Accounting for Derivative Instruments and Hedging Activities

PSE employs various energy 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 power cost adjustment (PCA). Therefore, wholesale market transactions and PSE's related hedging strategies are focused on reducing costs and risks where feasible, thus reducing volatility of costs in the portfolio. In order to manage its exposure to the variability in future cash flows for forecasted energy transactions, PSE utilizes a programmatic hedging strategy which extends out three years. 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 forward physical electric and natural gas purchase and sale agreements, fixed-for-floating swap contracts, and commodity call/put options. Currently, the Company does not apply cash flow hedge accounting and therefore records all mark-to-market gains or losses through earnings.

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, borrowings under its commercial paper program and its credit facilities to meet short-term funding needs. The Company may enter into swap instruments or other financial hedge instruments to manage the interest rate risk associated with these debts. As of September 30, 2017, the Company did not have any outstanding interest rate swap instruments.

The following table presents the volumes, fair values and locations of the Company's derivative instruments recorded on the balance sheets:



Puget Energy and Puget Sound Energy
	At September 30, 2017						At December 31, 2016
(Dollars in Thousands)	Volumes		Assets¹		Liabilities²		Volumes	Assets¹		Liabilities²
Interest rate swap derivatives³	$	—	$	—	$	—	$450 million	$	—	$	141
Electric portfolio derivatives	*		11,656		39,622		*	36,460		41,329
Natural gas derivatives (MMBtus)⁴	305.3 million		7,826		25,776		336.4 million	26,619		19,101
Total derivative contracts	**		$	19,482	$	65,398	**	$	63,079	$	60,571
Current	**		$	16,605	$	49,820	**	$	54,341	$	44,310
Long-term	**		2,877		15,578		**	8,738		16,261
Total derivative contracts	**		$	19,482	$	65,398	**	$	63,079	$	60,571

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¹	Balance sheet locations: Current and Long-term Unrealized gain on derivative instruments.


²	Balance sheet locations: Current and Long-term Unrealized loss on derivative instruments.


³	Interest rate swap contracts are only held at Puget Energy, and matured January 2017.

⁴

All fair value adjustments on derivatives relating to the natural gas business have been deferred in accordance with ASC 980, “Regulated Operations,” due to the purchased gas adjustment (PGA) mechanism. The net derivative asset or liability and offsetting regulatory liability or asset are related to contracts used to economically hedge the cost of physical gas purchased to serve natural gas customers.


^*	Electric portfolio derivatives consist of electric generation fuel of 165.0 million One Million British Thermal Units (MMBtu) and purchased electricity of 2.6 million Megawatt Hours (MWhs) at September 30, 2017, and 186.8 million MMBtus and 3.6 million MWhs at December 31, 2016.


**	Not meaningful and/or applicable.

It is the Company's policy to record all derivative transactions on a gross basis at the contract level without offsetting assets or liabilities. The Company generally enters into transactions using the following master agreements: WSPP, Inc. (WSPP) agreements, which standardize physical power contracts; International Swaps and Derivatives Association (ISDA) agreements, which standardize financial natural gas and electric contracts; and North American Energy Standards Board (NAESB) agreements, which standardize physical natural gas contracts. The Company believes that such agreements reduce credit risk exposure because such agreements provide for the netting and offsetting of monthly payments as well as the right of set-off in the event of counterparty default. The set-off provision can be used as a final settlement of accounts which extinguishes the mutual debts owed between the parties in exchange for a new net amount. For further details regarding the fair value of derivative instruments, see Note 4, "Fair Value Measurements" to the consolidated financial statements.

The following tables present the potential effect of netting arrangements, including rights of set-off associated with the Company's derivative assets and liabilities:



Puget Energy and Puget Sound Energy
	At September 30, 2017
	Gross Amount Recognized in the Statement of Financial Position¹		Gross Amounts Offset in the Statement of Financial Position		Net of Amounts Presented in the Statement of Financial Position		Gross Amounts Not Offset in the Statement of Financial Position
(Dollars in Thousands)							Commodity Contracts			Cash Collateral Received/Posted			Net Amount
Assets:
Energy derivative contracts	$	19,482	$	—	$	19,482	$	(12,961	)	$	—		$	6,521
Liabilities:
Energy derivative contracts	65,398		—		65,398		(12,961		)	(739		)	51,698



Puget Energy and Puget Sound Energy
	At December 31, 2016
	Gross Amount Recognized in the Statement of Financial Position¹		Gross Amounts Offset in the Statement of Financial Position		Net of Amounts Presented in the Statement of Financial Position		Gross Amounts Not Offset in the Statement of Financial Position
(Dollars in Thousands)							Commodity Contracts			Cash Collateral Received/Posted		Net Amount
Assets:
Energy derivative contracts	$	63,079	$	—	$	63,079	$	(42,858	)	$	—	$	20,221
Liabilities:
Energy derivative contracts	60,430		—		60,430		(42,858		)	—		17,572
Interest rate swaps²	141		—		141		—			—		141

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¹	All derivative contract deals are executed under ISDA, NAESB and WSPP master netting agreements with right of set-off.


²	Interest rate swap contracts are only held at Puget Energy, and matured January 2017.

The following table presents the effect and locations of the realized and unrealized gains (losses) of the Company's derivatives recorded on the statements of income:



Puget Energy and Puget Sound Energy		Three Months Ended September 30,						Nine Months Ended September 30,
(Dollars in Thousands)	Location	2017			2016			2017			2016
Interest rate contracts¹:
	Non-hedged interest rate swap (expense) income	$	—		$	563		$	28		$	(651	)
	Interest expense	—			(349		)	—			(349		)
Gas for Power Derivatives:
Unrealized	Unrealized gain (loss) on derivative instruments, net	903			(8,873		)	(20,979		)	41,957
Realized	Electric generation fuel	(6,753		)	(3,194		)	(14,773		)	(36,204		)
Power Derivatives:
Unrealized	Unrealized gain (loss) on derivative instruments, net	(880		)	2,546			(2,119		)	15,261
Realized	Purchased electricity	(4,356		)	(1,282		)	(14,434		)	(16,077		)
Total gain (loss) recognized in income on derivatives		$	(11,086	)	$	(10,589	)	$	(52,277	)	$	3,937

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¹ Interest rate swap contracts are only held at Puget Energy, and matured January 2017.

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, and exposure monitoring and mitigation.

The Company monitors counterparties for significant swings in credit default swap rates, credit rating changes by external rating agencies, ownership changes or financial distress. 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 September 30, 2017, approximately 98.5% of the Company's energy portfolio exposure, excluding normal purchase normal sale (NPNS) transactions, was with counterparties that are rated at least investment grade by rating agencies and 1.5% are either rated below investment grade or not rated by rating agencies. The Company assesses credit risk internally for counterparties that are not rated by the major rating agencies.

The Company computes credit reserves at a master agreement level by counterparty. The Company considers external credit ratings and market factors in the determination of reserves, such as credit default swaps and bond spreads. 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 determined by weighting the fair value and contract tenors for all deals for each counterparty to derive 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. The Company calculates a non-performance risk on its derivative liabilities by using its estimated incremental borrowing rate over the risk-free rate. Credit reserves are netted against the unrealized gain (loss) positions. As of September 30, 2017, the Company was in a net liability position with the majority of its counterparties, so the default factors of counterparties did not have a significant impact on reserves for the period. The majority of the Company's derivative contracts are with financial institutions and other utilities operating within the Western Electricity Coordinating Council. In March 2017, PSE began transacting power futures contracts on the Intercontinental Exchange (ICE) platform. Execution of these contracts on ICE requires the daily posting of margin calls as collateral through a futures and clearing agent. As of September 30, 2017, PSE had cash posted as collateral of $1.4 million related to contracts executed on this platform. As additional contracts are executed on this exchange, the amount of collateral to be posted will increase, subject to PSE’s established limit. PSE also has a $1.0 million letter of credit posted as collateral as a condition of transacting on a physical energy exchange and clearing house in Canada. PSE did not trigger any collateral requirements with any of its counterparties during the nine months ended September 30, 2017 nor were any of PSE's counterparties required to post collateral resulting from credit rating downgrades.

The table below presents the fair value of the overall contractual contingent liability positions for the Company's derivative activity at September 30, 2017:



Puget Energy and Puget Sound Energy
(Dollars in Thousands)	At September 30, 2017						At December 31, 2016
	Fair Value¹		Posted		Contingent		Fair Value¹		Posted		Contingent
Contingent Feature	Liability		Collateral		Collateral		Liability		Collateral		Collateral
Credit rating²	$	6,113	$	—	$	6,113	$	4,894	$	—	$	4,894
Requested credit for adequate assurance	27,214		—		—		7,427		—		—
Forward value of contract³	739		1,384		—		507		—		—
Total	$	34,066	$	1,384	$	6,113	$	12,828	$	—	$	4,894

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¹	Represents the derivative fair value of contracts with contingent features for counterparties in net derivative liability positions. 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 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.