DERIVATIVES AND RISK MANAGEMENT

Energy Commodity Derivatives

Avista Utilities is exposed to market risks relating to changes in electricity and natural gas commodity prices and certain other fuel prices. Market risk is, in general, the risk of fluctuation in the market price of the commodity being traded and is influenced primarily by supply and demand. Market risk includes the fluctuation in the market price of associated derivative commodity instruments. Avista Utilities utilizes derivative instruments, such as forwards, futures, swaps and options in order to manage the various risks relating to these commodity price exposures. The Company has an energy resources risk policy and control procedures to manage these risks. The Company’s Risk Management Committee establishes the Company’s energy resources risk policy and monitors compliance. The Risk Management Committee is comprised of certain Company officers and other members of management. The Audit Committee of the Company’s Board of Directors periodically reviews and discusses enterprise risk management processes, and it focuses on the Company’s material financial and accounting risk exposures and the steps management has undertaken to control them.

As part of our resource procurement and management operations in the electric business, we engage in an ongoing process of resource optimization, which involves the economic selection from available energy resources to serve our load obligations and the use of these resources to capture available economic value. We transact in wholesale markets by selling and purchasing electric capacity and energy, fuel for electric generation, and derivative contracts related to capacity, energy and fuel. Such transactions are part of the process of matching resources with our load obligations and hedging the related financial risks. These transactions range from terms of intra-hour up to multiple years.

Avista Utilities makes continuing projections of:


•	electric loads at various points in time (ranging from intra-hour to multiple years) based on, among other things, estimates of customer usage and weather, historical data and contract terms, and


•	resource availability at these points in time based on, among other things, fuel choices and fuel markets, estimates of streamflows, availability of generating units, historic and forward market information, contract terms, and experience.

On the basis of these projections, we make purchases and sales of electric capacity and energy, fuel for electric generation, and related derivative instruments to match expected resources to expected electric load requirements and reduce our exposure to electricity (or fuel) market price changes. Resource optimization involves generating plant dispatch and scheduling available resources and also includes transactions such as:


•	purchasing fuel for generation,


•	when economical, selling fuel and substituting wholesale electric purchases, and


•	other wholesale transactions to capture the value of generation and transmission resources and fuel delivery capacity contracts.

Avista Utilities’ optimization process includes entering into hedging transactions to manage risks. Transactions include both physical energy contracts and related derivative instruments.

As part of its resource procurement and management of its natural gas business, Avista Utilities makes continuing projections of its natural gas loads and assesses available natural gas resources including natural gas storage availability. Natural gas resource planning typically includes peak requirements, low and average monthly requirements and delivery constraints from natural gas supply locations to Avista Utilities’ distribution system. However, daily variations in natural gas demand can be significantly different than monthly demand projections. On the basis of these projections, Avista Utilities plans and executes a series of transactions to hedge a significant portion of its projected natural gas requirements through forward market transactions and derivative instruments. These transactions may extend as much as four natural gas operating years (November through October) into the future. Avista Utilities also leaves a significant portion of its natural gas supply requirements unhedged for purchase in short-term and spot markets.

Natural gas resource optimization activities include:


•	wholesale market sales of surplus natural gas supplies,


•	optimization of interstate pipeline transportation capacity not needed to serve daily load, and


•	purchases and sales of natural gas to optimize use of storage capacity.

The following table presents the underlying energy commodity derivative volumes as of December 31, 2012 that are expected to settle in each respective year (in thousands of MWhs and mmBTUs):



	Purchases				Sales
	Electric Derivatives		Gas Derivatives		Electric Derivatives		Gas Derivatives
Year	Physical (1) MWH	Financial (1) MWH	Physical mmBTUs	Financial mmBTUs	Physical MWH	Financial MWH	Physical mmBTUs	Financial mmBTUs
2013	713	3,365	18,523	88,391	264	2,712	7,252	91,962
2014	397	801	6,394	55,407	377	1,844	1,786	33,623
2015	379	614	3,390	42,930	286	982	—	35,575
2016	367	—	1,365	455	287	—	—	—
2017	366	—	—	—	286	—	—	—
Thereafter	583	—	—	—	443	—	—	—


(1)	Physical transactions represent commodity transactions where Avista will take delivery of either electricity or natural gas and financial transactions represent derivative instruments with no physical delivery, such as futures, swaps, options, or forward contracts.

The above electric and natural gas derivative contracts will be included in either power supply costs or natural gas supply costs during the period they settle and will be included in the various recovery mechanisms (ERM, PCA, and PGAs), or in the general rate case process, and are expected to eventually be collected through retail rates from customers.

Foreign Currency Exchange Contracts

A significant portion of Avista Utilities’ natural gas supply (including fuel for power generation) is obtained from Canadian sources. Most of those transactions are executed in U.S. dollars, which avoids foreign currency risk. A portion of Avista Utilities’ short-term natural gas transactions and long-term Canadian transportation contracts are committed based on Canadian currency prices and settled within sixty days with U.S. dollars. Avista Utilities economically hedges a portion of the foreign currency risk by purchasing Canadian currency contracts when such commodity transactions are initiated. This risk has not had a material effect on the Company’s financial condition, results of operations or cash flows and these differences in cost related to currency fluctuations were included with natural gas supply costs for ratemaking. The following table summarizes the foreign currency hedges that the Company has entered into as of December 31 (dollars in thousands):



	2012		2011
Number of contracts	20		28
Notional amount (in United States dollars)	$	12,621	$	7,033
Notional amount (in Canadian dollars)	12,502		7,192

Interest Rate Swap Agreements

Avista Corp. hedges a portion of its interest rate risk with financial derivative instruments, which may include interest rate swaps and U.S. Treasury lock agreements. These interest rate swap agreements are considered economic hedges against fluctuations in future cash flows associated with anticipated debt issuances.

The following table summarizes the interest rate swaps that the Company has entered into as of December 31 (dollars in thousands):



	2012		2011
Number of contracts	—		3
Notional amount	$	—	$	75,000
Mandatory cash settlement date	—		July 2012
Number of contracts	2		2
Notional amount	$	85,000	$	85,000
Mandatory cash settlement date	June 2013		June 2013
Number of contracts	2		—
Notional amount	$	50,000	$	—
Mandatory cash settlement date	October 2014		—
Number of contracts	1		—
Notional amount	$	25,000	$	—
Mandatory cash settlement date	October 2015		—

In May 2012, the Company cash settled interest rate swap contracts (notional amount of $75.0 million) and paid a total of $18.5 million. The interest rate swap contracts were settled in connection with the pricing of $80.0 million of First Mortgage Bonds. In September 2011, the Company cash settled interest rate swap contracts (notional amount of $85.0 million) and paid a total of $10.6 million. The interest rate swap contracts were settled in connection with the pricing of $85.0 million of First Mortgage Bonds.

Upon settlement of the interest rate swaps, the regulatory asset or liability (included as part of long-term debt) is amortized as a component of interest expense over the life of the forecasted interest payments.

Derivative Instruments Summary

The following table presents the fair values and locations of derivative instruments recorded on the Consolidated Balance Sheet as of December 31, 2012 (in thousands):



		Fair Value
Derivative	Balance Sheet Location	Asset		Liability			Collateral Netting		Net Asset (Liability)
Foreign currency contracts	Other current liabilities	$	7	$	(34	)	$	—	$	(27	)
Interest rate contracts	Other current liabilities	—		(1,406		)	—		(1,406		)
Interest rate contracts	Other property and investments - net	7,265		—			—		7,265
Commodity contracts	Current utility energy commodity derivative assets	10,772		(6,633		)	—		4,139
Commodity contracts	Non-current utility energy commodity derivative assets	18,779		(17,686		)	—		1,093
Commodity contracts	Current utility energy commodity derivative liabilities	50,227		(89,449		)	9,707		(29,515		)
Commodity contracts	Other non-current liabilities and deferred credits	2,247		(28,558		)	—		(26,311		)
Total derivative instruments recorded on the balance sheet		$	89,297	$	(143,766	)	$	9,707	$	(44,762	)

The following table presents the fair values and locations of derivative instruments recorded on the Consolidated Balance Sheet as of December 31, 2011 (in thousands):



		Fair Value
Derivative	Balance Sheet Location	Asset		Liability			Net Asset (Liability)
Foreign currency contracts	Other current assets	$	32	$	—		$	32
Interest rate contracts	Other property and investments-net	—		(16,253		)	(16,253		)
Interest rate contracts	Other non-current liabilities and deferred credits	—		(2,642		)	(2,642		)
Commodity contracts	Current utility energy commodity derivative assets	1,618		(479		)	1,139
Commodity contracts	Non-current utility energy commodity derivative assets	185		—			185
Commodity contracts	Current utility energy commodity derivative liabilities	40,090		(110,914		)	(70,824		)
Commodity contracts	Other non-current liabilities and deferred credits	44,308		(84,838		)	(40,530		)
Total derivative instruments recorded on the balance sheet		$	86,233	$	(215,126	)	$	(128,893	)

Exposure to Demands for Collateral

The Company's derivative contracts often require collateral (in the form of cash or letters of credit) or other credit enhancements, or reductions or terminations of a portion of the contract through cash settlement, in the event of a downgrade in the Company's credit ratings or changes in market prices. In periods of price volatility, the level of exposure can change significantly. As a result, sudden and significant demands may be made against the Company's credit facilities and cash. The Company actively monitors the exposure to possible collateral calls and takes steps to mitigate capital requirements. As of December 31, 2012, the Company had cash deposited as collateral of $10.1 million and letters of credit of $28.1 million outstanding related to its energy derivative contracts. The Consolidated Balance Sheet at December 31, 2012 reflects the offsetting of $9.7 million of cash collateral against net derivative positions where a legal right of offset exists.

Certain of the Company’s derivative instruments contain provisions that require the Company to maintain an investment grade credit rating from the major credit rating agencies. If the Company’s credit ratings were to fall below “investment grade,” it would be in violation of these provisions, and the counterparties to the derivative instruments could request immediate payment or demand immediate and ongoing collateralization on derivative instruments in net liability positions. The aggregate fair value of all derivative instruments with credit-risk-related contingent features that are in a liability position as of December 31, 2012 was $35.9 million. If the credit-risk-related contingent features underlying these agreements were triggered on December 31, 2012, the Company could be required to post $25.8 million of additional collateral to its counterparties.

Credit Risk

Credit risk relates to the potential losses that the Company would incur as a result of non-performance by counterparties of their contractual obligations to deliver energy or make financial settlements. The Company often extends credit to counterparties and customers and is exposed to the risk that it may not be able to collect amounts owed to the Company. Credit risk includes potential counterparty default due to circumstances:


•	relating directly to it,


•	caused by market price changes, and


•	relating to other market participants that have a direct or indirect relationship with such counterparty.

Changes in market prices may dramatically alter the size of credit risk with counterparties, even when conservative credit limits are established. Should a counterparty fail to perform, the Company may be required to honor the underlying commitment or to replace existing contracts with contracts at then-current market prices.

We enter into bilateral transactions between Avista and various counterparties. We also trade energy and related derivative instruments through clearinghouse exchanges.

The Company seeks to mitigate bilateral credit risk by:


•	entering into bilateral contracts that specify credit terms and protections against default,


•	applying credit limits and duration criteria to existing and prospective counterparties,


•	actively monitoring current credit exposures,


•	asserting our collateral rights with counterparties,


•	carrying out transaction settlements timely and effectively, and


•	conducting transactions on exchanges with fully collateralized clearing arrangements that significantly reduce counterparty default risk.

The Company's credit policy includes an evaluation of the financial condition of counterparties. Credit risk management includes collateral requirements or other credit enhancements, such as letters of credit or parent company guarantees. The Company enters into various agreements that address credit risks including standardized agreements that allow for the netting or offsetting of positive and negative exposures.

The Company has concentrations of suppliers and customers in the electric and natural gas industries including:


•	electric and natural gas utilities,


•	electric generators and transmission providers,


•	natural gas producers and pipelines,


•	financial institutions including commodity clearing exchanges and related parties, and


•	energy marketing and trading companies.

In addition, the Company has concentrations of credit risk related to geographic location as it operates in the western United States and western Canada. These concentrations of counterparties and concentrations of geographic location may impact the Company’s overall exposure to credit risk because the counterparties may be similarly affected by changes in conditions.

The Company maintains credit support agreements with certain counterparties and margin calls are periodically made and/or received. Margin calls are triggered when exposures exceed contractual limits or when there are changes in a counterparty’s creditworthiness. Price movements in electricity and natural gas can generate exposure levels in excess of these contractual limits. Negotiating for collateral in the form of cash, letters of credit, or performance guarantees is common industry practice.