PJM Load Product (Consumption Product)

Discussion Topics Executive Summary The PJM Load Product Rationale Compliment to the Reliable Power Product Price Risk Management Power Demand and Weather Product Design Product Management Future Products

Executive Summary Weather is the primary driver of short-term demand fluctuations for power in the PJM region. However, the power industry has been slow to adopt weather derivatives as a hedging tool for demand/consumption. To address one reason for the slow adoption - basis, we are proposing the creation of a tradable product around independently verifiable PJM Actual Load. This product is highly correlated to the weather and can eliminate the basis risk for the counter-parties. Internally, the product will transfer weather-related risks to the Weather Desk, which can lay it off with maximum efficiency.

The PJM Load Product The product is a swap on future demand for power in the PJM region. For the proposed initial product, the average weekly (week day only, eliminating holidays) load of PJM was chosen as our underlying index. The seller of the swap pays out a fixed amount of dollars (tick size) per Mw that actual consumption exceeds the agreed load. If the actual consumption is lower than the agreed load, the seller receives that fixed amount of dollars per Mw.

Rationale The objective of this product is to provide the market with a volume risk-management tool. Weather derivatives currently offer similar functionality but with basis risk. The product provides a price-discovery mechanism for the demand side of volumes (consumption). The product isolates demand risk from supply risk in the determination of prices. For many commodities supply in the short-term is fixed with the exception of shocks, i.e. insurable events. Therefore in the short-run demand becomes the principal price setting mechanism. Internally, the weather-related risk is transferred to the desk that can lay it off in the market.

Compliment to Reliable Power Product Power supply volume is established by the capacity of power plants in the pool and with access to the pool minus the planned and forced outages of those plants. The capacity of the power plants is known by the market. The planned outage schedule of the plants is known by the market. Surprise fluctuations result from forced outages. The Reliable Power product is a risk management tool for the supply side, isolating from prices and demand.

Price Risk Management The combination of the Consumption and Reliable Power products has the potential to provide the market with more efficient price risk management tools. If firms are able to mitigate both supply and demand, the risk of prices is also mitigated. Price risk does not vanish completely, since hedgers may suffer highly non-linear movements when there are extreme movements in both supply and demand. However, it becomes a second order problem.

Price Risk Management (II) Volume Demand Supply V Equilibrium P Equilibrium

Price Risk Management (III) Volume Expected Demand Supply V0 P0 Hedge Approximation P1 Actual Demand T1 T0 V1

Power Demand and Weather Power demand for a region is highly correlated to the weather (temperatures). For specific users the correlation is already significant. When all these consumers are aggregated together, the demand variations (in the short term) become completely dependent on the weather, because the weather and the economic growth are the only systematic factors that explain demand.

Power Demand and Weather (II) The non-systematic factors influencing demand vanish due to diversification. Using the PJM pool as a trial region, we found significant regressions, where the load is explained by temperatures and GDP growth. We got 98% R-squared for weekly loads, 94% R-Squared for daily loads.

Power Demand and Weather (III)

Power Demand and Weather (IV) The longer the aggregation period (where the load is found), the higher the R-Squared is. Daily idiosyncrasy vanishes during the aggregation period. It is important to include regional growth in the analysis. Economic growth systematically causes the growth of demand.

Product Design The Product is a swap around a notional load. If the actual load is greater (lower) than the notional, the buyer (seller) of the swap will be paid a fixed amount of dollars per Mw. The Underlying Period will be one week (week days only, excluding holidays*). The Trading Period will be the previous week’s (to the underlying period) business days, from 9am to 2pm. * Includes: New Year’s Day, President’s Day, Memorial Day, Independence Day, Labor Day, Thanks Giving, Christmas. If a business day is between one of these holidays and the weekend, this day will be treated as a holiday.

Product Design (II) The Platform is Enron On-Line. The Market Maker is the Weather Desk. The Index is the average of loads that are reported hourly by PJM for the underlying week.These amounts are disclosed in PJM web site (pjm.com), in its historical data. It is typically disclosed up to 2 weeks after the fact. Counterparties are current participants in the weather market and initially only the power desk for the consumption product. The Settlement will happen 5 business days after PJM has disclosed the hourly loads for the underlying period. The Tick-Size is $10/Mw per contract.

Product Design (III) The contracts are capped at $20,000 to either side in line with the Board mandate to cap all weather transaction exposure.

Product Management The weather desk can combine positions in the weather and positions in consumption. The basis risk between consumption and weather is held by the weather desk in a global well diversified portfolio. The global weather portfolio is the most efficient capital pool for the risk.

Product Management (II) The Weather Desk has found a relationship that establishes the load, given the weather. This relationship establishes the uncertainty of the load as well. Given that the Weather Desk can hedge the weather in the market, the risk is limited to basis (the cited “uncertainty”). The above relationship can be established by more than one method, which gives confidence in the results for different market conditions. The Weather Desk has found the inverse relationship between load and weather. It allows the Desk to clear possible arbitrages between the two markets.

Future Products The consumption idea can be extended to other commodity markets that have exposure to the weather. For instance: Natural gas, heating oil and propane. The consumption idea is also extendable to other geographic locations, e.g. Europe. With respect to power, this product is well suited to any market governed by a pool and/or for which consumption is highly correlated with weather.