Eversource 2002 Annual Report Download - page 22

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control compliance with these policies and procedures, NU has formed
a Risk Oversight Council (ROC) to monitor competitive energy risk
management processes independently from the businesses that create
or manage these risks. The ROC ensures that the polices pertaining to
these risks are followed and makes recommendations to the Board of
Trustees regarding periodic adjustment to the metrics used in measuring
and controlling portfolio risk while also confirming the methodologies
employed by management to discern portfolio values.
Wholesale and Retail Marketing: A significant portion of Select Energy’s
wholesale marketing business is providing energy to full requirements
customers, primarily regulated distribution companies. Under full
requirements contract terms, Select Energy is required to provide the
total energy requirement for the customers’ load at all times. Wholesale
and retail marketing transactions, including the full requirements contracts,
are intended to be part of Select Energy’s normal purchases and sales
and are recognized on the accrual basis of accounting.
An important component of Select Energy’s risk management strategy
is focused on managing the volume and price risks of full requirements
contracts. These risks include significant fluctuations in supply and
demand due to numerous factors such as weather, plant availability,
transmission congestion, and potentially volatile price fluctuations.
Select Energy uses energy contracts to hedge these risks. While not
classified as hedges for accounting purposes, these contracts, which are
included in the wholesale and retail marketing portfolios and are subject
to accrual accounting, are important to Select Energy’s risk management.
As discussed above, Select Energy’s 2002 results were negatively
impacted by weather patterns that resulted in contracted supply exceeding
demand in the warmer than expected winter and purchasing supply
during certain summer months at prices higher than those forecasted.
The competitive energy subsidiaries manage their portfolio of wholesale
and retail marketing contracts and assets to maximize value while
maintaining an acceptable level of risk. The lengths of contracts to buy
and sell energy vary in duration from daily/hourly to several years. At
any point in time, the wholesale and retail marketing portfolio may be
long (purchases exceed sales) or short (sales exceed purchases).
Portfolio and risk management disciplines with established policies and
procedures are used to manage exposures to market risks. At forward
market prices in effect at December 31, 2002, the wholesale marketing
portfolio, which includes the CL&P standard offer service contract and
other contracts that extend to 2013, had a positive fair value. This positive
fair value indicates a positive impact on Select Energy’s gross margin in
the future. However, there is significant volatility in the energy commodities
markets that will impact this position between now and when the contracts
are settled. Portfolio volatility reflects fluctuations in value due to
changes in energy prices in the region, new transactions entered into
during the period and positions settling during the period. Accordingly,
there can be no assurances that Select Energy will realize the gross
margin corresponding to the present positive fair value on its whole-
sale marketing portfolio. The gross margin realized could be at a level
that is not sufficient to cover Select Energy’s other operating costs,
including the cost of corporate overhead.
Hedging: Select Energy utilizes derivative financial and commodity
instruments, including futures and forward contracts, to reduce market
risk associated with fluctuations in the price of electricity and natural
gas purchases for firm sales commitments to certain customers.
Select Energy also utilizes derivatives, including price swap agreements,
call and put option contracts, and futures and forward contracts, to
manage the market risk associated with a portion of its anticipated
retail supply requirements. These derivatives have been designated as
cash flow hedging instruments and are used to reduce the market risk
associated with fluctuations in the price of electricity, natural gas or oil.
A derivative that effectively hedges exposure to the variable cash flows of
a forecasted transaction (a cash flow hedge) is initially recorded at fair
value with changes in fair value recorded in other comprehensive
income, which is a component of equity. Hedges impact earnings when
the forecasted transaction being hedged occurs, when hedge ineffectiveness
is measured and recorded, when the forecasted transaction being hedged
is no longer probable of occurring, or when there is accumulated other
comprehensive loss and the hedge and the forecasted transaction being
hedged are in a loss position on a combined basis. At December 31,
2002, Select Energy had hedging derivative assets of $22.8 million and
hedging derivative liabilities of $2 million. At December 31, 2001, Select
Energy had hedging derivative assets of $2.9 million and hedging
derivative liabilities of $60.7 million. The change from hedging derivative
liabilities at December 31, 2001 to hedging derivative assets at
December 31, 2002 resulted primarily from increased natural gas prices
and the maturity or termination of hedge instruments existing at
December 31, 2001.
Energy Trading: Energy trading transactions at Select Energy include
financial transactions and physical delivery transactions for electricity,
natural gas and oil in which Select Energy is attempting to profit from
changes in market prices. Energy trading contracts are recorded at fair
value, and changes in fair value impact earnings. For information regarding
changes in accounting for energy trading transactions, see Note 1C,
“New Accounting Standards,” to the consolidated financial statements.
At December 31, 2002, Select Energy had trading derivative assets of
$102.9 million and trading derivative liabilities of $61.9 million on a
counterparty-by-counterparty basis, for a net positive position of $41
million on the entire trading portfolio. At December 31, 2001, Select
Energy had trading derivative assets of $147.2 million and trading
derivative liabilities of $90.8 million on a counterparty-by-counterparty
basis, for a net positive position of $56.4 million on the entire trading
portfolio. These amounts are combined with other derivatives and are
included in derivative assets and derivative liabilities on the accompanying
consolidated balance sheets. Information regarding the other derivatives
is included in Note 3,“Derivative Instruments, Market Risk and Risk
Management,”to the consolidated financial statements.
There can be no assurances that Select Energy will actually realize cash
corresponding to the present positive net fair value of its trading portfolio.
Numerous factors could either positively or negatively affect the realization
in cash of the net fair value amount. These include the volatility of
commodity prices, changes in market design or settlement mechanisms,
the outcome of future transactions, the performance of counterparties,
and other factors.
Select Energy has policies and procedures requiring all trading positions
to be marked-to-market at the end of each trading day. Controls are in
place segregating responsibilities between individuals actually trading
(front office) and those confirming the trades (middle office). The
determination of the portfolio’s fair value is the responsibility of the
middle office independent from the front office. The methods used to