Fair Value of Financial Instruments

9 Months Ended

Sep. 30, 2017

Fair Value of Financial Instruments - MGE Energy and MGE.

Fair value is defined as the price that would be received to sell an asset or would be paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. The accounting standard clarifies that fair value should be based on the assumptions market participants would use when pricing the asset or liability including assumptions about risk. The standard also establishes a three level fair value hierarchy based upon the observability of the assumptions used and requires the use of observable market data when available. The levels are:

Level 1 - Pricing inputs are quoted prices within active markets for identical assets or liabilities.

Level 2 - Pricing inputs are quoted prices within active markets for similar assets or liabilities; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations that are correlated with or otherwise verifiable by observable market data.

Level 3 - Pricing inputs are unobservable and reflect management's best estimate of what market participants would use in pricing the asset or liability.

a. Fair Value of Financial Assets and Liabilities Recorded at the Carrying Amount.

At September 30, 2017, and December 31, 2016, the carrying amount of cash, cash equivalents, and outstanding commercial paper approximates fair market value due to the short maturity of those investments and obligations. The estimated fair market value of long-term debt is based on quoted market prices for similar financial instruments at September 30, 2017, and December 31, 2016. Since long-term debt is not traded in an active market, it is classified as Level 2. The estimated fair market values of financial instruments are as follows:

		September 30, 2017				December 31, 2016
(In thousands)		Carrying Amount		Fair Value		Carrying Amount		Fair Value
MGE Energy
Assets:
Cash and cash equivalents	$	104,733	$	104,733	$	95,959	$	95,959
Liabilities:
Short-term debt - commercial paper		7,000		7,000		-		-
Long-term debt^(a)		397,981		444,195		391,242		430,122

MGE
Assets:
Cash and cash equivalents	$	1,954	$	1,954	$	10,768	$	10,768
Liabilities:
Short-term debt - commercial paper		7,000		7,000		-		-
Long-term debt^(a)		397,981		444,195		391,242		430,122

(a) Includes long-term debt due within one year. Excludes debt issuance costs and unamortized discount of
$4.1 million at September 30, 2017, and December 31, 2016.

b. Recurring Fair Value Measurements.

The following table presents the balances of assets and liabilities measured at fair value on a recurring basis.

		Fair Value as of September 30, 2017
(In thousands)		Total		Level 1		Level 2		Level 3
MGE Energy
Assets:
Derivatives	$	1,536	$	673	$	-	$	863
Exchange-traded investments		816		816		-		-
Total Assets	$	2,352	$	1,489	$	-	$	863
Liabilities:
Derivatives	$	43,812	$	190	$	-	$	43,622
Deferred compensation		3,150		-		3,150		-
Total Liabilities	$	46,962	$	190	$	3,150	$	43,622

MGE
Assets:
Derivatives	$	1,536	$	673	$	-	$	863
Exchange-traded investments		78		78		-		-
Total Assets	$	1,614	$	751	$	-	$	863
Liabilities:
Derivatives	$	43,812	$	190	$	-	$	43,622
Deferred compensation		3,150		-		3,150		-
Total Liabilities	$	46,962	$	190	$	3,150	$	43,622

		Fair Value as of December 31, 2016
(In thousands)		Total		Level 1		Level 2		Level 3
MGE Energy
Assets:
Derivatives	$	1,527	$	1,041	$	-	$	486
Exchange-traded investments		500		500		-		-
Total Assets	$	2,027	$	1,541	$	-	$	486
Liabilities:
Derivatives	$	50,808	$	16	$	-	$	50,792
Deferred compensation		3,039		-		3,039		-
Total Liabilities	$	53,847	$	16	$	3,039	$	50,792

MGE
Assets:
Derivatives	$	1,527	$	1,041	$	-	$	486
Exchange-traded investments		143		143		-		-
Total Assets	$	1,670	$	1,184	$	-	$	486
Liabilities:
Derivatives	$	50,808	$	16	$	-	$	50,792
Deferred compensation		3,039		-		3,039		-
Total Liabilities	$	53,847	$	16	$	3,039	$	50,792

No transfers were made in or out of Level 1 or Level 2 for the nine months ended September 30, 2017.

Investments include exchange-traded investment securities valued using quoted prices on active exchanges and are therefore classified as Level 1.

Derivatives include exchange-traded derivative contracts, over-the-counter transactions, a purchased power agreement, and FTRs. Most exchange-traded derivative contracts are valued based on unadjusted quoted prices in active markets and are therefore classified as Level 1. A small number of exchange-traded derivative contracts are valued using quoted market pricing in markets with insufficient volumes and are therefore considered unobservable and classified as Level 3. Transactions done with an over-the-counter party are on inactive markets and are therefore classified as Level 3. These transactions are valued based on quoted prices from markets with similar exchange traded transactions. FTRs are priced based upon monthly auction results for identical or similar instruments in a closed market with limited data available and are therefore classified as Level 3.

The purchased power agreement (see Footnote 9) was valued using an internally-developed pricing model and therefore is classified as Level 3. The model projects future market energy prices and compares those prices to the projected power costs to be incurred under the contract. Inputs to the model require significant management judgment and estimation. Future energy prices are based on a forward power pricing curve using exchange-traded contracts in the electric futures market. A basis adjustment is applied to the market energy price to reflect the price differential between the market price delivery point and the counterparty delivery point. The historical relationship between the delivery points is reviewed and a discount (below 100%) or premium (above 100%) is derived. This comparison is done for both peak times when demand is high and off peak times when demand is low. If the basis adjustment is lowered, the fair value measurement will decrease, and if the basis adjustment is increased, the fair value measurement will increase.

The projected power costs anticipated to be incurred under the purchased power agreement are determined using many factors, including historical generating costs, future prices, and expected fuel mix of the counterparty. An increase in the projected fuel costs would result in a decrease in the fair value measurement of the purchased power agreement. A significant input that MGE estimates is the counterparty's fuel mix in determining the projected power cost. MGE also considers the assumptions that market participants would use in valuing the asset or liability. This consideration includes assumptions about market risk such as liquidity, volatility, and contract duration. The fair value model uses a discount rate that incorporates discounting, credit, and model risks.

The following table presents the significant unobservable inputs used in the pricing model.

	Model Input
Significant Unobservable Inputs	September 30, 2017	December 31, 2016
Basis adjustment:
On peak	92.4%	91.9%
Off peak	94.2%	93.4%
Counterparty fuel mix:
Internal generation	55% - 75%	55% - 75%
Purchased power	45% - 25%	45% - 25%

The deferred compensation plan allows participants to defer certain cash compensation into a notional investment account. These amounts are included within other deferred liabilities in the consolidated balance sheets. The notional investments earn interest based upon the semiannual rate of U.S. Treasury Bills having a 26 week maturity increased by 1% compounded monthly with a minimum annual rate of 7%, compounded monthly. The notional investments are based upon observable market data, however, since the deferred compensation obligations themselves are not exchanged in an active market, they are classified as Level 2.

The following table summarizes the changes in Level 3 commodity derivative assets and liabilities measured at fair value on a recurring basis.

		Three Months Ended				Nine Months Ended
		September 30,				September 30,
(In thousands)		2017		2016		2017		2016
Beginning balance	$	(45,605)	$	(51,883)	$	(50,305)	$	(53,501)
Realized and unrealized gains (losses):
Included in regulatory liabilities		2,846		1,455		7,547		3,073
Included in other comprehensive income		-		-		-		-
Included in earnings		(1,478)		(278)		(2,614)		(4,250)
Included in current assets		(14)		-		(111)		-
Purchases		6,299		5,814		18,481		16,751
Sales		-		-		-		-
Issuances		-		-		-		-
Settlements		(4,807)		(5,537)		(15,757)		(12,502)
Transfers in and/or out of Level 3		-		-		-		-
Balance as of September 30,	$	(42,759)	$	(50,429)	$	(42,759)	$	(50,429)
Total gains (losses) included in earnings attributed to
the change in unrealized gains (losses) related to
assets and liabilities held at September 30,^(b)	$	-	$	-	$	-	$	-

The following table presents total realized and unrealized losses included in income for Level 3 assets and liabilities measured at fair value on a recurring basis (b).

		Three Months Ended				Nine Months Ended
		September 30,				September 30,
(In thousands)		2017		2016		2017		2016
Purchased Power Expense	$	(1,460)	$	(278)	$	(2,377)	$	(4,250)
Cost of Gas Sold Expense		(18)		-		(237)		-
Total	$	(1,478)	$	(278)	$	(2,614)	$	(4,250)

(b) MGE's exchange-traded derivative contracts, over-the-counter party transactions, purchased power agreement, and FTRs are subject to regulatory deferral. These derivatives are therefore marked to fair value and are offset in the financial statements with a corresponding regulatory asset or liability.

- 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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