PG&E 2009 Annual Report Download - page 93

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PRICE RISK MANAGEMENT INSTRUMENTS
Price risk management instruments are composed of
physical and financial derivative contracts, including
futures, forwards, options, and swaps that are both
exchange-traded and over-the-counter (“OTC”)-traded
contracts. PG&E Corporation and the Utility consistently
apply valuation methodology among their instruments.
The Utility is permitted to defer the unrealized gains and
losses associated with these derivatives, as they are expected
to be refunded or recovered in future rates.
All energy options (exchange-traded and OTC) are
valued using the Black’s Option Pricing Model and
classified as Level 3 measurements primarily due to
volatility inputs.
The Utility holds CRRs to hedge financial risk of
CAISO-imposed congestion charges in the day-ahead
markets. The Utility’s demand response contracts (“DRs”)
with third-party aggregators of retail electricity customers
contain a call option entitling the Utility to require that the
aggregator reduce electric usage by the aggregator’s
customers at times of peak energy demand or in response
to a CAISO alert or other emergency. As the market for
CRRs and DRs has minimal activity, observable inputs
may not be available in pricing these instruments.
Therefore, the pricing models used to value these
instruments often incorporate significant estimates and
assumptions that market participants would use in pricing
the instrument. Accordingly, they are classified as Level 3
measurements. When available, observable market data is
used to calibrate pricing models.
Exchange-traded derivative instruments (other than
options) are generally valued based on unadjusted prices in
active markets using pricing models to determine the net
present value of estimated future cash flows. Accordingly, a
majority of these instruments are classified as Level 1
measurements. However, certain exchange-traded contracts
are classified as Level 2 measurements because the contract
term extends to a point at which the market is no longer
considered active but where prices are still observable. This
determination is based on an analysis of the relevant
characteristics of the market such as trading hours and
volumes, frequency of available quotes, and open interest.
In addition, a number of OTC contracts have been valued
using unadjusted exchange prices in active markets. Such
instruments are classified as Level 2 measurements as they
are not exchange-traded instruments. The remaining OTC
derivative instruments are valued using pricing models
based on the net present value of estimated future cash
flows based on broker quotations. Such instruments are
generally classified within Level 3 of the fair value
hierarchy, as broker quotes are only indicative of market
activity and do not necessarily reflect binding offers to
transact.
See Note 10 of the Notes to the Consolidated Financial
Statements for further discussion of the price risk
management instruments.
DIVIDEND PARTICIPATION RIGHTS
The dividend participation rights of the Convertible
Subordinated Notes are embedded derivative instruments
and, therefore, are bifurcated from Convertible
Subordinated Notes and recorded at fair value in PG&E
Corporation’s Consolidated Balance Sheets. The dividend
participation rights are valued based on the net present
value of estimated future cash flows using internal
estimates of future common stock dividends. The fair value
of the dividend participation rights is recorded as Current
Liabilities – Other and Noncurrent Liabilities – Other in
PG&E Corporation’s Consolidated Balance Sheets. (See
Note 4 of the Notes to the Consolidated Financial
Statements for further discussion of these instruments.)
FINANCIAL INSTRUMENTS
PG&E Corporation and the Utility use the following
methods and assumptions in estimating fair value for
financial instruments:
• The fair values of cash and cash equivalents, restricted
cash and deposits, net accounts receivable, short-term
borrowings, accounts payable, customer deposits, and the
Utility’s variable rate pollution control bond loan
agreements approximate their carrying values at
December 31, 2009 and 2008.
• The fair values of the Utility’s fixed rate senior notes and
fixed rate pollution control bond loan agreements, PG&E
Corporation’s Convertible Subordinated Notes, PG&E
Corporation’s fixed rate senior notes, and the ERBs issued
by PERF were based on quoted market prices at
December 31, 2009 and 2008.
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