Exelon 2003 Annual Report Download - page 71

69Management’s Discussion and Analysis of Financial Condition and Results of Operations
EXELON CORPORATION AND SUBSIDIARY COMPANIES
as weather, governmental environmental policies, changes
in supply and demand, state and Federal regulatory policies
and other events. Additionally, we have exposure to
commodity price in relation to CTC revenues we collect from
ComEd customers.
Normal Operations and Hedging Activities. Electricity avail-
able from our owned or contracted generation supply in
excess of our obligations to customers, including Energy De-
livery’s retail load, is sold into the wholesale markets. To re-
duce price risk caused by market fluctuations, we enter into
physical contracts as well as derivative contracts, including
forwards, futures, swaps, and options, with approved coun-
terparties to hedge our anticipated exposures. The max-
imum length of time over which cash flows related to energy
commodities are currently being hedged is three years. We
have an estimated 89% hedge ratio in 2004 for our energy
marketing portfolio. This hedge ratio represents the
percentage of our forecasted aggregate annual generation
supply that is committed to firm sales, including sales to
Energy Delivery’s retail load. Energy Delivery’s retail load
assumptions are based on forecasted average demand. The
hedge ratio is not fixed and will vary from time to time de-
pending upon market conditions, demand, energy market
option volatility and actual loads. During peak periods our
amount hedged declines to meet our commitment to Energy
Delivery. Market price risk exposure is the risk of a change in
the value of unhedged positions. Absent any opportunistic
efforts to mitigate market price exposure, the estimated
market price exposure for our non-trading portfolio asso-
ciated with a ten percent reduction in the annual average
around-the-clock market price of electricity is approximately
a $32 million decrease in net income. This sensitivity as-
sumes an 89% hedge ratio and that price changes occur
evenly throughout the year and across all markets. The
sensitivity also assumes a static portfolio. We expect to ac-
tively manage our portfolio to mitigate market price ex-
posure. Actual results could differ depending on the specific
timing of, and markets affected by, price changes, as well as
future changes in our portfolio.
Proprietary Trading Activities. We began to use financial con-
tracts for proprietary trading purposes in the second quarter
of 2001. Proprietary trading includes all contracts entered
into purely to profit from market price changes as opposed
to hedging an exposure. These activities are accounted for
on a mark-to-market basis. The proprietary trading activities
are a complement to our energy marketing portfolio but
represent a very small portion of our overall energy market-
ing activities. For example, the limit on open positions in
electricity for any forward month represents less than one
percent of our owned and contracted supply of electricity.
The trading portfolio is subject to a risk management policy
that includes stringent risk management limits including
volume, stop-loss and value-at-risk limits to manage ex-
posure to market risk. Additionally, the Exelon risk manage-
ment group and Exelon’s RMC monitor the financial risks of
the power marketing activities.
Our energy contracts are accounted for under SFAS No.
133. Most non-trading contracts qualify for the normal pur-
chases and normal sales exemption to SFAS No. 133 discussed
in Critical Accounting Policies and Estimates. Those that do
not are recorded as assets or liabilities on the balance sheet
at fair value. Changes in the fair value of qualifying hedge
contracts are recorded in OCI, and gains and losses are
recognized in earnings when the underlying transaction
occurs. Changes in the fair value of derivative contracts that
do not meet hedge criteria under SFAS No. 133 and the in-
effective portion of hedge contracts are recognized in earn-
ings on a current basis.
The following detailed presentation of our trading and
non-trading marketing activities at Generation is included to
address the recommended disclosures by the energy in-
dustry’s Committee of Chief Risk Officers. We do not consider
our proprietary trading to be a significant activity in our
business; however, we believe it is important to include
these risk management disclosures.
The following tables describe the drivers of our energy
trading and marketing business and gross margin included
in the income statement for the years ended December 31,
2003 and 2002. Normal operations and hedging activities
represent the marketing of electricity available from Gen-
eration’s owned or contracted generation, including Energy
Delivery’s retail load, sold into the wholesale market. As the
information in these tables highlights, mark-to-market
activities represent a small portion of the overall gross mar-
gin for Generation. Accrual activities, including normal pur-
chases and sales, account for the majority of the gross
margin. The mark-to-market activities reported here are
those relating to changes in fair value due to external
movement in prices. Further delineation of gross margin by
the type of accounting treatment typically afforded each
type of activity is also presented (i.e., mark-to-market vs. ac-
crual accounting treatment).