EITF Issue 15-A, “Application of the Normal Purchases
and Normal Sales Scope Exception to Certain
Electricity Contracts within Nodal Energy Markets”
Education Session – January 22, 2014
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Overview and agenda
 Issue 15-A relates to whether certain contracts for the physical delivery of
electricity through a nodal energy market should qualify for the normal
purchases and normal sales (NPNS) scope exception to derivative accounting
 Agenda:
-
Evolution of nodal energy markets
-
ISO transmission charges and LMP pricing
-
NPNS scope exception guidance
-
Accounting alternatives (to allow or not allow NPNS)
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Evolution of nodal energy markets
 Electricity is generally produced at a few relatively large generating plants in each region
and must be transmitted over wires to end users
 Historically, power companies in the U.S. built, owned, and operated their own electricity
grid transmission systems
-
In order to move power from generating plants to end users, each power company operated its
transmission system to ensure electricity supply was balanced with electricity consumed.
-
That balance is important because electricity cannot be stored economically and, therefore, must
be produced and delivered to end users in real time to maintain system integrity.
 During the early to mid 20th century, power companies formed “interconnection” groups
whereby several companies in the same geographic region connected their systems to:
-
Assure supply and demand was balanced over the entire interconnected grid
-
Provide access to electricity from multiple power generators
-
Improve grid reliability and reduce cost
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Evolution of nodal energy markets (cont.)
 In the late 20th century, changes in U.S. energy policy encouraged companies to join
Regional Transmission Organizations (RTOs)
-
One of the goals was to promote competition in wholesale power prices to lower the overall cost of
electricity for end users
 Under an RTO:
-
Transmission system operations are “unbundled” from other parts of the supply chain
-
Qualified market participants are given “open access” to the grid
-
Day-to-day operations of the grid are managed by an Independent System Operator (ISO)
-
The grid continues to be used to transport power from suppliers to users
-
There is no ability to reserve path-specific transmission capacity on a forward basis
 ISOs do not own the electricity grid. Rather, they are the operator that schedules the flow
of electricity through the grid and maintains its reliability.
 Today there are seven ISOs / RTOs within the U.S. that coordinate the transmission of
approximately two-thirds of the electricity consumed.
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North American RTOs / ISOs
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ISO transmission charges and LMP pricing
 ISOs charge market participants for their use of the grid
-
Transmission charges are based upon the difference between locational marginal pricing (LMP) at
the delivery and withdrawal locations (or “nodes”)
 LMP prices
-
Represent spot market prices at the respective nodes
-
Are the lowest cost of supplying the next increment of electric demand in order to balance supply
and demand at a specific node
-
Fluctuate based on various supply and demand factors
-
Are designed using sophisticated techniques to capture the cost of electricity, recoup ISO operating
costs (including payments to owners of transmission lines), and charge for congestion (the
difference in prices between two nodes) and line loss
 Such a nodal energy market promotes:
-
Use of the most efficient (least costly) paths of transmission
-
Generation of electricity by the most efficient available power plants
-
Rerouting of excess requests to use any one path to the next least costly route
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Simplified diagram of an ISO
Generator
Generator
Generator
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Topic 815 derivatives analysis
 A contract for the physical delivery of electricity on a forward basis meets the definition of
a derivative when it has the following characteristics:
-
Underlying (the price of electricity)
-
Notional amount (typically, stated volume of megawatt-hours)
-
No initial net investment required
-
Net settlement (typically, through delivery of an asset that is readily convertible to cash or a market
mechanism when there is a liquid market)
 Derivatives must be recognized at fair value each period as an asset or liability with
changes in fair value recognized through earnings (or OCI if the derivatives qualify for
cash flow hedge accounting) unless the contract qualifies for a scope exception, such as
NPNS.
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Normal purchases normal sales scope
exception
 NPNS allows qualifying contracts to be accounted for under the accrual method rather
than as a derivative
 NPNS is elective at any time, but irrevocable
 Requires documentation
 Net settlement of a contract designated as NPNS calls into question other similar
contracts designated as NPNS
 In the utility industry, two discrete sets of criteria can be considered to meet the NPNS
scope exception:
-
General exception (available to all entities)
-
Capacity contracts exception (specific to capacity contracts in the utility industry)
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NPNS – General criteria
 Normal terms and quantity
-
Contract terms must be consistent with the entity’s “normal” purchases or “normal”
sales
-
Judgment about an entity’s needs for the related assets, the locations to which
delivery is made, the entity’s prior practices, etc., is required
 Clearly and closely related underlying
-
Contracts with a price that is not clearly and closely related to the asset being sold or
purchased are not eligible for NPNS
•
For example, a contract for the sale of grain based in part on changes in the S&P 500 index
 Probable physical settlement
-
Must be probable at inception and throughout the term that the contract will result in
physical delivery
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NPNS – Capacity contracts criteria
 For both parties, the contract must:
-
Require physical delivery of electricity
-
Have an underlying that is clearly and closely related to electricity
-
Be a capacity contract – an agreement by an owner of capacity to sell the right to that capacity to
another party so it can satisfy its obligations
 For the seller of electricity, the contract must:
-
Involve electricity quantities expected to be sold in the normal course of business
 For the buyer of electricity:
-
The contract must:
•
•
-
Involve electricity quantities expected to be used or sold in the normal course of business
Be entered into to meet the buyer’s obligation to maintain sufficient capacity, including a reasonable established
reserve margin
The entity must:
•
•
Be engaged in selling electricity to retail or wholesale customers
Be statutorily or contractually obligated to maintain sufficient capacity to meet electricity needs of customers
 Certain option contracts and contracts subject to or scheduled to be “booked-out” are
eligible
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Example – Forward electricity purchase
contract
 Example:
-
PowerCo (a retail electric utility company that serves end-users in the PJM ISO) enters
into a contract with Genco (a power generator) to purchase electricity on a forward
basis
-
The forward purchase contract requires physical delivery of 100 thousand MWhs of
electricity to Location B at $45 per MWh
-
PowerCo needs electricity at Location A in order to delivery and sell it to end-user
customers
-
At the time of delivery, the LMP at Location B is $44.50 and the LMP at Location A is
$46, therefore, PowerCo pays the ISO $1.50 per MWh
-
The forward purchase contract meets the definition of a derivative
 Question: Should the contract meet the physical delivery criterion of the NPNS
scope exception?
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Example – Forward electricity purchase
contract – cash flows
PowerCo pays GenCo $4,500,000
(100K MWhs @ $45)
PowerCo pays ISO $150,000
[($44.50-46.00)*100K MWhs]
100K MWhs
Generator
100K MWhs
100K MWhs
Location B
(LMP $44.50)
Location A
(LMP $46)
End Users
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View A: Electricity contracts for physical delivery within nodal
energy markets should not be eligible for NPNS
ISO sells to
PowerCo @
$46
PowerCo buys from
GenCo @ $45 then
sells to ISO @
$44.50
100K MWhs
Generator
100K MWhs
100K MWhs
Location B
(LMP $44.50)
Location A
(LMP $46)
End Users
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View A: Electricity contracts for physical delivery within nodal
energy markets should not be eligible for NPNS (cont.)
 Proponent views:
- PowerCo takes delivery at Location B then immediately sells the
electricity to the ISO in the spot market based on the LMP at Location
B. PowerCo then purchases the electricity from the ISO at Location
A in the spot market.
- Sale to the ISO at Location B constitutes net settlement of the
forward purchase contract
- The forward contract is merely a hedge of the price of electricity at
Location A
- “Flash” title at Location B does not constitute physical delivery under
NPNS requirements
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View A: Electricity contracts for physical delivery within nodal
energy markets should not be eligible for NPNS (cont.)
 Proponent views (cont.):
- ISO acts like a principal because it takes title to the electricity
- ISO bills typically refer to “purchases” and “sales” of electricity
- Payment to ISO is not merely a transportation charge because it is
determined based upon the market price of electricity
- Forward purchase contract is “part of a series of sequential contracts
intended to accomplish ultimate acquisition” of electricity. Because
delivery under the contract does not occur at PowerCo’s customer
load zone (Location A), the contract does not qualify.
- PowerCo could have possibly contracted for delivery to Location A
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View B: Electricity contracts for physical delivery within nodal
energy markets should be eligible for NPNS
PowerCo
buys from
GenCo @ $45
100K MWhs
Generator
PowerCo incurs
transmission
charge @ $1.50
100K MWhs
100K MWhs
Location B
(LMP $44.50)
Location A
(LMP $46)
End Users
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View B: Electricity contracts for physical delivery within nodal
energy markets should be eligible for NPNS (cont.)
 Proponent views:
- The contract resulted in physical delivery from GenCo to PowerCo
- Physical delivery is evident because each delivery of electricity into the grid
results in a contemporaneous withdrawal
- Current guidance for capacity contracts only necessitates the contract
require physical delivery
- PowerCo does not convert electricity purchased to cash, and its intent was
not to speculate on electricity prices
- ISO is not a principal in substance
•
•
•
Although many ISOs take flash title, they are not market participants engaged in
buying and selling electricity
Title was conveyed to reduce credit exposure of all customers due to Federal
regulations
ISOs are required to be profit neutral
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View B: Electricity contracts for physical delivery within nodal
energy markets should be eligible for NPNS (cont.)
 Proponent views (cont.):
- Payment to ISO is merely a transportation charge, and ISOs role is
that of a facilitating counterparty
- Prior to evolution to nodal energy markets, entities could procure
electricity on a forward basis and assert NPNS. Because the physical
nature of transmission has not changed, these contracts should
continue to be eligible for NPNS.
- Using the ISO for transmission is the only way to transact in a nodal
energy market
- Even if PowerCo could have contracted for delivery at Location A and
asserted NPNS, this same issue would apply to the supplier’s ability
to assert NPNS for its delivery to Location A
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Outreach
 Results from utility trade group survey:
- Of the 12 respondents that transact in nodal energy markets, 10 assert
NPNS for these types of contracts
 Outreach with users has indicated they do not believe that marking
revenue and cost of sales transactions to market is decision-useful for
routine transactions
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Questions?
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