Accounting for Derivative Instruments and Hedging Activities

PSE employs various energy portfolio optimization strategies, but is not in the business of assuming risk for the purpose of realizing speculative trading revenue. The nature of serving regulated electric customers with its portfolio of owned and contracted electric generation resources exposes PSE and its customers to some volumetric and commodity price risks within the sharing mechanism of the PCA. Therefore, wholesale market transactions and related hedging strategies are focused on reducing costs and risks where feasible thus reducing volatility in costs in the portfolio. PSE's energy risk portfolio management function monitors and manages these risks using analytical models and tools. In order to manage risks effectively, PSE enters into forward physical and financial agreements, floating-for-fixed swap contracts, and commodity call/put options, which are appropriate for the service territory of PSE and are relevant to its regulated electric and natural gas portfolios. The forward physical electric contracts are both fixed and variable (at index) while the physical natural gas contracts are variable with investment grade counterparties that do not require collateral calls on the contracts. To fix the price of wholesale electricity and natural gas, PSE may enter into floating-for-fixed swap (financial) contracts with various counterparties. Beginning June 2013, PSE began trading natural gas call and put options. Utilizing options as an additional hedging instrument increases the hedging portfolio's flexibility to react to commodity price fluctuations, as well as creates a commodity price cap for customers, thus protecting rate payers against future price increases.

In order to manage its exposure to the variability in future cash flows for forecasted energy transactions, PSE utilizes a programmatic hedging strategy which extends out three years.

At the February 2009 merger date, Puget Energy recorded all derivative contracts at fair value as either assets or liabilities. Certain contracts meeting the criteria defined in ASC 815 were subsequently designated as Normal Purchase Normal Sale (NPNS) or cash flow hedges. The difference in the derivative unrealized gains/losses recorded through earnings between Puget Energy and PSE will occur through March 2015.

The Company manages its interest rate risk through the issuance of mostly fixed-rate debt with varied maturities. The Company utilizes internal cash from operations, borrowings under its commercial paper program, and its credit facilities to meet short-term funding needs. The Company may enter into swap instruments or other financial hedge instruments to manage the interest rate risk associated with these debts. As of June 30, 2013, Puget Energy had two interest rate swap contracts outstanding which extend to January 2017. PSE did not have any outstanding interest rate swap instruments.

The following table presents the volumes, fair values and locations of the Company's derivative instruments recorded on the balance sheets:



Puget Energy and Puget Sound Energy	June 30, 2013					December 31, 2012
(Dollars in Thousands)	Volumes	Assets ¹		Liabilities ²		Volumes	Assets ¹		Liabilities ²
Interest rate swap derivatives ³	$450 million	$	—	$	13,706	$450 million	$	—	$	21,524
Electric portfolio derivatives	*	10,474		83,957		*	9,557		131,193
Natural gas derivatives (MMBtus) ⁴	459,420,774	6,417		76,767		516,909,006	12,126		108,078
Total derivative contracts		$	16,891	$	174,430		$	21,683	$	260,795

Current		$	10,026	$	115,038		$	6,869	$	177,519
Long-term		6,865		59,392			14,814		83,276
Total derivative contracts		$	16,891	$	174,430		$	21,683	$	260,795

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^*	Electric portfolio derivatives consist of electric generation fuel of 143,999,235 MMBtus and purchased electricity of 7,797,825 MWhs at June 30, 2013, and 129,693,200 MMBtus and 10,722,415 MWhs at December 31, 2012.


¹	Balance sheet location: Current and Long-term Unrealized gain on derivative instruments.


²	Balance sheet location: Current and Long-term Unrealized loss on derivative instruments.


³	Interest rate swap contracts are only held at Puget Energy.

⁴

PSE had a net derivative liability and an offsetting regulatory asset of $70.4 million at June 30, 2013 and $96.0 million at December 31, 2012 related to contracts used to economically hedge the cost of physical gas purchased to serve natural gas customers. All fair value adjustments on derivatives relating to the natural gas business have been reclassified to a deferred account in accordance with ASC 980, “Regulated Operations” (ASC 980) due to the Purchased Gas Adjustment (PGA) mechanism.

For further details regarding the fair value of derivative instruments, see Note 4.

ASU 2013-01 requires disclosure of both gross and net information for recognized derivative assets and liabilities. It is the Company's policy to record all derivative transactions on a gross basis at the contract level, without offsetting assets or liabilities. The Company generally enters into transactions using the following master agreements: (1) WSPP, Inc. (WSPP) agreement - standardized power sales contract in the electric industry; (2) International Swaps and Derivatives Association (ISDA) agreements - standardized financial gas and electric contracts; and (3) North American Energy Standards Board (NAESB) agreements - standardized physical gas contracts. The Company believes that such agreements reduce credit risk exposure because such agreements provide for the netting and offsetting of monthly payments as well as right of set-off in the event of counterparty default. The set-off provision can be used as a final settlement of accounts which extinguishes the mutual debts owed between the parties in exchange for a new net amount. The following tables present the potential effect of netting arrangements, including rights of set-off associated with the Company's derivative assets and liabilities:



Puget Energy and Puget Sound Energy
At June 30, 2013 (Dollars in Thousands)	Gross Amount Recognized in the Statement of Financial Position¹		Gross Amounts Offset in the Statement of Financial Position		Net of Amounts Presented in the Statement of Financial Position		Gross Amounts Not Offset in the Statement of Financial Position
							Commodity Contracts			Cash Collateral Received/Posted		Net Amount
Assets
Energy Derivative Contracts	$	16,891	$	—	$	16,891	$	(10,434	)	$	—	$	6,457
Liabilities
Energy Derivative Contracts	$	160,725	$	—	$	160,725	$	(10,434	)	$	—	$	150,291
Interest Rate Swaps ²	$	13,706	$	—	$	13,706	$	—		$	—	$	13,706


At December 31, 2012 (Dollars in Thousands)	Gross Amount Recognized in the Statement of Financial Position¹		Gross Amounts Offset in the Statement of Financial Position		Net of Amounts Presented in the Statement of Financial Position		Gross Amounts Not Offset in the Statement of Financial Position
							Commodity Contracts			Cash Collateral Received/Posted		Net Amount
Assets
Energy Derivative Contracts	$	21,683	$	—	$	21,683	$	(14,126	)	$	—	$	7,557
Liabilities
Energy Derivative Contracts	$	239,271	$	—	$	239,271	$	(14,126	)	$	—	$	225,145
Interest Rate Swaps ²	$	21,524	$	—	$	21,524	$	—		$	—	$	21,524

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¹	All Derivative Contract deals are executed under ISDA, NAESB and WSPP Master Netting Agreements with Right of Offset.


²	Interest Rate Swap Contracts are only held at Puget Energy.

The following tables present the effect and locations of the Company's derivatives not designated as hedging instruments, recorded on the statements of income:



Puget Energy		Three Months Ended June 30,						Six Months Ended June 30,
(Dollars in Thousands)	Location	2013			2012			2013			2012
Interest rate contracts:	Other deductions	$	1,232		$	(7,297	)	$	2,260		$	(6,770	)
	Interest expense	1,902			(9,902		)	(676		)	(19,264		)
Commodity contracts:
Electric derivatives	Unrealized gain (loss) on derivative instruments, net ¹	(27,376		)	64,076			48,316			57,199
	Electric generation fuel	(930		)	(2,981		)	(13,568		)	(25,974		)
	Purchased electricity	(3,704		)	(39,540		)	(35,189		)	(84,953		)
Total gain (loss) recognized in income on derivatives		$	(28,876	)	$	4,356		$	1,143		$	(79,762	)

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¹	The six months ended June 30, 2012, differs from the amount stated in the statements of income as it does not include amortization related to contracts that were recorded at fair value at the time of the February 2009 merger and subsequently designated as NPNS of $2.2 million.



Puget Sound Energy		Three Months Ended June 30,						Six Months Ended June 30,
(Dollars in Thousands)	Location	2013			2012			2013			2012
Commodity contracts:
Electric derivatives	Unrealized gain (loss) on derivative instruments, net	$	(27,376	)	$	59,850		$	45,365		$	49,715
	Electric generation fuel	(930		)	(2,981		)	(13,568		)	(25,974		)
	Purchased electricity	(3,704		)	(39,540		)	(35,189		)	(84,953		)
Total gain (loss) recognized in income on derivatives		$	(32,010	)	$	17,329		$	(3,392	)	$	(61,212	)

For derivative instruments previously designated as cash flow hedges (including both commodity contracts and interest rate swaps), the effective portion of the gain or loss on the derivative was recorded as a component of OCI, and then is reclassified into earnings in the same period(s) during which the hedged transaction affects earnings. Puget Energy and PSE expect $2.8 million and $2.2 million of losses in accumulated OCI will be reclassified into earnings within the next twelve months, respectively. As the Company has discontinued cash flow hedging and currently records all mark-to-market adjustments through earnings, there were no additional amounts deferred into OCI during 2013 or 2012. The unrealized gain or loss on derivative contracts is reported in the statement of cash flows under the operating section. However, at the time of the merger, all derivative contracts at Puget Energy were assessed to identify contracts that have a “more than an insignificant” fair value. If the fair value was greater than 10% of the notional value, the contract was deemed as having a financing element. For those contracts, the cash inflows (outflows) are presented in the financing activities section of the statement of cash flows. For the six months ending June 30, 2013 and 2012, cash outflows related to financing activities of $26.0 million and $47.4 million, respectively, were reported on the Puget Energy statement of cash flows.

The following tables present the Company's pre-tax gain (loss) of derivatives that were in a previous cash flow hedge relationship, reclassified out of accumulated OCI into income:



Puget Energy		Three Months Ended June 30,						Six Months Ended June 30,
(Dollars in Thousands)	Location	2013			2012			2013			2012
Interest rate contracts:	Interest expense	$	(1,325	)	$	(10,905	)	$	(2,639	)	$	(14,763	)
Commodity contracts:
Electric derivatives	Electric generation fuel	—			—			—			100
	Purchased electricity	—			(188		)	164			12
Total		$	(1,325	)	$	(11,093	)	$	(2,475	)	$	(14,651	)



Puget Sound Energy		Three Months Ended June 30,						Six Months Ended June 30,
(Dollars in Thousands)	Location	2013			2012			2013			2012
Interest rate contracts:	Interest expense	$	(122	)	$	(122	)	$	(244	)	$	(244	)
Commodity contracts:
Electric derivatives	Electric generation fuel	—			(4,414		)	—			97
	Purchased electricity	—			—			(2,786		)	(7,468		)
Total		$	(122	)	$	(4,536	)	$	(3,030	)	$	(7,615	)

The Company is exposed to credit risk primarily through buying and selling electricity and natural gas to serve its customers. Credit risk is the potential loss resulting from a counterparty's non-performance under an agreement. The Company manages credit risk with policies and procedures for, among other things, counterparty credit analysis, exposure measurement, exposure monitoring and exposure mitigation.

The Company monitors counterparties that have significant swings in credit default swap rates, have credit rating changes by external rating agencies, have changes in ownership or are experiencing financial distress. Where deemed appropriate, the Company may request collateral or other security from its counterparties to mitigate potential credit default losses. Criteria employed in this decision include, among other things, the perceived creditworthiness of the counterparty and the expected credit exposure.

It is possible that volatility in energy commodity prices could cause the Company to have material credit risk exposure with one or more counterparties. If such counterparties fail to perform their obligations under one or more agreements, the Company could suffer a material financial loss. However, as of June 30, 2013, approximately 99.9% of the Company's energy portfolio exposure, excluding NPNS transactions, is with counterparties that are rated at least investment grade by the major rating agencies and 0.1% are either rated below investment grade or not rated by rating agencies. The Company assesses credit risk internally for counterparties that are not rated.

As the Company generally enters into transactions using the WSPP, ISDA and NAESB master agreements, it believes that such agreements reduce credit risk exposure because they provide for the netting and offsetting of monthly payments and, in the event of counterparty default, termination payments.

The Company computes credit reserves at a master agreement level by counterparty (i.e., WSPP, ISDA, or NAESB). The Company considers external credit ratings and market factors, such as credit default swaps and bond spreads, in the determination of reserves. The Company recognizes that external ratings may not always reflect how a market participant perceives a counterparty's risk of default. The Company uses both default factors published by Standard & Poor's and factors derived through analysis of market risk, which reflect the application of an industry standard recovery rate. The Company selects a default factor by counterparty at an aggregate master agreement level based on a weighted average default tenor for that counterparty's deals. The default tenor is used by weighting the fair value and contract tenors for all deals for each counterparty to derive an average value. The default factor used is dependent upon whether the counterparty is in a net asset or a net liability position after applying the master agreement levels.

The Company applies the counterparty's default factor to compute credit reserves for counterparties that are in a net asset position. Moreover, the Company applies its own default factor to compute credit reserves for counterparties that are in a net liability position. Credit reserves are booked as contra accounts to unrealized gain (loss) positions. As of June 30, 2013, the Company was in a net liability position with the majority of counterparties, so the default factors of counterparties did not have a significant impact on reserves for the quarter. The majority of the Company's derivative contracts are with financial institutions and other utilities operating within the Western Electricity Coordinating Council. As of June 30, 2013, despite its net liability position, PSE was not required to post any collateral with any of its counterparties. Additionally, PSE did not trigger any collateral requirements with any of its counterparties nor were any of PSE's counterparties required to post collateral resulting from credit rating downgrades.

The table below presents the fair value of the overall contractual contingent liability positions for the Company's derivative activity at June 30, 2013:



Puget Energy and Puget Sound Energy Contingent Feature (Dollars in Thousands)	Fair Value ¹ Liability			Posted Collateral		Contingent Collateral
Credit rating ²	$	(26,147	)	$	—	$	26,147
Requested credit for adequate assurance	(26,762		)	—		—
Forward value of contract ³	(710		)	—		—
Total	$	(53,619	)	$	—	$	26,147

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¹	Represents the derivative fair value of contracts with contingent features for counterparties in net derivative liability positions. Excludes NPNS, accounts payable and accounts receivable.


²	Failure by PSE to maintain an investment grade credit rating from each of the major credit rating agencies provides counterparties a contractual right to demand collateral.


³	Collateral requirements may vary, based on changes in the forward value of underlying transactions relative to contractually defined collateral thresholds.