Risk Management Overview
TransCanada has exposure to market risk, counterparty credit risk and liquidity risk. TransCanada engages in risk management activities with the 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 Company constructs and invests in large infrastructure projects, purchases and sells energy 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 strategy to manage the exposure to market risk that results from these activities. Derivative contracts used to manage market risk generally consist of the following:
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:
The Company assesses its commodity contracts and derivative instruments used to manage commodity risk to determine the appropriate accounting treatment. Contracts, with the exception of leases, have been assessed to determine whether they or certain aspects of them meet the definition of a derivative. Certain commodity purchase and sale contracts are derivatives but are not within the scope of the CICA Handbook Section 3855 "Financial Instruments — Recognition and Measurement", as they were entered into and continue to be held for the purpose of receipt or delivery in accordance with the Company's expected purchase, sale or usage requirements. Certain other contracts are not within the scope of Section 3855 as they are considered to meet other exemptions.
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 natural gas price movements. Fair value adjustments recorded each period on proprietary natural gas inventory in storage 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, 2009, the fair value of proprietary natural gas inventory in storage, as measured using a weighted average of forward prices for the following four months less selling costs, was $73 million (2008 — $76 million). The change in fair value of proprietary natural gas inventory in storage in 2009 resulted in a net pre-tax unrealized gain of $3 million (2008 — unrealized loss of $7 million; 2007 — nil), which was recorded as an increase to Revenues and Inventories. The net change in fair value of natural gas forward purchase and sales contracts in 2009 resulted in a net pre-tax unrealized loss of $2 million (2008 — unrealized gain of $7 million; 2007 unrealized gain of $10 million), which was recorded as a decrease 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 market interest rates.
A portion of TransCanada's earnings from its Pipelines and Energy segments is generated in U.S. dollars and, as such, movement 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. TransCanada has a greater exposure to U.S. currency fluctuations than in prior years due to growth in its U.S. operations, partially offset by increased levels of U.S. dollar-denominated debt.
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 exposures 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 interest rate swaps and options to manage its exposure to this risk.
On a consolidated basis, the impact of changes in the U.S. dollar on U.S. Pipelines and Energy earnings is largely offset by the impact on U.S. dollar interest expense. The resultant net exposure is managed using derivatives, effectively reducing the Company's exposure to changes in foreign exchange rates.
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, cross-currency interest rate swaps, forward foreign exchange contracts and foreign exchange options. At December 31, 2009, the Company had designated as a net investment hedge U.S. dollar-denominated debt with a carrying value of $7.9 billion (US$7.6 billion) (2008 — $7.2 billion (US$5.9 billion)) and a fair value of $9.8 billion (US$9.3 billion) (2008 — $5.9 billion (US$4.8 billion)). At December 31, 2009, $96 million was included in Intangibles and Other Assets (2008 — $254 million 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 amounts for the derivatives designated as a net investment hedge were as follows:
TransCanada uses a Value-at-Risk (VaR) methodology to estimate the potential impact resulting from its exposure to market risk on its open liquid positions. VaR estimates the potential change in pre-tax earnings over a given holding period for a specified confidence level. The VaR number calculated and used by TransCanada reflects a 95 per cent probability that the daily change resulting from normal market fluctuations in its open liquid positions will not exceed the reported VaR. The VaR methodology is a statistically- calculated, probability-based approach that takes into consideration market volatilities as well as risk diversification by recognizing offsetting positions and correlations among products and markets. Risks are measured across all products and markets, and risk measures are aggregated to arrive at a single VaR number.
There is currently no uniform industry methodology for estimating VaR. The use of VaR has limitations because it is based on historical correlations and volatilities in commodity prices, interest rates and foreign exchange rates, and assumes that future price movements will follow a statistical distribution. Although losses are not expected to exceed the statistically estimated VaR on 95 per cent of occasions, losses on the other five per cent of occasions could be substantially greater than the estimated VaR.
TransCanada's estimation of VaR includes wholly owned subsidiaries and incorporates relevant risks associated with each market or business unit. The calculation does not include the Pipelines segment as the rate-regulated nature of the pipeline business reduces the impact of market risks. TransCanada's Board of Directors has established a VaR limit, which is monitored on an ongoing basis as part of the Company's risk management policy. TransCanada's consolidated VaR was $12 million at December 31, 2009 (2008 — $23 million). The decline from December 31, 2008 was primarily due to decreased prices and lower open positions in the U.S. power portfolio.
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 they will protect it against all material losses.
TransCanada's maximum counterparty credit exposure with respect to financial instruments at the balance sheet date consisted primarily of non-derivative financial assets such as accounts receivable, loans and notes receivable, as well as the fair value of derivative assets. Within these balances, the Company does not have significant concentrations of counterparty credit risk with any individual counterparties and the majority of counterparty credit exposure is with counterparties who are investment grade. At December 31, 2009, there were no significant amounts past due or impaired.
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-creditworthy counterparties.
As a level of uncertainty continues to exist in the global financial markets, TransCanada continues to closely monitor and reassess the creditworthiness of its counterparties. This has resulted in TransCanada reducing or mitigating its exposure to certain counterparties where it was deemed warranted and permitted under contractual terms. As part of its ongoing operations, TransCanada must balance its market and counterparty credit risks when making business decisions.
Certain subsidiaries of Calpine Corporation (Calpine) filed for bankruptcy protection in both Canada and the U.S. in 2005. Gas Transmission Northwest Corporation (GTNC) and Portland reached agreements with Calpine for allowed unsecured claims in the Calpine bankruptcy. In February 2008, GTNC and Portland received initial distributions of 9.4 million common shares and 6.1 million common shares, respectively, of Calpine, which represented approximately 85 per cent of their agreed-upon claims. In 2008, these shares were sold into the open market and resulted in total pre-tax gains of $279 million. Claims by NGTL and Foothills Pipe Lines (South B.C.) Ltd. for $32 million and $44 million, respectively, were received in cash in January 2008 and were passed on to shippers on these systems in 2008 and 2009.
Liquidity risk is the risk that TransCanada will not be able to meet its financial obligations when 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 continuously 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, as discussed under the heading Capital Management below.
At December 31, 2009, the Company had committed revolving bank lines of US$1.0 billion, $2.0 billion, US$1.0 billion and US$300 million maturing November 2010, December 2012, December 2012 and February 2013, respectively. At December 31, 2009, the US$300 million facility was fully drawn and no draws were made on any of the other facilities. The Company has maintained continuous access to the Canadian commercial paper market on competitive terms.
The Company has access to capital markets under the following prospectuses:
The primary objective of capital management is to ensure TransCanada has strong credit ratings to support its businesses and maximize shareholder value. In 2009, the overall objective and policy for managing capital remained unchanged from the prior year.
TransCanada manages its capital structure in a manner consistent with the risk characteristics of the underlying assets. The Company's management considers its capital structure to consist of net debt, Non-Controlling Interests and Shareholders' Equity. Net debt is comprised of Notes Payable, Long-Term Debt and Junior Subordinated Notes less Cash and Cash Equivalents. Net debt only includes obligations that the Company controls and manages. Consequently, it does not include Cash and Cash Equivalents, Notes Payable and Long-Term Debt of TransCanada's joint ventures.
The capital structure was as follows:
Certain financial instruments included in Cash and Cash Equivalents, Accounts Receivable, Intangibles and Other Assets, Notes Payable, Accounts Payable, Accrued Interest and Deferred Amounts have carrying amounts that approximate their fair value due to the nature of the item 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 or other valuation techniques are used. Credit risk has been taken into consideration when calculating the fair value of derivatives.
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:
The following tables detail the remaining contractual maturities for TransCanada's non-derivative financial liabilities, including both the principal and interest cash flows at December 31, 2009:
Contractual Repayments of Financial Liabilities(1)
Interest Payments on Financial Liabilities
Derivative Financial Instruments Summary
Information for the Company's derivative financial instruments for 2009 is as follows:
The anticipated timing of settlement of the derivative contracts assumes constant commodity prices, interest rates and foreign exchange rates from December 31, 2009. Settlements will vary based on the actual value of these factors at the date of settlement. The anticipated timing of settlement of these contracts is as follows:
Derivative Financial Instruments Summary
Information for the Company's derivative financial instruments for 2008 is as follows:
Balance Sheet Presentation of Derivative Financial Instruments
The fair value of the derivative financial instruments in the Company's Balance Sheet was as follows:
Derivative Financial Instruments of Joint Ventures
Included in the Balance Sheet Presentation of Derivative Financial Instruments summary are amounts related to power derivatives used by one of the Company's joint ventures to manage commodity price risk. The Company's proportionate share of the fair value of these power sales derivatives was $105 million at December 31, 2009 (2008 — $75 million). These contracts mature from 2010 to 2015. The Company's proportionate share of the notional sales volumes of power associated with this exposure was 6,312 gigawatt hours (GWh) at December 31, 2009 (2008 — 7,600 GWh). The Company's proportionate share of the notional purchased volumes of power associated with this exposure was 2,747 GWh at December 31, 2009 (2008 — 47 GWh).
Fair Value Hierarchy
The Company's financial assets and liabilities recorded at fair value have been categorized into three categories based upon a fair value hierarchy. Fair value of assets and liabilities included in Level I is determined by reference to quoted prices in active markets for identical assets and liabilities. Assets and liabilities in Level II include valuations using inputs other than quoted prices for which all significant outputs are observable, either directly or indirectly. This category includes fair value determined using valuation techniques, such as option pricing models and extrapolation using observable inputs. Level III valuations are based on inputs that are not readily observable and are significant to the overall fair value measurement. Long-dated commodity transactions in certain markets and the fair value of guarantees are included in this category. Long-dated commodity prices are derived with a third party modelling tool that uses market fundamentals to derive long-term prices. The fair value of guarantees is estimated by discounting the cash flows that would be incurred if letters of credit were used in place of the guarantees.
Assets and liabilities measured at fair value as of December 31, 2009, including both current and non-current portions, are categorized as follows. There were no transfers between Level I and Level II in 2009.
The following table presents the net change in assets and liabilities measured at fair value and included in the Level III fair value category:
A 10 per cent increase or 10 per cent decrease in commodity prices, with all other variables held constant, would cause an $18 million decrease or an $18 million increase, respectively, in the fair value of derivative financial instruments outstanding as at December 31, 2009.
A 100 basis points increase or 100 basis points decrease in the letter of credit rate, with all other variables held constant, would cause a $6 million increase or a $6 million decrease, respectively, in the fair value of guarantee liabilities outstanding as at December 31, 2009. Similarly, the effect of a 100 basis points increase or 100 basis points decrease in the discount rate on the fair value of guarantee liabilities outstanding as at December 31, 2009 would cause a $2 million decrease in the liability or a $2 million increase in the liability, respectively.