Eversource 2003 Annual Report Download - page 30

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As indicated in the tables above and below, the fair value of energy trading
contracts decreased $8.5 million from $41 million at December 31, 2002
to $32.5 million at December 31, 2003. The change in the fair value of
the trading portfolio is attributable to several items, including the
termination and realization in 2003 of a contract with a positive fair
value of $5.7 million and the establishment of a credit reserve on a long-
term trading contract. The change in fair value attributable to changes in
valuation techniques and assumptions of $2.3 million in 2003 resulted
from a change in the discount rate management uses to determine the
fair value of trading contracts. In the second quarter of 2003, the rate
was changed from a fixed rate of 5 percent to a market-based LIBOR
discount rate to better reflect current market conditions.
In 2002, in connection with management’s review of the contracts in the
trading portfolio, the significant changes in the energy trading market
and the change in the focus of the energy trading activities, certain
long-term derivative energy contracts that were included in the trading
portfolio and valued at $33.9 million at November 30, 2002, were desig-
nated as normal purchases and sales. The impact of this designation is
that the contracts were adjusted to fair value at November 30, 2002 and
were not and will not be adjusted subsequently for changes in fair value.
The $33.9 million carrying value of these contracts was reclassified from
trading derivative assets to other long-term assets and is being amortized
on a straight-line basis to fuel, purchased and net interchange power
expense over the remaining terms of the contracts, some of which
extend to 2011. This amount is included in changes in fair values
attributable to changes in valuation techniques and assumptions.
The other negative $6 million reflected in changes in fair value attributable
to changes in valuation techniques and assumptions relates to $12 million
of contracts held by Select Energy New York, Inc. at acquisition that in
2002 were determined to be held for non-trading purposes by Select
Energy. Accordingly, the $12 million of contracts were removed from the
trading portfolio. Long-term trading contracts with maturities in excess
of four years and transmission congestion contracts (TCC) were revalued
during 2002 based on the availability of market information, which
added $6 million to the value of the trading portfolio.
Years Ended December 31,
2003 2002
(Millions of Dollars) Total Portfolio Fair Value
Fair value of trading contracts
outstanding at the beginning of the year $41.0 $56.4
Contracts realized or otherwise settled
during the period (10.7) (4.0)
Fair value of new contracts when entered
into during the year —13.7
Changes in fair values attributable to changes
in valuation techniques and assumptions 2.3 (39.9)
Changes in fair value of contracts (0.1) 14.8
Fair value of trading contracts outstanding
at the end of the year $32.5 $41.0
Changing Market: The breadth and depth of the market for energy
trading and marketing products in Select Energy’s markets continue to
be adversely affected by the withdrawal or financial weakening of a
number of companies who have historically done significant amounts of
business with Select Energy. In general, the market for such products has
become shorter term in nature with less liquidity, market pricing
information is becoming less readily available, and participants are more
often unable to meet Select Energy’s credit standards without providing
cash or LOC support. Select Energy is being adversely affected by these
factors, and there could be a continuing adverse impact on Select
Energy’s business lines. The decrease in the number of counterparties
participating in the market for long-term energy contracts also continues
to affect Select Energy’s ability to estimate the fair value of its long-term
wholesale energy contracts.
Changes are occurring in the administration of transmission systems in
territories in which Select Energy does business. Regional transmission
organizations (RTO) are being contemplated, and other changes in market
design are occurring within transmission regions. For example, SMD was
implemented in New England on March 1, 2003 and has created both
challenges and opportunities for Select Energy. For information regarding
the effects of SMD on Select Energy, see “Impacts of Standard Market
Design” in this Management’s Discussion and Analysis. As the market
continues to evolve, there could be additional adverse effects that
management cannot determine at this time.
Counterparty Credit: Counterparty credit risk relates to the risk of loss
that Select Energy would incur because of non-performance by counter-
parties pursuant to the terms of their contractual obligations. Select
Energy has established written credit policies with regard to its counter-
parties to minimize overall credit risk. These policies require an evaluation
of potential counterparties’ financial conditions (including credit ratings),
collateral requirements under certain circumstances (including cash
advances, letters of credit, and parent guarantees), and the use of
standardized agreements that allow for the netting of positive and
negative exposures associated with a single counterparty. This evaluation
results in establishing credit limits prior to Select Energy entering into
contracts. The appropriateness of these limits is subject to continuing
review. Concentrations among these counterparties may affect Select
Energy’s overall exposure to credit risk, either positively or negatively, in
that the counterparties may be similarly affected by changes to economic,
regulatory or other conditions. At December 31, 2003, approximately 89
percent of Select Energy’s counterparty credit exposure to wholesale and
trading counterparties was cash collateralized or rated BBB- or better.
Another one percent of the counterparty credit exposure was to unrated
municipalities. Select Energy held $46.5 million and $16.9 million of
counterparty cash advances at December 31, 2003 and 2002, respectively.
Asset Concentrations: At December 31, 2003, positions with four
counterparties collectively represented approximately $89 million, or 72
percent, of the $123.9 million trading derivative assets. The largest
counterparty’s position is secured with letters of credit and cash collateral.
Select Energy holds parent company guarantees at investment grade ratings
supporting the remaining positions of the counterparties. None of the
other counterparties represented more than 10 percent of trading
derivative assets at December 31, 2003.
Select Energy’s Credit: A number of Select Energy’s contracts require the
posting of additional collateral in the form of cash or letters of credit in
the event NU’s ratings were to decline and in increasing amounts
dependent upon the severity of the decline. At NU’s present investment
grade ratings, Select Energy has not had to post any collateral based on
credit downgrades. Were NU’s unsecured ratings to decline two to three
levels to sub-investment grade, Select Energy could, under its present