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Risk Management and Financial Instruments

Risk Management and Financial Instruments

Financial Risks and Financial Instruments

Risk Management Overview

TransCanada has exposure to market risk, counterparty credit risk, and liquidity risk. TransCanada engages in risk management activities with the primary objective being to protect earnings, cash flow and, ultimately, shareholder value.

Risk management strategies, policies and limits are designed to ensure TransCanada's risks and related exposures are in line with the Company's business objectives and risk tolerance. Risks are managed within limits ultimately established by the Company's Board of Directors, implemented by senior management and monitored by risk management and internal audit personnel. The Board of Directors' Audit Committee oversees how management monitors compliance with risk management policies and procedures, and oversees management's review of the adequacy of the risk management framework. Internal audit personnel assist the Audit Committee in its oversight role by performing regular and ad-hoc reviews of risk management controls and procedures, the results of which are reported to the Audit Committee. The Board of Directors also has a Governance Committee that assists in overseeing the risk management activities of TransCanada. The Governance Committee monitors, reviews with management and makes recommendations related to TransCanada's risk management programs and policies on an ongoing basis.

Market Risk

The Company constructs and invests in large infrastructure projects, purchases and sells commodities, issues short-term and long-term debt, including amounts in foreign currencies, and invests in foreign operations. These activities expose the Company to market risk from changes in commodity prices, foreign exchange rates and interest rates, which affect the Company's earnings and the value of the financial instruments it holds.

The Company uses derivatives as part of its overall risk management policy to manage exposure to market risk that results from these activities. Derivative contracts used to manage market risk generally consist of the following:

  • Forwards and futures contracts — contractual agreements to purchase or sell a specific financial instrument or commodity at a specified price and date in the future. TransCanada enters into foreign exchange and commodity forwards and futures to mitigate the impact of volatility in foreign exchange rates and commodity prices.
  • Swaps — contractual agreements between two parties to exchange streams of payments over time according to specified terms. The Company enters into interest rate, cross-currency and commodity swaps to mitigate the impact of changes in interest rates, foreign exchange rates and commodity prices.
  • Options — contractual agreements to convey the right, but not the obligation, of the purchaser to buy or sell a specific amount of a financial instrument or commodity at a fixed price, either at a fixed date or at any time within a specified period. The Company enters into option agreements to mitigate the impact of changes in interest rates, foreign exchange rates and commodity prices.

Commodity Price Risk

The Company is exposed to commodity price movements as part of its normal business operations, particularly in relation to the prices of electricity, natural gas and oil products. A number of strategies are used to mitigate these exposures, including the following:

  • Subject to the Company's overall risk management policies, the Company commits a significant portion of its expected power supply to fixed-price medium-term or long-term sales contracts, while reserving an amount of unsold supply to mitigate price risk in its asset portfolio.
  • The Company purchases a portion of the natural gas and oil products required for its power plants or enters into contracts that base the sales price of electricity on the cost of natural gas, effectively locking in a margin. A significant portion of the electricity needed to fulfill the Company's power sales commitments is purchased with contracts or fulfilled through power generation, thereby reducing the Company's exposure to fluctuating commodity prices.
  • The Company enters into offsetting or back-to-back positions and derivative financial instruments to manage price risk exposure in power and natural gas commodities created by certain fixed and variable pricing arrangements for different pricing indices and delivery points.

TransCanada manages its exposure to seasonal natural gas price spreads in its natural gas storage business by economically hedging storage capacity with a portfolio of third-party storage capacity contracts and proprietary natural gas purchases and sales. TransCanada simultaneously enters into a forward purchase of natural gas for injection into storage and an offsetting forward sale of natural gas for withdrawal at a later period, thereby locking in future positive margins and effectively eliminating exposure to price movements of natural gas. Fair value adjustments recorded each period on proprietary natural gas storage inventory and these forward contracts may not be representative of the amounts that will be realized on settlement.

Natural Gas Inventory Price Risk

At December 31, 2008, $76 million (2007 — $190 million) of proprietary natural gas inventory was included in Inventories. TransCanada measures its proprietary natural gas inventory held in storage at the one-month forward price for natural gas less selling costs. The Company did not have any proprietary natural gas inventory held in storage prior to April 2007. In 2008, the net change in fair value of proprietary natural gas held in inventory was a net unrealized loss of $7 million (2007 — nil), which was recorded as a decrease to Revenue and Inventory. In 2008, the net change in fair value of natural gas forward purchases and sales contracts was a net unrealized gain of $7 million (2007 — $10 million) which was included in Revenues.

Foreign Exchange and Interest Rate Risk

Foreign exchange and interest rate risk is created by fluctuations in the fair value or cash flow of financial instruments due to changes in foreign exchange rates and/or market interest rates.

A portion of TransCanada's earnings from its Pipelines and Energy operations is generated in U.S. dollars and is subject to currency fluctuations. The performance of the Canadian dollar relative to the U.S. dollar can affect TransCanada's earnings. This foreign exchange impact is offset by certain related debt and financing costs being denominated in U.S. dollars and by the Company's hedging activities. Due to its increased U.S. operations, TransCanada has a greater exposure to U.S. currency fluctuations than in prior years.

The Company uses foreign currency and interest rate derivatives to manage the foreign exchange and interest rate risks related to its debt and other U.S. dollar-denominated transactions, and to manage the interest rate exposure of the Canadian Mainline, Alberta System and Foothills operations. Certain of the realized gains and losses on these derivatives are shared with shippers on predetermined terms. These gains and losses are deferred as regulatory assets and liabilities until they are recovered from or paid to the shippers in accordance with the terms of the shipping agreements.

TransCanada has floating interest rate debt, which subjects it to interest rate cash flow risk. The Company uses a combination of forwards, interest rate swaps and options to manage its exposure to this risk.

Net Investment in Self-Sustaining Foreign Operations

The Company hedges its net investment in self-sustaining foreign operations (on an after-tax basis) with U.S. dollar-denominated debt, forward foreign exchange contracts, cross-currency interest rate swaps and foreign exchange options. At December 31, 2008, the Company had designated as a net investment hedge U.S. dollar-denominated debt with a carrying value of $7.2 billion (US$5.9 billion) (2007 — $4.7 billion (US$4.7 billion)) and a fair value of $5.9 billion (US$4.8 billion) (2007 — $4.8 billion (US$4.8 billion)). In January 2009, the Company issued an additional US$2.0 billion of long-term debt and designated it as a hedge of the net U.S. dollar investment in foreign operations. At December 31, 2008, $254 million was included in Deferred Amounts for the fair value of the forwards, swaps and options used to hedge the Company's net U.S. dollar investment in foreign operations.

The fair values and notional or principal amount for the derivatives designated as a net investment hedge were as follows:

  2008 2007
Asset/(Liability)
December 31
(millions of dollars)

Fair Value
Notional or Principal
Amount

Fair Value
Notional or Principal
Amount
U.S. dollar cross-currency swaps        
(maturing 2009 to 2014) (218) U.S. 1,650 77  U.S. 350
U.S. dollar forward foreign exchange contracts        
(maturing 2009) (42) U.S. 2,152 (4) U.S. 150
U.S. dollar options        
(maturing 2009) 6   U.S. 300 U.S. 600
  (254) U.S. 4,102 76  U.S. 1,100

Counterparty Credit Risk

Counterparty credit risk represents the financial loss the Company would experience if a counterparty to a financial instrument failed to meet its obligations in accordance with the terms and conditions of its contracts with the Company.

Counterparty credit risk is managed through established credit management techniques, including conducting financial and other assessments to establish and monitor a counterparty's creditworthiness, setting exposure limits, monitoring exposures against these limits, using master netting arrangements and obtaining financial assurances where warranted. In general, financial assurances include guarantees, letters of credit and cash. The Company monitors and manages its concentration of counterparty credit risk on an ongoing basis. The Company believes these measures minimize its counterparty credit risk but there is no certainty that these processes will protect it against all losses.

TransCanada has significant credit and performance exposures to financial institutions as they provide committed credit lines and cash deposit facilities, critical liquidity in the foreign exchange derivative, interest rate derivative and energy wholesale markets, and letters of credit to mitigate TransCanada's exposure to non-credit worthy counterparties.

During the deterioration of global financial markets in 2008, TransCanada continued to closely monitor and reassess the creditworthiness of its counterparties, including financial institutions. This has resulted in TransCanada reducing or mitigating its exposure to certain counterparties where it is deemed warranted and permitted under contractual terms. As part of its ongoing operations, TransCanada must balance its market risk and counterparty credit risk when making business decisions.

Certain subsidiaries of Calpine filed for bankruptcy protection in both Canada and the U.S. in 2005. Gas Transmission Northwest Corporation (GTNC) and Portland Natural Gas Transmission System (PNGTS) reached agreements with Calpine for allowed unsecured claims in the Calpine bankruptcy. In February 2008, GTNC and PNGTS received initial distributions of 9.4 million common shares and 6.1 million common shares of Calpine, respectively, which represented approximately 85 per cent of their agreed-upon claims. In 2008, these shares were subsequently sold into the open market and resulted in total pre-tax gains of $279 million. Claims by NOVA Gas Transmission Limited and Foothills Pipe Lines (South B.C.) Ltd. for $32 million and $44 million, respectively, were received in cash in January 2008 and will be passed on to shippers on these systems. At December 31, 2008, $22 million remained in regulatory liabilities for these claims.

Liquidity Risk

Liquidity risk is the risk that TransCanada will not be able to meet its financial obligations as they fall due. The Company's approach to managing liquidity risk is to ensure that, under both normal and stressed conditions, it always has sufficient cash and credit facilities to meet its obligations when due without incurring unacceptable losses or damage to the Company's reputation.

Management forecasts cash flows for a period of 12 months to identify financing requirements. These requirements are then managed through a combination of committed and demand credit facilities and access to capital markets. The Company's liquidity and cash flow management is also discussed in the "Liquidity and Capital Resources" and "Contractual Obligations" sections of this MD&A.

Fair Values

The fair value of financial instruments included in Cash and Cash Equivalents, Accounts Receivable, Other Assets, Notes Payable, Accounts Payable, Accrued Interest and Deferred Amounts approximates their carrying amounts due to the nature of the item and/or the short time to maturity. The fair value of foreign exchange and interest rate derivatives has been calculated using year-end market rates. The fair value of power, natural gas and oil products derivatives has been calculated using quoted market prices where available. In the absence of quoted market prices, third-party broker quotes are used. Credit risk has been taken into consideration when calculating fair values.

Valuation techniques that refer to observable market data or estimated market prices may also be used to calculate fair value. These include comparisons with similar instruments that have observable market prices, option pricing models and other valuation techniques commonly used by market participants. Fair values determined using valuation models require the use of assumptions about the amount and timing of estimated future cash flows and discount rates. In making these assumptions, the Company looks primarily to readily observable external market input factors such as interest rate yield curves, currency rates and price and rate volatilities, as applicable.

The fair value of the Company's Long-Term Debt was estimated based on quoted market prices for the same or similar debt instruments and, when such information was not available, was estimated by discounting future payments of interest and principal at estimated interest rates that were made available to the Company.

Non-Derivative Financial Instruments Summary

The carrying and fair values of non-derivative financial instruments were as follows:

  2008 2007
December 31 (millions of dollars) Carrying Amount Fair Value Carrying Amount Fair Value
Financial Assets(1)        
Cash and cash equivalents 1,308 1,308 504 504
Accounts receivable and other assets(2)(3) 1,404 1,404 1,231 1,231
Available-for-sale assets(2) 27 27 17 17
  2,739 2,739 1,752 1,752
Financial Liabilities(1)(3)        
Notes payable 1,702 1,702 421 421
Accounts payable and deferred amounts(4) 1,372 1,372 1,193 1,193
Accrued interest 359 359 261 261
Long-term debt and junior subordinated notes 17,367 16,152 13,908 15,334
Long-term debt of joint ventures 1,076 1,052 903 937
Other long-term liabilities of joint ventures(4) 60 60
  21,876 20,637 16,746 18,206
(1) Consolidated Net Income in 2008 and 2007 included unrealized gains or losses of nil for the fair value adjustments to each of these financial instruments.
(2) At December 31, 2008, the Consolidated Balance Sheet included financial assets of $1,257 million (2007 — $1,018 million) in Accounts Receivable and $174 million (2007 — $230 million) in Other Assets.
(3) Recorded at amortized cost, except for certain Long-Term Debt which is adjusted to fair value.
(4) At December 31, 2008, the Consolidated Balance Sheet included financial liabilities of $1,350 million (2007 — $1,175 million) in Accounts Payable and $22 million (2007 — $78 million) in Deferred Amounts.

Derivative Financial Instruments Summary

Information for the Company's derivative financial instruments is as follows:

  2008
December 31
(all amounts in millions unless otherwise indicated)
Power Natural
Gas
Oil
Products
Foreign
Exchange
Interest
Derivative Financial Instruments Held for Trading          
Fair Values(1)          
Assets $132  $144  $10  $41  $57 
Liabilities $(82) $(150) $(10) $(55) $(117)
Notional Values          
Volumes(2)          
Purchases
4,035  172  410     
Sales
5,491  162  252     
Canadian dollars         1,016 
U.S. dollars       U.S. 479  U.S. 1,575 
Japanese yen (in billions)       JPY 4.3   
Cross-currency       227/U.S. 157   
Net unrealized gains/(losses) in the year(3) $24  $(23) $1  $(9) $(61)
Net realized gains/(losses) in the year(3) $23  $(2) $1  $6  $13 
Maturity dates 2009-2014  2009-2011  2009  2009-2012  2009-2018 
           
Derivative Financial Instruments in Hedging Relationships(4)(5)          
Fair Values(1)          
Assets $115  $–  $–  $2  $8 
Liabilities $(160) $(18) $–  $(24) $(122)
Notional Values          
Volumes(2)          
Purchases
8,926  9       
Sales
13,113         
Canadian dollars         50 
U.S. dollars       U.S. 15  U.S. 1,475 
Cross-currency       136/U.S. 100   
Net realized (losses)/gains in the year(3) $(56) $15  $–  $–  $(10)
Maturity dates 2009-2014  2009-2011    2009-2013  2009-2019 
(1) Fair value is equal to the carrying value of these derivatives.
(2) Volumes for power, natural gas and oil products derivatives are in gigawatt hours, billion cubic feet and thousands of barrels, respectively.
(3) All power, natural gas and oil products realized and unrealized gains and losses are included in Revenues. All interest rate and foreign exchange realized and unrealized gains and losses are included in Financial Charges and Interest Income and Other, respectively. Realized gains and losses are included in Net Income upon settlement of the financial instrument.
(4) All hedging relationships are designated as cash flow hedges except for interest-rate derivative financial instruments designated as fair value hedges with a fair value of $8 million. In 2008, the Company did not record any amounts in Net Income related to ineffectiveness for fair value hedges.
(5) In 2008, Net Income included losses of $6 million for the changes in fair value of power and natural gas cash flow hedges that were ineffective in offsetting the change in fair value of their related underlying positions. In 2008, there were no gains or losses included in Net Income for discontinued cash flow hedges.

The anticipated timing of settlement of the derivative contracts assumes no changes in commodity prices, interest rates and foreign exchange rates from December 1, 2008. Actual settlements will vary based on changes in these factors. The anticipated timing of settlement of these contracts is as follows:

(millions of dollars) Total  2009  2010 
and 2011 
2012 
and 2013 
2014 and 
Thereafter 
Derivative financial instruments held for trading (30) 38  (46) (14) (8)
Derivative financial instruments in hedging relationships (199) (68) (65) (43) (23)
  (229) (30) (111) (57) (31)

Derivative Financial Instruments Summary

Information for the Company's derivative financial instruments is as follows:

  2007
December 31
(all amounts in millions unless otherwise indicated)
Power  Natural 
Gas 
Foreign 
Exchange 
Interest 
Derivative Financial Instruments Held for Trading        
Fair Values(1)        
Assets $55  $43  $11  $23 
Liabilities $(44) $(19) $(79) $(18)
Notional Values        
Volumes(2)        
Purchases
3,774  47  –  – 
Sales
4,469  64  –  – 
Canadian dollars –  –  –  615 
U.S. dollars –  –  U.S. 484  U.S. 550 
Japanese yen (in billions) –  –  JPY 9.7  – 
Cross-currency –  –  227/U.S. 157  – 
Net unrealized gains/(losses) in the year(3) $16  $(10) $8  $(5)
Net realized (losses)/gains in the year(3) $(8) $47  $39  $5 
Maturity dates 2008-2016  2008-2010  2008-2012  2008-2016 
         
Derivative Financial Instruments in Hedging Relationships(4)(5)        
Fair Values(1)        
Assets $135  $19  $–  $2 
Liabilities $(104) $(7) $(62) $(16)
Notional Values        
Volumes(2)        
Purchases
7,362  28  –  – 
Sales
16,367  –  – 
Canadian dollars –  –  –  150 
U.S. dollars –  –  U.S. 113  U.S. 875 
Cross-currency –  –  136/U.S. 100  – 
Net realized (losses)/gains in the year(3) $(29) $18  $–  $3 
Maturity dates 2008-2013  2008-2010  2008-2013  2008-2013 
(1) Fair value is equal to the carrying value of these derivatives.
(2) Volumes for power and natural gas derivatives are in gigawatt hours and billion cubic feet, respectively.
(3) All power and natural gas realized and unrealized gains and losses are included in Revenues. All interest rate and foreign exchange realized and unrealized gains and losses are included in Financial Charges and Interest Income and Other, respectively. Realized gains and losses are included in Net Income upon settlement of the financial instrument.
(4) All hedging relationships are designated as cash flow hedges except for interest rate derivative financial instruments designated as fair value hedges with a fair value of $2 million. In 2007, the Company did not record any amounts in Net Income related to ineffectiveness for fair value hedges.
(5) In 2007, Net Income included gains of $7 million for the changes in fair value of power and natural gas cash flow hedges that were ineffective in offsetting the change in fair value of their related underlying positions. In 2007, Net Income included a loss of $4 million for the changes in fair value of an interest-rate cash flow hedge that was reclassified as a result of discontinuance of cash flow hedge accounting when the anticipated transaction was not likely to occur by the end of the originally specified time period.

Balance Sheet Presentation of Derivative Financial Instruments

The fair value of the derivative financial instruments in the Company's Balance Sheet was as follows:

December 31 (millions of dollars) 2008   2007 
Current    
Other current assets 318   160 
Accounts payable (298) (144)
Long-term    
Other assets 191   204 
Deferred amounts (694) (205)