Pacific Northwest Electric was a significant producer of electric power. Seasons are a big deal to electricity companies: the colder the weather, the more electricity consumers use to power their heating. Looking back the last few years, CFO Mary Watts (an incredible electricity pun!) noticed a trend of relatively warm winters which in turn resulted in less-than-optimal financial results. Though the 1990’s are remembered as a time of a healthy economy, PNW suffered from a stagnant earnings-per-share growth during this period.
After receiving a report of yet another warmer winter coming, Watts turned to a product offered by Enron Corporation that claimed to minimize weather-related volume risk. There are many reasons derivatives could help PNW’s exposure to weather risk. For example, on a much smaller scale ice cream stores often go out of business because though summer sales are great, managers do not know how to take out loans and insurance to keep paying employees and other expenses during the off-season.
PNW works the opposite way, with less demand in the summer, but the loss of demand in the winter months could be compensated for by using the derivatives product and smoothing revenue. The risk of stock-outs and lost-opportunity costs could be hedged. The derivatives could also help stimulate sales and overall diversify investment portfolios with correlation between weather and return, whereas futures were only being used to hedge against price risk by agreeing to deliver or accept a commodity at a certain time and price.
The way the product worked is that PNW would be able to determine how much margin it would lose if the weather, measured by temperature, differed from the average readings in their geographic location. How much risk tolerance as far as planned income loss from weather could be set up by the company. In the end, the company would receive a payment to offset lost income from reduced demand if the result was below the original threshold. This would be called a floor, because the variable fell below the threshold though upper potential was still available.
Other structures could be a ceiling cap that compensates if variable goes above or a collar which combines attributes of both the floor and ceiling cap and can be great when it essentially. funds the purchase of insurance. A swap can produce similar results, except for its actions are triggered singularly whereas the collar relies on two separate tools. It is important to note that weather derivatives would not be included under an accounting rule that pertained to hedges under a market index rather than customized contracts.
Watts took into consideration correlation and geographic differences to realize that PNW needed protection from weather risk. Contracts she would approve to enter into with Enron would require an initial payment for entry, but would mean the company would receive a one-time payment at the end that adjusted to weather results and agreed tolerance levels. Whether or not the premium is worth it depends on the weather which has experienced a bad historical trend but in the end is quite unpredictable. The decision for a conservative company to enter this kind of contract is one that requires thought, but the largest focus should be setting threshold levels.
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