Fair Value Measurements

GAAP established a fair value hierarchy that prioritizes the inputs used to measure fair value. The hierarchy categorizes the inputs into three levels with the highest priority given to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurement) and the lowest priority given to unobservable inputs (Level 3 measurement). The three levels of the fair value hierarchy are as follows:

Level 1 - Quoted prices are available in active markets for identical assets or liabilities as of the reporting date. Level 1 primarily consists of financial instruments such as exchange-traded derivatives and listed equities. Equity securities that are also classified as cash equivalents are considered Level 1 if there are unadjusted quoted prices in active markets for identical assets or liabilities.

Level 2 - Pricing inputs are other than quoted prices in active markets included in Level 1, which are either directly or indirectly observable as of the reporting date. Level 2 includes those financial instruments that are valued using models or other valuation methodologies. Instruments in this category include non-exchange-traded derivatives such as over-the-counter forwards and options.

Level 3 - Pricing inputs include significant inputs that have little or no observability as of the reporting date. These inputs may be used with internally developed methodologies that result in management's best estimate of fair value.

Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. If a fair value measurement relies on inputs from different levels of the hierarchy, the entire measurement must be placed based on the lowest level input that is significant to the fair value measurement. The Company primarily determines fair value measurements classified as Level 2 or Level 3 using a combination of the income and market valuation approaches and inputs as determined by the manager of derivatives accounting who reports to the assistant controller. On a daily basis, the Company obtains quoted forward prices for the electric and natural gas market from an independent external pricing service. These forward price quotes are used in addition to other various inputs to determine the reported fair value. Some of the inputs, which are not significant, include the credit standing of the counterparties involved and the impact of credit enhancements (such as cash deposits, letters of credit and priority interests), assumptions for time value, and also the impact of the Company's nonperformance risk of its liabilities. For its interest rate swaps, the Company obtains monthly mark to market values from an independent external pricing service for LIBOR forward rates, which is a significant input. Some of the inputs of the interest rate swap valuations, which are not significant, include the credit standing of the counterparties, assumptions for time value and the impact of the Company's nonperformance risk of its liabilities. Cash equivalents and restricted cash classified as Level 2 fair value instruments consist of special money market funds and premium checking accounts. The Company valued Level 2 cash equivalents and restricted cash using the market approach based on the fair value of underlying investments at reporting date.

As of March 31, 2012, the Company considered the markets for its electric and natural gas commodity contracts and interest rate swaps as Level 2 derivative instruments, since such contracts are commonly traded as over-the-counter forwards with indirectly observable price quotes. However, certain energy derivative instruments are classified as Level 3 in the fair value hierarchy since Level 3 inputs are significant to the fair value measurement. Management's assessment was based on the trading activity volume in real-time and forward electric and natural gas markets. Each quarter, the Company confirms the validity of pricing service quoted prices (e.g., Level 2 in the fair value hierarchy) used to value commodity contracts with the actual prices of commodity contracts entered into during the most recent quarter.

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The following tables present the Company's financial assets and liabilities by level, within the fair value hierarchy, that were accounted for at fair value on a recurring basis and the reconciliation of the changes in the fair value of Level 3 derivatives in the fair value hierarchy as of March 31, 2012 and December 31, 2011:



Puget Energy	Fair Value Measurement								Fair Value Measurement
Puget Energy	At March 31, 2012								At December 31, 2011
(Dollars in Thousands)	Level 1		Level 2		Level 3		Total		Level 1		Level 2		Level 3		Total
Assets:
Electric derivative instruments	$	—	$	703	$	7,945	$	8,648	$	—	$	2,340	$	8,380	$	10,720
Natural gas derivative instruments	—		269		5,556		5,825		—		—		6,011		6,011
Cash equivalents	8,013		1,749		—		9,762		14,809		1,958		—		16,767
Restricted cash	1,967		630		—		2,597		2,043		735		—		2,778
Total assets	$	9,980	$	3,351	$	13,501	$	26,832	$	16,852	$	5,033	$	14,391	$	36,276
Liabilities:
Electric derivative instruments	$	—	$	154,130	$	115,309	$	269,439	$	—	$	165,643	$	98,691	$	264,334
Natural gas derivative instruments	—		203,499		8,723		212,222		—		195,852		11,052		206,904
Interest rate derivative instruments	—		38,689		—		38,689		—		52,409		—		52,409
Total liabilities	$	—	$	396,318	$	124,032	$	520,350	$	—	$	413,904	$	109,743	$	523,647



Puget Sound Energy	Fair Value Measurement at March 31, 2012								Fair Value Measurement at December 31, 2011
(Dollars in Thousands)	Level 1		Level 2		Level 3		Total		Level 1		Level 2		Level 3		Total
Assets:
Electric derivative instruments	$	—	$	703	$	7,945	$	8,648	$	—	$	2,340	$	8,380	$	10,720
Natural gas derivative instruments	—		269		5,556		5,825		—		—		6,011		6,011
Cash equivalents	6,900		1,749		—		8,649		9,200		1,958		—		11,158
Restricted cash	1,967		630		—		2,597		2,043		735		—		2,778
Total assets	$	8,867	$	3,351	$	13,501	$	25,719	$	11,243	$	5,033	$	14,391	$	30,667
Liabilities:
Electric derivative instruments	$	—	$	154,130	$	115,309	$	269,439	$	—	$	165,643	$	98,691	$	264,334
Natural gas derivative instruments	—		203,499		8,723		212,222		—		195,852		11,052		206,904
Total liabilities	$	—	$	357,629	$	124,032	$	481,661	$	—	$	361,495	$	109,743	$	471,238



Puget Energy and Puget Sound Energy Level 3 Roll-Forward Net (Liability)	Three Months Ended March 31,
(Dollars in Thousands)	2012				2011
Balance at beginning of period	$	(95,352	)		$	(91,295	)
Changes during period:
Realized and unrealized energy derivatives
Included in earnings	(21,947		)	¹	(15,707		)	²
Included in regulatory assets / liabilities	(1,283		)		1,119
Settlements ³	20,824				10,440
Transferred into Level 3	(16,874		)		—
Transferred out of Level 3	4,101				3,900
Balance at end of period	$	(110,531	)		$	(91,543	)

__________


¹	Includes unrealized gains (losses) on derivatives still held in position as of the reporting date for electric and natural gas derivatives of $(19.3) million and $2.7 million, respectively, for the three months ended March 31, 2012.


²	Includes unrealized gains (losses) on derivatives still held in position as of the reporting date for electric and natural gas derivatives of $(14.4) million and $1.1 million, respectively, for the three months ended March 31, 2011.


³	The Company had no purchases or issuances during the reported periods.

Realized gains and losses on energy derivatives for Level 3 recurring items are included in energy costs in the Company's consolidated statements of income under purchased electricity, electric generation fuel or purchased natural gas when settled. Unrealized gains and losses on energy derivatives for Level 3 recurring items are included in net unrealized (gain) loss on derivative instruments in the Company's consolidated statements of income.

In order to determine what assets and liabilities are classified as Level 3, the Company receives market data from its independent external pricing service defining the tenor of observable market quotes. To the extent any of the Company's commodity contracts extend beyond what is considered observable as defined by its independent pricing service, the contracts are classified as Level 3. The actual tenor of what the independent pricing service defines as observable is subject to change depending on market conditions. Therefore, as the market changes, the same contract may be designated Level 3 one month and Level 2 the next, and vice versa. These changes of fair value classification in Level 3 contracts are reported in the Level 3 Roll-forward table above as Transfers In/Out of Level 3 at the end of the quarter. The Company does periodically transact at locations, or market price points, that are illiquid and/or for which no prices are available from the independent pricing service. In such circumstances the Company uses a more liquid price point and performs a 15-month regression against the illiquid locations to serve as a proxy for market prices. Such transactions are classified as Level 3. The Company does not use internally developed models to make adjustments to significant unobservable pricing inputs. The only significant unobservable input into the fair value measurement of the Company's Level 3 assets and liabilities is the forward price for electric and natural gas contracts. Below are the forward price ranges during the period ended March 31, 2012.



	Valuation Technique	Low	High	Average
Electricity	Discounted cash flow	$13.75 per MWh	$75.75 per MWh	$44.67 per MWh
Natural gas	Discounted cash flow	$1.76 per MMBtu	$6.14 per MMBtu	$4.73 per MMBtu

Consequently significant increases or decreases in the forward prices of electricity or natural gas could result in a significantly higher or lower fair value for Level 3 assets and liabilities. At March 31, 2012, a hypothetical 10% increase or decrease in market prices of natural gas and electricity would change the fair value of the Company's derivative portfolio, classified as Level 3 within the fair value hierarchy, by $15.4 million.

The Company did not have any transfers between Level 2 and Level 1 during the three months ended March 31, 2012 or 2011.

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

At the time of merger, Puget Energy recorded the fair value of its intangible assets in accordance with ASC 360, “Property, Plant, and Equipment,” (ASC 360). The fair value assigned to the power contracts was determined using an income approach comparing the contract rate to the market rate for power over the remaining period of the contracts incorporating nonperformance risk. Management also incorporated certain assumptions related to quantities and market presentation that it believes market participants would make in the valuation. The fair value of the power contracts is amortized as the contracts settle. ASC 360 requires long-lived assets to be tested for impairment on an on-going basis, whenever events or circumstances would more likely than not reduce the fair value of the long-lived assets below its carrying value. One such triggering event is a significant decrease in market price.

Puget Energy completed a valuation and impairment test as of March 31, 2012 for long-term power purchase contracts. The valuation indicated impairment to one of the purchased power contracts. As of March 31, 2012, the carrying value for the intangible asset contract was $113.3 million and its fair value on a discounted basis was determined to be $96.7 million thereby requiring a $16.6 million write-off of the intangible asset with a corresponding reduction in the regulatory liability.

The valuation was measured using the income approach. Significant inputs included forward electricity prices and power contract pricing which provided future net cash flow estimates which are classified as Level 3 within the fair value hierarchy. An insignificant input is the discount rate reflective of PSE's cost of capital used in the valuation. Below are the quarterly significant unobservable inputs during the period ended March 31, 2012.



(Dollars in Thousands)	Valuation Technique	Low	High	Average
Electricity	Discounted cash flow	$10.36 per MWh	$49.78 per MWh	$34.98 per MWh
Power contract costs	Discounted cash flow	$3,185	$5,030	$4,663
Net cash flows	Discounted cash flow	$(808)	$6,773	$3,985