Notes to the consolidated financial statements - supplementary information
33. Commodity risk
We purchase electricity and gas in order to supply our customers in the US and also to meet our own energy requirements. We also engage in the sale of gas that is produced primarily by our West Virginia gas fields.
Substantially all of our costs of purchasing electricity and gas for supply to customers are recoverable at an amount equal to cost. The timing of recovery of these costs can vary between financial periods leading to an under- or over-recovery within any particular financial period.
We enter into forward contracts for the purchase of commodities, some of which do not meet the own use exemption for accounting purposes and hence are accounted for as derivatives. We also enter into derivative financial instruments linked to commodity prices, including index-linked swaps and futures contracts. These derivative financial instruments are used to manage market price volatility and are carried at fair value on the balance sheet. The mark-to-market changes in these contracts are reflected through earnings with the exception of those related to our West Virginia gas fields that are designated as cash flow hedges.
Our energy procurement risk management policy and Delegations of Authority govern our US commodity trading activities for energy transactions. The purpose of this policy is to ensure we transact within pre-defined risk parameters and only in the physical and financial markets where we or our customers have a physical market requirement.
The credit policy for commodity transactions is owned and monitored by the energy procurement risk management committee and establishes controls and procedures to determine, monitor and minimise the credit risk of counterparties. The valuation of our commodity contracts considers the risk of credit by utilising the most current default probabilities and the most current published credit ratings. We also use internal analysis to guide us in setting credit and risk levels and use contractual arrangements including netting agreements as applicable.
The counterparty exposure for our commodity derivatives is £105m (2009: £49m), and after netting agreements it was £91m (2009: £43m).
(a) Fair value analysis
The fair value of our commodity contracts by type can be analysed as follows:
| 2010 | 2009 | ||||||
|---|---|---|---|---|---|---|---|
| Assets £m | Liabilities £m | Total £m | Assets £m | Liabilities £m | Total £m |
||
| Commodity purchase contracts accounted for as derivative contracts | |||||||
| Forward purchases of electricity | – | (127) | (127) | – | (121) | (121) | |
| Forward purchases/sales of gas | 51 | (101) | (50) | 35 | (34) | 1 | |
| Derivative financial instruments linked to commodity prices | |||||||
| Electricity swaps | – | (47) | (47) | – | (30) | (30) | |
| Electricity options | 51 | – | 51 | – | – | – | |
| Gas swaps | 3 | (52) | (49) | 14 | (173) | (159) | |
| Gas options | – | – | – | – | (1) | (1) | |
| 105 | (327) | (222) | 49 | (359) | (310) | ||
The fair value classification of our commodity contracts is as follows; a definition of each level can be found in fair value analysis:
| 2010 | ||||
|---|---|---|---|---|
| Level 1 £m | Level 2 £m | Level 3 £m | Total £m |
|
| Assets | ||||
| Commodity contracts | – | 2 | 103 | 105 |
| Liabilities | ||||
| Commodity contracts | – | (100) | (227) | (327) |
| Total | – | (98) | (124) | (222) |
Our level 3 commodity contracts primarily consist of our forward purchases of electricity and gas where pricing inputs are unobservable, as well as other complex transactions. Complex transactions can introduce the need for internally developed models based on reasonable assumptions. Industry standard valuation techniques such as the Black-Scholes pricing model and Monte Carlo simulation are used for valuing such instruments. Level 3 is also applied in cases when optionality is present or where an extrapolated forward curve is considered unobservable. All published forward curves are verified to market data; if forward curves differ from market data by 5% or more they are considered unobservable.
The changes in the value of our level 3 commodity contracts are as follows:
| 2010 £m |
|
|---|---|
| At 1 April 2009 | (115) |
| Net gains for the year (i) | 8 |
| Purchases | (12) |
| Sales | (1) |
| Reclassification into level 3 | (3) |
| Reclassification out of level 3 | (1) |
| At 31 March 2010 | (124) |
- (i)
- Losses of £67m are attributable to assets or liabilities held at the end of the reporting period.
During the year £3m was transferred out of level 2 and into level 3. These transfers were driven by extrapolated forward curves moving from observable to unobservable.
The impacts on a post-tax basis of reasonably possible changes in significant level 3 assumptions are as follows:
| 2010 Income statement £m |
|
|---|---|
| 10% increase in commodity prices (i) | 46 |
| 10% decrease in commodity prices (i) | (39) |
| 10% increase in commodity volumes | (9) |
| 10% decrease in commodity volumes | 9 |
| Forward curve extrapolation (ii) | (12) |
- (i)
- Level 3 commodity price sensitivity is included within the sensitivity analysis disclosed in (d) below.
- (ii)
- Alternative regression assumption applied to the forward curve extrapolation.
The impacts disclosed above were considered on a contract by contract basis with the most significant unobservable inputs identified. The sensitivity is hypothetical only and should be used with caution as the relationship between complex valuation inputs varies over time.
(b) Maturity analysis
The maturity of commodity contracts measured at fair value can be analysed as follows:
| 2010 | 2009 | ||||||
|---|---|---|---|---|---|---|---|
| Assets £m | Liabilities £m | Total £m | Assets £m | Liabilities £m | Total £m |
||
| In one year or less | 21 | (184) | (163) | 41 | (203) | (162) | |
| Current | 21 | (184) | (163) | 41 | (203) | (162) | |
| In more than one year, but not more than two years | 8 | (49) | (41) | 6 | (41) | (35) | |
| In more than two years, but not more than three years | 11 | (21) | (10) | 2 | (27) | (25) | |
| In more than three years, but not more than four years | 13 | (19) | (6) | – | (17) | (17) | |
| In more than four years, but not more than five years | 11 | (19) | (8) | – | (16) | (16) | |
| In more than five years | 41 | (35) | 6 | – | (55) | (55) | |
| Non-current | 84 | (143) | (59) | 8 | (156) | (148) | |
| Total | 105 | (327) | (222) | 49 | (359) | (310) | |
(c) Notional quantities
For each class of commodity contract, our exposure based on the notional quantities is as follows:
| 2010 | 2009* | |
|---|---|---|
| Forward purchases of electricity (i) | 3,883 GWh | 4,524 GWh |
| Forward purchases/sales of gas (ii) | 171m Dth | 298m Dth |
| Electricity swaps | 3,141 GWh | 4,090 GWh |
| Electricity options | 30,294 GWh | 30,294 GWh |
| Gas swaps | 59m Dth | 88m Dth |
| Gas options | – | 1m Dth |
| NYMEX electricity futures (iii) | – | 18 GWh |
| NYMEX gas futures (iii) | 48m Dth | 30m Dth |
- *
- Prior year comparatives have been restated on a basis consistent with current year
- (i)
- Forward electricity purchases have terms up to 12 years. The contractual obligations under these contracts are £269m (2009: £348m).
- (ii)
- Forward gas purchases have terms up to 7 years. The contractual obligations under these contracts are £434m (2009: £700m).
- (iii)
- NYMEX futures have been offset with related margin accounts.
(d) Sensitivity analysis
A sensitivity analysis has been prepared on the basis that all commodity contracts are constant from the balance sheet date. Based on this, an illustrative 10% movement in commodity prices would have the following impacts after the effects of tax:
| 2010 | 2009* | ||||
|---|---|---|---|---|---|
| Income statement £m | Other equity reserves £m | Income statement £m | Other equity reserves £m |
||
| 10% increase in commodity prices | 71 | (1) | 33 | (1) | |
| 10% reduction in commodity prices | (64) | 1 | (43) | 1 | |
- *
- Prior year comparatives have been restated to be consistent on a post-tax basis
The income statement sensitivities would affect commodity remeasurements.