EITF Issue 15-A, Application of the Normal Purchases and Normal Sales Scope Exception to Certain Electricity Contracts within Nodal Energy Markets Education Session January 22, 2014 1
Overview and agenda Issue 15-A relates to whether certain contracts for the physical delivery of electricity through a nodal energy market should qualify for the normal purchases and normal sales (NPNS) scope exception to derivative accounting Agenda: - Evolution of nodal energy markets - ISO transmission charges and LMP pricing - NPNS scope exception guidance - Accounting alternatives (to allow or not allow NPNS) 2
Evolution of nodal energy markets Electricity is generally produced at a few relatively large generating plants in each region and must be transmitted over wires to end users Historically, power companies in the U.S. built, owned, and operated their own electricity grid transmission systems - In order to move power from generating plants to end users, each power company operated its transmission system to ensure electricity supply was balanced with electricity consumed. - That balance is important because electricity cannot be stored economically and, therefore, must be produced and delivered to end users in real time to maintain system integrity. During the early to mid 20 th century, power companies formed interconnection groups whereby several companies in the same geographic region connected their systems to: - Assure supply and demand was balanced over the entire interconnected grid - Provide access to electricity from multiple power generators - Improve grid reliability and reduce cost 3
Evolution of nodal energy markets (cont.) In the late 20 th century, changes in U.S. energy policy encouraged companies to join Regional Transmission Organizations (RTOs) - One of the goals was to promote competition in wholesale power prices to lower the overall cost of electricity for end users Under an RTO: - Transmission system operations are unbundled from other parts of the supply chain - Qualified market participants are given open access to the grid - Day-to-day operations of the grid are managed by an Independent System Operator (ISO) - The grid continues to be used to transport power from suppliers to users - There is no ability to reserve path-specific transmission capacity on a forward basis ISOs do not own the electricity grid. Rather, they are the operator that schedules the flow of electricity through the grid and maintains its reliability. Today there are seven ISOs / RTOs within the U.S. that coordinate the transmission of approximately two-thirds of the electricity consumed. 4
North American RTOs / ISOs 5
ISO transmission charges and LMP pricing ISOs charge market participants for their use of the grid - Transmission charges are based upon the difference between locational marginal pricing (LMP) at the delivery and withdrawal locations (or nodes ) LMP prices - Represent spot market prices at the respective nodes - Are the lowest cost of supplying the next increment of electric demand in order to balance supply and demand at a specific node - Fluctuate based on various supply and demand factors - Are designed using sophisticated techniques to capture the cost of electricity, recoup ISO operating costs (including payments to owners of transmission lines), and charge for congestion (the difference in prices between two nodes) and line loss Such a nodal energy market promotes: - Use of the most efficient (least costly) paths of transmission - Generation of electricity by the most efficient available power plants - Rerouting of excess requests to use any one path to the next least costly route 6
Simplified diagram of an ISO Generator Generator Generator 7
Topic 815 derivatives analysis A contract for the physical delivery of electricity on a forward basis meets the definition of a derivative when it has the following characteristics: - Underlying (the price of electricity) - Notional amount (typically, stated volume of megawatt-hours) - No initial net investment required - Net settlement (typically, through delivery of an asset that is readily convertible to cash or a market mechanism when there is a liquid market) Derivatives must be recognized at fair value each period as an asset or liability with changes in fair value recognized through earnings (or OCI if the derivatives qualify for cash flow hedge accounting) unless the contract qualifies for a scope exception, such as NPNS. 8
Normal purchases normal sales scope exception NPNS allows qualifying contracts to be accounted for under the accrual method rather than as a derivative NPNS is elective at any time, but irrevocable Requires documentation Net settlement of a contract designated as NPNS calls into question other similar contracts designated as NPNS In the utility industry, two discrete sets of criteria can be considered to meet the NPNS scope exception: - General exception (available to all entities) - Capacity contracts exception (specific to capacity contracts in the utility industry) 9
NPNS General criteria Normal terms and quantity - Contract terms must be consistent with the entity s normal purchases or normal sales - Judgment about an entity s needs for the related assets, the locations to which delivery is made, the entity s prior practices, etc., is required Clearly and closely related underlying - Contracts with a price that is not clearly and closely related to the asset being sold or purchased are not eligible for NPNS For example, a contract for the sale of grain based in part on changes in the S&P 500 index Probable physical settlement - Must be probable at inception and throughout the term that the contract will result in physical delivery 10
NPNS Capacity contracts criteria For both parties, the contract must: - Require physical delivery of electricity - Have an underlying that is clearly and closely related to electricity - Be a capacity contract an agreement by an owner of capacity to sell the right to that capacity to another party so it can satisfy its obligations For the seller of electricity, the contract must: - Involve electricity quantities expected to be sold in the normal course of business For the buyer of electricity: - The contract must: Involve electricity quantities expected to be used or sold in the normal course of business Be entered into to meet the buyer s obligation to maintain sufficient capacity, including a reasonable established reserve margin - The entity must: Be engaged in selling electricity to retail or wholesale customers Be statutorily or contractually obligated to maintain sufficient capacity to meet electricity needs of customers Certain option contracts and contracts subject to or scheduled to be booked-out are eligible 11
Example Forward electricity purchase contract Example: - PowerCo (a retail electric utility company that serves end-users in the PJM ISO) enters into a contract with Genco (a power generator) to purchase electricity on a forward basis - The forward purchase contract requires physical delivery of 100 thousand MWhs of electricity to Location B at $45 per MWh - PowerCo needs electricity at Location A in order to delivery and sell it to end-user customers - At the time of delivery, the LMP at Location B is $44.50 and the LMP at Location A is $46, therefore, PowerCo pays the ISO $1.50 per MWh - The forward purchase contract meets the definition of a derivative Question: Should the contract meet the physical delivery criterion of the NPNS scope exception? 12
Example Forward electricity purchase contract cash flows PowerCo pays GenCo $4,500,000 (100K MWhs @ $45) PowerCo pays ISO $150,000 [($44.50-46.00)*100K MWhs] 100K MWhs 100K MWhs 100K MWhs Generator Location B (LMP $44.50) Location A (LMP $46) End Users 13
View A: Electricity contracts for physical delivery within nodal energy markets should not be eligible for NPNS PowerCo buys from GenCo @ $45 then sells to ISO @ $44.50 ISO sells to PowerCo @ $46 100K MWhs 100K MWhs 100K MWhs Generator Location B (LMP $44.50) Location A (LMP $46) End Users 14
View A: Electricity contracts for physical delivery within nodal energy markets should not be eligible for NPNS (cont.) Proponent views: - PowerCo takes delivery at Location B then immediately sells the electricity to the ISO in the spot market based on the LMP at Location B. PowerCo then purchases the electricity from the ISO at Location A in the spot market. - Sale to the ISO at Location B constitutes net settlement of the forward purchase contract - The forward contract is merely a hedge of the price of electricity at Location A - Flash title at Location B does not constitute physical delivery under NPNS requirements 15
View A: Electricity contracts for physical delivery within nodal energy markets should not be eligible for NPNS (cont.) Proponent views (cont.): - ISO acts like a principal because it takes title to the electricity - ISO bills typically refer to purchases and sales of electricity - Payment to ISO is not merely a transportation charge because it is determined based upon the market price of electricity - Forward purchase contract is part of a series of sequential contracts intended to accomplish ultimate acquisition of electricity. Because delivery under the contract does not occur at PowerCo s customer load zone (Location A), the contract does not qualify. - PowerCo could have possibly contracted for delivery to Location A 16
View B: Electricity contracts for physical delivery within nodal energy markets should be eligible for NPNS PowerCo buys from GenCo @ $45 PowerCo incurs transmission charge @ $1.50 100K MWhs 100K MWhs 100K MWhs Generator Location B (LMP $44.50) Location A (LMP $46) End Users 17
View B: Electricity contracts for physical delivery within nodal energy markets should be eligible for NPNS (cont.) Proponent views: - The contract resulted in physical delivery from GenCo to PowerCo - Physical delivery is evident because each delivery of electricity into the grid results in a contemporaneous withdrawal - Current guidance for capacity contracts only necessitates the contract require physical delivery - PowerCo does not convert electricity purchased to cash, and its intent was not to speculate on electricity prices - ISO is not a principal in substance Although many ISOs take flash title, they are not market participants engaged in buying and selling electricity Title was conveyed to reduce credit exposure of all customers due to Federal regulations ISOs are required to be profit neutral 18
View B: Electricity contracts for physical delivery within nodal energy markets should be eligible for NPNS (cont.) Proponent views (cont.): - Payment to ISO is merely a transportation charge, and ISOs role is that of a facilitating counterparty - Prior to evolution to nodal energy markets, entities could procure electricity on a forward basis and assert NPNS. Because the physical nature of transmission has not changed, these contracts should continue to be eligible for NPNS. - Using the ISO for transmission is the only way to transact in a nodal energy market - Even if PowerCo could have contracted for delivery at Location A and asserted NPNS, this same issue would apply to the supplier s ability to assert NPNS for its delivery to Location A 19
Outreach Results from utility trade group survey: - Of the 12 respondents that transact in nodal energy markets, 10 assert NPNS for these types of contracts Outreach with users has indicated they do not believe that marking revenue and cost of sales transactions to market is decision-useful for routine transactions 20
Questions? 21