NOTE 7: DERIVATIVES

Use of Derivative Instruments

The Utility is exposed to commodity price risk as a result of its electricity and natural gas procurement activities. Procurement costs are recovered through customer rates. The Utility uses both derivative and non-derivative contracts to manage volatility in customer rates due to fluctuating commodity prices. Derivatives include physical and financial derivative contracts, such as power purchase agreements, forwards, futures, swaps, options, and CRRs that are traded either on an exchange or over-the-counter.

Derivatives are recorded at fair value and are presented in the Utility’s Condensed Consolidated Balance Sheets on a net basis in accordance with master netting arrangements for each counterparty. The fair value of derivative instruments is further offset by cash collateral paid or received where the right of offset and the intention to offset exist.

These instruments are not held for speculative purposes and are subject to certain regulatory requirements. The Utility expects to fully recover in rates all costs related to derivatives as long as the current ratemaking mechanism remains in place and the Utility’s price risk management activities are carried out in accordance with CPUC directives. Therefore, all unrealized gains and losses associated with the change in fair value of these derivatives are deferred and recorded within the Utility’s regulatory assets and liabilities on the Condensed Consolidated Balance Sheets. Net realized gains or losses on commodity derivatives are recorded in the cost of electricity or the cost of natural gas with corresponding increases or decreases to regulatory balancing accounts for recovery from or refund to customers.

The Utility elects the normal purchase and sale exception for eligible derivatives. Eligible derivatives are those that require physical delivery in quantities that are expected to be used by the Utility over a reasonable period in the normal course of business, and do not contain pricing provisions unrelated to the commodity delivered. These items are not reflected in the Condensed Consolidated Balance Sheets at fair value. Eligible derivatives are accounted for under the accrual method of accounting.

Volume of Derivative Activity

The volumes of the Utility’s outstanding derivatives were as follows:

		Contract Volume at
		September 30,	December 31,
Underlying Product	Instruments	2016	2015
Natural Gas (1) (MMBtus (2))	Forwards, Futures and Swaps	376,296,893	333,091,813
	Options	118,017,176	111,550,004
Electricity (Megawatt-hours)	Forwards, Futures and Swaps	3,128,038	3,663,512
	Congestion Revenue Rights (3)	172,756,395	216,383,389

(1) Amounts shown are for the combined positions of the electric fuels and core gas supply portfolios.

(2) Million British Thermal Units.

(3) CRRs are financial instruments that enable the holders to manage variability in electric energy congestion charges due to transmission grid limitations.

Presentation of Derivative Instruments in the Financial Statements

At September 30, 2016, the Utility’s outstanding derivative balances were as follows:

	Commodity Risk
	Gross Derivative						Total Derivative
(in millions)	Balance		Netting		Cash Collateral		Balance
Current assets – other	$	100	$	(8)	$	14	$	106
Other noncurrent assets – other		128		(8)		-		120
Current liabilities – other		(67)		8		10		(49)
Noncurrent liabilities – other		(104)		8		7		(89)
Net commodity risk	$	57	$	-	$	31	$	88

At December 31, 2015, the Utility’s outstanding derivative balances were as follows:

	Commodity Risk
	Gross Derivative						Total Derivative
(in millions)	Balance		Netting		Cash Collateral		Balance
Current assets – other	$	97	$	(4)	$	25	$	118
Other noncurrent assets – other		172		(2)		-		170
Current liabilities – other		(102)		4		44		(54)
Noncurrent liabilities – other		(140)		2		21		(117)
Net commodity risk	$	27	$	-	$	90	$	117

Gains and losses associated with price risk management activities were recorded as follows:

	Commodity Risk
	Three Months Ended				Nine Months Ended
	September 30,				September 30,
(in millions)	2016		2015		2016		2015
Unrealized gain (loss) - regulatory assets and liabilities (1)	$	(29)	$	(45)	$	30	$	(69)
Realized gain (loss) - cost of electricity (2)		(7)		1		(48)		4
Realized loss - cost of natural gas (2)		(9)		(3)		(15)		(8)
Net commodity risk	$	(45)	$	(47)	$	(33)	$	(73)

(1) Unrealized gains and losses on commodity risk-related derivative instruments are recorded to regulatory liabilities or assets, respectively, rather than being recorded to the Condensed Consolidated Statements of Income. These amounts exclude the impact of cash collateral postings.

(2) These amounts are fully passed through to customers in rates. Accordingly, net income was not impacted by realized amounts on these instruments.

Cash inflows and outflows associated with derivatives are included in operating cash flows on the Utility’s Condensed Consolidated Statements of Cash Flows.

The majority of the Utility’s derivatives contain collateral posting provisions tied to the Utility’s credit rating from each of the major credit rating agencies. At September 30, 2016, the Utility’s credit rating was investment grade. If the Utility’s credit rating were to fall below investment grade, the Utility would be required to post additional cash immediately to fully collateralize some of its net liability derivative positions.

The additional cash collateral that the Utility would be required to post if the credit risk-related contingency features were triggered was as follows:

	Balance at
	September 30,		December 31,
(in millions)	2016		2015
Derivatives in a liability position with credit risk-related
contingencies that are not fully collateralized	$	(8)		$	(2)
Related derivatives in an asset position		4			-
Collateral posting in the normal course of business related to
these derivatives		2			-
Net position of derivative contracts/additional collateral
posting requirements (1)	$	(2)		$	(2)

(1) This calculation excludes the impact of closed but unpaid positions, as their settlement is not impacted by any of the Utility’s credit risk-related contingencies.