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Fair Value Measurements

6 Months Ended

Jun. 30, 2020

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 $52.5 million at June 30, 2020, and $51.5 million at December 31, 2019, 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 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, 2020						At December 31, 2019
(Dollars in Thousands)	Level	Carrying Value		Fair Value		Carrying Value		Fair Value
Liabilities:
Long-term debt (fixed-rate), net of discount¹	2	$	6,162,530	$	7,608,405	$	5,512,225	$	7,004,316
Long-term debt (variable-rate)	2	234,000		234,000		408,100		408,100
Total liabilities		$	6,396,530	$	7,842,405	$	5,920,325	$	7,412,416


Puget Sound Energy		At June 30, 2020						At December 31, 2019
(Dollars in Thousands)	Level	Carrying Value		Fair Value		Carrying Value		Fair Value
Liabilities:
Long-term debt (fixed-rate), net of discount²	2	$	4,337,090	$	5,992,573	$	4,336,142	$	5,571,818
Total liabilities		$	4,337,090	$	5,992,573	$	4,336,142	$	5,571,818

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¹The carrying value includes debt issuances costs of $23.1 million and $24.1 million for June 30, 2020, and December 31, 2019, respectively, which are not included in fair value.

²The carrying value includes debt issuances costs of $23.6 million and $24.4 million for June 30, 2020, and December 31, 2019, 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 Puget Sound Energy	Fair Value At June 30, 2020										Fair Value At December 31, 2019
(Dollars in Thousands)	Level 2		Level 3		Total		Level 2		Level 3		Total
Assets:
Electric derivative instruments	$	19,763	$	526	$	20,289	$	19,282	$	651	$	19,933
Natural gas derivative instruments	13,634		620		14,254		9,852		1,523		11,375
Total assets	$	33,397	$	1,146	$	34,543	$	29,134	$	2,174	$	31,308
Liabilities:
Electric derivative instruments	$	25,103	$	29,135	$	54,238	$	13,474	$	4,030	$	17,504
Natural gas derivative instruments	9,425		278		9,703		8,376		241		8,617
Total liabilities	$	34,528	$	29,413	$	63,941	$	21,850	$	4,271	$	26,121

The following tables present 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)	2020										2019
Level 3 Roll-Forward Net Asset/(Liability)	Electric		Natural Gas		Total		Electric		Natural Gas		Total
Balance at beginning of period	$	(26,305)	$	1,092	$	(25,213)	$	5,012	$	2,758	$	7,770
Changes during period:
Realized and unrealized energy derivatives:
Included in earnings¹	(2,284)		—		(2,284)		(6,190)		—		(6,190)
Included in regulatory assets / liabilities	—		(39)		(39)		—		382		382
Settlements	(20)		(711)		(731)		574		(1,619)		(1,045)
Transferred into Level 3	—		—		—		—		—		—
Transferred out of Level 3	—		—		—		(1,842)		877		(965)
Balance at end of period	$	(28,609)	$	342	$	(28,267)	$	(2,446)	$	2,398	$	(48)


Puget Energy and Puget Sound Energy	Six Months Ended June 30,
(Dollars in Thousands)	2020										2019
Level 3 Roll-Forward Net Asset/(Liability)	Electric		Natural Gas		Total		Electric		Natural Gas		Total
Balance at beginning of period	$	(3,378)	$	1,282	$	(2,096)	$	1,362	$	1,673	$	3,035
Changes during period:
Realized and unrealized energy derivatives:
Included in earnings²	(26,837)		—		(26,837)		6,135		—		6,135
Included in regulatory assets / liabilities	—		284		284		—		2,279		2,279
Settlements	1,606		(1,224)		382		(12,909)		(2,718)		(15,627)
Transferred into Level 3	—		—		—		4,391		(398)		3,993
Transferred out of Level 3	—		—		—		(1,425)		1,562		137
Balance at end of period	$	(28,609)	$	342	$	(28,267)	$	(2,446)	$	2,398	$	(48)

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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 $(23.1) million and $(4.7) million for three months ended June 30, 2020 and 2019, 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 $(25.4) million and $(2.4) million for six months ended June 30, 2020 and 2019, 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.

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 weighted average price is calculated as the total market value divided by the total volume of the Company's Level 3 electric and gas commodity contracts, respectively, as of the reporting date.

The following table presents the forward price ranges for the Company's Level 3 commodity contracts as of June 30, 2020:


Puget Energy and Puget Sound Energy	Fair Value								Range
(Dollars in Thousands)	Assets¹		Liabilities¹		Valuation Technique	Unobservable Input	Low		High		Weighted Average
Electric	$	526	$	29,135	Discounted cash flow	Power prices (per MWh)	$	22.97	$	40.05	$	30.14
Natural gas	$	620	$	278	Discounted cash flow	Natural gas prices (per MMBtu)	$	1.10	$	3.08	$	1.78

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¹The 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, 2019:


Puget Energy and Puget Sound Energy	Fair Value								Range
(Dollars in Thousands)	Assets¹		Liabilities¹		Valuation Technique	Unobservable Input	Low		High		Weighted Average
Electric	$	651	$	4,030	Discounted cash flow	Power prices (per MWh)	$	9.00	$	43.85	$	33.99
Natural gas	$	1,523	$	241	Discounted cash flow	Natural gas prices (per MMBtu)	$	1.25	$	3.18	$	2.47

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¹The 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. As of June 30, 2020, and December 31, 2019, 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 $5.6 million and $2.5 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 recoverability whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. One such triggering event is a significant decrease in the forward market prices of power.

At March 31, 2020, Puget Energy completed valuation and impairment testing of its power purchase contracts classified as intangible assets. These intangible assets exist as a result of the merger in 2009, at which time the consolidated assets and liabilities were revalued in accordance with ASC 805, "Business Combinations". Differences between the fair market value and the carrying value of assets held at PSE were recorded at PE. The Rocky Reach contract was determined to be impaired due to a decrease in forward prices for this contract of 7.6% from December 31, 2019, causing an impairment of $52.6 million. While this impairment of the intangible asset held at Puget Energy is the result of a decline in forward prices and the corresponding valuation impact, the underlying power purchase contract is included within rates at PSE.

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, 2020	Rocky Reach	$	147,168	$	94,603	$	52,565

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. The unobservable input averages disclosed below represent the arithmetic average of the inputs and are not weighted by volume. A less significant input is the discount rate reflective of a market participant'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, 2020	Power prices (per MWh)	$	10.23	$	29.05	$	21.27
	Power contract costs per quarter (in thousands)	$	6,308	$	7,085	$	6,468
December 31, 2019	Power prices (per MWh)	$	11.75	$	31.44	$	22.53
	Power contract costs per quarter (in thousands)	$	6,237	$	7,087	$	6,421

- Definition

The entire disclosure for the fair value of financial instruments (as defined), including financial assets and financial liabilities (collectively, as defined), and the measurements of those instruments as well as disclosures related to the fair value of non-financial assets and liabilities. Such disclosures about the financial instruments, assets, and liabilities would include: (1) the fair value of the required items together with their carrying amounts (as appropriate); (2) for items for which it is not practicable to estimate fair value, disclosure would include: (a) information pertinent to estimating fair value (including, carrying amount, effective interest rate, and maturity, and (b) the reasons why it is not practicable to estimate fair value; (3) significant concentrations of credit risk including: (a) information about the activity, region, or economic characteristics identifying a concentration, (b) the maximum amount of loss the entity is exposed to based on the gross fair value of the related item, (c) policy for requiring collateral or other security and information as to accessing such collateral or security, and (d) the nature and brief description of such collateral or security; (4) quantitative information about market risks and how such risks are managed; (5) for items measured on both a recurring and nonrecurring basis information regarding the inputs used to develop the fair value measurement; and (6) for items presented in the financial statement for which fair value measurement is elected: (a) information necessary to understand the reasons for the election, (b) discussion of the effect of fair value changes on earnings, (c) a description of [similar groups] items for which the election is made and the relation thereof to the balance sheet, the aggregate carrying value of items included in the balance sheet that are not eligible for the election; (7) all other required (as defined) and desired information.

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