Dominion Power 2007 Annual Report Download - page 57

M ARKET R ISK S ENSITIVE I NSTRUMENTS
AND R ISK M ANAGEMENT
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 and equity
security prices as described below. Commodity price risk is pres-
ent in our electric operations, gas production and procurement
operations, and energy marketing and trading operations due to
the exposure to market shifts in prices received and paid for elec-
tricity, natural gas and other commodities. We use commodity
derivative contracts to manage price risk exposures for these oper-
ations. Interest rate risk is generally related to our outstanding
debt. In addition, we are exposed to equity price risk through
various portfolios of equity securities.
The following sensitivity analysis estimates the potential loss
of future earnings or fair value from market risk sensitive instru-
ments over a selected time period due to a 10% unfavorable
change in commodity prices and interest rates.
Commodity Price Risk
To manage price risk, we hold commodity-based financial
derivative instruments held for non-trading purposes associated
with purchases and sales of electricity, natural gas and other
energy-related products. As part of our strategy to market energy
and to manage related risks, we also hold commodity-based
financial derivative instruments for trading purposes.
The derivatives used to manage risk are executed within estab-
lished policies and procedures and may include instruments such
as futures, forwards, swaps, options and FTRs 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 market prices of
our non-trading commodity-based financial derivative instru-
ments would have resulted in a decrease in fair value of approx-
imately $338 million and $597 million as of December 31, 2007
and 2006, respectively. The decrease is primarily due to the
termination of derivatives related to the divestiture of our
non-Appalachian E&P business. A hypothetical 10% unfavorable
change in commodity prices would have resulted in a decrease of
approximately $8 million and $3 million in the fair value of our
commodity-based financial derivative instruments held for trad-
ing purposes as of December 31, 2007 and 2006, 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 commodity derivative instruments used for hedging
purposes, to the extent realized, will generally be offset by recog-
nition of the hedged transaction, such as revenue from sales.
Interest Rate Risk
We manage our interest rate risk exposure predominantly by
maintaining 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, 2007 and 2006, a hypothetical 10%
increase in market interest rates would have resulted in a decrease
in annual earnings of approximately $11 million and $25 million,
respectively. The decrease is due primarily to a decrease in variable
rate debt.
Investment Price Risk
We are subject to investment price risk due to marketable secu-
rities held as investments in decommissioning trust funds. These
marketable securities are managed by third-party investment
managers and are reported in our Consolidated Balance Sheets at
fair value.
Following the reapplication of SFAS No. 71 to the Virginia
jurisdiction of our utility generation operations, gains or losses on
those decommissioning trust investments are deferred as regu-
latory liabilities.
We recognized net realized gains (including investment
income) on nuclear decommissioning trust investments of $43
million and $63 million in 2007 and 2006, respectively. In 2007,
we recorded unrealized gains on these investments of $52 million
to AOCI and regulatory liabilities. We recorded, in AOCI,
unrealized gains on these investments of $194 million in 2006.
We also sponsor employee pension and other postretirement
benefit plans that hold investments in trusts to fund benefit
payments. To the extent that the values of investments held in
these trusts decline, the effect will be reflected in our recognition
of the periodic cost of such employee benefit plans and the
determination of the amount of cash to be contributed to the
employee benefit plans. Our pension and other postretirement
benefit plan assets generated actual returns of $520 million and
$674 million in 2007 and 2006, respectively. As of December 31,
2007, a hypothetical 0.25% decrease in the assumed rates of
return on our plan assets would result in an increase in net peri-
odic cost of approximately $12 million for pension benefits and
$2 million for other postretirement benefits. As of December 31,
2006, a hypothetical 0.25% decrease in the assumed rates of
return on our plan assets would have resulted in an increase in net
periodic cost of approximately $11 million for pension benefits
and $2 million for other postretirement benefits.
Risk Management Policies
We have established operating procedures with corporate manage-
ment to ensure that proper internal controls are maintained. In
addition, we have established an independent function at the
corporate level to monitor compliance with the risk management
policies of all subsidiaries. We maintain credit policies that
include the evaluation of a prospective counterparty’s financial
condition, collateral requirements where deemed necessary and
the use of standardized agreements that facilitate the netting of
cash flows associated with a single counterparty. In addition, we
also monitor the financial condition of existing counterparties on
an ongoing basis. Based on our credit policies and our
December 31, 2007 provision for credit losses, management
Dominion 2007 Annual Report 55