Dominion Power 2007 Annual Report Download - page 74

Notes to Consolidated Financial Statements, Continued
D ERIVATIVE I NSTRUMENTS D ESIGNATED AS H EDGING
I NSTRUMENTS
We designate a substantial portion of our derivative instruments
as either cash flow or fair value hedges for accounting purposes.
For all derivatives designated as hedges, we formally document
the relationship between the hedging instrument and the hedged
item, as well as the risk management objective and the strategy for
using the hedging instrument. We assess whether the hedging
relationship between the derivative and the hedged item is highly
effective at offsetting changes in cash flows or fair values both at
the inception of the hedging relationship and on an ongoing
basis. Any change in the fair value of the derivative that is not
effective at offsetting changes in the cash flows or fair values of the
hedged item is recognized currently in earnings. Also, we may
elect to exclude certain gains or losses on hedging instruments
from the measurement of hedge effectiveness, such as gains or
losses attributable to changes in the time value of options or
changes in the difference between spot prices and forward prices,
thus requiring that such changes be recorded currently in earn-
ings. We discontinue hedge accounting prospectively for
derivatives that cease to be highly effective hedges.
Cash Flow Hedges—A significant portion of our hedge strat-
egies represents cash flow hedges of the variable price risk asso-
ciated with the purchase and sale of electricity, natural gas and
other energy-related products. We also use foreign currency for-
ward contracts to hedge the variability in foreign exchange rates
and interest rate swaps to hedge our exposure to variable interest
rates on long-term debt. For transactions in which we are hedging
the variability of cash flows, changes in the fair value of the
derivative are reported in AOCI, to the extent they are effective at
offsetting changes in the hedged item, until earnings are affected
by the hedged item. Following the reapplication of SFAS No. 71,
to the Virginia jurisdiction of our utility generation operations,
for jurisdictions subject to cost-based regulation, changes in the
fair value of these derivative instruments result in the recognition
of regulatory assets or regulatory liabilities. Realized gains or losses
on the derivative instruments subject to regulatory accounting are
generally recognized when the related transactions impact
earnings. For cash flow hedge transactions, we discontinue hedge
accounting if the occurrence of the forecasted transaction is
determined to be no longer probable. We reclassify any derivative
gains or losses reported in AOCI to earnings when the forecasted
item is included in earnings, if it should occur, or earlier, if it
becomes probable that the forecasted transaction will not occur.
Fair Value Hedges—We also use fair value hedges to mitigate
the fixed price exposure inherent in certain firm commodity
commitments and natural gas inventory. In addition, we have
designated interest rate swaps as fair value hedges on certain fixed-
rate long-term debt to manage our interest rate exposure. For fair
value hedge transactions, changes in the fair value of the
derivative are generally offset currently in earnings by the recog-
nition of changes in the hedged item’s fair value. Following the
reapplication of SFAS No. 71, to the Virginia jurisdiction of our
utility generation operations, for jurisdictions subject to cost-
based regulation, changes in the fair value of these derivative
instruments result in the recognition of regulatory assets or regu-
latory liabilities. Realized gains or losses on the derivative instru-
ments subject to regulatory accounting are generally recognized
when the related transactions impact earnings. For fair value
hedge transactions, we discontinue hedge accounting if the
hedged item no longer qualifies for hedge accounting. We
reclassify derivative gains and losses from the hedged item to earn-
ings when the hedged item is included in earnings, or earlier, if
the hedged item no longer qualifies for hedge accounting.
Statement of Income Presentation—Gains and losses on
derivatives designated as hedges, when recognized, are included in
operating revenue, operating expenses or interest and related
charges in our Consolidated Statements of Income. Specific line
item classification is determined based on the nature of the risk
underlying individual hedge strategies. The portion of gains or
losses on hedging instruments determined to be ineffective and
the portion of gains or losses on hedging instruments excluded
from the measurement of the hedging relationship’s effectiveness,
such as gains or losses attributable to changes in the time value of
options or changes in the difference between spot prices and
forward prices, are included in other operations and maintenance
expense.
V
ALUATION M ETHODS
Fair value is based on actively-quoted market prices, if available.
In the absence of actively-quoted market prices, we seek indicative
price information from external sources, including broker quotes
and industry publications. If pricing information from external
sources is not available, we must estimate prices based on available
historical and near-term future price information and certain stat-
istical methods, including regression analysis.
For options and contracts with option-like characteristics
where pricing information is not available from external sources,
we generally use a modified Black-Scholes Model that considers
time value, the volatility of the underlying commodities and other
relevant assumptions when estimating fair value. We use other
option models under special circumstances, including a Spread
Approximation Model, when contracts include different
commodities or commodity locations and a Swing Option Mod-
el, when contracts allow either the buyer or seller the ability to
exercise within a range of quantities. For contracts with unique
characteristics, we estimate fair value using a discounted cash flow
approach deemed appropriate in the circumstances and applied
consistently from period to period. If pricing information is not
available from external sources, judgment is required to develop
the estimates of fair value. For individual contracts, the use of
different valuation models or assumptions could have a material
effect on the contract’s estimated fair value.
Investment Securities
We account for and classify investments in marketable equity and
debt securities into two categories. Debt and equity securities held
in rabbi trusts associated with certain deferred compensation
plans are classified as trading securities. Trading securities are
reported at fair value with net realized and unrealized gains and
losses included in earnings. All other debt and equity securities are
classified as available-for-sale securities, which are also reported at
fair value. Upon reapplication of SFAS No. 71 in April 2007 for
our utility generation operations, net realized and unrealized gains
and losses on our utility nuclear decommissioning trusts are
recorded to a regulatory liability for certain jurisdictions. For our
merchant generation nuclear decommissioning trusts, net realized
gains and losses and any other-than-temporary declines in fair
72 Dominion 2007 Annual Report