Eversource 2004 Annual Report Download - page 33

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To mitigate the risk of electricity price decreases on the fixed-price
electricity that was purchased, Select Energy in June 2004 began
selling wholesale natural gas contracts for 2005 and 2006. The intended
result of this risk mitigation strategy was that decreases in the value
of the fixed-price electricity purchase contracts would be offset in part
by increases in the value of the gas contracts, and vice versa. Select
Energy intended to purchase natural gas when quantities and prices
of electricity are secured by full requirements contracts or sales
contracts with load-serving entities. Natural gas was sold in this risk
mitigation strategy due to the high liquidity of the natural gas market
compared to the low liquidity of electricity in New England.
The electricity contracts were accounted for on the accrual basis
through 2004, which would have resulted in earnings recognition
when the electricity would have been delivered to customers in 2005
and 2006. These electricity purchase contracts were to be used to meet
electricity sales contract requirements, which was a key component of
the merchant energy wholesale business. Until the decision to cease
wholesale marketing activities was made, management believed that
this electricity would be delivered to its customers. The decision on
March 9, 2005 to exit the wholesale marketing business changed
management’s conclusion regarding the likelihood that many wholesale
marketing contracts would result in delivery to customers. This in
turn resulted in a change in March 2005 from accrual accounting to
fair value accounting for the wholesale marketing contracts that will
be sold. Under fair value accounting, changes in the fair value of these
contracts will impact 2005 earnings until the contracts are completed
or sold.
The natural gas contracts are recorded at current fair value with
changes in fair value impacting earnings. At December 31, 2004 the
fair value of the natural gas contracts was a negative $77.7 million.
The changes in fair values totaling a negative $77.7 million increased
fuel, purchased and net interchange power in 2004. Of the total fair
value of negative $77.7 million, approximately negative $68 million
relates to 2005 with approximately negative $10 million related to 2006.
The use of fair value accounting for the aforementioned natural gas
and electricity contracts has exposed and will continue to expose Select
Energy’s and NU’s earnings to future changes in natural gas and electricity
prices, which could be significant. This has and can reasonably be
expected to create uncertainty in 2005 regarding Select Energy’s and
NU’s earnings and earnings trends.
The natural gas contracts are included in non-trading derivative assets
and liabilities in the table in Note 3, “Derivative Instruments,” to the
consolidated financial statements.
Retail Marketing Activities: Select Energy manages its portfolio of retail
marketing contracts to maximize value while operating within NU’s
corporate risk tolerance. Select Energy generally acquires retail
customers in small increments, which while requiring careful sourcing
allows energy purchases to be acquired in small increments with low
risk. However, fluctuations in prices, fuel costs, competitive conditions,
regulations, weather, transmission costs, lack of market liquidity, plant
outages and other factors can all impact the retail business adversely
from time to time.
Generation Activities: The generation assets, either owned by NU
Enterprises or contracted with third parties, are subject to certain
operational risks, including but not limited to the length of scheduled
and non-scheduled outages, bidding and scheduling with various
ISOs, environmental issues and fuel costs. Generation is also subject
to various federal, state and local regulations. These risks may result
in changes in the anticipated gross margins which Select Energy
realizes from its generation portfolio/activities.
Hedging and Other Non-Trading: For information on derivatives used for
hedging purposes and non-trading derivatives, see Note 3, “Derivative
Instruments,” to the consolidated financial statements.
Wholesale Contracts Defined as “Energy Trading”: Historically, energy trading
transactions at Select Energy include financial transactions and
physical delivery transactions for electricity, natural gas and oil in
which Select Energy attempted to profit from changes in market prices.
Energy trading contracts are recorded at fair value, and changes in fair
value affect net income.
At December 31, 2004, Select Energy had trading derivative assets and
trading derivative liabilities as follows:
(Millions of Dollars) 2004
Current trading derivative assets $49.6
Long-term trading derivative assets 31.7
Current trading derivative liabilities (46.2)
Long-term trading derivative liabilities (5.5)
Portfolio position $29.6
There can be no assurances that Select Energy will realize cash
corresponding to the present positive net fair value of its trading
positions. Numerous factors could either positively or negatively affect
the realization of the net fair value amount in cash. These include the
sales price to be received on the sale of these contracts, the volatility
of commodity prices until the contracts are sold, 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 business day and segregating
responsibilities between the 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 determine the fair value of energy trading
contracts are identified and segregated in the table of fair value of
contracts at December 31, 2004. A description of each method is as
follows: 1) prices actively quoted primarily represent New York
Mercantile Exchange futures and options that are marked to closing
exchange prices; and 2) prices provided by external sources primarily
include over-the-counter forwards and options, including bilateral
contracts for the purchase or sale of electricity or natural gas, and are
marked to the mid-point of bid and ask market prices. Currently,
Select Energy has one contract for which a portion of the contract’s fair
value is determined based on a model or other valuation method. The
model utilizes natural gas prices and a conversion factor to electricity.
Management recorded a modeling reserve to reduce the value of the