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 as 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 markets from an independent external pricing service.

The Company considers its electric and natural gas contracts as Level 2 derivative instruments as such contracts are commonly traded as over-the-counter forwards with indirectly observable price quotes. 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. Management's assessment is 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 used to value Level 2 commodity contracts with the actual prices of commodity contracts entered into during the most recent quarter.

Assets and Liabilities with Estimated Fair Value

The carrying values of cash and cash equivalents, restricted cash, and short-term debt as reported on the balance sheet are reasonable estimates of their fair value due to the short-term nature of these instruments and are classified as Level 1 in the fair value hierarchy. The carrying value of other investments totaling $49.1 million and $48.5 million at June 30, 2018 and December 31, 2017, respectively, are included in "Other property and investments" on the balance sheet. These values are also reasonable estimates of their fair value and classified as Level 2 in the fair value hierarchy as they are valued based on market rates for similar transactions.

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



Puget Energy		At June 30, 2018				At December 31, 2017
(Dollars in Thousands)	Level	Carrying Value		Fair Value		Carrying Value		Fair Value
Liabilities:
Junior subordinated notes	2	$	—	$	—	$	250,000	$	238,935
Long-term debt (fixed-rate), net of discount¹	2	5,505,640		6,483,719		5,105,329		6,520,515
Long-term debt (variable-rate)	2	139,551		139,551		102,600		102,600
Total liabilities		$	5,645,191	$	6,623,270	$	5,457,929	$	6,862,050



Puget Sound Energy		At June 30, 2018				At December 31, 2017
(Dollars in Thousands)	Level	Carrying Value		Fair Value		Carrying Value		Fair Value
Liabilities:
Junior subordinated notes	2	$	—	$	—	$	250,000	$	238,935
Long-term debt (fixed-rate), net of discount²	2	3,895,042		4,598,167		3,499,911		4,550,130
Total liabilities		$	3,895,042	$	4,598,167	$	3,749,911	$	4,789,065

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¹	The carrying value includes debt issuances costs of $26.6 million and $27.9 million for June 30, 2018 and December 31, 2017, respectively, which are not included in fair value.


²	The carrying value includes debt issuances costs of $24.2 million and $24.6 million for June 30, 2018 and December 31, 2017, respectively, which are not included in fair value.

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The following table presents 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 and	Fair Value						Fair Value
Puget Sound Energy	At June 30, 2018						At December 31, 2017
(Dollars in Thousands)	Level 2		Level 3		Total		Level 2		Level 3		Total
Assets:
Electric derivative instruments	$	7,229	$	3,660	$	10,889	$	9,866	$	3,525	$	13,391
Natural gas derivative instruments	6,510		6,062		12,572		6,973		4,041		11,014
Total assets	$	13,739	$	9,722	$	23,461	$	16,839	$	7,566	$	24,405
Liabilities:
Electric derivative instruments	$	36,991	$	1,651	$	38,642	$	46,623	$	2,427	$	49,050
Natural gas derivative instruments	24,144		2,113		26,257		34,926		2,118		37,044
Total liabilities	$	61,135	$	3,764	$	64,899	$	81,549	$	4,545	$	86,094

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 June 30,
(Dollars in Thousands)	2018									2017
Level 3 Roll-Forward Net Asset/(Liability)	Electric			Natural Gas			Total			Electric			Natural Gas			Total
Balance at beginning of period	$	1,186		$	5,096		$	6,282		$	3,788		$	1,752		$	5,540
Changes during period:
Realized and unrealized energy derivatives:
Included in earnings¹	366			—			366			339			—			339
Included in regulatory assets / liabilities	—			354			354			—			1,124			1,124
Settlements	(151		)	(1,800		)	(1,951		)	(2,508		)	(1,974		)	(4,482		)
Transferred into Level 3	—			—			—			—			—			—
Transferred out of Level 3	608			299			907			(976		)	554			(422		)
Balance at end of period	$	2,009		$	3,949		$	5,958		$	643		$	1,456		$	2,099



Puget Energy and Puget Sound Energy	Six Months Ended June 30,
(Dollars in Thousands)	2018									2017
Level 3 Roll-Forward Net Asset/(Liability)	Electric			Natural Gas			Total			Electric			Natural Gas			Total
Balance at beginning of period	$	1,098		$	1,923		$	3,021		$	972		$	625		$	1,597
Changes during period:
Realized and unrealized energy derivatives:
Included in earnings²	1,985			—			1,985			1,045			—			1,045
Included in regulatory assets / liabilities	—			5,329			5,329			—			3,582			3,582
Settlements	(654		)	(3,602		)	(4,256		)	(3,838		)	(3,304		)	(7,142		)
Transferred into Level 3	(1,837		)	—			(1,837		)	2,191			(553		)	1,638
Transferred out of Level 3	1,417			299			1,716			273			1,106			1,379
Balance at end of period	$	2,009		$	3,949		$	5,958		$	643		$	1,456		$	2,099

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¹	Income Statement locations: Unrealized (gain) loss on derivative instruments, net. Amounts include unrealized gains (losses) on derivatives still held in position as of the reporting date for electric derivatives of $0.7 million and $0.5 million for the three months ended June 30, 2018 and 2017, respectively.


²	Income Statement locations: Unrealized (gain) loss on derivative instruments, net. Amounts include unrealized gains (losses) on derivatives still held in position as of the reporting date for electric derivatives of $1.7 million and $0.7 million for the six months ended June 30, 2018 and 2017, respectively.

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 tables. The Company did not have any transfers between Level 1 and Level 2 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 forward 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.

The following table presents the forward price ranges for the Company's Level 3 commodity contracts as of June 30, 2018:



Puget Energy and Puget Sound Energy	Fair Value						Range
(Dollars in Thousands)	Assets¹		Liabilities¹		Valuation Technique	Unobservable Input	Low		High		Weighted Average
Electric	$	3,660	$	1,651	Discounted cash flow	Power prices (per MWh)	$	20.97	$	40.25	$	26.52
Natural gas	$	6,062	$	2,113	Discounted cash flow	Natural gas prices (per MMBtu)	$	1.74	$	2.73	$	2.14

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

The following table presents the forward price ranges for the Company's Level 3 commodity contracts as of December 31, 2017:



Puget Energy and Puget Sound Energy	Fair Value						Range
(Dollars in Thousands)	Assets¹		Liabilities¹		Valuation Technique	Unobservable Input	Low		High		Weighted Average
Electric	$	3,525	$	2,427	Discounted cash flow	Power prices (per MWh)	$	7.02	$	28.94	$	18.61
Natural gas	$	4,041	$	2,118	Discounted cash flow	Natural gas prices (per MMBtu)	$	1.22	$	2.80	$	1.54

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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 June 30, 2018 and December 31, 2017, a hypothetical 10.0% 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 $1.1 million and $0.9 million, respectively.

Long-Lived Assets Measured at Fair Value on a Nonrecurring Basis

Puget Energy records 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 non-performance 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 the forward market prices of power.

As of June 30, 2018, Puget Energy completed valuation and impairment testing of its power purchase contracts classified as intangible assets and found no impairment. As of March 31, 2018, the Wells Hydro contract was determined to be impaired due to a decrease in forward prices for this contract of 39.0% from December 31, 2017, causing an impairment of $1.9 million.

The following table presents the impairment recorded to the Company's intangible asset contracts, with corresponding reductions to the regulatory liability:



Puget Energy
(Dollars in Thousands)
Valuation Date	Contract Name	Carrying Value		Fair Value		Write Down
March 31, 2018	Wells Hydro	$	4,302	$	2,395	$	1,907

The valuations were measured using a discounted cash flow, income-based valuation methodology. Significant inputs included forward electricity prices and power contract pricing which provided future net cash flow estimates classified as Level 3 within the fair value hierarchy. A less significant input is the discount rate reflective of PSE's cost of capital used in the valuation.

The following table presents the significant unobservable inputs used in estimating the impaired long-term power purchase contracts' fair value:



Puget Energy
Valuation Date	Unobservable Input	Low	High	Average
March 31, 2018	Power prices (per MWh)	$9.69	$25.30	$17.50
	Power contract costs per quarter (in thousands)	4,126	4,126	4,126