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 PSE's related hedging strategies are focused on reducing costs and risks where feasible, thus reducing volatility in costs in the portfolio. 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. PSE's hedging strategy includes a risk-responsive component for the core natural gas portfolio, which utilizes quantitative risk-based measures with defined objectives to balance both portfolio risk and hedge costs.

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 electric and natural gas purchase and sale agreements, fixed-for-floating swap contracts, and commodity call/put options. Currently, the Company does not apply cash flow hedge accounting, and therefore records all mark-to-market gains or losses through earnings.

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.

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



Puget Energy and Puget Sound Energy	At Year Ended December 31,
(Dollars in Thousands)	Volumes (millions)		Assets¹				Liabilities²
	2018	2017	2018		2017		2018		2017
Electric portfolio derivatives	*	*	33,287		13,391		27,284		49,050
Natural gas derivatives (MMBtus)³	336.6	332.1	15,732		11,014		30,472		37,044
Total derivative contracts			$	49,019	$	24,405	$	57,756	$	86,094
Current			$	46,507	$	22,247	$	46,661	$	64,859
Long-term			2,512		2,158		11,095		21,235
Total derivative contracts			$	49,019	$	24,405	$	57,756	$	86,094

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


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


³	All fair value adjustments on derivatives relating to the natural gas business have been deferred in accordance with ASC 980, “Regulated Operations,” due to the PGA mechanism. The net derivative asset or liability and offsetting regulatory liability or asset are related to contracts used to economically hedge the cost of physical gas purchased to serve natural gas customers.


^*	Electric portfolio derivatives consist of electric generation fuel of 194.8 million One Million British Thermal Units (MMBtus) and purchased electricity of 6.6 million megawatt hours (MWhs) at December 31, 2018 and 166.8 million MMBtus and 2.9 million MWhs at December 31, 2017.

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: WSPP, Inc. (WSPP) agreements, which standardize physical power contracts; International Swaps and Derivatives Association (ISDA) agreements, which standardize financial natural gas and electric contracts; and North American Energy Standards Board (NAESB) agreements, which standardize physical natural 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 the 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. For further details regarding the fair value of derivative instruments, see Note 11, "Fair Value Measurements," to the consolidated financial statements included in Item 8 of this report.

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 December 31, 2018
(Dollars in Thousands)	Gross Amounts 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	$	49,019	$	—	$	49,019	$	(25,388	)	$	—		$	23,631
Liabilities:
Energy derivative contracts	57,756		—		57,756		(25,388		)	—			32,368

Puget Energy and Puget Sound Energy
At December 31, 2017
(Dollars in Thousands)	Gross Amounts 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	$	24,405	$	—	$	24,405	$	(17,940	)	$	—		$	6,465
Liabilities:
Energy derivative contracts	86,094		—		86,094		(17,940		)	(353		)	67,801

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

The following tables present the effect and locations of the realized and unrealized gains (losses) of the Company's derivatives recorded on the statements of income:



Puget Energy and Puget Sound Energy		Year Ended December 31,
(Dollars in Thousands)	Location	2018		2017			2016
Interest rate contracts¹:
	Non-hedged interest rate swap (expense) income	$	—	$	28		$	(1,062	)
	Interest expense	—		—			—
Gas for Power Derivatives:
Unrealized	Unrealized gain (loss) on derivative instruments, net	23,186		(32,492		)	62,318
Realized	Electric generation fuel	26,222		(23,195		)	(39,656		)
Power Derivatives:
Unrealized	Unrealized gain (loss) on derivative instruments, net	18,476		1,702			21,477
Realized	Purchased electricity	12,240		(17,873		)	(21,998		)
Total gain (loss) recognized in income on derivatives		$	80,124	$	(71,830	)	$	21,079

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¹	Interest rate swap contracts were held at Puget Energy, and matured January 2017.

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, and exposure monitoring and mitigation.

The Company monitors counterparties for significant swings in credit default rates, credit rating changes by external rating agencies, ownership changes or 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 December 31, 2018, approximately 95.8% of the Company's energy portfolio exposure, excluding normal purchase normal sale (NPNS) transactions, is with counterparties that are rated investment grade by rating agencies and 4.2% are either rated below investment grade or not rated by rating agencies. The Company assesses credit risk internally for counterparties that are not rated by the major rating agencies.

The Company computes credit reserves at a master agreement level by counterparty. 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 determined 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. The Company calculates a non-performance risk on its derivative liabilities by using its estimated incremental borrowing rate over the risk-free rate. Credit reserves are netted against unrealized gain (loss) positions. As of December 31, 2018, 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 period. The majority of the Company's derivative contracts are with financial institutions and other utilities operating within the Western Electricity Coordinating Council. PSE also transacts power futures contracts on the Intercontinental Exchange (ICE), and natural gas contracts on the ICE NGX exchange platform. Execution of contracts on ICE requires the daily posting of margin calls as collateral through a futures and clearing agent. As of December 31, 2018, PSE had cash posted as collateral of $6.4 million related to contracts executed on the ICE platform. Also, as of December 31, 2018, PSE has a $1.0 million letter of credit posted as collateral as a condition of transacting on the ICE NGX exchange. PSE did not trigger any collateral requirements with any of its counterparties during the twelve months ended December 31, 2018, nor were any of PSE's counterparties required to post collateral resulting from credit rating downgrades.

The following table presents the aggregate fair value of all derivative instruments with credit-risk-related contingent features that are in a liability position and the amount of additional collateral the Company could be required to post:



Puget Energy and Puget Sound Energy	At December 31,
(Dollars in Thousands)	2018						2017
Contingent Feature	Fair Value¹ Liability		Posted Collateral		Contingent Collateral		Fair Value¹ Liability		Posted Collateral		Contingent Collateral
Credit rating²	$	574	$	—	$	574	$	3,187	$	—	$	3,187
Requested credit for adequate assurance	18,495		—		—		37,374		—		—
Forward value of contract³	—		—		—		353		2,639		—
Total	$	19,069	$	—	$	574	$	40,914	$	2,639	$	3,187

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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.