Notes to Consolidated Financial Statements
Risk Management Overview
TransCanada has exposure to market risk, counterparty credit risk and liquidity risk. TransCanada engages in risk management activities with the objective of protecting 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 financial 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:
Where possible, derivative financial instruments are designated as hedges, but in some cases derivatives do not meet the specific criteria for hedge accounting treatment and are accounted for at fair value with changes in fair value recorded in Net Income in the period of change. This may expose the Company to increased variability in reported operating results because the fair value of the derivative instruments can fluctuate significantly from period to period. However, the Company enters into the arrangements as they are considered to be effective economic hedges.
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 and natural gas. 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 fair value accounting is not required, 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 and are documented as such. In addition, fair value accounting is not required for other financial instruments that qualify for certain exemptions.
Natural Gas Storage Commodity Price Risk
TransCanada manages its exposure to seasonal natural gas price spreads in its non-regulated 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 on these forward contracts are not representative of the amounts that will be realized on settlement.
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 interest rates.
A portion of TransCanada's earnings from its Natural Gas Pipelines, Oil Pipelines and Energy segments is generated in U.S. dollars and, therefore, fluctuations in the value of the Canadian dollar relative to the U.S. dollar can affect TransCanada's net income. This foreign exchange impact is partially offset by U.S. dollar-denominated financing costs 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 interest expense.
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 foreign exchange rate exposures of the Alberta System and Foothills operations. Certain of the realized gains and losses on these derivatives 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.
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, 2011, the Company had designated as a net investment hedge U.S. dollar-denominated debt with a carrying value of $10 billion (US$9.8 billion) (2010 – $9.8 billion (US$9.8 billion)) and a fair value of $12.7 billion (US$12.5 billion) (2010 – $11.3 billion (US$11.4 billion)). At December 31, 2011, $79 million (December 31, 2010 – nil) was included in Other Current Assets, $66 million (December 31, 2010 – $181 million) was included in Intangibles and Other Assets, $15 million (December 31, 2010 – nil) was included in Accounts Payable, and $41 million (December 31, 2010 – nil) was included in Deferred Amounts for the fair value of the forwards and swaps 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 from its exposure to market risk on its liquid open positions. VaR represents the potential change in pre-tax earnings over a given holding period for a specified confidence level. The VaR number used by TransCanada is calculated assuming a 95 per cent confidence level that the daily change resulting from normal market fluctuations in its liquid open 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 regulated natural gas pipelines, as the nature of the rate-regulated 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, 2011 (2010 – $12 million).
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 the financial instruments 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 contract 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, without taking into account security held, consisted of accounts receivable, portfolio investments recorded at fair value, the fair value of derivative assets and notes, loans and advances receivable. The carrying amounts and fair values of these financial assets, except amounts for derivative assets, are included in Accounts receivable and other, and Available for sale assets in the Non-Derivative Financial Instruments Summary table located in the Fair Values section of this note. The majority of counterparty credit exposure is with counterparties that are investment grade or the exposure is supported by financial assurances provided by investment grade parties. The Company regularly reviews its accounts receivable and records an allowance for doubtful accounts as necessary using the specific identification method. At December 31, 2011, there were no significant amounts past due or impaired, and there were no significant credit losses during the year.
At December 31, 2011, the Company had a credit risk concentration of $274 million (2010 – $317 million) due from a counterparty. This amount is expected to be fully collectible and is secured by a guarantee from the counterparty's parent company.
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.
In August 2011, the Company received final distributions of 2.1 million common shares as a result of previous claims in the 2005 Calpine Corporation bankruptcy. These shares were sold into the open market resulting in total pre-tax gains of $30 million, of which the Company had accrued pre-tax gains of $15 million in 2010. In 2008, the Company had received 15.5 million common shares which were sold into the open market for $279 million. Claims by NGTL and Foothills PipeLines (South B.C.) Ltd. for $32 million and $44 million, respectively, were received in cash in 2008 and 2009 and were passed onto the shippers on these systems in 2008 and 2009.
Liquidity risk is the risk that TransCanada will not be able to meet its financial obligations as they become due. The Company's approach to managing liquidity risk is to ensure that sufficient cash and credit facilities are available to meet its operating, financing and capital expenditure obligations when due, under both normal and stressed economic conditions.
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 in the Capital Management section of this note.
At December 31, 2011, the Company had unutilized committed revolving bank lines of US$1.0 billion, US$1.0 billion, US$300 million and $2.0 billion maturing in October 2012, November 2012, February 2013 and October 2016, respectively. The Company has also maintained continuous access to the Canadian commercial paper market on competitive terms and recently initiated a commercial paper program in the U.S.
The primary objective of capital management is to ensure TransCanada has strong credit ratings to support its businesses and maximize shareholder value. In 2011, 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 Equity. Net debt comprises 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 total capital managed by the Company 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 and applying a discounted cash flow valuation model. The fair value of power and natural gas derivatives, and of available for sale investments, has been calculated using quoted market prices where available. In the absence of quoted market prices, third-party broker quotes or other valuation techniques have been used.
The fair value of the Company's Notes Receivable is calculated by discounting future payments of interest and principal using forward interest rates. The fair value of Long-Term Debt was estimated based on quoted market prices for the same or similar debt instruments. Credit risk has been taken into consideration when calculating the fair value of derivatives, Notes Receivable and Long-Term Debt.
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, 2011:
Contractual Repayments of Financial Liabilities(1)
Interest Payments on Financial Liabilities
Derivative Financial Instruments Summary
Information for the Company's derivative financial instruments for 2011, excluding hedges of the Company's net investment in self-sustaining foreign operations, 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, 2011. 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 2010, excluding hedges of the Company's net investment in self-sustaining foreign operations, 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 Derivative Financial Instruments Summary tables 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 derivatives was $35 million at December 31, 2011 (2010 – $48 million). These contracts mature from 2012 to 2018. The Company's proportionate share of the notional sales volumes of power associated with this exposure was 2,979 gigawatt hours (GWh) at December 31, 2011 (2010 – 3,772 GWh). The Company's proportionate share of the notional purchased volumes of power associated with this exposure was 1,595 GWh at December 31, 2011 (2010 – 2,322 GWh).
Derivatives in Cash Flow Hedging Relationships
Information about how derivatives and hedging activities affect the Company's financial position, financial performance and cash flows is as follows:
Credit Risk Related Contingent Features
Derivative contracts entered into to manage market risk often contain financial assurance provisions that allow parties to the contracts to manage credit risk. These provisions may require collateral to be provided if a credit-risk-related contingent event occurs, such as a downgrade in the Company's credit rating to non-investment grade. Based on contracts in place and market prices at December 31, 2011, the aggregate fair value of all derivative instruments with credit-risk-related contingent features that were in a net liability position was $110 million (2010 – $92 million), for which the Company has provided collateral of $28 million (2010 – $4 million) in the normal course of business. If the credit-risk-related contingent features in these agreements were triggered on December 31, 2011, the Company would have been required to provide additional collateral of $82 million (2010 – $88 million) to its counterparties. Collateral may also need to be provided should the fair value of derivative financial instruments exceed pre-defined contractual exposure limit thresholds. The Company has sufficient liquidity in the form of cash and undrawn committed revolving bank lines to meet these contingent obligations should they arise.
Fair Value Hierarchy
The Company's financial assets and liabilities recorded at fair value have been categorized into three categories based on a fair value hierarchy. In Level I, the fair value of assets and liabilities is determined by reference to quoted prices in active markets for identical assets and liabilities. In Level II, determination of the fair value of assets and liabilities includes valuations using inputs, other than quoted prices, for which all significant inputs are observable, directly or indirectly. This category includes fair value determined using valuation techniques, such as option pricing models and extrapolation using observable inputs. In Level III, determination of the fair value of assets and liabilities is based on inputs that are not readily observable and are significant to the overall fair value measurement. Long-dated commodity transactions in certain markets 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.
There were no transfers between Level I and Level II in 2011 or 2010. Financial assets and liabilities measured at fair value, including both current and non-current portions, are categorized as follows:
The following table presents the net change in the Level III fair value category:
A 10 per cent increase or decrease in commodity prices, with all other variables held constant, would result in a $10 million decrease or increase, respectively, in the fair value of outstanding derivative financial instruments included in Level III as at December 31, 2011.