Enron Corporation's Weather Derivative

Enron Corporation's Weather Derivatives (A)

Pacific Northwest Electric

Pacific Northwest Electric (PNW) is a utility servicing the Pacific Northwest region of the United States. In 1999, its share price underperformed broad market indexes and indexes of the utility industry due to its underperformance in earnings. This is a result of warmer-than-usual weathers of the past four years. Its debt rating had also slipped from A- to BBB+. As PNW was exposed to volume risk if weather were warmer than average, there may be a need for weather protection using weather derivatives.

Weather Risk

Variations in weather affect certain industries the most, including agriculture, apparel retailing, and ski resorts. "Weather" consists of conditions such as temperature, wind, precipitation, storms and hurricanes. Of the total U.S. gross national product, $1 trillion was sensitive to weather changes. Recently, there is increased uncertainty surrounding the mean temperature for a season, due to effects such as El Nino and global warming. Thus, firms can hedge weather risk to smooth revenues, cover excess costs, reimburse lost-opportunity costs, stimulate sales, and diversify investment portfolios.

Weather Derivatives

The introduction of weather-protection products allowed "companies to protect against weather conditions adversely affecting volume-related revenues". The main form of weather protection is weather derivatives, which provided protection against the deviation of actual cumulative degree-days from an established threshold. Weather derivatives generally cover low-risk, high-probability occurrences like temperature fluctuations, differing from insurance contracts that protect policyholders against low-probability catastrophic storms. The underlying asset in weather derivatives is temperature fluctuations, which is what companies want to hedge against. In terms of accounting, weather derivatives also does not have to be marked-to-market. Weather-protection products have many structures, such as a floor, ceiling cap, collar, swap, futures contract, and an option on a futures contract.