Eversource 2008 Annual Report Download - page 36

SFAS No. 157 to valuations of investments in our pension
and PBOP plans as of December 31, 2008. Implementing
SFAS No. 157 for our marketable securities expanded our
financial statement disclosures, but did not aect the
recorded fair value of investments.
For the year ended December 31, 2008, we recorded a net
after-tax reduction of earnings of $3.2 million as a result
of applying SFAS No. 157 to derivative liabilities for Select
Energy’s remaining wholesale marketing contracts.
As a result of implementing SFAS No. 157, we also recorded
changes in fair value of certain derivative contracts of
CL&P. Because CL&P is a cost-of-service, rate regulated
entity, the cost or benefit of the contracts is expected to be
fully recovered from or refunded to CL&P’s customers, and
an osetting regulatory asset or liability was recorded to
reflect these changes. Implementing SFAS No. 157 resulted
in a total increase to CL&P’s derivative liabilities, with an
oset to regulatory assets, of approximately $590 million
and a total decrease to derivative assets, with an oset
to regulatory liabilities, of approximately $30 million. The
increase to CL&P’s derivative liabilities primarily resulted
from an increase in the negative fair value of a CfD with a
generating plant to be built to reflect the estimated cost to
exit this contract, reflecting an increase in the probability
that the plant will be built and the recognition of a loss at
the inception of the contract of approximately $100 million
that was deferred under previous accounting guidance.
If we do not exit but rather serve out our derivative liability
contracts, we will not make payments for some portion of
the negative fair value recorded for the contracts. Likewise,
we could receive more cash for derivative assets than the
fair value recorded.
We use quoted market prices when available to determine
fair values of financial instruments and classify those
valuations as Level 1 within the fair value hierarchy.
If quoted market prices are not available, fair value is
determined using quoted prices for similar instruments
in active markets, quoted prices for identical or similar
instruments that are not active and model-derived
valuations in which all significant inputs are observable.
These valuations are classified as Level 2 within the fair
value hierarchy.
Many of our derivative contracts that are recorded at fair
value are classified as Level 3 within the hierarchy and are
valued using models that incorporate both observable
and unobservable inputs. Contracts valued using models
are classified according to the lowest level for which there
is at least one input that is significant to the valuation.
Therefore, an item may be classified as Level 3 even though
there may be some significant inputs that are readily
observable.
Contracts are valued using models when quoted prices in
active markets for the same or similar instruments are not
available. Fair value is modeled using techniques such as
discounted cash flow approaches adjusted for assumptions
relating to exit price and the Black-Scholes option pricing
model, incorporating the terms of the contracts. Significant
unobservable inputs utilized in the valuations include
energy and energy-related product prices for future
years for long-dated derivative contracts, future contract
quantities under full requirements and supplemental sales
contracts, and market volatilities. The observable inputs into
the valuation include contract purchase prices and future
energy prices for the near term. Discounted cash flow
valuations incorporate estimates of premiums or discounts,
reflecting risk adjusted profit that would be required by a
market participant to arrive at an exit price, using available
historical market transaction information. Valuations of
derivative contracts also reflect nonperformance risk,
including credit risk.
Changes in fair value of the remaining wholesale marketing
contracts of our unregulated businesses are recorded
in fuel, purchased and net interchange power on the
accompanying consolidated statements of income. For the
year ended December 31, 2008, there were net unrealized
gains of $4.3 million ($7 million pre-tax), related to the
valuation of these contracts. There were net realized
gains of $3 million ($5 million pre-tax) for the year ended
December 31, 2008. Key drivers of variability in fair values
include changes in energy prices and expected volumes
under the contracts. We utilize judgments in estimated
expected volumes that are dependent on a number of
factors including options exercised, customer utilization,
weather and availability of other power sources to our
counterparty. The valuations of our derivative contracts
are highly sensitive to changes in market prices of
commodities.
Changes in fair value of the regulated company derivative
contracts are recorded as regulatory assets or liabilities, as
we expect to recover these costs in rates. These valuations
are sensitive to the prices of energy and energy related
products in future years for which markets have not yet
developed. Assumptions made to implement SFAS No. 157
had a significant eect on derivative values, and changes in
assumptions may continue to have significant eects.
Total Level 3 derivative assets were 66 percent of our
total assets measured at fair value, and Level 3 derivative
liabilities were 91 percent of our total liabilities measured
at fair value at December 31, 2008. A significant portion
of our Level 3 derivative liabilities relate to the regulated
company derivative contracts for which changes in
fair value do not aect our earnings due to our use of
regulatory accounting. Changes in fair value of these
contracts are not material to our liquidity or capital
resources because the costs and benefits of the contracts
are recoverable from or refundable to customers on a
timely basis.
Our regulated and unregulated business activities that
result in the recognition of derivative assets create
exposures to credit risk of energy marketing and trading
counterparties. At December 31, 2008, we had $273.2
million of regulated company and NU parent derivative
assets that are contracted with multiple entities, of which
$125.5 million is contracted with investment grade entities,
$4.6 million is contracted with a government-backed entity,
$131.4 million is contracted with a non-rated subsidiary
of an investment grade company and the remainder
are contracted with multiple other counterparties. We
consider the credit ratings of these companies in our
valuation of derivative assets and we use published
probability of default indices based on the credit ratings of
the counterparties to discount the value of the derivative
asset. Changes in our counterparties’ credit impact our
ability to collect the derivative asset. Our derivative assets
are primarily related to our regulated companies. Credit
losses on regulated company contracts would not aect
our earnings because these entities are cost-of-service
regulated companies and costs of these contracts are
recoverable from our customers. In addition, we consider
our own credit rating in the valuation of derivative
liabilities. Adjusting our unregulated derivative liabilities
to incorporate our credit risk had an after-tax impact of
$0.7 million on the fair value of our derivative liability and
net income for the year ended December 31, 2008. Our
regulated companies derivative assets and liabilities were
also reduced to reflect the impact of our counterparties’
credit risk and our own credit risk on fair values, with no
eect on net income.
NU has a policy of margining counterparties in the event
that the fair value of a derivative contract exceeds a pre-
determined threshold. Depending on the credit rating
of the counterparty, an unsecured credit line is granted
to counterparties. In the event the fair value exceeds the
unsecured credit line, NU requires cash collateral for those
open positions. There are exceptions to this policy for
contracts whose terms are determined by regulators.
We review and update our fair value hierarchy
classifications on a quarterly basis. As of December 31,
2008, we hold $53.5 million of investment securities in
our supplemental benefit trust for non-pension retirement
benefits and $55.7 million of investment securities in our
WMECO spent nuclear fuel trust. These investments are
classified in Levels 1 and 2. Classification of an investment
security or group of investment securities into Level 3 may
occur if a significant amount of inputs to their valuation is
no longer observable due to a decline in market activity
or liquidity. We have assessed the impact of recently
increasing market illiquidity on the valuation of our
investments. Observable inputs remain available to value
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