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Resolution No. 95001 2 3 4 5 0 7 8 9 10 11 12 13 14 15 16 RESOLUTION NO. 9500 A RESOLUTION OF THE CITY COUNCIL OF THE CITY OF VERNON APPROVING AND ADOPTING A ENERGY AND CREDIT RISK MANAGEMENT POLICY FOR THE CITY OF VERNON WHEREAS, by Resolution No. 7276 adopted on February 16, 1999, the City Council of the City of Vernon approved a Resource Procurement Plan and Credit Risk Management Policy for the Light & Power Department in order to enable the Department to plan, execute and control the management of a variety of risks inherent in power resource procurement in the deregulated power market; and WHEREAS, by Resolution No. 7489 adopted on February 15, 2000, as amended by Resolution No. 7728 on March 21, 2001, the City Council of the City of Vernon approved a Strategic Direction and Risk Tolerance for Resource Procurement policy to establish a plan that enabled the Light & Power Department to provide low cost power and optimize its resource portfolio while managing and mitigating risk; 17 11 and 18 19 20 21 22 23 24 25 26 27 28 WHEREAS, on December 7, 2005, the City Council of the City of Vernon adopted Resolution No.' 8915 approving a Market Risk Mitigation Policy in Iorder to produce better financial and nonfinancial performance outcomes and less volatility; and WHEREAS, on December 7, 2005, the City Council of the City of Vernon adopted Resolution No. 8916 approving a Credit Risk & Counterparty Control Policy which established a wholesale credit policy to govern the financial interactions of the City and its wholesale counterparties, whether buying or selling power, natural gas, transmission, or ancillary services; and WHEREAS, the Light & Power Department has prepared an Energy 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 and Credit Risk Management Policy (the "Policy") replacing the current Credit Risk & Counterparty Control Policy, Market Risk Mitigation Policy, and the Credit Risk Management Policy; and WHEREAS, the Policy provides guidelines to govern the Light & Power Department's energy portfolio and risk control activities and provide a framework through which management and personnel will identify, measure, manage, and report financial and other portfolio risks; and WHEREAS, the Policy is not intended to deal with the mitigation of risk of catastrophic events, environmental impacts, or regulatory exposures; and WHEREAS, the Policy will support and operate in conjunction with the Resource Procurement Plan and Strategic Direction and Risk Tolerance for Resource Procurement. NOW, THEREFORE, BE IT RESOLVED BY THE CITY COUNCIL OF THE ICITY OF VERNON AS FOLLOWS: SECTION 1: The City Council of the City of Vernon hereby finds and determines that the recitals contained hereinabove are true and correct. SECTION 2: The City Council of the City of Vernon hereby approves and adopts the Energy and Credit Risk Management Policy, a copy of which is attached hereto as Exhibit A and incorporated by reference. SECTION 3: The City Council of the City of Vernon hereby repeals the Credit Risk & Counterparty Control Policy,'the Market Risk Mitigation Policy and the Credit Risk Management Policy portion of the Resource Procurement Plan and Credit Risk Management Policy effective December 17, 2007, and reaffirms its adoption of the Resource - 2 - I Procurement Plan, without that portion of the plan dealing with the 2 Credit Risk Management Policy, and Strategic Direction and Risk 3 Tolerance for Resource Procurement policy. 4 SECTION 4: The City Clerk of the City of Vernon shall 5 certify to the passage of this resolution, and thereupon and 6 thereafter the same shall be in full force and effect. 7 APPROVED AND ADOPTED this 17th day of December, 2007. 8 9 Leonia C. Malburg 10 Name: 11 Title: Mayor / yo ro- e 12 ATTEST: 13 14 MANALA LA GIRON, i y Clerk 15 16 17 18 19 20 21 22 23 24 25 26 27 28 3 - 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 STATE OF CALIFORNIA ) ) ss COUNTY OF LOS ANGELES ) I, MANUELA GIRON, City Clerk of the City of Vernon, do hereby certify that the foregoing Resolution, being Resolution No. 9500, was duly adopted by the City Council of the City of Vernon at a regular meeting of the City Council duly held on Monday, December 17, 2007, and thereafter was duly signed by the Mayor or Mayor Pro-Tem of the City of, Vernon. (SEAL) n� UELA GIR N, ity Clerk - 4 - EXHIBIT A City of Vernon Light & Power Department ENERGY AND CREDIT RISK MANAGEMENT POLICY November 27, 2007 TABLE OF CONTENTS 1. SUMMARY 3 2. OBJECTIVES 4 OVERVIEW 4 OBJECTIVES 4 RETAIN AND ATTRACT CUSTOMER BASE 4 BE FINANCIALLY SOUND 4 OPTIMIZE RESOURCES 4 3. ENERGY PORTFOLIO 5 PHYSICAL POSITION 5 PRICE RISK POSITION 5 4. RISKS 7 OPERATIONAL RISK $ RESOURCE COST RISK $ ORGANIZATIONAL RISK 9 TRADING 9 CREDIT RISK 9 COMPETITION 9 5. RESPONSIBILITIES & AUTHORIZATIONS 11 TRANSACTIONS AUTHORITY .11 RISK MANAGEMENT RESPONSIBILITIES 11 CITY ADMINISTRATOR 11 DIRECTOR OF LIGHT & POWER 12 ENERGY RISK MANAGER 12 RESOURCE PLANNING MANAGER & RESOURCE SCHEDULERS 12 6. RISK MANAGEMENT 14 RISK ANALYSIS 14 RISK MANAGEMENT TOOLS 14 HEDGES 14 STRATEGIES FOR MANAGING PRICE RISK 14 Energy Risk Management Policy 1 12/5/2007 7. AUTHORIZED TRANSACTION TYPE PHYSICAL FINANCIAL PURCHASES SALES AUTHORIZED TRADERS TRANSACTION LIMITS SOME TRANSACTION GUIDELINES CHANGING LIMITS 8. REPORTING REPORTING REQUIREMENTS APPENDIX A. CREDIT RISK CONTROL POLICY B. TRANSACTION TERMINOLOGY S 16 16 16 16 16 16 16 17 ERROR! BOOKMARK NOT DEFINED. 18 19 19 20 20 24 Energy Risk Management Policy 2 12/5/2007 1. SUMMARY The Light & Power (L&P) Department is responsible for generation, transmission, and distribution of electricity for the benefit of the City of Vernon (COV). L&P's primary objectives are to develop the least cost supply portfolio to meet load requirements and maximize revenues from sales of surplus energy, capacity, and other wholesale energy services. There are risks associated with L&P's responsibilities and objectives. This risk management Policy discusses and sets guidelines to help L&P identify and manage those risks. Specifically, the Policy: • Reflects the goals and risk tolerance of COV, establishing limits and reporting requirements, without placing undue restrictions on L&P Operations • Establishes guidelines for L&P to control the risks associated with an energy portfolio and energy transactions • Focuses on stabilizing the cost of energy and associated risk while maintaining reliable energy supplies for retail customers • Is not intended to deal with the mitigation of risk of catastrophic events, environmental impacts, or regulatory exposures This Policy is designed for the specific requirements and constraints of the Light & Power. Resulting risk management activities shall govern L&P's energy portfolio and risk control activities and provide a framework through which management and personnel will identify, measure, manage, and report financial and other portfolio risks. The results of risk management activities will be continually evaluated relative to L&P's objectives to ensure correct and beneficial implementation. Energy Risk Management Policy 3 12/5/2007 2. OBJECTIVES OVERVIEW The L&P Department endeavors to provide low cost, reliable energy to its customers without undue risk taking. In the volatile energy market, this is a significant challenge. To meet this challenge, L&P participates in different markets (physical and financial) with different requirements, transactions, and associated risks. Successful participation requires developing and implementing portfolio and risk management procedures, skills, and tools. OBJECTIVES The Light & Power Department's objectives, that risk management activities are designed to help achieve, are: RETAIN AND ATTRACT CUSTOMER BASE Provide reliable, quality service and satisfy customers, while maintaining low, and competitive electric rates. BE FINANCIALLY SOUND Plan and conduct operations such that the total expenses of the Department, including depreciation, are less than revenues. OPTIMIZE RESOURCES Utilize the skills and assets of existing staff to optimize energy resources, including allowing for hedging to protect against adverse changes in energy market prices and rate increases to customers. Energy Risk Management Policy 4 12/5/2007 3. ENERGY PORTFOLIO Following is an overview of COV's energy portfolio positions. The portfolio is comprised of the physical position (load/resource balance) and the price risk position. PHYSICAL POSITION The physical position or load/resource balance shows the energy demand (load) vs. the energy available (resources) to meet demand. COV's total resources (generation plus purchases) meet most or all of its on -peak and off-peak energy requirements for the foreseeable future. There are different ways to present a load/resource balance. Table 3.1 shows COV's peak load -resource capacity balance on a fiscal year basis for on -peak and off-peak requirementsl. Load growth is forecast to increase 1.5% annually for the next five years, and resources are shown on a capacity basis. Table 3.1— Peak Load vs. Resource Capacity Balance (MW) Qn Peak Peak Load 201 219 222 225 227; Hoover 22 22 22 22 22 Palo Verde 11 11 11 11 11 MGS 134 134 134 134 134 Purchases 50 25 0 0 0 Net Long/(Short) Position t.. ..,.k Off -Peak 16 FY08 (27) F'09:FY10 1 (55) (58) F1 (60) 1FY12: ._ Peak Load 161 1 179 181 184 186 Palo Verde 11 11 11 11 11 MGS 134 134 134 134 134 Purchases 0 0 0 0 0 Net Long/(Short) Position (16) (34) (36) (39) (41) PRICE RISK POSITION A utility's price risk position measures the utility's sales rates (retail and wholesale), against its costs of generation. Typically, the sales rates are fixed while some of the costs ' COV-based gas turbine and diesel units not shown 2 Load expected to increase by 15 MW around the clock starting Dec. 2008 3 Ibid Energy Risk Management Policy 5 12/5/2007 of generation are not fixed. This imbalance creates a "short" energy price risk, as floating energy costs will increase with the market while fixed sales rates will not. A short price position has the risk of the cost of resources nearing or exceeding sales rates at any time, particularly in high load periods (e.g. summer and winter) and during abnormal operating conditions (e.g. resource outages). If the cost of power exceeds sales rates, the result is a negative cash flow that, over time, will be detrimental to continued operations. For a balanced position, load must be met with resources that are purchased and priced4. (Depending on the resources, this may or may not be an economical decision. The issue here is risk.) Most of COV's resources are priced, except for a portion of the natural gas for MGS. The resulting price risk position is shown in Table 3.25. Table 3.2 —Price Risk Position (MW) On -Peak Peak Load 201 219 222 225 227 Hoover 22 22 22 22 22 Palo Verde 11 11 11 11 11 MGS 80 80 80 80 80 Purchases 50 25 0 0 0 Net Long/(Short) Position (38) (81.) (109) (112) (114) �� i"72- Qff-Peak. Peak Load 161 179 181 184 186 Palo Verde 11 11 11 11 11 MGS 80 80 80 80 80 Purchases 0 0 0 0 0 Net Long/(Short) Position (70) (88) (90) (93) (95) The fact that MGS is the primary resource means most of COV's energy price risk is in natural gas rather than power. This is an advantageous portfolio position, not least because natural gas prices are less volatile and more easily hedged than power prices. L&P and the Energy Risk Manager will ensure COV's price risk position stays within acceptable limits established by management. 4 Resources can be either physical or financial. Financial positions may be "converted" to physical resources when the financial positions expire. 5 Volumes are consistent with Table 3.1 Energy Risk Management Policy 6 12/5/2007 4. RISKS L&P is a fairly active participant in the volatile power and natural gas markets. Due to the volatility and other variables in those markets, COV is moderately exposed to cost uncertainty in its energy portfolio, potentially resulting in net revenue shortfalls. L&P is well positioned, however, in managing its energy cost and other uncertainties (risks) through its experienced staff and implementation of the directives & authorizations in this Policy. The following table identifies the types of risk relevant to COV through its energy market activities. It summarizes how those risks are addressed. Operational (Load - Resource imbalances) Resource Cost Organizational Table 4.1 - Types of Risk Insufficient or excess resources to serve load due to a range of potential conditions (resource or transmission outages; higher or lower demand conditions than expected; poor planning) Adverse fluctuations in the wholesale prices of power and natural gas purchased for resale or generation purposes Failure to capitalize on market opportunities to reduce costs. Unclear lines of authority or inadequate staffing, lack of deal "ownership" Higher costs than expected on surplus or deficit as position is balanced Energy costs higher than budget resulting in net revenue shortfalls Value not delivered to customers or COV. Sub -optimum pricing and operational decisions; confusion within and outside the organization Requires coordination on operational and financial risk issues. Builds on existing transaction authorizations & limits, as well as monitoring procedures. Allows for the use of risk management tools to stabilize prices and capture costs lower than budget Specifies transaction authorizations and limits, appropriate transactions flows, and reporting procedures. Energy Risk Management Policy 7 12/5/2007 Trading Trading activity Financial losses Permits limited asset - separate from, but related and portfolio - complementary to, consistent transactions asset -based (covered) under the authority of activity the Risk Manager Credit Inability or Resale of energy at Centralizes and unwillingness of a a lower price consolidates the counter -party to resulting in reduced responsibility for credit perform in a bilateral revenue or activities in the Finance transaction repurchase of Department energy at a higher price resulting in increased cost Competition More competitive Reduced revenue Authorizes L&P to electric rates offered by due to loss of respond with different competitors in customers energy pricing structures surrounding regions; for existing customers to loss of customers retain market share OPERATIONAL RISK All utilities have operational risks that are managed by standard and accepted industry practices, such as the following: • Maintaining adequate planning resource margins and operating reserves; • Owning or contracting for fuel storage and/or fuel supply to assure continued operations under potential shortage conditions; • Emergency action and customer curtailment plans to respond to emergency conditions. Operational risk of extreme load conditions and resource or transmission outages are not specifically addressed in this Policy because L&P is well experienced in preparing for and managing these risks. The importance of an accurate load/resource balance forecast and the ability to react to contingencies are well understood by L&P. RESOURCE COST RISK COV's firm resources are cost competitive, particularly the hydroelectric and nuclear energy resources. MGS is only at risk of being uneconomic relative to COV's retail or wholesale rates if natural gas prices are very high (over $10/MMBtu)6. COV has higher price risk exposure to power prices when and if COV must purchase energy to meet peak 6 More precisely, only 40% of MGS would be uneconomical at gas prices over $10/MMBtu because a net 60% of the gas for MGS is already priced (at less than $7/MMBtu). Energy Risk Management Policy 8 12/5/2007 load requirements. If costs are exceedingly high, it may be necessary for COV to increase its rates to recover high costs. To protect margins and avoid the need for rate increases, this Policy authorizes L&P to participate in the wholesale power and natural gas markets to manage its energy portfolio proactively, seizing opportunities to limit risk and produce additional revenues. The power and natural gas markets contain opportunities to stabilize prices through forward transactions, including hedges. L&P will continue to capitalize on those opportunities to support existing rates. ORGANIZATIONAL RISK Responsibilities and authorizations by L&P are clearly delineated in Section 5. TRADING Trading, also referred to revenue generation activities, is permitted on a limited basis to capitalize on occasional market opportunities in power and natural gas. A "trade" is a transaction in the wholesale power or natural gas markets for the sole purpose of generating a profit. The opening sale (or purchase) of power or natural gas will be closed with the purchase (or sale) of the same commodity, creating a financial gain or loss on the transaction due to a difference in the opening and closing prices. A power trade sale creates a short position at the outset. It is a sale in excess of available resources. A power trade purchase is one that is not required to serve load and does not replace a higher cost resource. Trading contains price risk, potentially leading to financial losses. COV's tolerance for potentially significant financial losses is low. Therefore, only limited and controlled transactions in highly liquid energy markets are permitted. Further, they are transactions that are supported by and within the experience of L&P staff and the Energy Risk Manager. Trading controls (responsibilities, limits, authorizations, and reports) are detailed in Sections 5, 6, and 7. CREDIT RISK Credit exposure is the risk that a counterparty in a transaction will be unable or unwilling to fulfill its present and future financial obligations; i.e. perform on a sale or purchase agreement. Substantial unrealized gains or losses may accrue in physical contracts before any delivery obligation. The value of outstanding contracts can escalate substantially over time without the counter -party having to post or deposit any security in the form of collateral. These credit exposures are a concern for over-the-counter (OTC) transactions, not for exchange -based transactions. COV's Credit Risk Control Policy (Appendix A) governs and specifies the means to manage counterparty credit risk. COMPETITION Among L&P's goals are to maintain and expand (if possible) market share and customer base, so L&P must be empowered to respond to and provide competitive rates. The Energy Risk Management Policy 9 12/5/2007 authorizations and directives in this Policy empower L&P to do that, allowing for rate changes to meet or beat competition while managing portfolio risks that may result from rate changes. Energy Risk Management Policy 10 12/5/2007 5. RESPONSIBILITIES & AUTHORIZATIONS In general, the areas of responsibility of an organization engaged in physical and financial power and natural gas transactions may be categorized as front, middle, and back -office functions. These are listed in Table 5.1. Table 5.1 - Front, Middle, and Back -Office Functions Responsibility of L&P Department • Marketing & counterparty contact • Pricing • Transaction booking • Positioning Responsibility of Risk Manager or Credit Manager (or equivalents) • Risk measurement, monitoring, and reporting • Risk control (hedging) • Counter -party credit authorization & Responsibility of L&P and Accounting Departments • Scheduling • Confirmations • Reconciliations • Account booking • Settlements • Invoicing TRANSACTIONS AUTHORITY Power transactions range from hourly to multi -year deals. The longer the term and the greater the volume, the higher the level of authority required to approve the transaction. Real-time power deals (hourly and balance -of -day) have the lowest level of authority, whereas multi -year deals must be approved at the highest level. Specific authorizations by level are shown in Table 7.1 The risks accompanying these transactions are managed in different ways across all authority levels. RISK MANAGEMENT RESPONSIBILITIES The individuals or groups responsible for implementing this Policy range from the City Administrator to Resource Schedulers. Risk management responsibilities by authority level are as follows: City Administrator The City Administrator is responsible to promote receptivity within COV to risk management activities. He should also: • Ensure COV's employees engage only in those activities that correlate with the business needs of the organization • Require management involvement to ensure adherence to this Policy at all levels • Support the implementation, tracking, and reporting of hedging and revenue generation activities that include the use of financial instruments such as futures, forwards, swaps, and options Energy Risk Management Policy 11 12/5/2007 Director of Light & Power The Director is responsible for the overall direction, structure, conduct, and reporting of risk management activities. He should report to the City Administrator periodically on the results of risk management activities. He should also: • Periodically assess the adequacy and functioning of risk management activities relative to COV's multi -year strategic direction • Ensure the risk in the energy portfolio is within COV's risk tolerance • Assure that adequate staffing and resources are devoted to implementation of this Policy • Authorize traders and approve transaction counter parties • Establish the tone of the organization with respect to the importance of the resource procurement and control activities • Set targets for energy purchases and sales to meet or beat budget projections • Assure adequate capital reserves are maintained for credit operations and liquidity Energy Risk Manager The Risk Manager is primarily responsible for implementation of this Policy. He shall: • Monitor compliance with this Policy • Measure and report the risk taking and risk management activities of L&P with a market position report • Serve as the in-house expert on financial products and pricing and structuring of physical contracts with embedded financial features • Provide financial and physical market pricing expertise when evaluating the feasibility of structured products and services to customers • Take specific courses of action if a portfolio position exceeds or approaches the limits established by this Policy • Ensure that risks for all transactions have been identified and can be valued • Monitor for breakdowns in execution of duties especially during changes in personnel or organizational structure • Be able to estimate the financial exposure in COV's energy portfolio by applying standard risk measurement and valuation tools • Recommend and implement agreed upon portfolio hedges • Work with the Resource Planning Manager and Resource Schedulers to generate additional revenues through opportunistic market transactions Resource Planning Manager & Resource Schedulers The L&P Resource Planning Manager and Resource Schedulers are responsible for execution and management of physical energy portfolio activities. Regarding risk management, they are responsible to: Develop physical and financial transaction expertise in power and natural gas markets Energy Risk Management Policy 12 12/5/2007 • Abide by transaction limits specified herein • Provide a first line of defense against credit risk by helping to identify and by not transacting with counter parties that are known or believed to be not creditworthy or which lack integrity • Maintain communications with the Director and Energy Risk Manager on the status of all risk taking and resource procurement activities Utilize and provide input for the market position report • Monitor market conditions and maintain operational procedures to manage positions proactively • Monitor the effectiveness of internal communications, e.g. distribution of market information among relevant parties. Energy Risk Management Policy 13 12/5/2007 6. RISK MANAGEMENT Risk management is the process of identifying, assessing, and controlling risks associated with physical and financial market transactions. Risk management activities may vary considerably among entities. Some entities may focus on reducing, limiting, and avoiding risk, while others focus on accepting, selecting, altering, and even taking risk. L&P risk management focuses on ensuring risks remain within acceptable limits. RISK ANALYSIS Analysis and reporting of COV's energy portfolio risk are the responsibility of the Risk Manager, primarily through a market position report. The position report, or mark -to - market report, is a valuable tool for measuring and monitoring risk. It contains a summary of all forward open energy positions. All open positions, such as required energy purchases, are marked to market to provide information on the current value and cash flows associated with the open positions. For many organizations, the position report enables value -at -risk (VAR) calculations to be made on a transactional and portfolio basis. VAR is not critical for a municipal utility like COV as long as its energy costs may be passed through to its customers. When and if COV's rate structure changes such that COV has more significant financial risk, VAR may be an appropriate risk measure for COV's portfolio. RISK MANAGEMENT TOOLS One or more of the following transaction tools have been and will be used by the Risk Manager and L&P to manage energy price risk: • Futures: financial positions (contracts) on the New York Mercantile Exchange (NYMEX) in power or natural gas • Forwards: same as futures, except the position is a bilateral contract with a specific counter -party in the over-the-counter market • Swaps: a contract exchanging fixed for floating payments on a given quantity of power or gas • Options: a contract that, for a fixed premium, gives the buyer the right to buy or sell power at a given price (the strike price) on or before a specific date HEDGES Hedges are transactions that reduce price risk relative to a current or future physical position. They can help protect COV against high fuel costs and/or increasing costs of required energy purchases. Typically, hedges are financial in nature and on a next -month forward basis. Hedges may include transactions in the power and natural gas futures markets. STRATEGIES FOR MANAGING PRICE RISK Table 6.1 lists different strategies for managing (or hedging) exposure to higher forward energy prices. Energy Risk Management Policy 14 12/5/2007 Table 6.1— Hedging Strategies for Energy Purchase Requirements A) Buy fixed forward' B) Buy index forward Q Buy fixed forward plus buy put option $ D) Buy index forward plus buy call option 9 E) Buy index forward plus buy call option and sell put option Fix the price of energy in a future month Float the price of energy until delivery month Fix price in future month, protect against downside price risk Float price until delivery month, protect against upside price risk Float price until delivery month, protect against upside price risk at reduced (or zero) premium Eliminates upside price risk and locks in purchase price at an approved level Purchase price will be "at the market" Eliminates upside price risk, locks in purchase price at approved level, and price won't be "out of the market" by more than the difference in the purchase price less the strike price of the put option Purchase price will be "at the market" but won't exceed strike price of call option Purchase price will be "at the market", at strike price of call option, or at strike price of put option ' Ideally, the fixed price is at or below the "buy" level for the month. 8 Or buy put option spread to reduce the net premium paid. 9 Or buy call option spread to reduce the net premium paid. Market price may be lower at time of delivery Market price may be higher at time of delivery Market price may be lower at delivery, down to strike price of put option with loss in put option premium Market price may be higher at delivery, up to strike price of call option with loss in call option premium Market,price may be higher up to strike price of call option or market may be lower than strike price of put option Energy Risk Management Policy 15 12/5/2007 7. AUTHORIZED TRANSACTIONS TYPE Physical Physical transactions are executed by Resource Schedulers. The transactions are in WECC (Western Electricity Coordinating Council) power, and may be fixed -price, exchanges (buy/sells), options, capacity, transmission, and ancillary services. Transaction counter -parties are members of the WSPP (Western System Power Pool), the California ISO, and other credit -approved parties Financial Financial power transactions may be executed by Resource Schedulers, but they are the primary responsibility of the Energy Risk Manager and require his involvement. Financial natural gas transactions are only executed by the Energy Risk Manager. The financial power and natural gas transactions are: • Fixed or floating swaps on underlying physical markets • Basis swaps related to locations traded in the physical markets • Futures and futures options Purchases Physical or financial energy purchases are for the purpose of meeting or hedging excess load requirements, providing reliability, replacing higher cost resources, or capturing market opportunities. Sales Physical or financial energy sales are for the purpose of producing or hedging revenues from excess generation, balancing excess purchases, or capturing market opportunities. Power sales shall not create a short physical portfolio position in any period, particularly the 3rd quarter. AUTHORIZED TRADERS In order of authority: Energy Risk Manager Director of L&P Resource Planning Manager Resource Schedulers Energy Risk Management Policy 16 12/5/2007 TRANSACTION LIMITS Specifying and adhering to transaction limits is vital to controlling operational, financial, and credit risk. Limits ensure risk is controlled at various levels of position aggregation (e.g. by counter -party, delivery location, delivery period, instrument type, etc.). The primary purpose of L&P's energy transactions is to meet load requirements in a prudent, economical fashion. Limits do not apply to these transactions. L&P engages in other "second tier" energy transactions to hedge risk or generate additional revenues. Hedging transactions are for the purpose of helping L&P achieve the Objectives listed on p.4. Revenue generation transactions are for the purpose of creating additional revenues by taking advantage of perceived market opportunities. These second tier transactions (hedges and revenue generation) are limited in type, time, and volume to ensure any associated risks are controlled and within acceptable bounds. Authorizations and limits for hedges are specified in Table 7.1. Table 7.1— Hedging Authorizations & Limits Authorizations and limits for revenue generation are specified in Table 7.2. 10 Transactions in financial power must involve the Energy Risk Manager Energy Risk Management Policy 17 12/5/2007 Table 7.2 — Revenue Generation Authorizations & Limits Physical power 'Financial natural Type gas Both Both Financial power 11 Time ahead Up to one year Same Same. Same Duration Up to one quarter Up to six months Up to one year Up to two years Volume: Per transaction 25 MW 10 contracts 12 Same Same Total open 50 MW long 50 contracts Up to Up to additional position per 25 MW short additional 50% 100% month Counter -party From approved Same Same Same credit list CHANGING LIMITS Limits depend on evolving business needs and/or risk tolerance. Limits may be adjusted, upward or downward, by the City Administrator. The Risk Manager is responsible for monitoring and maintaining transaction limits. He shall assess the effectiveness of limits for achieving net revenue targets and propose changes in limits as market conditions, operating circumstances, and opportunities warrant. 11 Transactions in financial power must involve the Energy Risk Manager 12 1 contract = 10,000 MMBtu Energy Risk Management Policy 18 12/5/2007 8. REPORTING Risk management and risk -related reports communicate the market and credit risks of an organization, and provide information to evaluate the portfolio performance and the effectiveness of the risk management program. The reports are used as a basis for risk management discussions and future energy transactions and strategy. Reporting Requirements The following table identifies the risk management and related reports that must be produced, their normal frequency, distribution, and the originator of the report: Table 8.1— Risk Management Reports :Rep©xt x'�Fequeri `j1agmator Load/Resource Monthly Resource Schedulers balance Position Report Monthly Risk Manager Credit approved As updated Finance Dept. counter -parties Energy Risk Management Policy 19 12/5/2007 APPENDIX A. CREDIT RISK CONTROL POLICY The City of Vernon (COV) recognizes the need to manage credit risk as an essential component of the management of its business. In addition to the existing retail credit policy governing the financial interactions of COV and its customers, this Credit Risk Control Policy shall govern the financial interactions between COV and its wholesale counterparties in power, natural gas, transmission, or ancillary services transactions. Such transactions` contain the risk of non-performance in payment for products, and the risk of non-performance in delivery or receipt of such products. To control those risks, the following rules for wholesale credit will be adhered to in the course of business at COV: 1. The L&P Department will only transact with approved counterparties (CP's). The City Council grants authority to the City Administrator and the Director of Light and Power to approve or disapprove of counterparties proposed by Light & Power (L&P). 2. For each counterparty (CP), the City Council authorizes the City Administrator and the Director of L&P to establish individual levels of unsecured credit exposure commensurate with the CP's ability to perform in and remit payment for the wholesale transactions it undertakes with COV. These unsecured credit limits will be derived from documented and replicable credit analyses. From time to time, but at least once every 12 months, such credit limits will be reviewed and updated. CP's falling in the lowest credit risk category will be given a de minimus unsecured credit limit. 3. The credit exposure to each CP will be calculated to include payables and receivables in each month, and the mark -to -market of any open forward contracts across the next 24 months with the CP. These will be kept evergreen and reported by L&P staff to the Director of L&P. 4. The maximum uncollateralized credit exposure to any CP will be capped according to counterparty "Class". Counterparty Class and the corresponding maximum unsecured credit extended to CP's in each class are listed in the following section on Credit Procedures. The amount of unsecured credit will be extended beyond the specified unsecured maximum only to organizations having the highest credit ratings and assessments, and recognized as trading partners of strategic value to COV, and with whom COV has traded in large enough volumes over a sufficient time to warrant confidence in the CP's performance. The City Administrator and the Director of L&P shall judge the satisfaction of these terms. Credit agreements will be negotiated with all existing CP's to provide mechanisms for collateralization should a CP exceed its credit limit, to establish protections required by COV in the event of CP bankruptcy, and to formalize and document credit activities between the parties. These agreements will be reviewed by the Director of L&P and signed by the City Administrator. Prior to conclusion of such agreements, all CP's will be held to 25% of their recommended credit limit. 6. The management of Credit Procedures, counterparty limits, and credit agreements are the responsibility of L&P staff. Energy Risk Management Policy 20 12/5/2007 7. L&P will not engage in credit intermediation ("sleeving") transactions without approval by the Director of L&P. 8. Options transactions will only be conducted with approved Class I counterparties, unless otherwise approved by the Director of L&P. 9. The only exception to these rules and associated procedures is the event of the need to transact with a CP in real time to balance COV's energy position. CREDIT PROCEDURES A. Counterparty Approval 1. L&P will consider all existing CP's (those with currently open forward contracts and/or those with whom the City has historically done business) as "conditionally approved" until such time as the CP's can be evaluated for credit worthiness by L&P staff and the Director of L&P, and assigned a credit limit. 2. Credit limits will be based on a CP's assessment score. Some latitude may be allowed for the strategic significance of the CP to COV's business, but the counterparty's limits will be consistent with the limits and assessments of other CP's in the same Class. Any additional credit "latitude" assigned the CP must be requested by the CP, recommended by L&P staff, and approved by the Director of L&P. 3. For each new proposed CP, prior to transacting with that CP, L&P staff and the Director of L&P must assess the credit worthiness of the proposed CP and establish a credit limit consistent with CP's in the same Class. 4. Transacting with the CP may proceed after credit approval by the Director of L&P and the City Administrator (or his designee). 5. The credit extended will be limited to 25% of the proposed credit limit until such time as credit agreements are completed between COV and the CP. B. Credit Assessment 1. Credit assessment will be performed by L&P staff using the workbook tool currently employed. 2. The workbook tool provide for the introduction of both quantitative and _ qualitative measures related to the CP's credit worthiness. L&P staff will maintain documentation of the reason for the scores given each CP. 3. From time to time, L&P staff may decide to alter the tool or change its weighting functions. L&P will reassess all CP's with the modified tool. Any changes will be documented and reported to the Director of L&P, along with any changes in credit limits suggested by the new assessment. C. Establishment and Maintenance of Credit Limits 1. CP's will be divided into three qualitative categories. All entities with a credit assessment greater than 3.00 will be deemed Class I or "high quality" credits. CP's with ratings between 2.00 and 3.00 will be deemed Class II or "good" Energy Risk Management Policy 21 12/5/2007 credits. CP's scoring below 2.00 will be deemed Class III or "questionable" credits. 2. Class I and II credits will be assigned individual credit limits consistent with their assessment ratings. The maximum single exposure for Class I counterparties is $10 million, while the maximum single exposure for Class II counterparties is $3.5 million. Should the order of the credit limits differ from the order of assessment scores, L&P staff will document reasons for the discrepancy and report them to the Director of L&P. 3. Class III credits will be extended no unsecured credit beyond a de minimus amount of $25,000 for purposes of convenience. . 4. Class III credits will be limited to real-time and pre -schedule trading. Forward contracts will not be entered into with Class III credits. Credit limits will be reassessed every 12 months for Class I credits, every 6 months for Class II credits, and as often as L&P deems useful and practical for Class III credits. 6. L&P is responsible to remain current on significant financial changes among approved CP's. In particular, CP's must be reassessed upon any downgrade or upgrade by a major credit rating organization or any material change in the CP's business status. 7. Additional credit, beyond the unsecured credit limits defined above, may be negotiated with an approved CP. Acceptable forms of credit enhancement include letters of credit where the issuing institution is rated "A" or better, prepayment, parental guarantees, or other forms of acceptable collateral as determined by L&P staff. D. Exposure Calculation and Reporting 1. Credit exposure for each CP will be defined as the [discounted] sum of payables, receivables, and the mark -to -market for all forward power and natural gas contracts with final delivery beyond the current pre -schedule period up to 24 months ahead. 2. Exposure amounts will be netted and offset to the extent that COV has credit contracts in place with the CP enabling such treatment. Otherwise, credit exposure will be defined in each month as the sum of payables and mark -to - market. 3. The daily change in payables and receivables will be estimated between each monthly accounting book close for COV. 4. After each monthly close, the estimated payables and receivables will be updated to be consistent with COV's books. 5. After receivables and payables are exchanged according to the terms of the contracts, the Treasurer's office will notify L&P of changes to payables and receivables. Energy Risk Management Policy 22 12/5/2007 6. The Treasurer's office will immediately notify the Director of L&P of any failure of a CP to make payments due. Any CP that fails to make a scheduled payment beyond the core period agreed to in the resolution of disputes will be considered to have exceeded its credit limit. Any additional transactions with the CP will be suspended until the arrears are paid in full. E. Credit Agreements 1. L&P will negotiate mutual netting, set-off, and collateral agreements with all existing and proposed CP's. 2. Those agreements may be chosen from one of several agreements available and in common use such as WSPP and/or EEI for physical trades, and ISDA for financial derivatives. 3. Prior to the completion of such agreements, the CP will be held to 25% of its full credit line. F. Credit Watch and Credit Limit 1. When a CP reaches 80% of its credit limit, it will be designated on the Credit Report as being on credit watch. Authority for additional transactions with the CP will then be shifted one level of authority higher than currently applicable. 2. When the CP goes on credit watch, L&P must decide what course of action to take regarding the CP in the event it passes its credit limit. These actions will be limited to: a. Increasing the credit limit; b. Demanding collateralization per COV's agreements with the CP; c. Ending trading with the CP and/or requesting that offsetting trades be entered into with that same CP. 3. When a CP reaches 90% of its credit limit, transactions will be limited to 25 MW (total volume) and less than one forward month in duration. 4. If a CP reaches its credit limit, L&P staff's response determined at the beginning of the credit watch will be implemented. Energy Risk Management Policy 23 12/5/2007 B. TRANSACTION TERMINOLOGY Broker is a derivative agent, who introduces counter -parties to a transaction, arranges the transaction, and charges a fee for this service. A broker never takes a principal position in the market. Call is an option contract that gives the holder the right to buy a specified commodity or security from the writer of the option for a specified volume at a specified price (strike price) on or before a specific date. Clearinghouse is an organization that registers, monitors, matches and guarantees trades on a future market and performs financial settlement of future transactions. Clearing Member is an exchange's member broker who is responsible for the fulfillment of a future (options) contract. Brokers that are not clearing members must clear their trades through clearing members. Closed Position is a transaction whose value is locked -in and is not susceptible to changes in market prices or credit factors. Collar is an option strategy designed to minimize or eliminate the up -front cost of a cap (floor) through the sale of a floor (cap). Collateral is an obligation, security, cash, or asset provided in conjunction with a derivative contract obligation to secure its performance. Credit Risk is the risk that, in a financial or physical transaction, the counter -party will not perform in accordance with its contractual commitments. Derivatives are financial instruments whose value is based on a commodity or other security, e.g., futures, options, swaps, and forwards. Futures Commission Merchant (Futures Broker) is a'broker who is a member of an organized futures exchange and who charges a commission for his/her services. Hedge is a transaction that reduces price risk relative to a position that the organization has or intends to take in the physical market. Liquid Market refers to a market for financial instruments in which buying and selling can be performed with ease, due to the presence of a large number of buyers and sellers prepared to trade substantial quantities at small price differences. (Opposite is an illiquid marketplace.) Margin is the amount of money deposited as a guarantee of fulfillment of contract obligations. Initial margin is posted when a futures contract is initiated. Variation margin is paid (collected) in order to maintain a minimum margin level based on daily fluctuations in contract market value. Market Maker, also known as an intermediary, dealer, or issuer, is the division that makes a market in an OTC instrument by offering to both buy and sell the instrument. Mark -to -Market is the daily adjustment of the value of open positions to reflect gains and losses resulting from price movements occurring during the last trading session. This periodic review values all positions in a hedge portfolio at current market prices. Energy Risk Management Policy 24 12/5/2007 Master Swap Agreement is a contract between two derivative counter -parties that specifies all definitions, terms, conditions and laws governing any swap transaction. It enables the parties to execute one agreement and transact multiple swaps through appendices to that agreement, if necessary; rather than executing multiple agreements for multiple transactions. Open Position is a transaction whose value changes with the market and/or contains a degree of credit risk. Option is a contractual agreement between two counter -parties, where the writer (seller) grants a right to the buyer, for a fee (premium) to buy or sell a commodity, security, or asset at a given price (strike price) on a specific date ("European" option) or on or before a specific date ("American" option). Over -the -Counter (OTC) is the purchase and sale of financial instruments when not conducted on an organized exchange. OTC is also referred to as the bilateral market. Physical Market means the cash market in which the actual commodity is bought and sold. Power Marketer is a business entity engaged in buying and selling power, but does not own generating or transmission facilities. Power marketers take ownership of power and are involved in interstate trade. These entities file with FERC for status as power marketers. Premium is the price paid for an option or instrument with an option -like feature. Put is an option contract that gives the holder the right to sell a specified commodity, security, or asset to the writer of the option for a specified volume at a specified price (strike price) on or before a specific date. Realized gain/loss is the amount of capital that has actually been received or paid out to counter -parties as a result of transactional activities. Strike Price is the pre -determined price level at which option exercise takes place. Swap is a contractual agreement between two counter -parties to exchange fixed for floating payments on a given quantity of a commodity or security. Volatility is the degree to which the price of a commodity or security fluctuates around some mean value. It is usually measured as the variance or standard deviation of the price. Energy Risk Management Policy 25 12/5/2007 CITY CLERK'S OFFICE INTEROFFICE MEMORANDUM DATE: January 2, 2008 TO: Donal O'Callaghan, Director of Light & Power FROM-/ Nelly Giron, City Clerk RE: Resolution No. 9500 - A Resolution of the City Council of the City of Vernon Approving and Adopting a Energy and Credit Risk Management Policy for the City of Vernon Transmitted herewith is a copy of Resolution No. 9500 referenced above, which was approved by City Council on December 17, 2007. Thank you. NG:dr c: Resolution File No. 9500