Accounting for Derivative Instruments and Hedging Activities

PSE employs various 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 are focused on balancing PSE's energy portfolio, reducing costs and risks where feasible and reducing volatility in costs and margins 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 physical and financial transactions which are appropriate for the service territory of PSE and are relevant to its regulated electric and natural gas portfolios.

At the February 2009 merger date, Puget Energy de-designated its derivative contracts that were designated on PSE's books as NPNS or cash flow hedges and recorded such contracts at fair value as either assets or liabilities. Certain contracts meeting the criteria defined in ASC 815 were subsequently re-designated as NPNS or cash flow hedges.

On July 1, 2009, Puget Energy and PSE elected to de-designate all energy related derivative contracts previously recorded as cash flow hedges for the purpose of simplifying its financial reporting. The contracts that were de-designated related to physical electric supply contracts and natural gas swap contracts used to fix the price of natural gas for electric generation. For these contracts and for contracts initiated after such date, all mark-to-market adjustments are recognized through earnings. The amount previously recorded in accumulated OCI is transferred to earnings in the same period or periods during which the hedged transaction affects earnings or sooner if management determines that the forecasted transaction is probable of not occurring. As a result, the Company will continue to experience the earnings impact of these reversals from OCI in future periods.

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, commercial paper, and credit facilities to meet short-term funding needs. Short-term obligations are commonly refinanced with fixed-rate bonds or notes when needed and when interest rates are considered favorable. The Company may enter into swap instruments or other financial hedge instruments to manage the interest rate risk associated with these debts. As of March 31, 2012 Puget Energy had three interest rate swap contracts outstanding and PSE did not have any outstanding interest rate swap instruments.

In February 2009, Puget Energy entered into a cash flow hedge using interest rate swaps to hedge the risk associated with one-month LIBOR floating rate debt. Subsequently, in order to satisfy a commitment the Company made to the Washington Commission and to mitigate refinancing risk, the Company refinanced a portion of the underlying debt hedged by the interest rate swaps in 2010 and again during 2011. As a result of refinancing, the Company de-designated the cash flow hedge accounting relationship between the debt and interest rate swaps in 2010. On February 10, 2012, the Company terminated its previous term loan and capital expenditure credit facility (which originally acted as a portion of the underlying variable rate debt in the cash flow hedge) in favor of a new five year $1.0 billion revolving senior secured credit facility and used this new senior secured credit facility to pay off the remaining balance on the original term loan and capital expenditure credit facility. At March 31, 2012, the balance on the new senior secured credit facility was $859.0 million. In order to better align its existing swap notional with the new credit facility, the Company settled an additional $277.4 million of the interest rate swaps on February 15, 2012, thereby reducing the swap notional to $1.0 billion. The transaction did not impact the consolidated statements of income as the fair value losses for those swaps had already been recorded through earnings. Since replacing the previous term loan and capital expenditure credit facility with the new senior secured credit facility effectively replaced debt with like debt, the original hedged forecasted interest payments are still probable of occurring and there is no anticipated reclassification of existing amounts deferred in accumulated OCI to earnings as a result of this transaction. Therefore at March 31, 2012 the outstanding notional balance of the interest rate swaps was $1.0 billion, exceeding the balance of $859.0 million in variable rate debt of which the swaps are hedging. During the period in which the Company's interest rate swaps are in excess of the Company's variable rate debt, the Company will be subject to additional interest rate risk.

The following tables present the fair value and locations of the Company's derivative instruments recorded on the balance sheets at March 31, 2012 and December 31, 2011:



Derivatives Not Designated as Hedging Instruments
Puget Energy	March 31, 2012				December 31, 2011
(Dollars in Thousands)	Assets ¹		Liabilities ²		Assets ¹		Liabilities ²
Interest rate swaps:
Current	$	—	$	20,895	$	—	$	25,210
Long-term	—		17,794		—		27,199
Electric portfolio:
Current	3,597		193,421		5,212		173,582
Long-term	5,051		76,018		5,508		90,752
Natural gas portfolio: ³
Current	1,827		143,488		1,435		128,297
Long-term	3,998		68,734		4,576		78,607
Total derivatives	$	14,473	$	520,350	$	16,731	$	523,647



Derivatives Not Designated as Hedging Instruments
Puget Sound Energy	March 31, 2012				December 31, 2011
(Dollars in Thousands)	Assets ¹		Liabilities ²		Assets ¹		Liabilities ²
Electric portfolio:
Current	$	3,597	$	193,421	$	5,212	$	173,582
Long-term	5,051		76,018		5,508		90,752
Natural gas portfolio: ³
Current	1,827		143,488		1,435		128,297
Long-term	3,998		68,734		4,576		78,607
Total derivatives	$	14,473	$	481,661	$	16,731	$	471,238

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¹	Balance sheet location: Unrealized gain on derivative instruments.


²	Balance sheet location: Unrealized loss on derivative instruments.

PSE had a derivative liability and an offsetting regulatory asset of $206.4 million at March 31, 2012 and $200.9 million at December 31, 2011 related to financial 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 due to the PGA mechanism. All increases and decreases in the cost of natural gas supply are passed on to customers with the PGA mechanism and the gains and losses on the hedges in future periods will be recorded as gas costs.

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

The following tables present the net unrealized (gain) loss of the Company's derivative instruments recorded on the statements of income for the three months ended March 31, 2012 and 2011:



Puget Energy	Three Months Ended March 31,
(Dollars in Thousands)	2012			2011
Natural gas / Power NPNS ¹	$	(2,151	)	$	(8,050	)
Natural gas for power generation	(51		)	(41,523		)
Power	6,928			16,454
Total net unrealized (gain) loss on derivative instruments	$	4,726		$	(33,119	)
Interest expense – interest rate swaps	$	1,740		$	(1,926	)
Other deductions – interest rate swaps	$	(14,323	)	$	(1,800	)

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¹	Amount represents amortization expense related to contracts that were recorded at fair value as of the date of the merger.



Puget Sound Energy	Three Months Ended March 31,
(Dollars in Thousands)	2012			2011
Natural gas for power generation	$	(49	)	$	(24,678	)
Power	10,184			18,694
Total net unrealized (gain) loss on derivative instruments	$	10,135		$	(5,984	)

The following tables present the effect of hedging instruments on Puget Energy's OCI and statements of income, related to derivatives that were in a previous cash flow hedge relationship, for the three months ended March 31, 2012, and 2011:



Puget Energy (Dollars in Thousands)
Three Months Ended March 31
Derivatives in Cash Flow Hedging Relationships	Gain (Loss) Recognized in OCI on Derivatives (Effective Portion ¹)				Gain (Loss) Reclassified from Accumulated OCI into Income (Effective Portion ²)
	2012		2011		Location	2012			2011
Interest rate contracts:	$	—	$	—	Interest expense	$	(3,859	)	$	(6,512	)
Commodity contracts: Electric derivatives	—		—		Electric generation fuel	100			(30		)
					Purchased electricity	200			(258		)
Total	$	—	$	—		$	(3,559	)	$	(6,800	)

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¹	Changes in OCI are reported in after-tax dollars.


²	A reclassification of a loss in OCI increases accumulated OCI and decreases earnings. Amounts reported are in pre-tax dollars.

The following table presents the effect of hedging instruments on PSE's OCI and statements of income for the three months ended March 31, 2012, and 2011:



Puget Sound Energy (Dollars in Thousands)
Three Months Ended March 31
Derivatives in Cash Flow Hedging Relationships	Gain (Loss) Recognized in OCI on Derivatives (Effective Portion ¹)				Gain (Loss) Reclassified from Accumulated OCI into Income (Effective Portion ²)
	2012		2011		Location	2012			2011
Interest rate contracts:	$	—	$	—	Interest expense	$	(122	)	$	(123	)
Commodity contracts: Electric derivatives	—		—		Electric generation fuel	97			(16,873		)
					Purchased electricity	(3,055		)	(2,496		)
Total	$	—	$	—		$	(3,080	)	$	(19,492	)

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¹	Changes in OCI are reported in after-tax dollars.


²	A reclassification of a loss in OCI increases accumulated OCI and decreases earnings. Amounts reported are in pre-tax dollars.

For derivative instruments that met cash flow hedge criteria, the effective portion of the gain or loss on the derivative was reported as a component of OCI, then reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. Puget Energy expects that $12.8 million of losses in OCI will be reclassified into earnings within the next twelve months. PSE expects that $12.7 million of losses in OCI will be reclassified into earnings within the next twelve months. The maximum length of time over which the Company is hedging its exposure to the variability in future cash flows extends to March 2015 for purchased electricity contracts, October 2018 for gas for power generation contracts and February 2014 for interest rate swaps.

The following tables present the effect of Puget Energy's derivatives not designated as hedging instruments on income during the three months ended March 31, 2012, and 2011:



Puget Energy		Three Months Ended March 31,
(Dollars in Thousands)	Location	2012			2011
Interest rate contracts:	Other deductions	$	527		$	(48	)
	Interest expense	(6,641		)	(4,577		)
Commodity contracts:
Electric derivatives	Unrealized gain (loss) on derivative instruments, net ¹	$	(6,876	)	$	25,069
	Electric generation fuel	(22,993		)	(40,814		)
	Purchased electricity	(45,413		)	(14,672		)
Total gain (loss) recognized in income on derivatives		$	(81,396	)	$	(35,042	)

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¹	Differs from the amounts stated in the statements of income as it does not include amortization expense 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 and $8.1 million for the three months ended March 31, 2012 and 2011 respectively.



Puget Sound Energy		Three Months Ended March 31,
(Dollars in Thousands)	Location	2012			2011
Commodity contracts:
Electric derivatives	Unrealized gain (loss) on derivative instruments, net	$	(10,135	)	$	5,984
	Electric generation fuel	(22,993		)	(40,814		)
	Purchased electricity	(45,413		)	(14,672		)
Total gain (loss) recognized in income on derivatives		$	(78,541	)	$	(49,502	)

The Company had the following outstanding interest rate and commodity contracts as of March 31, 2012:



Derivatives not designated as hedging instruments:	Number of Units
Puget Energy:
Interest rate swaps	$1.0 billion
Puget Energy and Puget Sound Energy:
Natural gas derivatives ¹	490,052,220 MMBtus
Electric generation fuel	133,830,360 MMBtus
Purchased electricity	12,251,900 MWhs

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¹	Unrealized gains (losses) on natural gas derivatives are offset by a regulatory asset or liability in accordance with ASC 980 due to the PGA mechanism.

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 problems. 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 March 31, 2012, 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.

The Company generally enters into the following master agreements: (1) WSPP, Inc. (WSPP) agreements - 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 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 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 and coming up with 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 March 31, 2012, 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. Despite its net liability position, PSE was not required to post any additional 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 additional collateral resulting from credit rating downgrades.

As of March 31, 2012, the Company did not have any outstanding energy supply contracts with counterparties that contained credit risk related contingent features, which could result in a counterparty requesting immediate payment or demanding immediate and ongoing full overnight collateralization on derivative instruments in a net liability position.

The table below presents the fair value of the overall contractual contingent liability positions for the Company's derivative activity at March 31, 2012:



Puget Energy and Puget Sound Energy Contingent Feature (Dollars in Thousands)	Fair Value ¹ Liability			Posted Collateral		Contingent Collateral
Credit rating ²	$	(52,462	)	$	—	$	52,462
Requested credit for adequate assurance	(90,291		)	—		—
Forward value of contract ³	(17,322		)	—		—
Total	$	(160,075	)	$	—	$	52,462

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¹	Represents the derivative fair value of contracts with contingent features for counterparties in net derivative liability positions at March 31, 2012. 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’s 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.