Dominion Power 2005 Annual Report Download - page 50

Management’s Discussion and Analysis of Financial Condition and Results of Operations, Continued
48 Dominion 2005
emissions are under consideration in the United States Congress.
The cost of compliance with the Protocol or other mandatory green-
house gas reduction obligations could be significant. Given the
highly uncertain outcome and timing of future action, if any, by
the U.S. federal government on this issue, we cannot predict the
financial impact of future climate change actions on our operations
at this time.
Restructuring of Contracts with Nonutility Generator
In October 2005, we reached an agreement in principle to restruc-
ture three long-term power purchase contracts. The restructured
contracts expire between 2015 and 2017 and are expected to
reduce capacity and energy payments by approximately $44 million
and $6 million, respectively, over the remaining term of the con-
tracts. The transaction became effective in February 2006 and did
not result in a cash outlay or charge to earnings.
Sale of Gas Distribution Subsidiaries
On March 1, 2006 we entered into an agreement with Equitable
Resources, Inc. to sell two of our wholly-owned regulated gas distri-
bution subsidiaries, The Peoples Natural Gas Company and Hope
Gas, Inc., for $969.6 million plus adjustments to reflect capital
expenditures and changes in working capital. We expect to com-
plete the transaction by the first quarter of 2007, subject to state
regulatory approvals in Pennsylvania and West Virginia, as well as
approval under the federal Hart-Scott-Rodino Act.
Market Risk Sensitive Instruments and Risk
Management
Our financial instruments, commodity contracts and related finan-
cial derivative instruments are exposed to potential losses due to
adverse changes in commodity prices, interest rates, foreign cur-
rency exchange rates and equity security prices as described below.
Commodity price risk is present in our electric operations, gas and
oil production and procurement operations, and energy marketing
and trading operations due to the exposure to market shifts in
prices received and paid for natural gas, oil, electricity and other
commodities. We use derivative commodity contracts to manage
price risk exposures for these operations. Interest rate risk is gener-
ally related to our outstanding debt. We are exposed to foreign cur-
rency exchange rate risks related to our purchase of fuel services
denominated in a foreign currency. In addition, we are exposed to
equity price risk through various portfolios of equity securities.
As discussed in Note 28 to our Consolidated Financial State-
ments, we performed an evaluation of our Clearinghouse trading
and marketing operations, which resulted in a decision to exit cer-
tain trading activities and instead focus on the optimization of com-
pany assets. In connection with the reorganization, certain
commodity derivative contracts previously designated as held for
trading purposes are now held for non-trading purposes.
The following sensitivity analysis estimates the potential loss of
future earnings or fair value from market risk sensitive instruments
over a selected time period due to a 10% unfavorable change in
commodity prices, interest rates and foreign currency
exchange rates.
Commodity Price Risk
As part of our strategy to market energy and to manage related risks,
we hold commodity-based financial derivative instruments for trading
purposes. We also manage price risk associated with purchases and
sales of natural gas, oil, electricity and certain other commodities
using commodity-based financial derivative instruments held for
non-trading purposes.
The derivatives used to manage risk are executed within estab-
lished policies and procedures and include instruments such as
futures, forwards, swaps and options that are sensitive to changes
in the related commodity prices. For sensitivity analysis purposes,
the fair value of commodity-based financial derivative instruments
is determined based on models that consider the market prices of
commodities in future periods, the volatility of the market prices in
each period, as well as the time value factors of the derivative
instruments. Prices and volatility are principally determined based
on actively quoted market prices.
A hypothetical 10% unfavorable change in commodity prices
would have resulted in a decrease of approximately $3 million and
$23 million in the fair value of our commodity-based financial deriv-
ative instruments held for trading purposes as of December 31,
2005 and 2004, respectively. A hypothetical 10% unfavorable
change in market prices of our non-trading commodity-based finan-
cial derivative instruments would have resulted in a decrease in
fair value of approximately $691 million and $576 million as of
December 31, 2005 and 2004, respectively.
The impact of a change in energy commodity prices on our non-
trading commodity-based financial derivative instruments at a point
in time is not necessarily representative of the results that will be
realized when such contracts are ultimately settled. Net losses from
derivative commodity instruments used for hedging purposes, to
the extent realized, will generally be offset by recognition of the
hedged transaction, such as revenue from sales.
Interest Rate Risk
We manage our interest rate risk exposure predominantly by main-
taining a balance of fixed and variable rate debt. We also enter into
interest rate sensitive derivatives, including interest rate swaps and
interest rate lock agreements. For financial instruments outstanding
at December 31, 2005, a hypothetical 10% increase in market
interest rates would decrease annual earnings by approximately
$20 million. A hypothetical 10% increase in market interest rates,
as determined at December 31, 2004, would have resulted in a
decrease in annual earnings of approximately $10 million.
In addition, we retain ownership of mortgage investments,
including subordinated bonds and interest-only residual assets
retained from securitizations of mortgage loans originated and pur-
chased in prior years. Note 27 to our Consolidated Financial State-
ments discusses the impact of changes in value of these
investments.
Foreign Currency Exchange Risk
Our Canadian natural gas and oil exploration and production activi-
ties are relatively self-contained within Canada. As a result, our
exposure to foreign currency exchange risk for these activities is
limited primarily to the effects of translation adjustments that arise
from including that operation in our Consolidated Financial State-
ments. We monitor this exposure and believe it is not material. In
addition, we manage our foreign exchange risk exposure associated
with anticipated future purchases of nuclear fuel processing ser-
vices denominated in foreign currencies by utilizing currency for-
ward contracts. As a result of holding these contracts as hedges,
our exposure to foreign currency risk is minimal. A hypothetical 10%
unfavorable change in relevant foreign exchange rates would have
resulted in a decrease of approximately $8 million and $13 million