Interest Rate Risk. The Corporation is exposed to changes in interest rates as a result of significant financing through its issuance of variable-rate debt, fixed-rate debt, commercial paper and auction market preferred stock, as well as fixed-to-floating interest rate swaps. The Corporation manages its interest rate exposure by limiting its variable-rate exposure to a certain percentage of total capitalization, as set by policy, and by monitoring the effects of market changes in interest rates. (See Notes 11 and 14 to the Consolidated Financial Statements.)
If market interest rates average 1% more in 1998 than in 1997, the Corporation’s interest expense, after considering the effect of the interest rate swap agreements, would increase, and income before taxes would decrease by approximately $23.6 million. This amount has been determined by considering the impact of the hypothetical interest rates on the Corporation’s variable-rate debt balances, commercial paper balances, auction market preferred stock balances and interest rate swap agreements as of December 31, 1997. These analyses do not consider the effects of the reduced level of overall economic activity that could exist in such an environment. In the event of a significant change in interest rates, management would likely take actions to further mitigate its exposure to the change. However, due to the uncertainty of the specific actions that would be taken and their possible effects, the sensitivity analysis assumes no changes in the Corporation’s financial structure.
Commodity Price Risk. The Corporation, substantially through its subsidiaries, is exposed to the impact of market fluctuations in the price and transportation costs of natural gas, electricity and petroleum products marketed and employs established policies and procedures to manage its risks associated with these market fluctuations using various commodity derivatives, including futures, swaps and options. (See Note 8 to the Consolidated Financial Statements.) The Corporation measures the risk in its commodity derivative portfolio on a daily basis utilizing a Value-at-Risk (VAR) model to determine the maximum potential one-day favorable or unfavorable impact on its earnings and monitors its risk in comparison to established thresholds. The Corporation also utilizes other measures to monitor the risk in its commodity derivative portfolio on a monthly, quarterly and annual basis. The VAR computations are based on an historical simulation, which utilizes price movements over a specified period to simulate forward price curves in the energy markets to estimate the favorable or unfavorable impact of one-day’s price movement on the existing portfolio. The VAR computations utilize several key assumptions, including the confidence level for the resultant price movement and the holding period chosen for the calculation. The Corporation’s calculation includes commodity derivative instruments held for trading purposes and excludes the effects of written and embedded physical options in the trading portfolio. At December 31, 1997, the Corporation’s estimated potential one-day favorable or unfavorable impact on income before taxes, as measured by VAR, related to its commodity derivatives held for trading purposes was approximately $2 million. Changes in markets inconsistent with historical trends could cause actual results to exceed predicted limits. Market risks associated with commodity derivatives held for purposes other than trading were not material at December 31, 1997.
Subsidiaries of the Corporation are also exposed to market fluctuations in the price of natural gas liquids (NGLs) related to their ongoing gathering and processing operating activities. Because the Corporation generally does not maintain an inventory of NGLs or actively trade commodity derivatives related to NGLs, the Corporation was not exposed to this risk at December 31, 1997. However, the Corporation closely monitors the risks associated with NGL price changes on its future operations.
Equity Price Risk. The Corporation maintains trust funds, as required by the Nuclear Regulatory Commission, to fund certain costs of nuclear decommissioning. (See Note 12 to the Consolidated Financial Statements.) As of December 31, 1997, these funds were invested primarily in domestic and international equity securities, fixed-rate, fixed income securities and cash and cash equivalents. By maintaining a portfolio that includes long-term equity investments, the Corporation is maximizing the returns to be utilized to fund nuclear decommissioning, which in the long-term will better correlate to inflationary increases in decommissioning costs. However, the equity securities included in the Corporation’s portfolio are exposed to price fluctuation in equity markets, and the fixed-rate, fixed income securities are exposed to changes in interest rates. The Corporation actively monitors its portfolio by benchmarking the performance of its investments against certain indexes and by maintaining, and periodically reviewing, established target allocation percentages of the assets in its trusts to various investment options. Because the accounting for nuclear decommissioning recognizes that costs are recovered through the Corporation’s Electric Operations’ rates, fluctuations in equity prices or interest rates do not affect the earnings of the Corporation.
Foreign Operations Risk. The Corporation has investments in several international operations, many of which are joint ventures. At December 31, 1997, the Corporation had investments in international affiliates of $230.1 million. These investments represent primarily investments in affiliates which own energy-related production, generation and transmission facilities.
The Corporation is exposed to foreign currency risk, sovereign risk and other foreign operations risks, primarily through investments in affiliates of $43.6 million in Asia and $100.7 million in South America. In order to mitigate risks associated with foreign currency fluctuations, the majority of contracts entered into by the Corporation or its affiliates are denominated in or indexed to the U.S. dollar. Other exposures to foreign currency risk, sovereign risk or other foreign operations risk are periodically reviewed by management and were not material to the Corporation’s consolidated results of operations or financial position during the period.
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