IAS39, the international accounting standard for the recognition and measurement of financial instruments, is widely viewed as causing particular implementation difficulties. It has caused controversy that's far from being resolved. Electricity derivative users are among those who find this standard a big challenge and have doubts about the effect it has on income statement amounts--namely, in hedging strategies.
This area is complex for two main reasons: electricity is a non-financial item and it is not always clear whether it is covered by IAS39 or not; and it is a non-storable commodity, which creates unique issues concerning the physical delivery of the contracts compared with other commodity contracts.
The first question to consider is: do commodity contracts actually fall within the scope of IAS39? The standard applies to "contracts to buy or sell a non-financial item" if that contract can be net settled. But IAS39 allows an exemption for contracts that are entered into for the purpose of the receipt or delivery of a non-financial item in accordance with the firm's expected purchase, sale or usage requirements. There are strict criteria governing this exemption: the contracts are designated for "own use" purposes from inception; they are settled by physical delivery; and the firm does not normally net settle similar contracts. The adoption of this exemption for exchange-traded derivatives must be assessed on a case-by-case basis and most of the time it depends on business practices, control objectives and management's intentions about physical delivery. Besides, electricity futures clearly meet the definition of a derivative and meet the intention of the International Accounting Standards Board regarding the scope of IAS39 (see IAS39 basis for conclusions, paragraph 221). Additionally, electricity is a commodity that's actively quoted in both spot and futures markets, so it always meets the "readily convertible to cash" criterion. The IAS39 accounting rules for derivatives will, therefore, affect most companies involved with electricity futures.
As a general rule, IAS39 requires that all derivatives are measured at fair value, with movements in fair value recognised immediately through the income statement. But it also allows hedge accounting for certain hedging relationships, overriding the normal accounting treatment of IAS39.
Hedge accounting mitigates the volatile impact of derivative adoption in the income statement by matching the timing of recognition of gains and losses on both the hedged item and the hedging instruments. In order to apply hedge accounting rules, the transactions must meet strict requirements, usually seen as onerous and complex, that relate to the formal documentation of the transaction since inception, including prospective and retrospective effectiveness tests. Yet, when hedges are accomplished with standard exchange-traded futures, as in the case of Mibel electricity futures, compliance with IAS39's hedge accounting rules is quite straightforward (see panel, left).
The Mibel derivatives market was launched on July 3, 2006 (see panel on the right of page 39) and was a fundamental step in the Iberian electricity market-building process. There are two basic types of Mibel futures contracts: one has a physical delivery and the other foresees a purely financial settlement at maturity, with the peculiarity that both types of contracts benefit from a common order book. The remaining characteristics are common to both types of contracts: they are "baseload" contracts; the contract unit is 1MW x contract number of hours and the quotation and tick is in euros per MWh, with a 0.01 euros per MWh tick; delivery periods are weeks, months, quarters and years; there's daily cash settlement (mark-to-market); and the spot reference price used for settlement at maturity for both types of contracts is the monetary value of the "Spel base" index, representing an average price of electric energy in the Spanish zone, based on values in the cash market managed by Omel, the Iberian electricity spot market.
Establishing a short (selling) hedge protects participants in the energy industry from a decline in the market price. The following example is a short hedge for use by an electricity producer that wishes to protect itself against a price decline in an anticipated sale. (In IAS39 terminology "anticipated sale" refers to forecast transactions, rather than transactions that qualify as firm commitments, even when these will take place in the future. Hedges of unrecognised firm commitments are fair-value hedges under IAS39.)
On June 8, a producer expects to sell 7,200MWh of electricity in September. It hedges its position, therefore, by selling ten electricity futures contracts (FTB M Sep) at 56.25 [euro] per MWh for delivery in September. The company designates this strategy as a cash flow hedge under IAS39. The standard allows that, until the transaction takes place, the effective part of the hedge is not recognised in the income statement. This procedure mitigates the volatility that could be introduced into the income statement. In fact, once a forecast transaction is not taken to the balance sheet, the general rule of considering all gains and losses of derivatives in the income statement would generate income volatility, because there would not be the offsetting accounting entry of the hedged position.
By June 30, the financial reporting date of the producer, September electricity futures prices have fallen to 55.80 [euro] per MWh. The producer records a gain of 3,240 [euro] on its futures position ([56.25--55.80] x 720 x 10 contracts) taken to equity. (See panel 1, opposite page.)
By August 29--the last trading day (LTD) of the September futures contract--the producer liquidates its short position by buying ten September contracts at 55.00 [euro] per MWh and realises a cumulative gain in the futures market amounting to 9,000 [euro] ([56.25--55] x 720 x 10). During September, it realises its anticipated sale and sells the 7,200MWh of electricity on the spot market for an average price of 52.47 [euro] per MWh, equivalent to 377 [euro], 772. The hedging gain (or loss. if that were the case) taken previously to equity is then recycled to the income statement in each period the electricity is sold. (See panel 2, opposite page).
Alternatively, the prooucer might have not closed the futures contracts and entered in the delivery period. OmiClear proceeds to a daily cash settlement by the difference between the spot reference price and the LTD futures settlement price (55.00 [euro] per MWh) during the delivery period. In financial delivery contracts, there is a notional supply of electricity at constant power of 1MW during all the hours of the delivery period. The delivery is purely financial based on the spot reference price. (See panel 3, opposite page.)
Futures with physical delivery imply the delivery of electricity through Omel (the Spanish spot market). The supply of electricity is at constant power of 1 MW during all the hours of the delivery period. (See panel 4, above left.)
By entering the delivery period, the short hedge has the net effect of locking the delivery price of the electricity at the futures contract price on June 8, of 56.25 [euro]/MWh. (See panel 5, top.)
Lastly, as in most futures contracts, there are margin requirements in the Mibel futures market. The initial margin covers the potential future price variations and the replacement costs in case a clearing member defaults. It is theoretically due when a new position is opened. From a balance sheet point of view, it should be separated from cash margin deposits, which should be taken inside the balance sheet from a securities deposit or bank guarantee, which should remain off-balance sheet. (See panel 6, above.)
Formal documentation template example
1 Description of risk management objective and strategy.
2 Type of hedging relationship (fair value hedge or cash flow hedge).
3 The nature of the risk being hedged (commodity).
4 Identification of the hedged item.
a Is the hedged item a forecast transaction? If yes:
b Expected hedged amount.
c Nature of forecast transaction,
d Expected timing of forecast transaction.
e Expected price for forecast transaction.
f Why it is highly probable to occur.
g Method of reclassifying into profit and loss amounts deferred in equity (basis adjustment or not).
5 Identification of hedging instrument.
6 Prospective effectiveness testing.
a Description of the method and its application to testing.
b Frequency of testing.
7 Retrospective effectiveness testing.
a Description of the method and its application to testing.
b Frequency of testing.
A nominal equals MW x 24 hours x the number of days in the delivery period. For example, a November contract has a nominal of: 1MW x 24h x 30 = 720MWh.
For weekly contracts the nominal is usually 168MWh. For monthly contracts the nominal ranges from 672MWh (February) to 745MWh (October, which has an extra hour owing to the clock change). For quarterly contracts the nominal ranges from 2,159MWh (Q1) to 2,209MWh (Q4). For calendar-year contracts the nominal is 8,760MWh (8,784MWh in a leap year).
What as Mibel?
The Iberian electricity market (Mercado Iberico de Electricidade), known as Mibel, is a joint initiative by the governments of Portugal and Spain and is a step towards an internal electricity market.
The management of the organised markets of Mibel is based on an interconnected bipolar structure where:
* The management of the day-ahead and intra-day market is the responsibility of the Spanish node, which is known as Omel (Operador del Mercado Iberico de Energia--Polo Espanol).
* The derivatives markets is the responsibility of the Portuguese node, called Omip (Operador do Mercado Iberico de Energia--Polo Portugues).
Omip manages the Mibel derivatives market jointly with OmiClear (Sociedade de Compensagao de Mercados de Energia), a company owned by Omip, which fulfils the role of clearing house and central counterparty.
Electricity futures settlement during delivery
Mibel baseload physical futures Physical settlement Positions are sent to Omel's day-ahead market for physical delivery. Open positions Financial settlement OmiClear cash settles the differences between the spot reference price and the final settlement price. Mibel baseload financial futures Open positions Financial settlement OmiClear cash settles the differences between the spot reference price and the final settlement price.
Patricia Teixeira Lopes is assistant professor in the faculty of economics at the University of Porto.
technical matters 1 Accounting entries To simplify presentation, entries to record daily cash settlements (mark to market) between the selected reporting dates have been ignored. June 8--transaction fees Transaction fees Debit Credit Other operating expenses 144 Payables/cash 144 To record transaction fees on the sale of 10 futures contracts: 0.01 [euro] (trading fee) + 0.01 [euro] (clearing fee) per MWh ([0.01 x 720 x 10] + [0.01 x 720 x 10]). June 30--reporting date FTB M Sep futures price has fallen to 55.80 [euro] per MWh. Debit Credit Receivables--futures contracts 3,240 Equity--cash flow hedges 3,240 To record the futures contracts at their fair value. Debit Credit Cash 3,240 Receivables--futures contracts 3,240 To record the cash settlement of the futures contracts that occurred each day throughout the period with open positions. 2 Accounting entries--closing futures positions on the last trading day (LTD) At August 29 the short futures position is closed out by buying ten FTB M Sep futures contracts at 55 [euro] per MWh. Last mark-to-market Debit Credit Receivables--futures contracts 5,760 Equity--cash flow hedges 5,760 To record the futures contracts at their fair value. Debit Credit Cash 5,760 Receivables--futures contracts 5,760 To record the cash settlement of the futures contracts that occurred each day throughout the period with open positions. Transaction fees Debit Credit Other operating expenses 144 Cash 144 To record transaction fees on the purchase of 10 futures contracts: 0.01 [euro] (trading fee) + 0.01 [euro] (clearing fee) per MWh ([0.01 x 720 x 10] + [0.01 x 720 x 10]). Recycling of amounts in "Equity--cash flow hedges" Debit Credit Equity--cash flow hedges (equity) 9,000 Revenue--electricity sales 9,000 To reclassify as earnings the gain on futures contracts that was deferred in "Equity--cash flow hedges" (cumulative amount). 3 Accounting entries--entering in the delivery period Last mark-to-market Debit Credit Receivables--futures contracts 5,760 Equity--cash-flow hedges 5,760 To record the futures contracts at their fair value. Debit Credit Cash 5,760 Receivables--futures contracts 5,760 To record the cash settlement of the futures contracts that occurred each day throughout the period with open positions. The case of financial futures Transaction fees Settlement by OmiClear every day during delivery period (September 1-30). Delivery Spel LTD fut set Difference Cash moves period base (a) price (b) (c) = (b) - (a) (c) x 24 x10 01/09 59.19 55.00 -4.19 -1,005.60 02/09 51.15 55.00 3.85 924.00 03/09 42.40 55.00 12.60 3,024.00 30/09 43.98 55.00 11.02 2,644.80 Average 52.47 Total 18,228.00 September 1 Debit Credit Equity--cash flow hedges 1,005.6 Payables--futures contracts 1,005.6 Debit Credit Payables--futures contracts 1,005.6 Cash 1,005.6 To record the financial settlement by OmiClear (if spot reference price is greater than futures LTD settlement price). September 2 Debit Credit Receivables--futures contracts 924 Equity--cash flow hedges 924 Debit Credit Cash 924 Receivables--futures contracts 924 To record the financial settlement by OmiClear (if spot reference price is less than futures LTD settlement price). ... until September 30 Reclassification to income of the amount registered in "Equity--cash flow hedges" during the delivery period Debit Credit Equity--cash flow hedges (equity) 27,228 Revenue--electricity sales 27,228 To reclassify as earnings the gain on futures contracts that was deferred in "Equity--cash flow hedges" (cumulative amount: 9,000 [euro] + 18,228 [euro]). 4 Accounting entries--the case of physical delivery futures Transaction fees each day during the delivery period (September 1-30) Debit Credit Other operating expenses 2.4 Payables/cash 2.4 To record transaction fees on the physical delivery (0.01 [euro] x 24 x 10), assuming no netting with other positions. Physical settlement during delivery period Delivery period Spel base (a) Electricity sales at Omel 01/09 59.19 14,205.60 02/09 51.15 12,276.00 30/09 43.98 10,555.20 Average 52.47 Total 377,772.00 September 1 Debit Credit Receivables 14205.60 Revenue--electricity sales 14205.6 For the sale of electricity in each delivery moment (59.19 [Spel base] x 1 [euro]/MWh x 24 x 10) September 2 Debit Credit Receivables 12,276 Revenue--electricity sales 12,276 For the sale of electricity in each delivery moment (51.15 [Spel base] x 1 [euro]/MWh x 24 x 10) .... Until September 30 Cash settlement by OmiClear: same as for financial delivery futures. Reclassification to income of the amount registered in "Equity--cash flow hedges" (including the amount of cash settlement during delivery period, 18,228 [euro]), during the delivery period: same as for financial delivery futures. 5 Summary of the hedge (futures taken to delivery) Gain in futures contracts During trading period 9,000 During delivery period 18,228 Total futures gain 27,228 Sale of electricity on spot market 377,772 [euro] * Selling price (post-hedging) 56.25/MWh ** * (52.47 [euro]/MWh [average spot price, based on Spel base] x 7,200 MWh). ** (377,772 + 27,228)--7,200. 6 Accounting treatment for margin requirements Initial margin deposit or subsequent margin requirements. 1 Cash Debit Credit Receivables--initial margin 89,100 Cash 89,100 To record the initial margin deposit (hypothetically, 22 per cent of the contract's nominal value) on the sale of ten futures contracts on June 8: 22 per cent x 720 x 56.25 [euro] per MWh x 10. 2 Securities deposit or bank guarantee No accounting entries. Disclosure only. For the margin return, the reverse accounting entry is due by the amount returned by OmiClear…