FASB Scope Exceptions Normal Purchases and Normal Sales Exception for Certain Option-Type Contracts and Forward Contracts in Electricity

FASB: Scope Exceptions: Normal Purchases and Normal Sales Exception for Certain Option-Type Contracts and Forward Contracts in Electricity

Derivatives Implementation Group

Statement 133 Implementation Issue No. C15

Title: Scope Exceptions: Normal Purchases and Normal Sales Exception for Option-Type Contracts and Forward Contracts in Electricity
Paragraph references: 10(b), 58(b)
Date cleared by Board: June 27, 2001 (Revised December 19, 2001)
Date posted to website: June 29, 2001
Date latest revision posted to website: November 10, 2003
Affected by: FASB Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities
(Revised November 5, 2003)

QUESTION

Can the normal purchases and normal sales exception be extended to power purchase or sale agreements (whether forward contracts, option contracts, or combinations of both), including capacity contracts, for the purchase or sale of electricity?

BACKGROUND

In many situations, companies in the electric industry enter into contracts that permit one party to purchase electricity (also referred to as "power") from another. Such contracts can vary substantially in terms, with some requiring delivery of a specific quantity or power and others providing optionality regarding the quantity to be delivered.

The types of contracts typically used to buy and sell power are driven by the characteristics of the electric power industry. A unique characteristic of the industry is that electricity cannot be readily stored in significant quantities. As a result, some of the contracts to buy and sell electricity permit the buyer some flexibility in determining when to take electricity and in what quantity in order to match power to fluctuating demand.

Another characteristic of the industry is that fixed costs are a very high percentage of the total cost of producing power. In order to provide for recovery of such fixed costs, power contracts that are option contracts typically include a specified charge (sometimes referred to as the capacity or demand charge) to provide for recovery of the cost of the plant (or, in some cases, recovery of the market-based value of the plant) and related financing. An option contract will also include a variable charge to recover, among other things, the variable cost of producing power (the energy charge). Option contracts that contain a specified capacity charge that is based on recovering the cost of the plant and a variable energy charge are often referred to as capacity contracts, although that term is also used for certain forward contracts.

In a regulated electric industry, regulators set rates in order to recover plant fixed costs and variable costs plus a reasonable return. Tariffs are established that generally separate the capacity charge and the energy charge, among other charges. With the introduction of independent power plants, some contracts to buy and sell power also include capacity charges and energy charges, which in the past were generally established by regulators. The intent to physically deliver power at rates that will recover the cost of plant and energy while giving the purchaser the ability to have some control over when and in what quantity power is delivered is a consistent characteristic of these contracts.

With the deregulation of the electric utility industry, the above industry characteristics continue to drive how contracts to buy and sell power are structured. The buyer of power needs some flexibility in when to take power and in what quantity, and the seller needs to price such arrangements in order to cover the high fixed costs of producing electricity. In some cases, the purchase price of the electricity is entirely fixed, as in a forward contract or in an option contract that involves an initial premium payment for the time value of the option. More commonly for option contracts, the purchase price of the electricity is composed of an initial specified element and a variable element that is payable only if the option is exercised and electricity is delivered.

RESPONSE

Paragraph 10(b)(4), as amended by Statement 149, permits power purchase or sales agreements (whether forward contracts, option contracts, or combinations of both) for the purchase or sale of electricity to qualify for the normal purchases and normal sales exception (in paragraph 10(b)(4)) provided that all of the applicable criteria in paragraph 58(b), as amended, are met. Those criteria are presented below, with supplemental comments for criterion 2.

Criteria applicable to both parties to the contract:

  1. The terms of the contract require physical delivery of electricity. That is, the contract does not permit net settlement, as described in paragraphs 9(a) and 57(c)(1). For an option contract, physical delivery is required if the option contract is exercised.

  2. The power purchase or sales agreement (whether a forward contract, an option contract, or a combination of both) is a capacity contract, as defined in Statement 133 (as amended). Differentiating between an option contract that is a capacity contract and a traditional option contract (that is, a financial option on electricity) is a matter of judgment that depends on the facts and circumstances. For power purchase or sale agreements that contain option features, the characteristics of an option contract that is a capacity contract and a traditional option contract, which are set forth in the appendix to this Issue, should be considered in that evaluation; however, other characteristics not listed in the appendix may also be relevant to that evaluation.

Criterion applicable only to the seller of electricity:

  1. The electricity that would be deliverable under the contract involves quantities that are expected to be sold by the reporting entity in the normal course of business.

Criteria applicable only to the buyer of electricity:

  1. The electricity that would be deliverable under the contract involves quantities that are expected to be used or sold by the reporting entity in the normal course of business.

  2. The buyer of the electricity under the power purchase or sales agreement is an entity that is engaged in selling electricity to retail or wholesale customers and is statutorily or otherwise contractually obligated to maintain sufficient capacity to meet electricity needs of its customer base.

  3. The contracts are entered into to meet the buyer’s obligation to maintain a sufficient capacity, including a reasonable reserve margin established by or based upon a regulatory commission, local standards, regional reliability councils, or regional transmission organizations.

Because electricity cannot be readily stored in significant quantities and the entity engaged in selling electricity is obligated to maintain sufficient capacity to meet the electricity needs of its customer base, an option contract for the purchase of electricity that meets the above criteria qualifies for the normal purchases and normal sales exception in paragraph 10(b). In contrast, Statement 133 Implementation Issue No. C10, "Can Option Contracts and Forward Contracts with Optionality Features Qualify for the Normal Purchases and Normal Sales Exception?" prohibits that exception from being applied to a contract for the purchase of an asset other than electricity if the contract contains an optionality feature that can modify the quantity of the asset to be delivered under the contract.

Power purchase or sales agreements that meet only the above applicable criteria qualify for the normal purchases and normal sales exception even if they are subject to being booked out or are scheduled to be booked out. Forward contracts for the purchase or sale of electricity that do not meet the criteria in this Issue as well as other forward contracts are nevertheless eligible to qualify for the normal purchases and normal sales exception in paragraph 10(b)(1) by meeting all the criteria in that paragraph, unless those contracts are subject to unplanned netting (that is, subject to possibly being booked out).

The above guidance does not affect the accounting for requirements contracts that would not be required to be accounted for under the guidance in Statement 133 pursuant to Statement 133 Implementation Issue No. A6, "Notional Amounts of Commodity Contracts." Contracts that qualify for the normal purchases and normal sales exception based on the guidance in this Issue do not require compliance with any additional guidance in paragraph 10(b). However, contracts that have a price based on an underlying that is not clearly and closely related to the electricity being sold or purchased or that are denominated in a foreign currency that meets neither of the criteria in paragraphs 15(a)–15(d) shall not be considered normal purchases and normal sales.

For contracts that qualify for the normal purchases and normal sales exception provided by this Issue, the entity shall document the basis for concluding that the agreement is a capacity contract.

The guidance in this Issue should not be applied by analogy to the accounting for other types of contracts not meeting the criteria in the above paragraphs.

EFFECTIVE DATE

The effective date of the implementation guidance in this Issue for each reporting entity is the first day of its first fiscal quarter beginning after June 29, 2001, the date that the Board-cleared guidance was first posted on the FASB website. Revisions were subsequently made on October 10 and December 19, 2001. The effective date of those revisions to the implementation guidance in this Issue for each reporting entity is the first day of its second fiscal quarter beginning after December 28, 2001, the date that the revised cleared guidance was posted on the FASB website. Revisions were also made on November 5, 2003. The effective date of those revisions to the implementation guidance in this Issue for each reporting entity is the first day of its first fiscal quarter beginning after November 10, 2003, the date that the most recently revised cleared guidance was posted on the FASB website. The revised implementation guidance applies to all power purchase or sales agreements existing on or after that effective date. Early application is permitted. The revisions made on March 26, 2003, do not affect the effective date.


The above response has been authored by the FASB staff and represents the staff’s views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation.


Appendix to Implementation Issue No. C15

Characteristics of both Option Contracts That Are Capacity Contracts and Financial Options
on Electricity

 

Option Contract That Is a Capacity Contract

Financial Option Contract on Electricity

1

The contract usually specifies the power plant or group of power plants providing the electricity.

No reference is made to the generation origination of the electricity.

2

The strike price (paid upon exercise) includes pricing terms to compensate the plant operator for variable operations and maintenance costs expected during the specified production periods.

The strike price is structured based on the expected forward prices of power.

3

The specified quantity is based on individual needs of parties to the agreement.

The specified quantity reflects standard amounts of electric energy, which facilitate market liquidity (for example, exercise in increments of 10,000 KwH).

4

The title transfer point is usually at one or a group of specified physical delivery point(s), as opposed to a major market hub.

The specified index transfer point is a major market hub (liquid trading hub), not seller- or buyer-site specific.

5

The contract usually specifies certain operational performance by the facility (for example, the achievement of a certain heat rate).

No operational performance is specified (not plant specific).

6

The contract sometimes incorporates requirements for interconnection facilities, physical transmission facilities, or reservations for transmission services.

None specified.

7

The contract may specify jointly agreed-to plant outages (for example, for maintenance) and provide for penalties in the event of unexpected outages.

Penalties for outages are not specified (not plant specific).

8

Damage provisions upon default are usually based on a reduction of the capacity payment (which is not market based). If default provisions specify market liquidating damages, they usually contain some form of floor, ceiling, or both. The characteristics of the default provision are usually tied to the expected generation facility.

Damage provisions upon default are based on market liquidating damages.

9

The contract’s term is usually long (one year or more).

The contract’s term is not longer than 18 to 24 months because financial options on electricity are currently illiquid beyond that period.