Fair Value Measurements

ASC 820 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 less significant, include the credit standing of the counterparties, assumptions for time value and the impact of the Company's nonperformance risk of its liabilities. The Company classifies cash and cash equivalents, and restricted cash as Level 1 financial instruments due to cash being at stated value, and cash equivalents at quoted market prices.

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, 2014						At December 31, 2013
(Dollars in Thousands)	Level 1		Level 2		Total		Level 1		Level 2		Total
Assets:
Cash and Cash Equivalents	$	26,470	$	—	$	26,470	$	44,302	$	—	$	44,302
Restricted Cash	54,251		—		54,251		7,171		—		7,171
Notes Receivable and Other	—		52,795		52,795		—		53,449		53,449
Total assets	$	80,721	$	52,795	$	133,516	$	51,473	$	53,449	$	104,922
Liabilities:
Short-term debt	$	—	$	25,000	$	25,000	$	162,000	$	—	$	162,000
Total liabilities	$	—	$	25,000	$	25,000	$	162,000	$	—	$	162,000



	Carrying / Fair Value						Carrying / Fair Value
Puget Sound Energy	At September 30, 2014						At December 31, 2013
(Dollars in Thousands)	Level 1		Level 2		Total		Level 1		Level 2		Total
Assets:
Cash and Cash Equivalents	$	26,412	$	—	$	26,412	$	44,111	$	—	$	44,111
Restricted Cash	54,251		—		54,251		7,171		—		7,171
Notes Receivable and Other	—		52,795		52,795		—		53,449		53,449
Total assets	$	80,663	$	52,795	$	133,458	$	51,282	$	53,449	$	104,731
Liabilities:
Short-term debt	$	—	$	25,000	$	25,000	$	162,000	$	—	$	162,000
Short-term debt owed to parent	—		28,933		28,933		—		29,598		29,598
Total liabilities	$	—	$	53,933	$	53,933	$	162,000	$	29,598	$	191,598

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, 2014				December 31, 2013
(Dollars in Thousands)	Level	Carrying Value		Fair Value		Carrying Value		Fair Value
Liabilities:
Junior subordinated notes	2	$	250,000	$	324,414	$	250,000	$	269,366
Long-term debt (fixed-rate), net of discount	2	4,691,825		5,977,877		4,683,476		5,594,314
Long-term debt (variable-rate)	2	299,000		299,000		299,000		299,000
Total		$	5,240,825	$	6,601,291	$	5,232,476	$	6,162,680

Puget Sound Energy		September 30, 2014				December 31, 2013
(Dollars in Thousands)	Level	Carrying Value		Fair Value		Carrying Value		Fair Value
Liabilities:
Junior subordinated notes	2	$	250,000	$	324,414	$	250,000	$	269,366
Long-term debt (fixed-rate), net of discount	2	3,513,259		4,341,809		3,513,258		4,038,455
Total		$	3,763,259	$	4,666,223	$	3,763,258	$	4,307,821

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:



Puget Energy	Fair Value						Fair Value
Puget Energy	At September 30, 2014						At December 31, 2013
(Dollars in Thousands)	Level 2		Level 3		Total		Level 2		Level 3		Total
Interest rate derivative instruments	$	9,560	$	—	$	9,560	$	13,223	$	—	$	13,223
Total derivative liabilities	$	9,560	$	—	$	9,560	$	13,223	$	—	$	13,223



Puget Energy and	Fair Value						Fair Value
Puget Sound Energy	At September 30, 2014						At December 31, 2013
(Dollars in Thousands)	Level 2		Level 3		Total		Level 2		Level 3		Total
Assets:
Electric derivative instruments	$	2,906	$	4,254	$	7,160	$	14,661	$	3,818	$	18,479
Natural gas derivative instruments	10,391		1,999		12,390		5,448		2,673		8,121
Total assets	$	13,297	$	6,253	$	19,550	$	20,109	$	6,491	$	26,600
Liabilities:
Electric derivative instruments	$	15,711	$	17,461	$	33,172	$	18,073	$	19,239	$	37,312
Natural gas derivative instruments	15,398		3,737		19,135		32,642		3,034		35,676
Total liabilities	$	31,109	$	21,198	$	52,307	$	50,715	$	22,273	$	72,988

The following table presents the Company's reconciliation of the changes in the fair value of Level 3 derivatives in the fair value hierarchy:



Puget Energy and Puget Sound Energy	Three Months Ended September 30,
Level 3 Roll-Forward Net Asset/(Liability)	2014									2013
(Dollars in Thousands)	Electric			Gas			Total			Electric			Gas			Total
Balance at beginning of period	$	(4,693	)	$	(273	)	$	(4,966	)	$	(36,899	)	$	(2,873	)	$	(39,772	)
Changes during period:
Realized and unrealized energy derivatives:
Included in earnings ¹	(3,116		)	—			(3,116		)	(392		)	—			(392		)
Included in regulatory assets / liabilities	—			(725		)	(725		)	—			(957		)	(957		)
Settlements³	(965		)	(680		)	(1,645		)	(1,270		)	466			(804		)
Transferred into Level 3	2,055			—			2,055			730			—			730
Transferred out of Level 3	(6,488		)	(60		)	(6,548		)	8,712			565			9,277
Balance at end of period	$	(13,207	)	$	(1,738	)	$	(14,945	)	$	(29,119	)	$	(2,799	)	$	(31,918	)



Puget Energy and Puget Sound Energy	Nine Months Ended September 30,
Level 3 Roll-Forward Net Asset/(Liability)	2014									2013
(Dollars in Thousands)	Electric			Gas			Total			Electric			Gas			Total
Balance at beginning of period	$	(15,421	)	$	(361	)	$	(15,782	)	$	(33,924	)	$	(1,602	)	$	(35,526	)
Changes during period:
Realized and unrealized energy derivatives:
Included in earnings ²	1,939			—			1,939			(11,593		)	—			(11,593		)
Included in regulatory assets / liabilities	—			1,654			1,654			—			(967		)	(967		)
Settlements³	1,114			(1,256		)	(142		)	7,792			(762		)	7,030
Transferred into Level 3	5,155			(585		)	4,570			(7,799		)	—			(7,799		)
Transferred out of Level 3	(5,994		)	(1,190		)	(7,184		)	16,405			532			16,937
Balance at end of period	$	(13,207	)	$	(1,738	)	$	(14,945	)	$	(29,119	)	$	(2,799	)	$	(31,918	)

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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 $(3.3) million and $(0.8) million for the three months ended September 30, 2014 and 2013, 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 $(3.3) million and $(15.0) million for the nine months ended September 30, 2014 and 2013, respectively.


³	The 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 did not have any transfers between Level 2 and Level 1 during the reported periods. 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, 2014:



	Fair Value						Range
(Dollars in Thousands)	Assets ¹		Liabilities ¹		Valuation Technique	Unobservable Input	Low	High	Weighted Average
Electric	$	4,254	$	17,461	Discounted cash flow	Power Prices	$17.64 per MWh	$44.50 per MWh	$35.21 per MWh
Natural gas	$	1,999	$	3,737	Discounted cash flow	Natural Gas Prices	$3.60 per MMBtu	$3.83 per MMBtu	$3.70 per MMBtu

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

Below are the forward price ranges for the Company's purchased commodity contracts, as of December 31, 2013:



	Fair Value						Range
(Dollars in Thousands)	Assets ¹		Liabilities ¹		Valuation Technique	Unobservable Input	Low	High	Weighted Average
Electric	$	3,818	$	19,239	Discounted cash flow	Power Prices	$17.06 per MWh	$47.09 per MWh	$38.74 per MWh
Natural gas	$	2,673	$	3,034	Discounted cash flow	Natural Gas Prices	$3.62 per MMBtu	$4.19 per MMBtu	$3.78 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, 2014 and December 31, 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 $5.1 million and $7.0 million, respectively.