Dominion Power 2003 Annual Report Download - page 64

62.Dominion 2003
Notes to Consolidated Financial Statements, Continued
for trading purposes as part of its strategy to market energy and
to manage related risks.
All derivatives not qualifying for the normal purchase and nor-
mal sales exception are reported on the Consolidated Balance
Sheets at fair value. Commodity contracts representing unreal-
ized gain positions and purchased options are reported as
derivative and energy trading assets. Commodity contracts
representing unrealized losses and options sold are reported as
derivative and energy trading liabilities. For derivatives that are
not designated as hedging instruments, any changes in fair value
are recorded in earnings.
Valuation Methods
Fair value is based on actively quoted market prices, if available.
In the absence of actively quoted market prices, Dominion seeks
indicative price information from external sources, including bro-
ker quotes and industry publications. If pricing information from
external sources is not available, Dominion must estimate prices
based on available historical and near-term future price informa-
tion and certain statistical methods, including regression analysis.
For options and contracts with option-like characteristics
where pricing information is not available from external sources,
Dominion generally uses a modified Black-Scholes Model that
considers time value, the volatility of the underlying commodities
and other relevant assumptions when estimating fair value. Other
option models are used by Dominion under special circum-
stances, including a Spread Approximation Model, when con-
tracts include different commodities or commodity locations and
a Swing Option Model, when contracts allow either the buyer or
seller the ability to exercise within a range of quantities. For con-
tracts with unique characteristics, Dominion estimates fair value
using a discounted cash flow approach deemed appropriate in
the circumstances and applied consistently from period to period.
If pricing information is not available from external sources, judg-
ment is required to develop the estimates of fair value. For indi-
vidual contracts, the use of different assumptions could have a
material effect on the contract’s estimated fair value.
Derivative Instruments Designated as Hedging Instruments
Dominion designates a substantial portion of derivative instru-
ments, held for purposes other than trading, as fair value or cash
flow hedges for accounting purposes. For all derivatives desig-
nated as hedges, the relationship between the hedging instru-
ment and the hedged item is formally documented, as well as the
risk management objective and strategy for using the hedging
instrument. Dominion assesses whether the hedge relationship
between the derivative and the hedged item is highly effective in
offsetting changes in fair value or cash flows both at the inception
of the hedge and on an ongoing basis. Any change in fair value
of the derivative that is not effective in offsetting changes in the
fair value of the hedged item is recognized currently in earnings.
Also, in the case of options that are designated as hedging instru-
ments, management may elect to exclude changes in time value
from the measurement of hedge effectiveness, thus requiring that
such changes be recorded currently in earnings. Dominion dis-
continues hedge accounting prospectively for derivatives that
have ceased to be highly effective hedges.
Cash Flow Hedges A significant portion of Dominion’s
hedge strategies represents cash flow hedges of the variable
price risk associated with the purchase and sale of electricity, nat-
ural gas, oil and other commodities. Dominion also uses foreign
currency forward contracts to hedge the variability in foreign
exchange rates and interest rate swaps to hedge variable interest
rates on long-term debt. For cash flow hedge transactions in
which Dominion is hedging the variability of cash flows, changes
in the fair value of the derivative are reported in accumulated
other comprehensive income (AOCI) until earnings are affected
by the hedged item.
Fair Value Hedges Dominion also engages in fair value
hedges by using derivative instruments to mitigate the fixed price
exposure inherent in firm commodity commitments and certain
natural gas inventory. In addition, Dominion has designated inter-
est rate swaps as fair value hedges to manage its exposure to
fixed interest rates on certain long-term debt. For fair value hedge
transactions, changes in the fair value of the derivative will gener-
ally be offset currently in earnings by changes in the hedged
item’s fair value.
Statement of Income Presentation Gains and losses on
derivatives designated as hedges, when recognized, are included
in operating revenue, operating expenses or interest and related
charges in the Consolidated Statements of Income. Specific line
item classification is determined based on the nature of the risk
underlying individual hedge strategies. The portion of gains or
losses on hedging instruments determined to be ineffective and
any gains or losses attributable to the changes in the time value of
options, excluded from the measurement of effectiveness, are
included in other operations and maintenance expense.
Derivative Instruments Held for Trading and Other Purposes
As part of its strategy to market energy and to manage related
risks, Dominion manages a portfolio of commodity-based deriva-
tive instruments held for trading purposes, primarily natural gas
and electricity. Dominion uses established policies and proce-
dures to manage the risks associated with the price fluctuations in
these energy commodities and uses various derivative instruments
to reduce risk by creating offsetting market positions.
Certain derivative instruments are not held for trading purposes
and are not designated as hedges for accounting purposes. How-
ever, to the extent Dominion does not hold offsetting positions for
such derivatives, management believes these instruments represent
economic hedges that mitigate exposure to fluctuations in com-
modity prices, interest rates and foreign exchange rates.