Physical forward contracts for the purchase or sale of coal may meet the definition of a derivative instrument. The key consideration in determining if a coal contract meets the definition of a derivative instrument is whether the contract meets the net settlement criterion. Figure 3-17 highlights the derivative evaluation for a typical coal contract; however, each contract should be evaluated based on its individual facts and circumstances.

Figure 3-17
Does a coal contract meet the definition of a derivative?

We would expect financially settled forward contracts for coal to meet the definition of a derivative and such contracts are not further discussed herein. In evaluating physically settled contracts for coal, the key question typically is whether the contract has the characteristic of net settlement.

Factors to consider in assessing whether coal contracts meet the net settlement criterion are further discussed in the following paragraphs. See UP 3.2.3 for further information on overall application of the net settlement criterion.

When evaluating whether the net settlement criterion is met, a reporting entity should first consider whether the contract explicitly or implicitly provides for net settlement of the entire contract. Forward contracts for coal typically require physical delivery and do not permit explicit net settlement. However, the type of contract and the terms should be carefully reviewed for any implicit net settlement terms or liquidating damage provisions that may imply that the contract could be net settled.

In this form of net settlement, one of the parties is required to deliver an asset, but there is an established market mechanism that facilitates net settlement outside the contract. ASC 815-10-15-110 through 15-116 provide indicators to consider in assessing whether an established market mechanism exists. A key aspect of a market mechanism is that one of the parties to the agreement can be fully relieved of its rights and obligations under the contract. We are not aware of any U.S. coal markets such that a provider has the ability to be relieved of its full rights and obligations under a previously executed contract.

Whether there is an active spot market for the particular product being sold under the contract is the key factor in assessing whether an asset is readily convertible to cash. To be deemed an active market, a market must have transactions with sufficient frequency and volume to provide pricing information on an ongoing basis. In addition, quoted prices from that market will be readily available on an ongoing basis. The analysis should consider the type of coal being sold in the contract and whether the transportation costs are at a level to support an assertion that the coal is readily convertible to cash (e.g., it may be too costly to transport the coal from the mine to a liquid trading hub). There may be some markets and mines where reporting entities have concluded that there is sufficient frequency and volume to support a conclusion that an active spot market exists for a particular type of coal and trading location. See UP 3.2.3.3 for information on evaluating the readily-convertible-to-cash criterion for commodities, including how to evaluate costs to transport a commodity to a liquid trading location.

A contract for coal may meet the net settlement criterion, depending on the type of contract and the related markets. Reporting entities should revisit this conclusion periodically as markets may evolve, potentially changing the conclusion. If a reporting entity concludes a coal contract does not meet the definition of a derivative because it fails the net settlement criterion, it may also consider conditionally designating the contracts under the normal purchases and normal sales scope exception if physical delivery is probable throughout the life of the contract and the other criteria for application of this exception are met. If a conditionally designated normal purchases and normal sales contract meets the definition of a derivative at a later date, it would be accounted for as a normal purchases and normal sales contract from the time the contract becomes a derivative. See UP 3.3.1 for further information.

Retail electricity contracts typically result in the physical delivery of electric energy to an end user, such as a retail consumer or direct access customer. Retail contracts for delivery of electric energy may meet the definition of a derivative, if the contract has a notional amount and the net settlement criterion is met. Figure 3-18 highlights the derivative evaluation for a typical retail electricity contract; however, each contract should be evaluated based on its individual facts and circumstances.

Figure 3-18
Does a retail electricity contract meet the definition of a derivative?

Although this type of contract is typically structured to meet the needs of one of the parties to the contract (i.e., a requirements contract), it may still meet the definition of a derivative. A reporting entity will need to analyze the terms of the contract to determine whether the contract contains a notional amount and whether it meets the criterion of net settlement.

In evaluating a retail electricity sales agreement, the parties should consider whether the contract contains a notional amount. In particular, many retail electricity contracts are requirements contracts that are designed to meet the needs of the retail customer, with purchases limited to the amount needed for the customer’s own use. In such cases, unless the contract specifies a minimum quantity, there would be no notional amount. However, if the contract does not limit purchases for the off-taker’s own use, the contract may have a notional amount and further evaluation under the net settlement criteria will be required. See UP 3.2 for further information on evaluating whether a contract has a notional amount.

As further discussed in ASC 815-10-15-83(c), there are three possible forms of net settlement: net settlement under the contract terms, net settlement through a market mechanism, and net settlement because the contract requires delivery of an asset that is readily convertible to cash. Retail electricity sales agreements typically require physical delivery and do not permit explicit net settlement. Furthermore, because the notional, if any, is not usually a standard market quantity, there would be no market mechanism for net settlement. Therefore, the key question is whether the parties to the contract have access to a market where power is readily convertible to cash. This assessment will depend on the price of transmission to access a liquid market hub from the delivery point (see UP 3.2.3.3 Access to an active market). The fact that one of the parties to the contract (i.e., the retail customer) may not have the knowledge to access the market would not change the conclusion that the contract is readily convertible to cash.

A retail electricity sales agreement may meet the definition of a derivative, depending on whether the contract has a notional amount and the energy can be sold in a liquid market.

Retail power sales contracts that meet the definition of a derivative may be designated as normal purchases and normal sales if delivery is probable throughout the term of the contract and all other requirements are met. To designate the contract as a normal purchase or normal sale, the reporting entity will need to support the assertion that delivery is probable and that the other criteria for designation as normal are met (see UP 3.3.1).

In some situations, a retail contract for a fixed quantity may exceed the off-taker’s forecasted needs in some hours of the day or periods during the year and as a result, the power in those periods would not be delivered. In such cases, the contract would not qualify for the normal purchases and normal sales scope exception for either party because physical delivery is not probable, even if the excess quantities are not significant in relation to the overall contract. In accordance with ASC 815-10-15-35, physical delivery must be “probable at inception and throughout the term of the individual contract.” As such, a contract that may settle net in some periods would not meet this assertion.

Additionally, if a reporting entity concludes that a retail electricity sales agreement does not meet the definition of a derivative because it fails the net settlement criterion, it may also consider conditionally designating the contract under the normal purchases and normal sales scope exception if physical delivery is probable throughout the life of the contract and the other criteria for application of this exception are met. If a conditionally designated normal purchases and normal sales contract meets the definition of a derivative at a later date, the contract would be accounted for as a normal purchases and normal sales contract from the time it becomes a derivative. Absent such a designation, the reporting entity would be required to initially fair value the contract at the time the contract is determined to be a derivative. See UP 3.3.1 for further information on the normal purchases and normal sales scope exception.

Retail electricity contracts may also include ancillary services or other products such as capacity, renewable energy credits, energy-efficiency equipment, demand-side management, or maintenance. Retail contracts that include multiple deliverables would not meet the definition of a derivative in their entirety unless the contract has explicit or implicit net settlement provisions. However, the reporting entity should analyze the contract to determine if it includes one or more embedded derivatives that require separation from the host contract. Figure 3-19 summarizes this analysis.

Figure 3-19
Does a retail electricity contract with multiple products and/or services include an embedded power derivative that requires separation?

In evaluating this type of contract, the reporting entity should first assess whether the energy component is clearly and closely related to the other products or services in the contract. A retail electricity contract that includes more than the sale of energy often provides for the delivery of multiple products or services at different times. Furthermore, although some of the contractual elements may impact power consumption (e.g., energy-efficient equipment, demand-side management services), the value and cost of these products or services are separate from the energy. As such, the energy component generally is not clearly and closely related to these other products and services due to their nature, and bifurcation of the contract would be required. See UP 3.4.3 for further information on the clearly and closely related assessment for contracts with multiple products.

The determination of whether a separate instrument with the same terms would meet the definition of a derivative for the energy component is performed in a manner consistent with the evaluation of a stand-alone power agreement.

Seasonal power exchange contracts typically result in the physical delivery of electric energy over a period of time or at a certain location in exchange for physical receipt of energy at a future point in time and/or in a different location. Seasonal power exchanges may be executed to enhance system reliability or to help utilities balance their available generation resources with their load requirements. These contracts are often highly structured and the derivative determination may be complex, with varying conclusions depending on the specific contract terms. In addition, the assessment may change over the various stages of the contract. Figure 3-20 highlights the derivative evaluation for a typical seasonal power exchange contract; however, each contract should be evaluated based on its individual facts and circumstances.

Figure 3-20
Does a seasonal power exchange contract meet the definition of a derivative?

Factors to consider in assessing the accounting for a seasonal power exchange are further discussed below. See UP 3.2.1 and UP 3.2.3 for further information on the determination of notional amounts and evaluation of embedded derivatives, respectively.

Determining whether a contract has a notional amount is often the most difficult aspect of evaluating a seasonal exchange contract, particularly if the contract includes more than one exchange or some form of optionality. Reporting entities should evaluate all aspects of the contract, such as the initial delivery provisions, return requirements, and any provisions for net settlement or optional repayment in lieu of return of energy.

Seasonal power exchange contracts that specify the quantity, delivery period, and delivery location for both the initial delivery and the return of energy have a notional amount and should be accounted for as a derivative. Upon initial delivery, the receiving utility has a payable for the return of power, while the delivering party has a receivable. The asset or liability is a hybrid instrument comprising a payable or receivable and a forward contract for the future delivery or receipt of energy. The value of the receivable or payable will fluctuate with power price changes. As a result, once the initial leg of the power exchange is delivered, the remainder of the contract is a hybrid instrument with an embedded derivative (the forward purchase or sale of power) that should be separated.

Figure 3-21
Does a seasonal exchange include an embedded derivative after initial delivery occurs?

Even if the contract in its entirety does not meet the definition of a derivative, derivative accounting may be applicable after the initial energy is delivered.

Seasonal power exchange contracts are usually intended to help balance load requirements, provide system reliability, or meet other operational needs. Therefore, the initial leg of the transaction, as well as the embedded derivative will often qualify for the normal purchases and normal sales scope exception (see the response to Question 3-22). However, if the contract includes optionality with respect to timing and volumes of delivery, or net settlement provisions in lieu of return of energy as an option of one of the parties, the embedded forward purchase or sale (created after the initial delivery) would not qualify for the normal purchases and normal sales scope exception if physical delivery is not probable.

In a typical tolling agreement, one party provides the fuel source for a specific power generation facility in exchange for the energy and capacity from the power plant. A plant-specific contract should initially be assessed to determine if it contains a lease (see UP 1 and UP 2). If the contract does not contain a lease, the reporting entity should next assess whether it is a derivative in its entirety. A reporting entity should then consider whether the contract contains any embedded derivatives requiring separation from the host contract (unless the contract is a derivative in its entirety). The following analysis assumes that the tolling agreement is not a lease.

The determination of whether a tolling agreement is a derivative or contains one or more embedded derivatives will depend on the terms of the contract as well as the market in which delivery is required. Key questions to consider in the evaluation of this type of contract are highlighted below; however, individual contracts will require further evaluation based on the specific contract terms. Tolling agreements are not standard and the underlying markets vary significantly across the United States.

The determination of whether the contract has a notional amount will depend on the specific terms of the contract. Some tolling agreements are for a specified quantity of energy and capacity, while other contracts may be for all or a portion of the capacity and production from a specific plant. In such cases, the reporting entity will need to consider the default provisions and other relevant terms to determine if there is a notional. See UP 3.2.1 for further information on the assessment of notional amount. If the contract does not have a notional amount, no further evaluation under the derivative framework is required.

The key factor in determining whether the contract is a derivative in its entirety is whether the contract has the characteristic of net settlement. As further discussed in ASC 815-10-15-83(c), there are three possible forms of net settlement: net settlement under the contract terms, net settlement through a market mechanism, and net settlement because the contract requires delivery of an asset that is readily convertible to cash.

Most tolling agreements do not include explicit net settlement provisions and currently there are no market mechanisms to net settle a long-term power supply contract in the United States. However, the evaluation of whether the contract requires delivery of an asset that is readily convertible to cash will depend on the specific local market for power. In many parts of the United States, the markets for power and capacity have been unbundled and there is no market for a combined capacity and power product. However, in other situations, the standard power product may include bundled capacity. In such cases, the reporting entity may conclude that the contract meets the definition of a derivative, if all applicable criteria are met.

We are not aware of a market mechanism or active spot market for tolling agreements and thus we believe that derivative accounting is generally not applicable to these contracts as a whole. However, as noted above, there may be circumstances where the market standard power product includes bundled capacity, resulting in a conclusion that the contract is a derivative in its entirety. If the agreement is not a derivative in its entirety, the reporting entity should perform further evaluation to determine if the contract includes one or more embedded derivatives.

The next step in the analysis is to determine if the power or capacity supplied under the agreement is an embedded derivative that requires separation from the host contract. The analysis for capacity contracts will be similar to that for a stand-alone contract for capacity as discussed in UP 3.6.1. Figure 3-22 summarizes the key considerations for the separate power component in a typical tolling agreement. However, each contract should be evaluated based on its individual facts and circumstances.

Figure 3-22
Does a tolling agreement include an embedded power derivative that requires separation?

If the energy portion of the contract is an embedded derivative that requires separation, it may be eligible for designation as a normal purchase or normal sale or as a hedge, if the applicable criteria are met.

Bilateral transmission contracts generally will not meet the definition of a derivative. Note that transmission-related contracts in an environment where there is a regional transmission organization may have additional considerations and are not addressed in the following discussion. See UP 4 for information on regional transmission organizations and related contracts. Figure 3-23 highlights the derivative evaluation for a typical transmission contract; however, each contract should be evaluated based on its individual facts and circumstances.

Figure 3-23
Does a transmission contract meet the definition of a derivative?

Transmission contracts are not usually financially settled; however, if this type of contract included terms that required explicit or implicit net settlement, we would expect it to meet the definition of a derivative. In general, transmission contracts do not meet the definition of a derivative because they fail the net settlement criterion. As further discussed in ASC 815-10-15-83(c), there are three possible forms of net settlement: net settlement under the contract terms, net settlement through a market mechanism, and net settlement by delivery of an asset that is readily convertible to cash. Factors to consider in assessing whether transmission contracts meet the net settlement criterion are further discussed in the following paragraphs. See UP 3.2.3 for further information on overall application of the net settlement criterion.

When evaluating whether the net settlement criterion is met, a reporting entity should first consider whether the contract explicitly or implicitly provides for net settlement of the entire contract. Forward contracts for transmission typically require physical delivery and do not permit explicit net settlement. However, the type of contract and the terms should be carefully reviewed for any implicit net settlement terms or liquidating damage provisions that may imply that the contract could be net settled.

In this form of net settlement, one of the parties is required to deliver an asset, but there is an established market mechanism that facilitates net settlement outside the contract. ASC 815-10-15-110 through 15-116 provide indicators to consider in assessing whether an established market mechanism exists. A key aspect of a market mechanism is that one of the parties to the agreement can be fully relieved of its rights and obligations under the contract. We are not aware of any markets in the United States for traditional transmission contracts such that a provider has the ability to be relieved of its full rights and obligations under a previously executed contract.

Whether there is an active spot market for the particular product being sold under the contract is the key factor in assessing whether an asset is readily convertible to cash. Current market conditions should always be considered in this analysis. To be deemed an active market, a market must have transactions with sufficient frequency and volume to provide pricing information on an ongoing basis. In addition, quoted prices from that market will be readily available on an ongoing basis. See UP 3.2.3.3 for further information on the determination of whether a market is active. We are not aware of any active spot markets for transmission in the United States.

We are not aware of a market mechanism or active spot market for transmission and thus we believe that derivative accounting is generally not applicable to these contracts. However, a reporting entity should evaluate all facts and circumstances in concluding on the appropriate accounting for transmission contracts, including whether there is a market mechanism or active spot market. In addition, a reporting entity should monitor its conclusion periodically as markets may evolve, potentially rendering this type of contract a derivative.

Reporting entities may also consider conditionally designating transmission contracts under the normal purchases and normal sales scope exception if physical delivery is probable throughout the life of the contract and the other criteria for application of this exception are met (ASC 815-10-15-22 through 15-51 as applicable). If a conditionally designated normal purchases and normal sales contract meets the definition of a derivative at a later date, it would be accounted for as a normal purchases and normal sales contract from the time the contract becomes a derivative. Absent such a designation, the reporting entity would be required to record the contract at its fair value at the time it becomes a derivative. See UP 3.3.1 for further information on the normal purchases and normal sales scope exception.

Some transmission contracts may contain a lease. For example, a transmission contract for the entire use of a dedicated line with variable pricing as specified in the contract would likely represent a lease of the specified transmission assets. Whether a contract contains a lease should be determined prior to evaluating whether it is a derivative or contains one or more embedded derivatives. See UP 2 for further information on lease accounting considerations.

A forward contract for the physical purchase or sale of water generally will not meet the definition of a derivative instrument because it fails the net settlement criterion. Figure 3-24 highlights the derivative evaluation for a typical water contract; however, each contract should be evaluated based on its individual facts and circumstances.

Figure 3-24
Is a forward physical sale or purchase of water a derivative?

In general, a physically settled water contract does not meet the definition of a derivative because it fails the net settlement criterion.

Typically, water-related contracts are not financially settled; however, if a contract with an underlying of water was to be financially settled we would expect it to meet the definition of a derivative. Factors to consider in assessing whether physically settled water contracts meet the net settlement criterion are discussed in the following paragraphs. See UP 3.2.3 for further information on overall application of the net settlement criterion.

When evaluating whether the net settlement criterion is met, a reporting entity should first consider whether the contract explicitly or implicitly provides for net settlement of the entire contract. Forward contracts for water typically require physical delivery and do not permit explicit net settlement. However, the contract terms should be carefully reviewed for any terms or liquidating damage provisions that the contract could be net settled.

In this form of net settlement, one of the parties is required to deliver an asset, but there is an established market mechanism that facilitates net settlement outside the contract. ASC 815-10-15-110 through 15-116 provide indicators to consider in assessing whether an established market mechanism exists. A key aspect of a market mechanism is that one of the parties to the agreement can be fully relieved of its rights and obligations under the contract. We are not aware of any markets in the United States for water such that a provider has the ability to be relieved of its full rights and obligations under a previously executed contract.

Whether there is an active spot market for the particular product being sold under the contract is the key factor in assessing whether an asset is readily convertible to cash. Current market conditions should always be considered in this analysis. To be deemed an active market, a market must have transactions with sufficient frequency and volume to provide pricing information on an ongoing basis. In addition, quoted prices from that market will be readily available on an ongoing basis (see UP 3.2.3.3 for further information on active markets). We are not aware of any active spot markets for water.

We are not aware of a market mechanism or active spot market for water and thus we believe that derivative accounting is generally not applicable to these contracts. However, a reporting entity should evaluate all facts and circumstances in concluding on the appropriate accounting for water contracts, including evaluating whether there is a market mechanism or active spot market. In addition, a reporting entity should monitor its conclusion periodically as markets evolve, potentially rendering this type of contract a derivative. In addition, reporting entities should evaluate this type of contract to determine if there are any embedded derivatives that require separation.

Reporting entities may also consider conditionally designating these contracts under the normal purchases and normal sales scope exception if physical delivery is probable throughout the life of the contract and the other criteria for application of this exception are met (ASC 815-10-15-22 through 15-51 as applicable). If a conditionally designated normal purchases and normal sales contract meets the definition of a derivative at a later date, it would be accounted for as a normal purchases and normal sales contract from the time the contract becomes a derivative. Absent such a designation, the reporting entity would be required to record the contract at its fair value at the time the contract becomes a derivative. See UP 3.3.1 for further information on the normal purchases and normal sales scope exception.

ASC 815-10-15-59 provides a specific scope exception for non-exchange-traded contracts with an underlying based on a climatic or geological variable, such as a weather-related contract with pricing based on the number of cooling-degree days. Consistent with this exception, derivative accounting is only applicable to weather-related contracts traded on an exchange.

However, ASC 815-45 does provide specific nonderivative guidance on accounting for non-exchange-traded weather derivatives. The guidance includes two different accounting models, depending on the reporting entity’s purpose for executing the contracts. The models are summarized in Figure 3-25 and further discussed in ASC 815-45.

Figure 3-25
Weather derivative contract accounting models

______________

¹ As discussed in ASC 815-45-30-3A, a purchased or written option may contain an embedded premium or discount if the contract terms are not consistent with current market terms. In those circumstances, the embedded premium or discount should be quantified, removed from the quantified strike price, and accounted for following the guidance for premiums and discounts.

The accounting model applied largely depends on whether a non-exchange-traded weather derivative was executed as part of a reporting entity’s trading activities. ASC 815-45-55-1 through 55-6 provide guidance on identifying trading activities relating to weather derivatives, including fundamental and secondary indicators.

ASC 815-45-20 defines trading as follows:

Overall, a reporting entity is considered to be involved in trading activities related to weather derivatives if it enters into the contracts with an objective of generating short-term profits from the contracts. In accordance with ASC 815-45-55-1, the evaluation of trading versus nontrading should be performed based on the activities of an organization or legal entity. However, if a reporting entity conducts both trading and nontrading activities and those activities are not segregated in such a manner, contracts should be evaluated at inception in accordance with the indicators outlined in ASC 815-45-55-1 through 55-6 to determine if they are trading or nontrading. Only those contracts that are deemed trading should be accounted for at fair value. See UP 3.7 for further information on trading activities.

In general, nontrading weather derivatives are accounted for using the intrinsic value method described in ASC 815-45-35-2. ASC 815-45-55-7 through 55-11 provide application examples, including sample calculations and accounting assuming that the contracts were executed as part of a reporting entity’s nontrading operations. In addition, reporting entities should recognize subsequent changes in the fair value of nontrading written option contracts instead of following the intrinsic value method.

In accordance with ASC 815-45-50-1, non-exchange-traded weather derivatives are financial instruments; therefore, these transactions are subject to the disclosure requirements for financial instruments in ASC 825, Financial Instruments (ASC 825).