Exelon 2003 Annual Report Download - page 66

64 Management’s Discussion and Analysis of Financial Condition and Results of Operations
EXELON CORPORATION AND SUBSIDIARY COMPANIES
supply. These models include assumptions regarding cus-
tomer load growth rates, which are influenced by the
economy, weather and the impact of customer choice, and
generating unit availability, particularly nuclear generating
unit capability factors. Significant changes in these assump-
tions could result in these contracts not qualifying for the
normal purchases and normal sales exception.
Identification of an energy contract as a qualifying cash-
flow hedge requires us to determine that the contract is in
accordance with our Risk Management Policy, the forecasted
future transaction is probable, and the hedging relationship
between the energy contract and the expected future pur-
chase or sale of energy is expected to be highly effective at
the initiation of the hedge and throughout the hedging rela-
tionship. Internal models that measure the statistical
correlation between the derivative and the associated
hedged item determine the effectiveness of such an energy
contract designated as a hedge. We reassess these cash-flow
hedges on a regular basis to determine if they continue to be
effective and that the forecasted future transactions are
probable. When the contract does not meet the effective or
probable criteria of SFAS No. 133, hedge accounting is dis-
continued and the fair value of the derivative is recorded
through earnings.
As a part of our accounting for derivatives, we make esti-
mates and assumptions concerning future commodity
prices, load requirements, interest rates, the timing of future
transactions and their probable cash flows, the fair value of
contracts and the changes in the fair value we expect in de-
ciding whether or not to enter into derivative transactions,
and in determining the initial accounting treatment for de-
rivative transactions. We use quoted exchange prices to the
extent they are available or external broker quotes in order
to determine the fair value of energy contracts. When ex-
ternal prices are not available, we use internal models to
determine the fair value. These internal models include as-
sumptions of the future prices of energy based on the
specific energy market the energy is being purchased in us-
ing externally available forward market pricing curves for all
periods possible under the pricing model. We use the Black
model, a standard industry valuation model, to determine
the fair value of energy derivative contracts that are marked-
to-market. To determine the fair value of our outstanding
interest-rate swap agreements we use external broker
quotes or calculate the fair value internally using the
Bloomberg swap valuation tool. This tool uses the most re-
cent market inputs and is a widely accepted valuation
methodology.
Regulatory Accounting
We account for our regulated electric and gas operations in
accordance with SFAS No. 71, “Accounting for the Effects of
Certain Types of Regulation” (SFAS No. 71), which requires us
to reflect the effects of rate regulation in our financial state-
ments. Use of SFAS No. 71 is applicable to our utility oper-
ations that meet the following criteria: (1) third-party
regulation of rates; (2) cost-based rates; and (3) a reasonable
assumption that all costs will be recoverable from customers
through rates. As of December 31, 2003, we have concluded
that the operations of ComEd and PECO meet the criteria. If
we conclude in a future period that a separable portion of
our business no longer meets the criteria, we are required to
eliminate the financial statement effects of regulation for
that part of our business, which would include the elimi-
nation of any regulatory assets and liabilities that had been
recorded within our Consolidated Balance Sheets. The im-
pact of not meeting the criteria of SFAS No. 71 could be mate-
rial to our financial statements as a one time extraordinary
item and through impacts on continuing operations. See
Note 4 of the Notes to Consolidated Financial Statements for
further information regarding regulatory issues.
Regulatory assets represent costs that have been de-
ferred to future periods when it is probable that the regu-
lator will allow for recovery through rates charged to
customers. Regulatory liabilities represent revenues received
from customers to fund expected costs that have not yet
been incurred. As of December 31, 2003, we had recorded $5.3
billion and $1.9 billion of regulatory assets and regulatory
liabilities, respectively, within our Consolidated Balance
Sheets. See Note 20 of the Notes to Consolidated Financial
Statements for further information regarding our significant
regulatory assets and liabilities.
For each regulatory jurisdiction where we conduct busi-
ness, we continually assess whether the regulatory assets
and liabilities continue to meet the criteria for probable fu-
ture recovery or settlement. This assessment includes
consideration of factors such as changes in applicable regu-
latory environments, recent rate orders to other regulated
entities in the same jurisdiction, the status of any pending or
potential deregulation legislation and the ability to recover
costs through regulated rates.
The electric businesses of both ComEd and PECO are cur-
rently subject to rate freezes or rate caps that limit the
opportunity to recover increased costs and the costs of new
investment in facilities through rates during the rate freeze
or rate cap period. Because our current rates include the re-
covery of existing regulatory assets and liabilities and rates
in effect during the rate freeze or rate cap periods are ex-
pected to allow us to earn a reasonable rate of return during
that period, management believes the existing regulatory
assets and liabilities are probable of recovery. This determi-
nation reflects the current political and regulatory climate in
the states where we do business but is subject to change in
the future. If future recovery of costs ceases to be probable,
the regulatory assets and liabilities would be recognized in