7. Risk Management Instruments, Hedging Activities and Credit Risk

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Duke Energy, substantially through its subsidiaries, is exposed to the impact of market fluctuations in the price of natural gas, electricity and other energy-related products marketed and purchased. Duke Energy employs established policies and procedures to manage its risks associated with these market fluctuations using various energy trading contracts and commodity derivatives, including forward contracts, futures, swaps and options for trading purposes and for activity other than trading activity (primarily hedge strategies). The following table shows the fair value of Duke Energy’s energy trading and derivative portfolio as of December 31, 2002.

Fair Value of Contracts as of December 31, 2002

		Type of Contract	Maturity in 2003				Maturity in 2004				Maturity in 2005					Maturity in 2006 and Thereafter					Total Fair Value
			(in millions)
		Trading contracts	$	55			$	84			$	23				$	327				$	489
		Hedge contracts		187				174				109					215					685
		Total	$	242			$	258			$	132				$	542				$	1,174

Commodity Cash Flow Hedges. Some Duke Energy subsidiaries are exposed to market fluctuations in the prices of various commodities related to their ongoing power generating and natural gas gathering, distribution, processing and marketing activities. Duke Energy closely monitors the potential impacts of commodity price changes and, where appropriate, enters into contracts to protect margins for a portion of future sales and generation revenues. Duke Energy uses commodity instruments, such as swaps, futures, forwards and collared options, as cash flow hedges for natural gas, electricity and NGL transactions. Duke Energy is hedging exposures to the price variability of these commodities for a maximum of 15 years.

The ineffective portion of commodity cash flow hedges and the amount recognized for transactions that no longer qualified as cash flow hedges were not material in 2002 or 2001. As of December 31, 2002, $179 million of after-tax deferred net gains on derivative instruments related to commodity cash flow hedges were accumulated on the Consolidated Balance Sheet in a separate component of stockholders’ equity, in OCI, and are expected to be recognized in earnings during the next 12 months as the hedged transactions occur. However, due to the volatility of the commodities markets, the corresponding value in OCI will likely change prior to its reclassification into earnings.

Commodity Fair Value Hedges. Some Duke Energy subsidiaries are exposed to changes in the fair value of some unrecognized firm commitments to sell generated power or natural gas due to market fluctuations in the underlying commodity prices. Duke Energy actively evaluates changes in the fair value of such unrecognized firm commitments due to commodity price changes and, where appropriate, uses various instruments to hedge its market risk. These commodity instruments, such as swaps, futures and forwards, serve as fair value hedges for the firm commitments associated with generated power and natural gas sales. Duke Energy is hedging exposures to the market risk of such items for a maximum of 10 years. For 2002 and 2001, the ineffective portion of commodity fair value hedges was not material.

Trading Contracts. Duke Energy provides energy supply, structured origination, trading and marketing, risk management, and commercial optimization services to large energy customers, energy aggregators and other wholesale companies. These services require Duke Energy to use natural gas, electricity, NGL and transportation contracts that expose it to a variety of market risks. Duke Energy manages its trading exposure with policies that limit its market risk and require daily reporting of potential financial exposure to management. These policies include statistical risk tolerance limits using historical price movements to calculate a daily earnings at risk measurement.

Interest Rate (Fair Value or Cash Flow) Hedges. Changes in interest rates expose Duke Energy to risk as a result of its issuance of variable-rate debt and commercial paper. Duke Energy manages its interest rate exposure by limiting its variable-rate and fixed-rate exposures to percentages of total capitalization and by monitoring the effects of market changes in interest rates. Duke Energy also enters into financial derivative instruments, including, but not limited to, interest rate swaps, swaptions and U.S. Treasury lock agreements to manage and mitigate interest rate risk exposure. Duke Energy’s existing interest rate derivative instruments and related ineffectiveness were not material to its consolidated results of operations, cash flows or financial position in 2002 and 2001.

		Interest Rate Derivatives		December 31,
				2002												2001
				Notional Amounts				Fair Value				Contracts Expire				Notional Amounts				Fair Value				Contracts Expire
				(dollars in millions)
		Fixed-to-floating    rate swaps		$	800			$	80				2005–2028			$	875			$	20				2003–2019
		Cancelable fixed-to-    floating rate swaps			352				23				2014–2025				455				7				2014–2025
		Floating-to-fixed    rate swaps			475				(30	)			2013–2033				—				—				—
		International floating-to-    fixed rate swaps			403				(29	)			2003–2010				—				—				—

Gains and losses deferred in anticipation of planned financing transactions on interest rate swap derivatives are included in OCI and amortized over the life of the underlying debt once issued. These deferred gains and losses were not material in 2002 or 2001. As a result of the interest rate swap contracts, interest expense for the relative notional amount is recognized at the weighted-average rates as depicted in the following table.

		Weighted-Average Rates for Interest Rate Swaps		For the Years Ended December 31,
				2002					2001					2000
		Fixed-to-floating rate swaps			3.05	%				3.92	%				6.50	%
		Cancelable fixed-to-floating rate swaps			2.16	%				3.23	%				5.09	%
		International floating-to-fixed rate swaps			3.71	%				—					—
		Commercial paper swaps			—					—					6.11	%
		Interest Rate Locks			5.10	%				—					—

Foreign Currency (Fair Value, Net Investment or Cash Flow) Hedges. Duke Energy is exposed to foreign currency risk from investments in international affiliates and businesses owned and operated in foreign countries. To mitigate risks associated with foreign currency fluctuations, contracts may be denominated in or indexed to the U.S. dollar and/or local inflation rates, or investments may be hedged through debt denominated or issued in the foreign currency. Duke Energy may also use foreign currency derivatives, where possible, to manage its risk related to foreign currency fluctuations. To monitor its currency exchange rate risks, Duke Energy uses sensitivity analysis, which measures the impact of devaluation of foreign currencies.

Financial Instruments. The fair value of financial instruments not currently carried at market value is summarized in the following table. Judgment is required in interpreting market data to develop the estimates of fair value. Accordingly, the estimates determined as of December 31, 2002 and 2001, are not necessarily indicative of the amounts Duke Energy could have realized in current markets.

		Financial Instruments	2002								2001
			Book Value				Approximate  Fair Value				Book Value					Approximate  Fair Value
				(in millions)
		Long-term debt (a)	$	21,550			$	22,693			$	12,582				$	13,239
		Guaranteed preferred beneficial   interests in subordinated    notes of Duke Energy or    subsidiaries		1,408				1,466				1,407					1,440
		Preferred stock (a)		159				155				247					242

The fair value of cash and cash equivalents, receivables, payables and commercial paper are not materially different from their carrying amounts because of the short-term nature of these instruments or because the stated rates approximate market rates.

Credit Risk. Duke Energy’s principal customers for power and natural gas marketing and transportation services are industrial end-users, marketers, local distribution companies and utilities located throughout the U.S., Canada, Asia Pacific, Europe and Latin America. Duke Energy has concentrations of receivables from natural gas and electric utilities and their affiliates, as well as industrial customers and marketers throughout these regions. These concentrations of customers may affect Duke Energy’s overall credit risk in that risk factors can negatively impact the credit quality of the entire sector. Where exposed to credit risk, Duke Energy analyzes the counterparties’ financial condition prior to entering into an agreement, establishes credit limits and monitors the appropriateness of those limits on an ongoing basis.

Duke Energy frequently uses master collateral agreements to mitigate certain credit exposures, primarily in its trading and marketing operations. The collateral agreements provide for a counterparty to post cash or letters of credit for exposure in excess of the established threshold. The threshold amount represents an unsecured credit limit, determined in accordance with the corporate credit policy. The collateral agreement also provides that the inability to post collateral is sufficient cause to terminate a contract and liquidate all positions.

Natural Gas Transmission and Field Services also obtain cash or letters of credit from customers, where appropriate, based on their financial analysis of the customer and the regulatory or contractual terms and conditions applicable to each transaction.

Collateral amounts held or posted may be fixed or may vary depending on the value of the underlying contracts and cover trading, normal purchases and normal sales, and hedging contracts outstanding. Duke Energy may be required to return certain held collateral and post additional collateral should price movements adversely impact the value of open contracts or positions. In many cases, Duke Energy’s and its counterparties’ publicly disclosed credit ratings impact the amounts of additional collateral to be posted. Recent downgrades in Duke Energy’s affiliates’ credit ratings resulted in Duke Energy posting more collateral with counterparties and any further downgrade could require the posting of additional collateral. Likewise, downgrades in credit ratings of counterparties could require counterparties to post additional collateral to Duke Energy.

The change in market value of New York Mercantile Exchange-traded futures and options contracts requires daily cash settlement in margin accounts with brokers. Financial derivatives are generally cash settled periodically throughout the contract term. However, these transactions are also generally subject to margin agreements with many of Duke Energy’s counterparties.

Following the bankruptcy of Enron Corp., Duke Energy terminated substantially all contracts with Enron Corp. and its affiliated companies (collectively, Enron). As a result, in 2001 Duke Energy recorded as a charge, a non-collateralized accounting exposure of $43 million. The $43 million non-collateralized accounting exposure was composed of charges of $24 million at Other Energy Services, $12 million at DENA, $3 million at International Energy, $3 million at Field Services and $1 million at Natural Gas Transmission. These amounts were stated on a pre-tax basis as charges against the reporting segment’s earnings in 2001.

Duke Energy’s claims made in the Enron bankruptcy case exceeded its non-collateralized accounting exposure. Bankruptcy claims that exceed this amount primarily relate to termination and settlement rights under normal purchases and normal sales contracts where Enron was the counterparty.

Substantially all contracts with Enron were completed or terminated prior to December 31, 2001. Duke Energy has continuing contractual relationships with certain Enron affiliates, which are not in bankruptcy. In Brazil, a power purchase agreement between a Duke Energy affiliate, Companhia de Geracao de Energia Electrica Paranapanema (Paranapanema), and Elektro Eletricidade e Servicos S/A (Elektro), a distribution company approximately 100% owned by Enron, will expire December 31, 2005. The contract was executed by Duke Energy’s predecessor in interest in Paranapanema, and obligates Paranapanema to provide energy to Elektro on an irrevocable basis for the contract period. In addition, a purchase/sale agreement expiring September 1, 2005 between a Duke Energy affiliate and Citrus Trading Corporation (Citrus), a joint venture between Enron and El Paso Corporation, continues to be in effect. The contract requires the Duke Energy affiliate to provide natural gas to Citrus. Citrus has provided a letter of credit in favor of Duke Energy to cover its obligations.

©Copyright 2003

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