CEG » Topics » Use of Derivative Instruments

These excerpts taken from the CEG 10-K filed Feb 27, 2009.

Use of Derivative Instruments

Nature of Our Business and Associated Risks

Our business activities primarily include our merchant energy business and our regulated electric and gas business. Our merchant energy business includes:

    the generation of electricity from our owned and contractually-controlled physical assets,
    the sale of power, gas, and other energy commodities to wholesale and retail customers, and
    risk management services and energy trading activities.

        Our regulated electric and gas businesses engage in electricity and gas transmission and distribution activities in Central Maryland at prices set by the Maryland PSC that are generally designed to recover our costs, including purchased fuel and energy. Substantially all of our risk management activities involving derivatives occur outside our regulated businesses.

        In carrying out our merchant energy business activities, we purchase and sell power, fuel, and other energy-related commodities in competitive markets. These activities expose us to significant risks, including market risk from price volatility for energy commodities and the credit risks of counterparties with which we enter into contracts. The sources of these risks include, but are not limited to, the following:

    the risks of unfavorable changes in power prices in the wholesale forward and spot markets in which we sell a portion of the power from our power generation facilities and purchase power to meet our load-serving requirements,
    the risk of unfavorable fuel price changes for the purchase of a portion of the fuel for our generation facilities under short-term contracts or on the spot market. Fuel prices can be volatile, and the price that can be obtained for power produced from such fuel may not change at the same rate as fuel costs.
    the risk that one or more counterparties may fail to perform under their obligations to make payments or deliver fuel or power,
    interest rate risk associated with variable-rate debt and the fair value of fixed-rate debt used to finance our operations; and
    foreign currency exchange rate risk associated with international investments and purchases of equipment and commodities in currencies other than U.S. dollars.

Objectives and Strategies for Using Derivatives

Risk Management Activities

To lower our exposure to the risk of unfavorable fluctuations in commodity prices, interest rates, and foreign currency rates, we routinely enter into derivative contracts, such as fixed-price forward physical purchase and sales contracts, futures, financial swaps, and option contracts traded in the over-the-counter markets or on exchanges, for hedging purposes. The objectives for entering into such hedging transactions primarily include:

    fixing the price for a portion of anticipated future electricity sales from our generation operations,
    fixing the price of a portion of anticipated fuel purchases for the operation of our power plants,
    fixing the price for a portion of anticipated energy purchases to supply our load-serving customers, and
    managing our exposure to interest rate risk and foreign currency exchange risks.

Non-Risk Management Activities

In addition to the use of derivatives for risk management purposes, we also enter into derivative contracts for trading purposes primarily to achieve the following objectives:

    optimizing the margin on surplus electricity generation and load positions and surplus fuel supply and demand positions,
    obtaining knowledge of prices and developing expertise in less-liquid markets, and
    deploying risk capital in an effort to generate additional returns.

Use of Derivative Instruments



Nature of Our Business and Associated Risks



Our business activities primarily include our merchant energy business and our regulated electric and gas business. Our merchant energy business
includes:





    the
    generation of electricity from our owned and contractually-controlled physical assets,
    the
    sale of power, gas, and other energy commodities to wholesale and retail customers, and
    risk
    management services and energy trading activities.



        Our
regulated electric and gas businesses engage in electricity and gas transmission and distribution activities in Central Maryland at prices set by the Maryland PSC that are generally
designed to recover our costs, including purchased fuel and energy. Substantially all of our risk management activities involving derivatives occur outside our regulated businesses.




        In
carrying out our merchant energy business activities, we purchase and sell power, fuel, and other energy-related commodities in competitive markets. These activities expose us to
significant risks, including market risk from price volatility for energy commodities and the credit risks of counterparties with which we enter into contracts. The sources of these risks include, but
are not limited to, the following:





    the
    risks of unfavorable changes in power prices in the wholesale forward and spot markets in which we sell a portion of the power from our power generation facilities and
    purchase power to meet our load-serving requirements,
    the
    risk of unfavorable fuel price changes for the purchase of a portion of the fuel for our generation facilities under short-term contracts or on the spot
    market. Fuel prices can be volatile, and the price that can be obtained for power produced from such fuel may not change at the same rate as fuel costs.
    the
    risk that one or more counterparties may fail to perform under their obligations to make payments or deliver fuel or power,
    interest
    rate risk associated with variable-rate debt and the fair value of fixed-rate debt used to finance our operations; and
    foreign
    currency exchange rate risk associated with international investments and purchases of equipment and commodities in currencies other than U.S. dollars.



Objectives and Strategies for Using Derivatives



Risk Management Activities



To
lower our exposure to the risk of unfavorable fluctuations in commodity prices, interest rates, and foreign currency rates, we routinely enter into derivative contracts,
such as fixed-price forward physical purchase and sales contracts, futures, financial swaps, and option contracts traded in the over-the-counter markets or on exchanges, for
hedging purposes. The objectives for entering into such hedging transactions primarily include:





    fixing
    the price for a portion of anticipated future electricity sales from our generation operations,
    fixing
    the price of a portion of anticipated fuel purchases for the operation of our power plants,
    fixing
    the price for a portion of anticipated energy purchases to supply our load-serving customers, and
    managing
    our exposure to interest rate risk and foreign currency exchange risks.



Non-Risk
Management Activities



In
addition to the use of derivatives for risk management purposes, we also enter into derivative contracts for trading purposes primarily to achieve the following
objectives:





    optimizing
    the margin on surplus electricity generation and load positions and surplus fuel supply and demand positions,
    obtaining
    knowledge of prices and developing expertise in less-liquid markets, and
    deploying
    risk capital in an effort to generate additional returns.



EXCERPTS ON THIS PAGE:

10-K (2 sections)
Feb 27, 2009
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