Fair Value Measurements

9 Months Ended

Sep. 30, 2013

Fair Value Disclosures [Abstract]

Fair Value Measurements

Fair Value

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 measured at fair value are classified in their entirety in the appropriate fair value hierarchy based on the lowest level of input that is significant to the fair value measurement. The Company's assessment of the significance of a particular input to the fair value measurement requires judgment, and may affect the valuation of fair value assets and liabilities and their placement within the fair value hierarchy. The Company primarily determines fair value measurements classified as Level 2 or Level 3 using a combination of the income and market valuation approaches. The process of determining the fair values is the responsibility of the derivative accounting department which reports to the Controller and Principal Accounting Officer. Inputs used to estimate the fair value of forwards, swaps and options include market-price curves; contract terms and prices; credit-risk adjustments; and discount factors. Additionally, for options, the Black-Scholes option valuation model and implied market volatility curves are used. Inputs used to estimate fair value in industry-standard models are categorized as Level 2 inputs because substantially all assumptions and inputs are observable in active markets throughout the full term of the instruments. On a daily basis, the Company obtains quoted forward prices for the electric and natural gas market from an independent external pricing service. For interest rate swaps, the Company obtains monthly mark-to-market values from an independent external pricing service for London Interbank Offered Rate (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.

The Company considers its electric, natural gas and interest rate swap contracts as Level 2 derivative instruments as such contracts are commonly traded as over-the-counter forwards with indirectly observable price quotes. Management's assessment was based on the trading activity 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. However, certain energy derivative instruments with maturity dates falling outside the range of observable price quotes are classified as Level 3 in the fair value hierarchy.

Assets and Liabilities with Estimated Fair Value

The following table presents the fair value hierarchy by level, the carrying value for cash, cash equivalents, restricted cash, notes receivable and short-term debt. The carrying values below are representative of fair values due to the short-term nature of these financial instruments.

	Carrying / Fair Value						Carrying / Fair Value
Puget Energy	At September 30, 2013						At December 31, 2012
(Dollars in Thousands)	Level 1		Level 2		Total		Level 1		Level 2		Total
Assets:
Cash and Cash Equivalents	$	—	$	14,033	$	14,033	$	105,000	$	30,542	$	135,542
Restricted Cash	5,305		2,460		7,765		914		2,786		3,700
Notes Receivable and Other	—		52,844		52,844		—		63,802		63,802
Total assets	$	5,305	$	69,337	$	74,642	$	105,914	$	97,130	$	203,044
Liabilities:
Short Term Debt	$	129,000	$	—	$	129,000	$	181,000	$	—	$	181,000
Total liabilities	$	129,000	$	—	$	129,000	$	181,000	$	—	$	181,000

	Carrying / Fair Value						Carrying / Fair Value
Puget Sound Energy	At September 30, 2013						At December 31, 2012
(Dollars in Thousands)	Level 1		Level 2		Total		Level 1		Level 2		Total
Assets:
Cash and Cash Equivalents	$	—	$	13,863	$	13,863	$	105,000	$	30,530	$	135,530
Restricted Cash	5,305		2,460		7,765		914		2,786		3,700
Notes Receivable and Other	—		52,844		52,844		—		63,802		63,802
Total assets	$	5,305	$	69,167	$	74,472	$	105,914	$	97,118	$	203,032
Liabilities:
Short Term Debt	$	129,000	$	—	$	129,000	$	181,000	$	—	$	181,000
Short Term Debt owed to parent	—		29,598		29,598		—		29,598		29,598
Total liabilities	$	129,000	$	29,598	$	158,598	$	181,000	$	29,598	$	210,598

The fair value of the junior subordinated and long-term notes were estimated using the discounted cash flow method with U.S. Treasury yields and Company credit spreads as inputs, interpolating to the maturity date of each issue. Carrying values and estimated fair values were as follows:

Puget Energy		September 30, 2013				December 31, 2012
(Dollars in Thousands)	Level	Carrying Value		Fair Value		Carrying Value		Fair Value
Liabilities:
Junior subordinated notes	2	$	250,000	$	258,389	$	250,000	$	264,842
Long-term debt (fixed-rate), net of discount	2	4,690,693		5,665,300		4,662,200		6,197,179
Long-term debt (variable-rate), net of discount	2	299,000		299,000		434,000		434,000
Total		$	5,239,693	$	6,222,689	$	5,346,200	$	6,896,021
Puget Sound Energy		September 30, 2013				December 31, 2012
(Dollars in Thousands)	Level	Carrying Value		Fair Value		Carrying Value		Fair Value
Liabilities:
Junior subordinated notes	2	$	250,000	$	258,389	$	250,000	$	264,842
Long-term debt (fixed-rate), net of discount	2	3,523,258		4,144,357		3,526,258		4,628,509
Total		$	3,773,258	$	4,402,746	$	3,776,258	$	4,893,351

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. The Company did not have any transfers between Level 2 and Level 1 during the three and nine months ended September 30, 2013 and 2012.

Puget Energy	Fair Value						Fair Value
	At September 30, 2013						At December 31, 2012
(Dollars in Thousands)	Level 2		Level 3		Total		Level 2		Level 3		Total
Interest rate derivative instruments	$	14,722	$	—	$	14,722	$	21,524	$	—	$	21,524
Total derivative liabilities	$	14,722	$	—	$	14,722	$	21,524	$	—	$	21,524

Puget Energy and	Fair Value						Fair Value
Puget Sound Energy	At September 30, 2013						At December 31, 2012
(Dollars in Thousands)	Level 2		Level 3		Total		Level 2		Level 3		Total
Assets:
Electric derivative instruments	$	2,223	$	5,621	$	7,844	$	1,259	$	8,298	$	9,557
Natural gas derivative instruments	2,100		3,343		5,443		6,769		5,357		12,126
Total assets	$	4,323	$	8,964	$	13,287	$	8,028	$	13,655	$	21,683
Liabilities:
Electric derivative instruments	$	37,699	$	34,740	$	72,439	$	88,971	$	42,221	$	131,192
Natural gas derivative instruments	64,494		6,142		70,636		101,119		6,960		108,079
Total liabilities	$	102,193	$	40,882	$	143,075	$	190,090	$	49,181	$	239,271

Puget Energy and Puget Sound Energy	Three Months Ended September 30,
Level 3 Roll-Forward Net (Liability)	2013									2012
(Dollars in Thousands)	Electric			Gas			Total			Electric			Gas			Total
Balance at beginning of period	$	(36,899	)	$	(2,873	)	$	(39,772	)	$	(80,453	)	$	(2,819	)	$	(83,272	)
Changes during period:
Realized and unrealized energy derivatives:
Included in earnings 1	(392		)	—			(392		)	5,332			—			5,332
Included in regulatory assets / liabilities	—			(957		)	(957		)	—			(183		)	(183		)
Settlements 3	(1,270		)	466			(804		)	11,606			1,102			12,708
Transferred into Level 3	730			—			730			—			—			—
Transferred out of Level 3	8,712			565			9,277			11,831			471			12,302
Balance at end of period	$	(29,119	)	$	(2,799	)	$	(31,918	)	$	(51,684	)	$	(1,429	)	$	(53,113	)
Puget Energy and Puget Sound Energy	Nine Months Ended September 30,
Level 3 Roll-Forward Net (Liability)	2013									2012
(Dollars in Thousands)	Electric			Gas			Total			Electric			Gas			Total
Balance at beginning of period	$	(33,924	)	$	(1,602	)	$	(35,526	)	$	(90,311	)	$	(5,041	)	$	(95,352	)
Changes during period:
Realized and unrealized energy derivatives:
Included in earnings 2	(11,593		)	—			(11,593		)	(11,538		)	—			(11,538		)
Included in regulatory assets / liabilities	—			(967		)	(967		)	—			(1,470		)	(1,470		)
Settlements 3	7,792			(762		)	7,030			47,021			1,208			48,229
Transferred into Level 3	(7,799		)	—			(7,799		)	(55,548		)	(297		)	(55,845		)
Transferred out of Level 3	16,405			532			16,937			58,692			4,171			62,863
Balance at end of period	$	(29,119	)	$	(2,799	)	$	(31,918	)	$	(51,684	)	$	(1,429	)	$	(53,113	)

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¹  Income Statement location: Unrealized (gain) loss on derivative instruments, net. Includes unrealized gains (losses) on derivatives still held in position as of the reporting date for electric derivatives of $(0.8) millionand $5.1 million for the three months ended September 30, 2013 and 2012, respectively.

²  Income Statement location: Unrealized (gain) loss on derivative instruments, net. Includes unrealized gains (losses) on derivatives still held in position as of the reporting date for electric derivatives of $(15.0) million and $(7.6) million for the nine months ended September 30, 2013 and 2012, respectively.

³The Company had no purchases, sales 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 which 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. The changes of fair value classification into or out of Level 3 are recognized each month, and reported in the Level 3 Roll-forward table above. The Company does periodically transact at locations, or market price points, that are illiquid 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 for the Company's purchased commodity contracts, as of September 30, 2013:

(Dollars in Thousands)
	Fair Value						Range
Derivative Instrument	Assets 1		Liabilities 1		Valuation Technique	Unobservable Input	Low	High	Weighted Average
Electric	$	5,621	$	34,740	Discounted cash flow	Power Prices	$12.49 per MWh	$42.80 per MWh	$31.03 per MWh
Natural gas	$	3,343	$	6,142	Discounted cash flow	Natural Gas Prices	$3.53 per MMBtu	$4.54 per MMBtu	$4.15 per MMBtu

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¹  The valuation techniques, unobservable inputs and ranges are the same for asset and liability positions.

The significant unobservable inputs listed above would have a direct impact on the fair values of the above instruments if they were adjusted. Consequently significant increases or decreases in the forward prices of electricity or natural gas in isolation would result in a significantly higher or lower fair value for Level 3 assets and liabilities. Generally, interrelationships exist between market prices of natural gas and power. As such, an increase in natural gas pricing would potentially have a similar impact on forward power markets. At September 30, 2013, 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 $16.2 million.

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 annual basis, and upon the occurrence of any events or circumstances that would be more likely than not to reduce the fair value of the long-lived assets below their carrying value. One such triggering event is a significant decrease in market price.

At June 30, 2013, Puget Energy completed a valuation and impairment test of its purchased power contracts classified as intangible assets. The valuation indicated a fair value of $484.1 million with an impairment to one of the purchased power contracts. As of June 30, 2013, the carrying value for the Priest Rapids Reasonable Portion intangible asset contract was $47.1 million and its fair value on a discounted basis was determined to be an asset of $33.6 million, thereby requiring a write-down of $13.5 million to 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 significant unobservable inputs used estimating the long-term power purchase contracts' fair value of $484.1 million on June 30, 2013:

Valuation Technique	Unobservable Input	Low			High			Weighted Average
Discounted cash flow	Power prices	$	30.85	per MWh	$	65.35	per MWh	$	48.47	per MWh
Discounted cash flow	Power contract costs (in thousands)	$	389	per year	$	6,845	per year	$	4,110	per year