We begin the new year with a recap of the major rulings issued last year by state public utility commissions (PUCs).
Electricity took center stage as state commissioners began in...
buyer could "pay" for the protection by giving away some of its potential upside with a cap. Together a floor and a cap provide a "collar," which limits a company's earnings to within the band of the collar.
Figure 2(a) shows a collar, but where the floor offers protection only over a certain range. This, in turn, imposes a limit on how much the seller has to pay in the event of extremely warm winter conditions, and is common in practice. Figure 2(b) shows the pay-off structure of a weather derivative contract that provides such protection. The other common type of weather derivative is known as a "swap," where the company exchanges volatile earnings for constant earnings. This is equivalent to the floor and cap being set at the same point in Figure 2(a). 6
For a buyer to implement a particular risk profile, the company also needs to understand its portfolio of risk, and recognize the impact of naturally offsetting hedges. For example, an LDC that operates around the country may be partially naturally hedged. 7
What Price for a Hedge?
Some buyers may worry that the seller will sell them too much of the wrong product at too high a price-a result of the seller's and the buyer's economic incentives not being fully aligned. These concerns have at least some foundation in fact.
A review of quotes obtained from the Internet for an energy trading and marketing company showed that in the beginning of this year, unsophisticated consumers often were offered annual premiums of 100 percent over the contract's expected payout. 8 Premiums, of course, need to be measured relative to the baseline payout for "normal" weather. The derivative industry tends to use the last 10 years-which on the whole have been warmer than the last 30 years; the latter measure commonly is used by energy companies for regulatory proceedings. Interviews with a number of market makers suggest that by shopping around, these premiums often can be reduced to 10 to 30 percent above the expected payout. The premium should reflect the likelihood of a particular payment. An alternative pricing formula puts the premium at a similar percentage of the standard deviation of the expected payout.
The issue of counter-party credit worthiness also has grown in importance for potential buyers following the collapse of Enron and the ensuing credit issues faced by many energy trading and marketing companies. As mentioned earlier, some of their activities are being taken up by financial institutions. Beyond the issue of premium charges and credit worthiness, buying a derivative is not a particularly risky enterprise for the buyer. 9
How to Value a Contract?
When a seller sets the price of the weather derivative, the buyer needs to consider the implicit premium being paid. A quick way to do this is to estimate the intrinsic (i.e., pre-premium) value of the weather derivative. This back-of-the-envelope approach simply estimates what the average pay-off of such a contract would have been over the last 10 years (the "burn rate"), and then compares the expected payment with the price