HBS CASE – ENRON CORPORATION’S WEATHER DERIVATIVES

The following Assignment Questions are intended for

guiding the reading and discussion of the case:

CASE (A)

DEFINITION of 'Heating Degree Day - HDD'

The number of degrees that a day's average temperature is below 65oFahrenheit (18o Celsius),
the temperature below which buildings need to be heated. The price of weather derivatives traded
in the winter is based on an index made up of monthly HDD values. The settlement price for a
weather futures contract is calculated by summing HDD values for a month and multiplying that
sum by $20.

BREAKING DOWN 'Heating Degree Day - HDD'

To calculate HDD, take the average of a day's high and low temperatures and subtract from 65.
For example, if the day's average temperature is 50o F, its HDD is 15. If every day in a 30-day
month had an average temperature of 50o F, the month's HDD value would be 450 (15 x 30). The
nominal settlement value for this month's weather derivative contract would therefore be $9,000
(450 x $20).

HDD = MAX[(65- daily average temperature),0] -> Max[0; St-X] call

CDD = MAX[0, (daily average temperature-65)] ->Max[x-St; 0] put

Read more: Heating Degree Day - HDD Definition | Investopedia

http://www.investopedia.com/terms/h/heatingdegreeday.asp#ixzz4PPcKK4xf

If the cumulative HDD is high is favourable for PNW; higher use of electricity
If the cumulative HDD is low is unfavourable for PNW; lower use of electricity ; hedge this away
thru derivative contract or swap
1) Why do they call these contracts derivatives? Where is the optionality in these
contracts?

A weather derivative or weather option is a financial instrument that has a payoff derived from
variables such as temperature, snowfall, humidity and rain-fall. However, the industry has set
up temperature as the common underlying for those contracts.

Unlike insurance and catastrophe linked-instruments, which cover high-risk and low
probability events, weather derivatives shield revenues against low-risk and high probability
events (such as mild winters). Temperature contracts are more specifically traded in what is
called Heating Degree-Days (HDD) or Cooling Degree-Days (CDD) defined on daily average
temperatures.

The optionality is that one does not have to execute the agreement, one has the option once
said agreement is purchased. If the agreement is not in the purchaser’s favor, they do not owe
any more than the prepaid option fee, as calculated using Black and Sholes. This is very unlike
that of a futures contract, which can move out of the favor of the purchaser, but the purchaser
remains liable.

A difference between derivatives and insurance contracts is that the holder of an insurance
contract has to prove that they have suffered a financial loss due to weather in order to be
compensated. If they are not able to show a loss, the insurance company will not pay. Payouts
of weather derivatives are based only on the actual outcome of the weather, regardless of how
it affects the holder of the derivative. One does not need to have any weather sensitive
production, for example, to buy and benefit from a weather derivative.

A closer inspection of these two products reveals many differences. The first difference is the weather
events that each tool covers. Insurance contracts are written on rare weather events such as extreme
cold or heat and hurricanes or floods. These events are highly liked to create great catastrophes with
huge impact on the revenues of the company. In contrast, weather derivatives can protect a company
from recurrent weather conditions with large probability of occurrence. Unlike insurance and
catastrophe-linked instruments, which cover high-risk and low-probability events, weather derivatives
usually shield revenues against low-risk and high-probability events (e.g., mild or cold winters).

Claiming compensation from an insurance company usually is time consuming and expensive. The
insured party must first prove that the weather had catastrophic effects on his company while the
outcome depends on the subjective opinion of each regulator. On the other hand, in the case of weather
derivatives, the company receives the profit of the contract immediately. In addition, there is no need for
a catastrophe to occur on the company in order to receive the compensation. Weather derivatives are
based on objective criteria like the index of the temperature, the rainfall, or any other underlying index
which is accurately measured on a predefined weather station.

Another advantage of weather derivatives is the additional freedom that they offer to the buyer in
contrast to the insurance contracts. Hedging the impact of the weather on the competitive companies
using weather derivatives is possible. For example, an agricultural company on area A can hedge
against weather effects in a different area B where a competitive company is established. Favorable
weather conditions in area B will result to the increase of the quantity and quality of a particular
agricultural product in area B. Consequently, the demand and price for this particular product from the
company in area A will decrease.

Finally, since weather derivatives are financial instruments, a weather derivative can be later sold in a
third party, for speculative reasons, before the expiration day of the contract.
 What type of companies will benefit from cold summer or hot winter?

1. Construction
2. Travel
3. Energy
4. Agriculture
5. Retail
6. Amusement

Energy companies are the main investors of the weather market. In 2004, the 69% of the weather
market was consisting of energy companies. As more participants were entering the market, the energy
companies were corresponding to 46% of the weather market in 2005.

Agricultural companies are greatly affected by weather conditions. However, only recently, companies
from the agricultural sector started to participate in the weather market. Transportation, public utilities,
retail sales, amusement and recreation services, and construction sectors are also very sensitive to
weather.

Weather can affect the revenues of a company directly by affecting the volume of sales. An amusement
park that wants to hedge against rainy days in which fewer visitors will be attracted can enter a weather
contract written on rainfall. Similarly, an electricity company that wants to avoid a reduced demand in
electricity due to a warm winter can use a temperature derivative. A ski resort could use weather
derivatives to hedge against a reduced snowfall which will attract fewer visitors. On the other hand,
government organization can use weather derivatives in order to avoid an increase in the costs of
cleaning roads in case of snowfall or icy days.

Weather can also affect the revenues or induce costs to the company indirectly, for example, a
construction company that experiences delays when constructors cannot work due to weather. Similarly,
cancellation of flights due to weather conditions can cause large costs to airlines.
2) Draw a diagram of payoffs at the end of life for the contract presented in case
Exhibit 1.

Enron will cap the payout applying a floor on the “long put” sold to PNW.

They(Enron) will do this by shorting a put (Strike price X1) and long put (Strike price X2)
3) Deconstruct the options embedded in the contract given in case Exhibit 1. Are they
puts or calls? Are the positions long or short from PNW’s standpoint?
4) What are the pros and cons of weather protection from PNW’s perspective?

The Pros are the advantages over insurance and the optionally of the derivative. The “weather
derivative” is simply an insurance policy that has an upfront premium and pays out if certain
situations arise without need for proof of a loss. This is unlike the “typical” weather insurance
policy in that you don’t have to prove there was a loss to receive remediation. Also, PNW
expects “bad” weather and a continuing warming of the winders so they would like to
reduce/hedge their EPS and Bond rating risks which they have suffered.

It was also a protection instrument that was lower than weather insurance (for catastrophic
event), this filled the gap for PNW in the event when weather was unfavourable to PNW, the
will be able to hedge this away by sacrificing some upside, thus reducing their earnings due to
volatility of the weather

The cons include the unfamiliarity of PNW with this instrument. Also, the unpredictability of
the weather is a large factor. Also, the payoff is $0 with a sudden change and top-off at
$800,000. This does not balance well will PNW’s costs or lost revenues, which correlate very
closely with the weather, the “weather derivative” is roughly a step change.

5) Why is Enron in this situation? What does Enron stand to gain?

Enron is in the energy business, which is very sensitive to the weather. The US Department of
Commerce estimated that at least $1 trillion of the total US GNP (~ 7 trillion) is sensitive to
various in weather. Enron’s power companies’ believe that “weather risk is the biggest
independent variable in the power business”

6) How should Mary Watts proceed to assess, and decide upon, the use of weather
protection for PNW? What criteria should she use to make her decision?
Mary should consider the impact the weather has on revenues, profits, and costs. Then relate
this to HDD’s to determine how much impact it has on HDD with the revenues, sales, and
profits. Mary should consider the strike price and how much risk she is willing to absorb. Also
she should consider the size of the compensation; where caps and floors have maximum
payout limits the premium will be less than would otherwise be the case. Also consideration
must be made to the meteorological data. The time period is important as well because of the
correlation between the weather in one month with the weather in the month before and
after.
CASE (B)
1) Which, if any, of the available contracts would you be willing to accept?
2) Which is the best contract for you?
3) If you could design your own contract to reduce your exposure to the greatest
extent, what would it be?

São Paulo, 31st October 2016