• No. Black-Scholes assumes a random walk in the price of the underlying
asset over a period of time

• Here, we have a cumulative level as our underlying, so their “walk”


through time is not random. It is based on prior days’ events.

• A simulation tool like Crystal Ball would have to be used to simulate


possible payouts under a large number of trials. An expected payout
would then be found and a premium set above that level.

• You need to look at a reasonably large sample of historical records to find


the average HDDs and CDDs and their standard deviations. Then you need
determine if there is a trend to consider.

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