Essay Enron s Weather Derivatives

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Case summary – Enron Corporation’s Weather Derivatives
Steve Haik, Dan Sleker and Bas van Bellegem – March 2003

Background
In October Mary Watts, CFO of Pacific Northwest Electric (PNW) reviewed the forward plan for PNW’s 200-2001 season. PNW’s has been experiencing nearly no EPS growth since 1995 due to deregulation and warmer-than-average winter climate. The stock price had suffered accordingly, but there maybe a way to hedge the weather risk via a new “weather derivative” being proposed by Enron’s Mike James. Since the colder the season, the greater the electrical usage and the recent weather advisory called for another unseasonably warm winter, Mary was considering on of the Enron “weather derivatives”.

Problem Statement
Mary
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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.

2- What are the pro’s and con’s 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.

The cons include the unfamiliarity of PNW with this instrument. Also, the

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