Industries

Energy, Utilities & Mining

Intertwined: the physical

and the financial
Commodity risk in the oil & gas, power utility and mining sectors

*connectedthinking
Contents

1 Introduction

2 Executive summary

4 New challenges affecting oil and gas, power utility and mining companies
4 Price volatility
6 Changing patterns of global trade
6 Geopolitical risk
6 Emissions trading
8 Carbon offset/carbon credit markets
9 Weather risk
10 Changing commodity trading regulation

12 Tackling industry-specific challenges

12 Oil & gas
15 Power utilities
18 Mining

22 Responding to the challenges

22 Proprietary trading
22 Asset-based trading for optimisation
22 Hedging
23 Do company shareholders understand and value hedging?
24 How is risk capacity established in practice?
27 Executing the hedging strategy
27 Conclusion

28 Embedding commodity risk management in the organisation

28 Organisational design and processes
30 Accounting
32 Valuation
33 Tax

34 How PwC can help

35 Contact us

The hard-hat world of the oil and gas, power utility
and mining industries and the hard-ball world of
financial trading have progressively become more
intertwined. In the past five years, in particular, the
interplay between these two worlds has increased in
both extent and complexity.
Greater liquidity, increased participation of financial
players, new types of exchanges and new types of
commodities, such as emission rights, have all
contributed to the growing importance of the use of
financial instruments and, in some sectors, trading.
The increase in commodity trading in markets
affecting oil and gas, power utility and mining
companies has an impact on short- and long-term
contract prices, on price volatility, on the choices
faced by end-customers and on the regulatory
landscape governing markets.
Companies are increasingly engaging in trading to
optimise and add more flexibility to their asset
position. More and more, oil and gas and power
utility companies in particular are involved in
commodity mechanisms that are financial rather than
physical in nature. In mining, physical transactions
remain predominant but, again, rising and fluctuating
commodity prices make the management of
commodity risk an important part of their activities
as they increase production to meet growing market
demand.
Richard Paterson Manfred Wiegand
Global Energy, Utilities Global Utilities Leader
and Mining Leader
Introduction 1
These changes are producing new types of risk for
companies that require a re-examination of their risk
strategies and the way they conduct their risk
management. Companies need to understand and
engage with the market environment in ways that are
consistent with their commercial imperatives and risk
appetite. Crucially, they need to be sure that they
have the risk frameworks, controls and systems in
place to manage risks and opportunities effectively.
Intertwined: the physical and the financial looks at the
new commodity risk challenges facing companies in
the oil and gas, power utility and mining industries.
It also looks at the specific challenges that arise
within each of the industry sectors. Key questions
such the role of trading and hedging within company
strategies are examined as well as how best to get
key building blocks such as organisational structure,
tax, valuation and accounting right. Finally, we
conclude by looking at what companies should do to
embed effective risk management in this new
environment across the whole of their company.
Tim Goldsmith
Global Mining Leader
2 Executive summary

A range of new challenges and opportunities

are affecting oil and gas, power utility and
mining companies. Commodity prices have
risen dramatically but this has been
accompanied by significant price volatility for
many commodities. In part, this has been
attributable to the increasing attraction of oil
and gas, power and mining markets to financial
players including hedge funds. An investigation
by a US Senate committee estimated that,
over the past few years, large financial
institutions, hedge funds, pension funds and
other investment funds have been pouring
billions of dollars into the energy commodities
markets perhaps as much as $60 billion in
the regulated U.S. oil futures market alone to
try to take advantage of price changes or to
hedge against them.1

Greater complexity has also come from the

advent of new commodities, principally CO2
allowances, which can critically impact
companies investment decisions and ongoing
operational optimisation. In addition, the
number of trading platforms and types of
trading mechanisms has increased. These
commodity market changes are occurring
against a background of changes in a range of
other factors that are key to companies risk
management considerations changing
patterns of world trade, geopolitical risk and
increasing regulation.

1
United States Senate Permanent Subcommittee on Investigations,
Committee on Homeland Security and Governmental Affairs, The Role
of Market Speculation on Rising Oil and Gas Prices, June 2006.

In Europe, the adoption by individual EU
countries of the Markets in Financial
Instruments Directive (MiFID) by November
2007 put EU rules into effect which impact
commodity derivatives trading and some
market participants. An ongoing review
instigated by the European Commission could
throw the regulatory net wider in the future,
particularly in respect of energy derivatives
trading. In the US, there has been increased
scrutiny on the markets as a result of record
commodity prices, the impacts of perceived
or real speculative trading and some well-
publicised abuses and losses associated with
energy trading. In this climate, the number of
complaints and frequency of proactive
regulatory reviews will probably continue to
increase.
A range of specific issues affect companies in
the different sectors. We review issues such as
exploration risk, long-term contract pricing
mechanisms, project development hedging,
international arbitrage opportunities and
liquefied natural gas (LNG) market
developments in the oil and gas sector. In the
power utility sector, issues such as new
generation capacity, optimisation of generation,
demand for long-term supply contracts and
changing customer expectations are also
discussed. The mining industry is undergoing
major consolidation and companies also face
price volatility and cost pressures as well as
specific environmental and geopolitical risk.
3
We look at how companies are using trading
and hedging to respond to these pressures.
A key issue, when assessing the value from
both trading and hedging, is the lack of clarity
over what, precisely, the company is trying to
achieve. Where on the spectrum from engaging
in proprietary trading for profit to using hedging
to mitigate price risk do different activities sit?
Failure to articulate clear risk management
objectives can lead to management pursuing
contradictory objectives and strategies. In turn,
the success of the strategy will be thrown into
doubt and confusion created externally
amongst investors and other stakeholders.
Companies need to be clear about how exactly
they decide to engage in and use trading to
optimise and add more flexibility to their asset
position and, equally important, establish clear
objectives for their hedging strategy.
Finally, we consider what companies should do
to embed effective risk management in this
environment across the whole of their
company. We discuss the different legal and
organisational design approaches that can be
taken. We look at the challenges that can arise
with independent and decentralised models.
Most importantly, we highlight the need to
ensure risks are identified and controlled
effectively within and across departments and
at board level. Key issues concerning
accounting, valuation and tax are reviewed
including accounting risk associated with
financial instruments such as derivatives,
embedded derivatives, hedge accounting and
weather derivatives.
4 New challenges affecting oil and gas, power utility
and mining companies

Price volatility Hedge fund activity in the US energy market was brought
into sharp focus by a senate report into excessive
Commodity prices in the oil and gas, power utility and speculation in natural gas prices (United States Senate
mining industries have risen dramatically in recent years. Permanent Subcommittee on Investigations, op cit.). The
Increased price volatility has accompanied record high investigation had been prompted in part by abnormal
prices not only for oil and gas but also for coal and spikes in the price of ICE swaps and a knock-on impact
electricity in certain regions and markets. A range of on the settlement of Nymex natural gas futures. The various
factors are at work. Global economic growth in the rapidly issues were further highlighted by the spectacular 2006
expanding Asian economies has spurred demand and collapse of Amaranth, a hedge fund that lost billions of
highlighted resource scarcity. Security of input resources dollars in natural gas swap trades on the US
is a key concern of companies and governments. New Intercontinental Exchange.
market platforms have been established, for example
for gas and electricity, including the increased use of All of the factors above have contributed to the observed
over-the-counter (OTC) markets. behaviour in global commodity prices over the past five
years dramatically higher prices, increasing price
Increasing stakes have been taken in commodities by volatility and diverging cash versus forward prices. Price
fund managers and the entry of large and liquid volatility for electricity in Europe, for example, has seen
investments have caused market prices to diverge from price spikes of more than EUR 1000/MWh followed
the levels that would be predicted by the fundamentals. closely by almost negative power prices. The LME copper
This effect has been exacerbated further during the credit and aluminium price charts opposite illustrate further
crunch with players in the financial sector looking for new examples of this volatility, and characterise the observed
kinds of investments. Hedge funds are playing an general price behaviours of the industrial metals complex.
increasing role and, in some cases, this has had a The chart below shows price trends for various energy
dramatic effect on prices. In the mining sector for commodities over a three-year period.
example, in one day at the start of 2007 the copper price
fell four per cent and the zinc price dropped more than
nine per cent. Much of this fall was attributed to market
fears of heavy losses at a major metals hedge fund
manager (Financial Times, 5 February, 2007).

Prices of a range of commodities: oil, gas, electricity, coal and emissions, 2005-2008

160 API2 Coal (US$)

140 Dated Brent Oil (US$)

120 France Electricity (EUR)

Germany Electricity (EUR)

100
UK Electricity (GBP)
80
TTF Gas (EUR)
Price

60

40

20

0
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ne

ar
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ar

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ar
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M
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M

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M

Source: PricewaterhouseCoopers analysis based on market prices

 Drift Drift

Ap

-60%
-40%
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120%

-80%
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Se ril
p 19
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88 ril
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ril
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p Ap 89
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90 19
Se
p Ap 90
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91 19
Se Ap 91
p ril
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92 Ap 92
Se
p r il
19 19

Source: London Metals Exchange

Source: London Metals Exchange
93 Ap 93
Se ril
p 19
19 94
94 Ap
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p 19
19 Ap 95
95 ril
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p ar
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LME Copper 252 day price volatility & rolling average mean, 1986-2007

Se ar
p 20
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LME Aluminium 252 day price volatility & rolling average mean, 1986-2007
M 03
Se 02 ar
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Volatility
Volatility

Drift
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Volatility
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5
6 New challenges affecting oil and gas, power utility
and mining companies
Changing patterns of global trade
The demand side of the global supply-demand equation
for the oil and gas, power utility and mining sectors has
shifted considerably with the driving force for growth
coming from the east rather than the west. Chinas
economy expanded by over 11% in 2007. This was the
fifth consecutive year of double-digit growth, creating
huge demand for energy and raw materials. More than 15
million people are estimated to be moving to Chinas cities
from the countryside each year driving unprecedented
infrastructure, housing and household product needs.
Even with more modest 2008 growth targets, given
inflationary concerns, there will continue to be strong
demand for the energy, metals and other commodities
vital for meeting Chinas projected manufacturing and
construction needs. Elsewhere in Asia, industrial booms in
South Korea and India have also contributed to demand
for oil and gas, power and mining commodities.
In the energy sector, there is an increasing demand for
natural gas and this has been accompanied by the
expansion of trade in liquefied natural gas (LNG). The
ability of LNG to be traded globally and not be dependent
on fixed pipeline routes has introduced arbitrage into the
market. It has also enabled countries anxious about
securing supply to diversify away from over-reliance on
single supply sources. Much of the growth in LNG is
being driven by expansion of liquefaction in countries
such as Qatar, Nigeria and Australia that can serve a
range of markets in both the Pacific and Atlantic basins.
The result is a gradual shift towards a global market that
is set to be fairly evenly balanced between Asia, Europe
and North America. However, the challenges that
companies face in delivering these large mega-projects
are considerable. This has introduced extra risk into the
market as the knock-on impact of a major project not
coming on stream or being substantially delayed can be
significant.
Geopolitical risk
The geopolitical risk facing companies in the oil and gas,
power utility and mining industries is considerable and
takes many forms. Demand growth and supply scarcity
means that the effect of disruption to production can be
considerable. Such risks are not confined to higher risk
locations. In Spring 2008, oil traded at record levels close
to US$120 a barrel against the background of the start of
a strike at the Grangemouth refinery in Scotland which
came on top of ongoing violence in Nigeria. The
Grangemouth strike caused significant disruption to oil
output from the UK sector of the North Sea with the
closure of the 700,000-barrels-a-day Forties crude
pipeline. The unrest in Nigeria closed more than half of the
countrys oil output.
Geopolitical risk is not confined to civil strife. A key risk
variable for companies comes from their relations with
governments and certainty or uncertainty around
regulatory frameworks. These range from risks arising
from production sharing agreements or ownership rights
in the extractive industries sectors through to government
policies on different generation technologies, such as
nuclear and renewables, and carbon emissions that have
a critical impact on investment decisions in the power
utilities sector. The investment decisions regarding new
power plants have a major impact on the companies
commodity risks. The political environment is one of the
decision drivers for new investments.
Emissions trading
The advent of emissions trading has created a whole new
source of commodity and investment risk. The EU scheme
is now firmly into its second phase. Elsewhere, carbon
trading is set to be introduced in countries such as
Australia and Canada. In the United States, there has
been progress on the climate issue at both a federal and
state level. While the Bush administration remains focused
on the role of technology in addressing climate change, a
number of bipartisan approaches in the US Senate
proposing firm carbon targets are gaining ground (e.g.
Lieberman-Warner, Bingaman-Specter bills and others).
At the state level, there are significant policy proposals
under development including the Regional Greenhouse
Gas Initiative (RGGI) covering ten north-eastern and mid-
atlantic states, and plans for the first mandatory state cap
in California.
The expectation among market participants and
policymakers, both within the US and the EU, is that the
post-2012 world could well involve linked regional carbon
trading markets, irrespective of progress at the
international level. Belief in the longevity of emissions
trading as a policy instrument is high. The most recent
IETA market sentiment survey, conducted by
PricewaterhouseCoopers, found that 80% of respondents
were confident that the carbon market would continue
after 2012, notwithstanding the challenges of reaching a
follow-on treaty to the Kyoto Protocol (Trouble entry
accounting: Uncertainty in accounting for the EU
Emissions Trading Scheme and Certified Emission
Reductions, PwC and IETA, 2007).
 7

Prices for EU carbon allowances (EUAs) collapsed at the Key elements include:
end of the first phase of the EU scheme (see graph), due
to an over-allocation in Phase 1 and a ban on cross- more stringent carbon targets to align with the EU
period banking from Phase 1 to Phase 2. Forward prices objective of achieving a minimum 20% reduction in
for EUAs during Phase 2 have risen gradually during 2008 emissions (from 1990 levels) by 2020;
and are currently trading in the range of EUR 25-29 t/CO2 centralised cap-setting and improved harmonisation of
depending on the delivery year. There is reasonable allowance allocation;
consensus among analysts, however, that prices may rise inter-period banking of EU allowances between Phase 2
further over the medium term. Leading carbon analysts and Phase 3;
expect carbon prices to rise to a level significantly above greater use of auctioning as an allocation method, with
EUR 25t/CO2. Price volatility is expected to remain at a mandatory, differentiated percentages on the use of
high level even though price collapses as in Phase 1 are auctioning by sector with a move to full auctioning by
seen as a singular effect due to insufficient information in 2020;
the starting phase of the system. The anticipated high full auctioning for the power sector from the start of
level of volatility results from the strong link of carbon with Phase 3;
energy prices, the interdependency of the EUA market expansion of the EU-ETS to include additional sectors
with weather and the linkage with other carbon markets. (chemicals, aluminium, aviation and carbon capture and
storage activities) and other greenhouse gases (such as
From a risk management perspective, market participants nitrous oxide); and
will have to evaluate how to adjust their carbon risk possible introduction of a carbon equalisation system
management approach and strategy. The latest survey by (in effect, some form of border tax adjustment) to assist
PricewaterhouseCoopers on emissions trading and risk energy intensive industries within the EU that are
management of German companies shows that nearly half exposed to significant international competition.
of market participants are considering revisions to their
current risk management policies on carbon and emission Following consultation between the various EU bodies
trading, due to rising volatility and price risks and member states, a final version of the Directive is
(PricewaterhouseCoopers, Herausforderungen an das likely to be in place by 2010. The result is that a faint
Risikomanagement im CO2-Emissionshandel, Chancen forward curve for CO2 allowance prices is slowly
nutzen, Risiken reduzieren, 2008). emerging. There is general expectation of a tighter
carbon regime and the need to integrate CO2 allowance
Step-change investments in cleaner technologies and price scenarios more carefully into major capital
products require sufficient visibility on the regulatory investment decisions and policy decisions across a
horizon for carbon and the likely cost of emissions. range of industries.
EU market participants have begun to see some greater
certainty following the release of the European
Commissions proposals to amend the EU-ETS Directive
in time for Phase 3, which will start in 2013.

EUA futures

35 EUA futures period 1: Dec 2007

30 EUA futures period 2: Dec 2008

Price in EUR/tonne CO2

25

20

15

10

0
06

06

08
6

08
06

06
5

07
05

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07
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05

07
05

06

07
00
00

20

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20
20

20

20
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20

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20
20

20

20
20

20

20
r2
r2

ril
b

c
ct

ril

g
n

ct
g

ct

b
Ap
Ap

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Au

De

Fe
De
Ju
Ju

Fe
De

Au
Au

Ap
Ap
Fe
O

O
O

Source: European Climate Exchange

8 New challenges affecting oil and gas, power utility
and mining companies
Carbon offset/carbon credit markets
The development of project-based carbon credit or carbon Five years ago, for example, there was very little visibility
offset markets is also key for companies facing binding
emissions targets. These markets involve governments or
companies who face binding emissions targets being
allowed to undertake certain types of emission reduction
activities outside of national boundaries which can then be
traded or offset against their emission obligations. The
approach involves the development of a robust scenario that
considers the likely emissions in the absence of the project
activity and compares those with the emissions attributable
to the project. Assuming the various regulatory approvals are
successfully negotiated and abatement is deemed to have
occurred, the result is the creation of a new tradable
commodity denoted by one tonne of carbon dioxide that has
value.
But the value attributed to carbon credits varies widely. The
market is highly diverse in terms of product characteristics
and quality can be difficult to determine. In broad terms,
there are compliance offset markets and voluntary offset many choose to contract projects at an early stage, with
markets. Each will be considered in turn.
Compliance-grade carbon credits focus largely around the
exponential growth of the Clean Development Mechanism
(CDM). Subject to certain limits, CDM credits have full
fungibility (equivalence) with EU allowances and can be
used for compliance or as a risk-hedging instrument. Their
value is also enhanced by relatively clear governance
structures around project approval, verification of abatement
activities and tracking of issued units. On the sell-side, the
origination, structuring and sale of CDM projects remains a
highly fragmented market, both in terms of the underlying
technologies, and the countries and companies involved. In
spite of the significant risks involved in developing such
projects and uncertainty over the final value that will be
realised, the market has grown rapidly and is still attracting
capital. Indeed, the value in the secondary market for CDM
credits increased by an order of magnitude during 2007 and
was worth around EUR 5.7 billion.
Although much of the low-hanging fruit typically, projects
involving the abatement of industrial gases with low marginal
costs and technical risks have been taken, there is still
interest in areas such as large-scale landfill gas
capture/conversion, abatement of coal mine methane
(especially in China) and industrial energy efficiency. Other
areas to watch include certain types of forestry projects and
new methodologies for creating carbon offsets in the
transport sector. How much of this carbon credit volume will
actually materialise and be transacted is open to much
speculation. Key transaction issues that may impact
negatively on volume include fairly standard project finance
risks such as finance raising, regulatory approvals and
construction delays as well as delivery risks associated with
the underlying technologies, many of which have limited
operational precedent.
The CDM market has evolved significantly over the last
five years, and is now, gradually, becoming commoditised.
around determinants of price and contractual terms such
as how delivery of certified emission reductions (CERs)
would take place and what would happen if it did not.
The majority of buyers were government-sponsored
carbon procurement funds or multilateral vehicles such
as the Prototype Carbon Fund (PCF).
Since then, interest in the CDM as a new commodity play
has grown exponentially. The year 2006, in particular, was
a landmark year as significant numbers of projects began
to achieve registration by the CDM Executive Board the
key regulatory hurdle. The market has also embraced a
diverse range of speculative financial investors including
investment banks, hedge funds and private specialist
investors.
On the sell-side, the approach taken by project
developers has varied significantly. In the primary market,
simple, fixed-price contracts stipulating that if the project
generates CERs, the seller receives them, but with very
limited recourse if the project fails to deliver. Early stage
projects are less sensitive to market developments for EU
allowances and prices tend to be determined by overall
scale, technology risks and financial strength of the
developer. Alternatively, if expected carbon volumes are
significant and material to corporate earnings going
forward, a more structured approach may be suitable.
This would involve different volumes and vintages being
sold to a range of counterparties, possibly using an
auction approach to access the market initially and gain a
comparative perspective on deal structures.
Credit risks are crucial in a market driven mainly by
forward contracts but these tend to be curiously
asymmetric; with carbon credit sellers (often having no, or
limited, credit ratings) seeking to contract with some of
the worlds leading utilities and investment banks. Credit
wrap structures and other risk transfer products are now
emerging to address some of these issues and bolster
market confidence.
Transaction costs in the primary market can be significant
and many developers with a portfolio of projects in the
same asset class will seek to bundle or aggregate during
both the regulatory and sale process. Larger projects (of
perhaps 100,000 tonnes of CO2 per year or more) that
follow established methodologies with a good track
record for issuance of CERs tend to attract the most
appetite in the market, particularly amongst natural
players, whose principal aim is often to ensure
compliance. Performance rates (i.e. actual CERs
generated versus estimated) for different CDM activities
can vary considerably.

The secondary market for CERs really took off during 2007
with the large investment banks taking market-making
positions, standardisation of contract forms and increasing
liquidity and transparency. The majority of secondary CER
trading is still on a forward, OTC basis. Spot trading of
CERs has been delayed due to technical difficulties but is
expected to start in 2008, with various exchanges
competing for market share.
Notwithstanding these challenges, the market is beginning
to mature with a greater understanding of how to price the
various components of risk. Product sophistication has
increased beyond simple CER/EUA swaps and forwards
and now includes collateralised debt obligations (CDO)
type structures and the securitisation of the underlying
contracts or Emission Reduction Purchase Agreements
(ERPAs). Furthermore, the prospect of additional earnings
streams through the CDM has led a number of banks to
re-appraise project finance activities in emerging markets.
Apart from CERs, compliance carbon offsets can also be
earned through the mechanism of Joint Implementation
(JI). The JI market, where the underlying commodity is an
Emission Reduction Unit (ERU), is still in its infancy
compared to the CDM. This reflects different governance
structures and timetables for developing eligible project
activities. Russia and Ukraine may well emerge as key host
countries for JI projects, but traded volumes for ERUs are
currently fairly low, at around 3% of the volume of traded
CERs.
Voluntary or retail-grade carbon credits derive from
emission reduction activities that are developed without
universally agreed standards or contractual procedures,
although various standards do exist. These include
independently developed, third party standards such as the
Voluntary Gold Standard, the Voluntary Carbon Standard
as well as those developed and promoted by offset
retailers themselves. Voluntary markets are significant in
that they represent an active demand by businesses and
individuals for some form of action on climate change in
the absence of direct regulation. The market for voluntary
credits, although small relative to the compliance grade
CDM market, has grown strongly in recent years. Prices for
voluntary credits tend exhibit a very wide range both within
and across different project types and are strongly
influenced by the choice of standard used to develop the
project.
The market is also experiencing some degree of
consolidation as many financial players take direct or
indirect stakes in some of the underlying propositions, such
as the origination and structuring of credits, or investment
vehicles that are focused on converting warm air to cash.
9
It is estimated that over US$10 billion of public and
private money has been raised globally by pure carbon
funds to date and capital flows into the wider markets of
clean technologies are much higher. The City of London
remains the hub for this activity, but may face challenge
from other financial centres as the market matures.
The future for the project-based credit markets, both
compliance and voluntary, remains highly uncertain, but
continues to attract an ever greater range of market
participants.
Weather risk
In 1997, the El Nio phenomenon created in the United
States a real awareness of climatic risks for energy
companies. The economic impact of these risks caused
major energy companies to realise that policies needed to
be put in place to manage and, where possible, mitigate
the impact of weather and climate change-related risks.
Since then, the weather market has grown rapidly and is
no longer limited to energy companies. In a survey
conducted in 2006 by PricewaterhouseCoopers, the total
amount of the weather risk contracts concluded had
increased from US$2 million in 2000 to US$45 million by
2006 (annual survey for Weather Risk Management
Association, 2006).
So what exactly do we define as the weather risk
market? Although this market began as a response to the
El Nio phenomenon, weather risk refers to any
measurable and tradable variations to a definable
benchmark (directly impacting on projected business
outcomes) caused by ordinary changes of climate
variables such as temperature, snow, rain, humidity. More
extreme or catastrophic events are excluded from this
definition, as these are generally covered by insurance
products.
In Europe the market is growing slowly but surely. More
and more companies are aware that a simple change in a
climate variable can have an important impact on their
results. At the same time, investors and shareholders are
becoming more aware of these risks and are increasingly
requiring companies to provide information about the way
weather exposures are managed.
With growing awareness and concern about global
warming, the weather risk issue is rising to the fore and
becoming an important concern for companies in the vast
range of industries which are affected in one way or
another by the weather. However, it is the energy sector,
which has arguably the best understanding of the impact
of an ordinary change in the weather, that is following
developments in risk mitigation techniques with the
closest interest.
10 New challenges affecting oil and gas, power utility
and mining companies
Changing commodity trading regulation
Europe
Commodity (and exotic) derivatives trading is not directly
legislated at an EU level. Some member states of the
European Economic Area (EEA)2 have national regulatory
regimes in place for certain types of commodity trading
for example, the Energy and Oil Market Participants
regimes in the UK. However, the adoption of the Markets
in Financial Instruments Directive (MiFID) in November
2007 introduced EU rules which impact commodity
derivatives trading, and some market participants. An
ongoing review instigated by the European Commission
(the Commission) could throw the regulatory net wider in
the future, particularly in respect of energy derivatives
trading.
MiFID significantly modernised, and in some respects
extended, Europes previous approach to the regulation of
investment services. A key extension was the inclusion of
commodity and exotic derivatives in the definition of
financial instrument in order to capture investment firms
commodity derivative trading activities under the MiFID
rules, given that commodity derivatives are seen as a
growing component of financial institutions investment
strategies.
MiFID has established certain exemptions which enable
the trading arms of commodity production/supply firms
and specialist commodity traders to remain outside its
scope. It aimed to ensure that the rules only apply when
these derivatives are used for investment rather than
commercial purposes. It explicitly extended coverage to
include equivalent trades in commodity derivatives on a
third country trading facility transacted by EU investment
firms. However, there are interpretative differences
between European states as to which types of firm these
exemptions can apply, and exempted firms may still be
subject to national regimes. It is not clear that the line
between investment and commercial is always drawn in
the same place from one country to another. Also, the
common approach to determining a third country trading
facility is that the assessment will be undertaken on a
case-by-case basis by each country separately. EU
legislators, knowing that MiFID has not found the perfect
solution for commodity and exotic derivatives trading,
included in it a requirement for a follow-up review. The
Commission is required to reassess the validity of the
exemptions in one of the so-called Article 65 reports by
October 2008.
MiFID investment firms are also subject to regulatory
capital requirements in line with the EUs Basel II
implementation by means of the Capital Requirements
Directive 2006/48/EC (CRD) and the recast Capital
Adequacy Directive 2006/49/EC (CAD). Article 48(1)3 of the
revised Capital Adequacy Directive currently exempts
commodity derivative traders from these rules. However,
unless this article is formally amended by 31 December
2010, the rules will apply to them. Article 48(2) of the
Capital Requirements Directive (CRD) also required the
Commission to report on the desirability of amending
MiFID to create a specific category of investment firm
exclusively involved in the provision of investment
services and activities in relation to energy derivatives.
Industry has put forward various arguments against the
extension of MiFID or CRD rules to a broader range of
commodity derivative traders. Such arguments point out
that commodity derivative trades take place in the
wholesale domain and, therefore, do not raise direct
investor/consumer protection concerns. Also, there have
been few market failures and, where these have occurred
such as with Enron, they have had no systemic impact on
the financial markets. However, it is far from certain that
these arguments will win out. Early indications are that
there could be an extension, albeit with a lighter touch, of
MiFID and CRD rules to energy derivatives.
Additionally, in December 2007, the Commission required
the Committee of European Securities Regulators (CESR)
and the European Regulators Group for Electricity and
Gas (ERGEG) to provide technical advice in respect of
market transparency and record keeping in the electricity
and gas supply and derivatives markets. This mandate
also sought further clarification on the scope of the
current EU rules on market manipulation with regards to
these markets. The final advice on this has to be provided
by December 2008 after the deadline for the Article 65
report.
2
In addition to the EU Member States, Iceland, Liechtenstein and
Norway are members of the European Economic Area and apply EU
legislation relating to financial services.
3
Recast Capital Adequacy Directive 2006/49/EC.
 11

Changing commodity trading regulation
United States
Trends in commodity trading regulation in the US continue
to focus on transparency, self-reporting and co-operation.
There has been increased scrutiny on the markets as a
result of record commodity prices, the impacts of
perceived or real speculative trading and recent well-
publicised abuses and losses associated with commodity
trading. In this climate, the number of complaints and
frequency of proactive regulatory reviews will probably
continue to increase. The US Senate Permanent
Subcommittee on Investigations in its investigation of the
role of market speculation recently stated: To the extent
that energy prices are the result of market manipulation or
excessive speculation, only a cop on the beat with both
oversight and enforcement authority will be effective (op.
cit, page 2).
In addition to CFTC and FERC compliance, there are new
regulations facing financial institutions in the US. The US
regulators adoption of the Basel II capital accord in the
autumn of 2007 provides a new framework for assessing
the credit and operational risks of the largest, international
US banks.
What are the implications? In the EU, commodity firms are
lobbying to keep the existing exemptions but are likely to
see enhanced regulatory requirements, at least, in terms
of governance processes. In the US, management teams,
even those with mature compliance programmes, are
reassessing the integrity of their internal processes.4 The
combination of increased expectations from regulators on
the attributes of company processes4, the growing
number of institutions engaged in commodity trading and
the related turnover of key employees have all added to
the frequency and scope of trading compliance reviews.

The Commodity Futures Trading Commission (CFTC),

Issue Penalty
through its enforcement of the commodities exchange act
(US$ million)*
(CEA), monitors the integrity of the futures markets by
protecting market participants against fraud, manipulation Settled Violation of commission order (gas) US$2.0
cases
and abusive trading practices. The CFTCs year-to-date Capacity release (gas) US$7.0
enforcement actions have been robust. By mid-March Shipper-must-have-title (gas) US$5.1
2008, the CFTC had settled or taken action on over 20
Affiliate code of conduct (power) US$2.0
cases with penalties and or claims in excess of US$400
million. The charges for these cases range from lack of Open access transmission tariff (OATT) US$3.0
Open Access Same-Time Information System
proper registration and reporting; misrepresentations and (OASIS) posting (power)
improper solicitations; fraudulent trading; and false price
Market basted rate, electric quarterly reports
reporting.
(EQR) filing (power) US$0.5

The Federal Energy Regulatory Commission (FERC), an OASIS business practice standards (power) US$1.0
independent government agency that regulates the Market behaviour rules (power) US$0.5
interstate transmission of electricity, natural gas, and oil, is OATT, standards of conduct (power) US$10.0
also taking aggressive enforcement action. The energy
OATT (power) US$9.0
policy act of 2005 gave FERC the ability to enforce
electric industry compliance with various statutes, orders, Outcome Market manipulation (gas) US$200
pending
rules, regulations and standards through the imposition of Market manipulation (gas) US$82
new monetary penalties for noncompliance up to
Source: Federal Energy Regulatory Commission
US$1 million per violation per day. FERC has stated its
intent to use monetary enforcement mechanisms to create
a culture of mandatory compliance.

Since issuing the Policy Statement on Enforcement, FERC

has settled a number of cases with market participants,
and two additional cases are pending. In all, FERC has
imposed over US$40 million in civil penalties with pending
cases in excess of US$200 million.

4
For example, FERCs Policy Statement on Enforcement for attributes of
an effective compliance programme as well as FERCs Policy Statement
on Natural Gas and Electric Price Indices.
12 Tackling industry-specific challenges
Oil & Gas
Exploration outlook, risk and commitments
Various sources believe that peak oil has happened, is
here or is near. Most respected observers are sceptical
that significant new finds are near or could be developed
rapidly. The larger companies have increased exploration
budgets significantly. However a large portion of that
increase is to cover cost inflation, not to truly increase the
number of exploration plays. Government hosts have
made inbound investment less attractive in some cases.
Large development projects are experiencing slippage.
Pricing mechanisms in long-term contracts
Renegotiation of long-term production sharing and
development contracts has been occurring with
frequency. Sakhalin and Kashagan are the most prominent
of these developments. The sustained high oil price
environment has had an effect on host government
contracts and put pressure on certain long-term fixed off-
take arrangements entered into in the past. This is
especially the case for larger LNG developments which
needed a floor in order to secure approvals for project
development spend.
Project development hedging
The rising cost of most oilfield service and oil and gas
development inputs is a clear trend for the industry. The
outlook for most companies is a continued tightness in
labour availability, steel and drilling rigs. The ability to
hedge the cost side of the development equation has
been difficult. Drilling rigs currently under construction
could relieve some of the tightness in that market in
coming years. It may be possible that larger companies
might reconsider some direct ownership of key
exploration and production drilling equipment assets.
Shipping, pipeline and storage strategies
Shipping day rates have also increased recently.
Specialised vessels and committed routes have limited
the flexibility of physical movements internationally.
Significant additional capacity is under construction
although much of this is dedicated to known projects and
the LNG trade. Various divestments of midstream or
infrastructure assets over the recent decade or so have
resulted in additional basis risk for supply moving through
pipes or storage facilities owned by third parties. In
addition, many of these infrastructure assets can be
subject to open access regimes and regulatory oversight.
It is possible that insurance policies for producers and
marketers are being underutilised. Another interesting
development is the investment in ships by national oil
companies.
International arbitrage opportunities
Basis differentials globally have created new risk
management and trading opportunities. The demand in
China, for example, is driving significant product flows.
Many countries in the Middle East are enhancing refining
capacity to begin exporting more products and capturing
additional downstream value before leaving the exporting
countrys borders. While export refineries enhance
flexibility on the ultimate end-use location for the
products, they introduce significant additional
complexities for logistics and the potential stranding of
portions of these refineries output. In addition, some
companies are locating their supply and trading function
closer to the asset and are being more asset-specific in
their trading activities. This is an effort to enhance not
only the utilisation of refinery assets but to optimise
spreads and define optimal yields based on real-time
market conditions.

LNG market developments and outlook
The LNG market has continued to develop and expand.
General consensus is that, on its own, it has not reached
commodity status but it has become a much more
important part of global and regional gas supply and
demand strategies. The control of gasification facilities
close to production, the access to specialised ships and
the rights to re-gasification terminals have been
dominated by large industry players to date. Whatever
part of the market these large industry players operate in,
companies with LNG assets have to consider what type of
contractual and trading strategy they wish to enter into.
The traditional model was a contractual one based on
long-term supply and purchase agreements. However, this
is now being overlaid with trading from asset and non-
asset based players.
Trends in exchange traded derivatives
Hedging strategies during periods of high volatility and
the recent upward trend in oil prices have been evolving.
The necessity for some producers to have initial floors on
prices (for example, large gas projects) is being achieved
through the use of a combination of exchange traded
derivatives and longer-term physical contracts.
Geopolitics and the effects of recent oil
price volatility
The situation in Venezuela and the range of responses by
the affected companies provides insight on possible
future unrest or risk given the market reaction, political
responses and commercial reaction by affected parties.
The lessons from the recent moves by Russia on natural
gas supply eastward are also worth studying.
Global credit and control issues
With a high oil price and the recent credit crunch, there
has been a renewed focus on counterparty risk.
Companies have re-evaluated policies for trading
counterparties and have renewed efforts to ensure that
systems and controls in the front, mid and back office are
sufficiently robust to prevent or quickly detect any rogue
trading activity.
13
Credit availability has an impact on trading activities and
companies are reassessing their access to the letters of
credit, lines of credit and collateralised deposits required
by their trading instruments. The increased cost of credit
instruments, combined with the high commodity prices,
has impacted the economic assessments of various
trading and hedging strategies. A companys risk
management strategy and potential volatility in earnings
can have a knock-on effect on all corporate access to
credit and an increased potential for loan covenant
default.
As well as taking a look at systems, companies are
reviewing human resource behavioural aspects of control
and accountability. Proper design and effectiveness of
daily controls has never been more critical. A number of
trading houses, for example, have introduced additional or
enhanced formalities for daily sign-off of trading book
completeness and accuracy. In addition, further control
enhancements have been introduced covering the
alignment of trading systems to relevant accounting
systems to ensure that management reporting is truly
reflective of profitability and results from trading activities.
Standardisation of these processes has been an ongoing
focus for most trading enterprises. Many companies have
revisited their incentive compensation plans for trading
professionals in order to address risk management
concern regarding conflict of interest and pressure points
which might give rise to behaviour not in keeping with
company policies and established controls.
Shared services and outsourcing
Additional complexity has arisen from the use by a
number of larger oil and gas trading operations of shared
services and outsourcing. The cost reduction objective
has been the primary driver. The challenge has been to
maintain accountability and standardisation of these
processes to prevent breakdowns in controls between
front office and back office while still delivering cost
savings.
14 Tackling industry-specific challenges
Oil & Gas
Overview and outlook on tax effects of
trading activities
Various tax authorities have been exploring their rules and
regulations regarding transfer pricing of oil and gas. Given
the possibility of physical trading of cargoes multiple
times in international waters, tax authorities are
increasingly likely to seek to capture additional
downstream value in the assessment of profits taxes.
Indirect taxes also can come into play for inventories of
LNG or products in various jurisdictions. Direct taxation of
oil and gas trading activities is a complex and highly
specialist area. Many jurisdictions have specific direct tax
regimes for the oil and gas sector that can differ greatly
from regimes that apply to companies operating in other
areas. The taxation of derivative contracts is often
complex and can depend crucially on local accounting
practice, the underlying subject matter of contracts, and
the reason why particular contracts were entered into.
It is often the case that these two sets of rules may not
operate together as consistently as they should and, as
such, it is critical for groups involved in oil and gas trading
to take specific advice on the activities they are engaged
in. Movements in commodity prices can result in
significant profits or losses on trading contracts and the
resulting tax effects have a material impact on the final
return to the business. The indirect tax rules, applicable to
trading in oil and gas, are complex and differ in many
aspects to the general indirect tax rules applicable to the
financial services sector. Given the volume and amounts
involved there are potentially significant risks both in
terms of indirect tax liability and indirect tax compliance.
Regulatory and accounting developments
The principles of the US Foreign Corrupt Practices Act are
a good benchmark for a company to ensure adequacy of
its risk management practices. Competition authorities in
numerous jurisdictions have increased their focus on
detecting and punishing anticompetitive behaviour in the
trading arena. Certain markets are liberalising access for
natural gas across territorial borders. The impact on price
and volatility is evolving. Given some of the spectacular
failures of companies in the recent past, there are varying
degrees of regulatory oversight on trading operations
around the world.
In the area of price reporting, certain minimal standards
for controls and internal certification may be required by
the authorities. In many cases, systems modifications are
undertaken in order to minimise manual intervention to
such processes. The increased transparency required by
recent accounting and financial reporting standards has
led to an increased focus by management on a robust risk
management programme for oil and gas trading. It has
also highlighted the importance of top management
communicating effectively the risk appetite and overall
trading objectives of the company.

This is particularly the case for gas and oil traded using
derivative contracts. Forwards, futures, options or swaps,
for example, present additional complexity in terms of the
contract terms (cash settled vs deliverable), place of
supply and compliance. The indirect tax treatment of
cross-border trading can also be complex and the type of
contract and place of supply is vital in order to determine
the correct indirect tax treatment. PwC has established an
Energy Network in order to share knowledge of indirect
tax liabilities and requirements when trading in physicals
and derivatives in other member states.

Power utilities
New generation capacity
New generation capacity is a priority in most markets as
utility companies respond to increasing demand and the
need to replace ageing plant. Planning and construction
of new generation plant takes a long time, typically
between five and ten years, and involves a wide spectrum
of risk. There is a renewed emphasis in some countries on
nuclear plant and, in such cases, the planning and
commissioning time frame can get stretched even longer.
The long timetable for generation investment itself poses
an investment risk as it increases uncertainty and
vulnerability to policy reversals or changes in market
economics. Market risk in terms of demand and pricing is
a key factor in profitability assessments. The CO2
allowance price is an added fundamental factor affecting
the profitability and planning of new generation. The
competitiveness and sustainability of more expensive,
cleaner types of generation such as nuclear, renewables
or plant that incorporates carbon capture technology
depend on the indirect effect of the CO2 allowance price
on higher emitting generation. Companies planning
carbon emitting generation investment also have to
calculate the gains of investing now in non-carbon
capture plant versus the uncertainty of waiting for cleaner
coal technology. All plants also face geopolitical risk with
planning opposition increasingly a fact of life, not just for
nuclear plant but also for coal and renewable generation
as well.
15
Securing fuel supplies
Considerable volatility affects the price for fuel supplies
needed in power generation. In liquid markets it is
common to use financial derivatives to hedge the price
risk. However, it is not just the price risk that has to be
considered. Securing actual physical supply of inputs
such as coal, oil, gas, uranium and CO2 allowances is
vital. There are price quotations for uranium in the market
but physical trades in this commodity are regulated.
Uranium is not physically tradable on the market. The
long-term physical supply and pricing of uranium fuel rods
for nuclear power plants is the subject of direct
negotiation with a limited number of suppliers. A key risk
management factor is, thus, this counterparty risk. Other
commodities, such as coal, oil or CO2 allowances are
traded actively on global or regional markets and, here,
financial derivatives are used to hedge price risk. Securing
physical supply is also an important issue but not as
severe as for uranium. Very volatile markets introduce the
risk that counterparties are no longer able or willing to
fulfil delivery obligations and, thus, counterparty risk again
needs to be managed adequately. Finally, for gas, oil and
coal, transportation capacities and risks need to be
managed to secure the physical supply.
16 Tackling industry-specific challenges
Power utilities
Optimisation of generation
With the exception of power plants where electricity is
sold through long-term supply contracts mirroring the
production costs, risk strategies require plant management
to be based on market prices. The price landscape needs
to cover all commodities included in the generation
process. A power plant is managed as an option for
electricity. This is based on the so-called dark spread,
which is the price differential between the coal price and
the electricity price adjusted to the details of a specific
power plant (clean or dirty spread dependent on the CO2
situation). The future period covered is dependent on
having liquid forward price quotations for all commodities
(i.e. electricity, coal and emission rights) in order to
effectively optimise the dark spread on both sides. In
practice, active dark spread management starts 36 to 24
months before delivery and, within this period, the power
plant outputs and inputs are sold and purchased many
times. Such optimisation activities may be considered as
trading rather than generation. For accounting under IFRS
it is clear that these activities are often trading even if the
derivatives require physical delivery.
Demand for long-term supply contracts and
capacity arrangements
Price volatility and the rising price of electricity have
created a demand for supply contracts that are
independent of electricity market prices. One outcome of
customer negotiations is long-term power supply
contracts with price clauses based on the investment and
generation costs of a power plant. A utility may enter into
an electricity sale contract over a period of up to 20 years
with a pricing based on sufficient interest on investment
costs and generation costs (i.e. coal, CO2, labour costs
etc). Under a typical risk management strategy, selling
electricity for prices different from electricity market prices
is only applied to periods where liquid electricity markets
exist. The long-term contract discussed above is an
exception to this with the costs of an existing power plant
being naturally hedged (i.e. the costs of the power plant
are mirrored through the pricing clause of the electricity
supply contract). With such a natural hedge, a companys
risk is reduced but the quid pro quo is that the ability to
generate additional profits from any fluctuation in prices is
removed. These contracts vary between real participation
in existing or planned power plants or virtual power plant
contracts, where there is no link to a specific power plant.
The legal and accounting considerations should be
evaluated, especially regarding the ownership of such
power plants. Under IFRS certain contracts may require
de-recognition of the power plant on the balance sheet
and recognition of a financial asset (lease receivable).
In such a case, from the accounting view, there is no
economic ownership of the power plant and no revenues
will be recorded from the sale of electricity produced.
Changing customer services
In the past, full service contracts were the norm for
industrial consumers. Under such a contract a customer
could order all electricity needed for its production at a
specified price. Such contracts are expensive for the
consumer because a utility calculates the price based on
an expected fixed volume and an option for expected
additional volumes in excess of the fixed volume (i.e.
option premium). Customers are, of course, price
sensitive. Since larger customers can also access
electricity wholesale markets, the utility company faces
the risk that the customer will execute its volume flexibility
based on market prices and not physical needs or buying
its supplies directly on the market. This has led power
utilities to offer services to secure the customer
relationship for example, portfolio management service
to large customers giving the customers indirect access
to the market (i.e. through a pricing mechanism or other
services). When providing these services a utility may fall
under the regulation of investment services, such as
MiFID, by the respective authority in its territory. Also
consulting and advice to customers regarding price
developments may fall under such a regulation.
Weather risk
Temperature is a major influence on electricity demand
from retail customers. Weather is, thus, a central factor in
any risk assessment or valuation model in the energy
sector. The weather has a direct impact on a utility
companys earnings and, therefore, its share price.
Recently, for example, some electricity and gas
companies attributed their decrease in volumes, and
share price, to mild winter weather. Contracts may be
open market-based or through over the counter markets.
A temperature index developed for energy companies is
the degree day (DD). DDs are used to measure the extra
energy required to heat a building in order to maintain an
internal temperature at or above 65F (18C) in the winter
(heating DD) or to cool a building in the summer (cooling
DD). A degree day represents the difference between the
actual temperature on a given day and the reference
temperature.
 17

Utility companies can use weather futures markets and One basis for a price determination beyond liquid periods
options as part of their weather risk management. for electricity prices could be average costs of an efficient
Contracts are available using heating degree days (HDD) power plant. For example, a new coal-fired power plant
indexes and cooling degree days (CDD) indexes as a could be assumed to be price-setting for base load
basis. For example, an electricity distribution company, energy prices in the future periods. Based on this
concerned that a cool summer will lead to lower than assumption the future base load price might depend on
expected earnings, has the possibility to use forward the production costs of such power plant, including
cover (sale of CDD futures). In this case, the electricity efficiency of production, future coal prices, prices for
company will lose money when the CDD index increases emission certificates and a profit margin. Another issue in
(a low CDD index means that the summer is colder than this context is the price development from liquid periods
normal). The company needs compensation for a colder to the valuation model in illiquid periods. There could be a
than normal summer so, therefore, it needs to sell the significant difference between the observable market
CDD futures to hedge the underlying business. prices in the last liquid period and the estimated prices in
the illiquid periods based on the valuation model. Such a
In some territories weather derivatives are expensive difference should lead to a review of the adequacy of the
because there are no other parties with offsetting risks. valuation model.
The counterparties on OTC markets (such as insurance
companies) require premiums which mostly absorb the Day one gains or losses resulting from valuing contracts
utilities profits in retail. With an appropriate strategy for with the companys valuation model should be evaluated.
the management of weather risks, energy companies can The reasons for such day one gains/losses may be a
mitigate the impact on their financial results across the failure in the valuation model. In this case, a company
supply chain, from commodity sourcing to sales forecast, may need to adjust the valuation model to take the
and can respond to likely shareholder questions regarding different market price expectation into account.
their risk management policies. Alternatively, a day one gain/loss could be the result of
good or bad negotiation with the counterparty. In such a
case, either the company or the counterparty may have
Valuation of long-term contracts better market information than the other. In practice, it will
(in excess of liquid period) be difficult for the valuation model prices to be met in
negotiations with counterparties. Thus, day one gains or
Forward information on gas, coal and electricity prices is losses are common for long-term contracts.
usually available for a 36-month period. Valuing contracts,
such as take-or-pay contracts, beyond the period of
available market data requires the company to account
beyond the so-called liquid period. Companies have to
make assumptions of the future development of the
market price (i.e. long-term forecasts to match the period
of long-term contracts). It is not feasible or acceptable to
limit the valuation of the contracts to the duration of the
active market period (i.e. 36 months). Also, any
assumption that the price remains constant after the liquid
period is questionable. Most of the inputs in such contract
models are largely driven by a companys individual
expectations based on observable data. These
assumptions should be understandable,
re-performable and the inputs should be clearly
distinguished by endogenous and exogenous inputs and
assumptions. Furthermore, it is important to document
any changes to the model and the underlying
assumptions, because those changes can have a major
effect on the fair value of the valued contract(s).
18 Tackling industry-specific challenges
Mining
Global mining growth and consolidation
There has been unprecedented global merger and
acquisition activity. High commodity prices, buoyant
market capitalisations and optimism about the industrys
long-term growth and profitability have seen mining
companies embarking on ambitious long-term growth
strategies. Consolidation through acquisition has been
increasingly viewed as a way for mining companies to
overcome record high exploration costs, achieve
production synergies through scale, circumvent protracted
exploration and greenfield mining regulatory processes
and address specific mining skills shortages.
Upstream integration, with companies in industries such
as aluminium, power and steel moving upstream into
mining, has been a key trend. Steel producers, for
example, are scrambling to find any iron ore mines that
are available. The major aluminium producers including
Alcan, Alcoa, Rusal, Chalco, Norsk Hydro, Dubal and
Indal, are all actively seeking to secure direct bauxite/
alumina supply. While not necessarily a new strategy for
the aluminium producers, it is increasing in its pace.
Transactions are viewed by mining companies as a key
mechanism for filling and accelerating the pipeline of mine
development projects and diversify ore body portfolios in
terms of both commodities and geography.
There have been increasingly significant international
moves by Russian and Chinese companies, with the
intervention of Chinalco in the battle for Rio Tinto a prime
example. Competition for deals is intense. The total value
of mining deals conducted by entities from these two
countries rose six-fold, from just US$5.3bn in 2005 to
US$32.7bn in 2007, accounting for a fifth of total mining
deal value worldwide (PricewaterhouseCoopers, Mining
Deals 2007, 2008). Underpinning this activity is the quest
for world-scale resource diversification or in some cases
the desire to secure sources of commodity supply that are
independent of the global mining houses. Organic mining
company growth has also been very strong, funded by
strong cashflows and, until the credit crisis, easy access
to equity and debt funding.
Global and regional cost pressures
The mining industry continues to face sharply increasing
costs on a number of fronts. The spike in global energy
prices directly impacts the cost base of energy intensive
production and processing and is felt indirectly through
higher transportation costs. In many regions the lack of
skilled workers, equipment shortages and the fact that
many new mines are in remote locations or in countries
with poorly developed infrastructure all contribute to
ongoing cost pressures. There may be capacity for mining
companies to pass these cost pressures onto consumers
through higher prices but in the longer term they are
selling their product through global pricing mechanisms
and are often seen as price takers.
 19

Empirical evidence on the cost of inputs is not Increasing geopolitical risk

consistently presented but it is clear that variable
operating costs have increased significantly and are
unlikely to decrease in the short term. Shortages of
inputs, such as labour, infrastructure, energy and tyres,
are projected to continue. There have also been
significant fixed cost increases such as higher wage
levels, which will be more challenging to remove if prices
turn down. This could sharply squeeze operating margins,
placing increased pressure on sound financial risk
management.
The mining industry will continue to see a greater
proportion of production sourced in developing countries
and an increasing role of industrialising nations in the
development and operation of new mining sites. The drive
to secure supplies has driven global mining into higher
risk countries with commensurate increased volatility in
operational metrics and potentially future supply. This, in
turn, has contributed to diverging views by stakeholders
in the global commodity markets on the projections for
future commodity supply and demand.

Environmental risk

Mining environmental concerns are an increasingly

relevant influence on global commodity pricing.
Environmental stakeholder engagement and the ability of
mining companies to manage ongoing environmental risks
in a cost-effective manner could become an increasing
competitive advantage. The level and costs of active
engagement with local stakeholders in the development of
mine sites and ongoing mining operations are growing.
Often the wider environmental stakeholder group is not
itself transparent or consistent across projects or
countries and may include local communities, NGOs such
as environmental groups, and local and national
governments as well as the mining companys employees.
The ability of mining companies to manage environmental
concerns is a critical factor in securing new mine sites
and building sustainable mining operations. Mining
companies are also increasingly affected by emissions
regulation. Greenhouse gas emission regulations
(reporting and trading) are being rolled out in a growing
number of jurisdictions.
20 Tackling industry-specific challenges
Mining
Pricing volatility and hedging
As we discussed on page 4, mining companies are being
affected by considerable price volatility. Minimising price
or currency volatility risk through hedging is an important
risk management strategy for many mining companies.
In setting up such a hedge programme, in our view,
companies should go through a structured process to
analyse whether and how hedging is aligned with their
overall financial strategy.
1. First, they must consider the overall rationale for
hedging and how exactly it could add value to their
company establish financial risk management
objectives.
2. Second, they can undertake a structured consideration
of the factors that should influence the decision to
hedge and, if so, when?
3. Third, if, after consideration of other financial levers, a
hedging programme is required what is the most
appropriate hedging strategy and how should it be
executed?
Lack of clarity over the exact goals of hedging is a
common trap that companies fall into. In a typical
example of contradictory objectives resulting from
changing market views, a large mining company stated in
its financial statements that: hedges are primarily
entered into to minimise the downside risk of metal price
fluctuation. Contradicting this, the Chairmans letter to
the shareholders in the following years annual report
stated that: We hedge gold and silver production to
protect cash flows, and hedge more or less, depending on
our views of the metals cycles.
As an example of a clearly thought through and
communicated hedging philosophy, BHP Billiton (BHPB),
following comprehensive analysis of its financial and
commodity risk profile and overall risk capacity , adopted
a conditional self-insurance model. The condition for
hedging is that the ratio of cashflow at risk (CfaR) to
projected three-year cumulative cashflow does not reach
levels which are deemed to exceed BHPBs risk capacity,
or which might otherwise compromise the companys
broader strategic objectives. Detailed portfolio modelling
supported the claim that strong portfolio diversification
benefits largely negated for hedging under expected
market scenarios.
An analysis of major mining and energy companies
appears to demonstrate a connection between market
risk management philosophy and overall
financial/corporate strategy. For example, companies
whose financing strategies and/or strategic investment
programmes place heavy demands on capital resources
show a greater propensity to hedge their market risks. In
contrast, companies whose strategies involve extracting
value from a more or less stable portfolio of assets, and
doing so from a position of projected financial strength,
appear less inclined to hedge.
A third, smaller category consists of companies that have
transformed their market risk management capability and
ability to leverage risk into a core value proposition to
both customers and investors. This requires a clear
understanding of the companys comparative advantage
in risk-taking across and between markets. There are
significant profit opportunities to be gained from informed
risk-taking. The graphic on page 21 highlights a number
of mechanisms through which risk leverage (as distinct
from risk mitigation) can be undertaken.
 21

Financial risk mitigation versus risk leverage in a mining company

A: Profit distribution (risk)

Risk mitigation strategies driven Value enhancing (risk leverage)

from portfolio level analysis of strategies based on leveraging the
future capital needs, risk appetite, companys comparative advantages in
risk capacity and cost of hedging assets, market share specialised
logistics or other marketing skills,
Financial risk management privileged market information, special
portfolio EaR/VaR modelling relationships etc.
driven hedging
Marketing and contract
Proactive capital management management

Approporiate controls and Contango/backwardation structures

governance for metal and concentrate book

Appropriate organisational Ability to buy/sell in foreign currencies

structure
0 E
Profit from interest rate differentials
Limits and stop losses
Ability to take large quantities and split
Risk reporting and profit up for resale to smaller customers
attribution
Warehousing of concentrates/metals
Insurance programme
optimisation Consignement financing of stock at
B: Impact of risk management on profit distribution
consumers yards
(and hence on expected profits)
Location swaps to save freight etc.

Time swaps to help

producers/consumers regulate their
production rates/inventory position

Export pre-financing

Quality swaps

Penalties

TC RC differentials

Price participation
1
0 E E Tolling of concentrates to metal

Dirty/clean spreads

Barter business

Source: PricewaterhouseCoopers, Intertwined: the physical and the financial, 2008

22 Responding to the challenges
Management strategies for commodity trading activities
vary in practice across the oil and gas, power utilities and
mining sectors. They range from pure hedging to pure
propriety trading. Only in rare circumstances does
commodity trading only include hedging. Most companies
have a more diversified strategy comprising a blend of
activities. The extent of each activity is based on the risk
strategy and risk appetite of management. It is crucial that
risk strategy is defined clearly and based on a systematic
approach to managing these risks properly.
Proprietary trading
Speculative trading based on market price changes is
known as proprietary trading. Additional value is pursued
through taking a view on market prices. The extent of
such activity is governed by the amount of additional risk
capital and limits that are set by a companys
management for this activity. Typically this is very limited
given the considerable risk that stems from the huge
volatility of commodity prices and the scepticism of
investors arising from cases such as Enron. An example
of a prudent approach taken to such trading by one large
utility company comes from the following annual report
wording: Our energy business also engages in
proprietary trading in accordance with detailed guidelines
and within narrowly defined limits.
Asset-based trading for optimisation
Optimisation may be defined as maximising the
companys total margin over its value chain. This type of
trading activity is asset-based which means that
commodity trading supports the optimising of the
production and sales portfolio. One of the tasks is to
generate additional value from hedged positions based on
market price views. In the utility sector, typical strategies
include spark-spread-optimisation or dark-spread-
optimisation. In such cases, commodity trading optimises
the price differential of a specific power plant until the
delivery of electricity.
Decisions on whether electricity is produced or not are
based on the expected price at delivery between gas/coal
and electricity. This optimisation activity is based on
expected price developments and seeks to align the
hedged position with this expectation (open an already
hedged position or close an open position). Another
strategy is to optimise the production portfolio based on a
real-option model. In this instance, commodity trading
optimises the production facilities (i.e. power plants)
based the value of the option against the market. From a
risk management perspective certain activities may also
qualify as proprietary trading since a hedged position may
be opened again through optimisation.
As a result of these strategies, commodity trading plays a
central role within the companys strategy. It is used to
manage the asset base and can be seen in terms of asset
management rather than trading per se. Such
management is clearly limited to the short-term time
horizon for which the commodity markets are liquid. The
long-term strategy and decisions, such as whether a gas
field should be explored, are made outside of commodity
trading.
Hedging
The key activity by which a companys management may
decide to mitigate the impact of commodity or currency
price volatility is through a systematic programme of
hedging. However, one of the recurring issues that arises,
when assessing the value from hedging, is the lack of
clarity over what, precisely, the company is trying to
achieve. The objectives of a hedging programme should,
of course, be aligned with the overall financial
expectations of the companys stakeholders (including but
not limited to investors). In practice we find this value
proposition is often not very clear. Typical stated
objectives might be:
to reduce earnings volatility;
to protect a specified minimum cash flow;
to ensure that a specified debt covenant is not
breached;
to hedge a fixed portion of production;
to monetise the value of the commodity in the ground;
to outperform budgeted targets;
to protect existing or anticipated underlying cash in
relation to physical positions/investments;
to guarantee prices to customers;
to hedge exposure based on sales projections/orders;
to keep within pre-determined price ranges.
 23

Failure to articulate clear risk management objectives can
lead to management pursuing contradictory objectives
and hedging strategies. In turn, the success of the
strategy will be thrown into doubt and confusion created
externally amongst investors and other stakeholders (see
our discussion in the industry specific challenges for
examples in the mining sector highlighting the importance
of clear communication of hedging goals). The increased
complexity, volatility and interrelationships across global
commodity markets increase the challenges in executing
these strategies effectively to add rather than destroy
shareholder value. While we do not prescribe a single
preferred objective to drive financial risk management
strategy, we do believe that a structured consideration of
risk capacity and other drivers of risk capacity and risk
appetite should be undertaken before setting policy. Some
real-life examples of company approaches to this issue
are discussed in the mining section under industry
specific challenges.
Do company shareholders understand and
value hedging?
Often stated hedge objectives are overlaid with a view-
based approach. More specifically, there seems to be a
distinct tendency for companies to allow hopes of
speculative profits, or picking commodity cycles, to enter
into the hedging decision, even to the point where the
original risk mitigation objectives are forgotten. In some
cases exotic derivatives have been used to create tailored
risk-return profiles. This further confuses the value
proposition to the shareholder.
In assessing an appropriate hedging policy, investor
expectations should be considered. Typically we have
found that investors are either indifferent to whether
companies hedge or not, or view the existence of
unhedged exposures as a positive investment proposition
(the equity seen as a vehicle for providing indirect
exposure to a particular price view). It is normally
assumed that non-systematic risks are diversifiable at the
investor level and are, therefore, not factored into the cost
(risk premium) required in providing capital. Most
importantly, investors require clear disclosure of risk and
risk management strategies as a basis for making
informed investment decisions.

There is a somewhat discredited view, prevalent in many

industries, that investors buy shares as a speculative play
on the price of the commodities they produce. So, to
hedge the exposure is to frustrate the objectives of the
investor. Better to leave it unhedged, disclose that fact,
and let the investors decide. But if speculation on
commodity prices is what is driving shareholder
investment decisions, there are surely more
straightforward means for them to obtain it. For example,
they could take direct positions in commodity futures
markets.

A subtler version of this argument says that an equity

stake in a company is like a purchased call option on the
company. As such, the greater the volatility in the value of
the company, the greater is the value of that option.
Accordingly, to hedge the exposure would be to reduce
investor value. This argument may explain the claim often
made by investor relations managers that they are more
often criticised for having hedged away the benefits when
commodity prices increase than for having failed to hedge
when prices fall. However, in our experience, most
institutional shareholders are focused on sustainable
growth and, therefore, on the ability of the company to
fund and execute its exploration and development of
quality mining assets and subsequent profitable extraction
and processing of its ore reserves. This may justify a
hedging programme if, and when, projected risk capacity
(cashflow generation) might potentially curtail the
companys ability to fund and execute its planned IRR-
positive projects while meeting other critical financial
targets.
24 Responding to the challenges
How is risk capacity established in practice?
The board of directors, based on their assessment of
value to the shareholders, should set the overall level of
acceptable risk. It needs to define and quantify the
understanding of the underlying exposures, measure the
capital the company is prepared to place at risk and
decide the capital allocation to given investment
strategies. The companys defined level of confidence or
risk appetite provides the foundation for establishing,
monitoring and modifying the hedge strategies used.
Objective an integrated understanding of commodity and financial markets risk
Commodity risks Energy risks
Currency risks Interest rate risks
Source: PricewaterhouseCoopers, Intertwined: the physical and the financial, 2008
An integral step is gaining a clear understanding of the
sensitivity of cash flow and target financial ratios (implied
by a target credit rating). At the simple end, running
expected, high and low price forecasts through a budget
plan can give an indication of the expected impact of
financial risk on earnings going forward. Howeve,r more
detailed modelling of a companys supply and demand for
capital under different corporate strategies (i.e. production
mix/growth plans), with simultaneous flexing of financial
prices based on historical volatility, can provide detailed
insight into many areas in addition to the requirement to
hedge.
Integrated view of risks
Must account for risk dependencies
Need quantification and linkage to financial metrics
 25

The continuing integration of quantitative risk

management concepts, such as cash flow distribution
analysis (also referred to as cash flow at risk, together
with corporate value driver analysis, is enabling
companies to better analyse and develop their risk
management and hedging approaches. The graphic
below shows how distributions for future cash flow
(supply) should be benchmarked against planned cash
usage (demand) to determine if (at a given level of
confidence) a potential short fall might arise.

Cash flow modelling is an important step in establishing appropriate hedge policy

ANALYSIS

Revenues Results (cash flow)

Costs Database

Others
Upper Bound Investment

Expected Value Cash Flow

Financial Stress Test
Covenants
Lower Bound

Risk Management Minimum

Source: PricewaterhouseCoopers, Intertwined: the physical and the financial, 2008
Strategy Cash Amount

CF@R
26 Responding to the challenges
After taking diversification and natural hedges into
account, it is important to consider the potential for
changing the timing and distribution of cash flows through
a range of management actions, only one of which is
hedging. Business simulation modelling can provide a
structured and quantitative basis for exploring these
dynamics. Modelling supply and demand for capital under
different business strategies will provide a set of scenarios
from which risk management decisions can be made.
The graphic below shows how distributions for future
cash flow (supply) should be benchmarked against
planned cash usage (demand) to determine if (at a given
level of confidence) a potential shortfall might arise.
Cash flow should be compared against projected cash usage over 3-5 year horizon
Probability
Projected ability to meet financial obligations
Risk of cash shortfall
Dividends Taxes Interest Change in Key capital
working investments
capital
The outcome of such modelling may indicate that a large,
diversified company with a strong balance sheet can
afford to remain unhedged for statistically likely
production volumes, commodity price and currency
scenarios. Alternatively, it might show that cash flows at
risk might threaten the companys planned growth targets
and the decision may be taken to reduce the risks by
hedging or flexing other financial levers.
The impact of market price scenarios could also be offset
by a variety of business/financial responses this is a
valid and reasonable alternative to pre-emptive hedging.
These include but are not limited to:
flexibility of capex and investment programme,
including reconsidering the priority of projects based on
enhanced assessment of their risk versus return profile;
possible changes in the dividend policy;
changes in the capital structure, including raising more
equity (or deferring share buy-backs) and accessing
commitment bank credit lines.
Distribution with risk mitigation
Distribution without risk mitigation
EBITDA

Executing the hedging strategy
A hedging programme requires investment in
infrastructure and governance to support various
functions, including risk analysis, deal execution,
reporting, settlement and accounting.
Considerations should include the following.
Understand the range of financial instruments or
derivatives available in the marketplace to mitigate
exposure to the identified risks.
Evaluate the benefits, costs and risks associated with
the proposed strategy and tools to be used.
Consider direct transactional costs (bid/offer spread) for
using hedge instruments such as futures, forwards,
swaps and options.
Consider potential systematic costs of hedging reflected
in the shape of the forward price or yield curve.
Consider the increased management and operational
costs for the establishment and implementation of
required systems.
Consider increased compliance costs associated with
accounting, legislative and stakeholder requirements.
Consider how the hedges to be used will qualify under
the new accounting rules.
Any hedging programme where the full economic effects
are not properly understood, controlled and managed,
whether or not derivatives are used, can have disastrous
consequences for an organisation, its employees,
customers, suppliers and other stakeholders. There have
been high-profile examples of hedging programmes going
dramatically wrong as a consequence of inadequate
control and monitoring.
Recent high profile collapses, while not directly resulting
from the use of derivatives to hedge exposures,
demonstrate the importance of good corporate
governance and the necessity for both non-executive and
executive managements to understand fully the underlying
risks in their business, including any associated hedging
activities. Unfortunately, our experience is that, although
senior management usually understand these on a
conceptual level, they often fail to establish a truly
effective and appropriate governance and risk
management framework to underpin their activities,
leaving themselves exposed to the risk of serious control
failure.
27
Conclusion
If there is a single rule to follow in developing a hedging
approach it is that a comprehensive study of the impact of
risk should be carried out first. There is no common
approach that will suit every organisation and no single
hedge approach will always suit a company all of the
time. However, identifying and maintaining an overarching
consistent philosophy and set of objectives is paramount
in achieving risk management best practice.
Key points to consider when formulating your companys
financial risk management and hedging approach are as
follows.
Do ensure that your hedging philosophy can be
supported by a thorough exposition of how it
contributes to shareholder value (either by itself or,
preferably, in the context of the wider financial and
corporate strategy).
Do undertake a business impact analysis in order to
understand properly and measure the impact financial
risk is having on your business and how hedging might
impact on the objectives of internal and external
stakeholders.
Do ensure that that there is clear communication to
investors of the resulting risk profile.
Do conduct regular performance assessments of your
hedge policy to ensure that objectives are being met.
Has the business changed in a way that means the
hedge approach needs re-visiting?
28 Embedding commodity risk management in
the organisation
Organisational design and processes
The global business environment nowadays requires
greater transparency in assessing the risks versus returns
of business operations and more breadth and depth of
financial and non-financial data to differentiate high-
performing companies from their peers. The complexity
and diversity of stakeholders requires a wealth of financial
and risk data as well as operational performance data.
To cope with these challenges, leading companies have
established effective organisational design, rigorous
enterprise-wide risk management, sound compliance
policies and procedures, and corporate governance
frameworks that truly represent the interest of those
stakeholders.
The commodity business within the Energy Utilities &
Mining (EU&M) industry generally comprises the following
activities:
exploration coal, ore, uranium, oil and gas;
generation/production of power, oil, gas;
transmission/transportation of wholesale power over
large distances using high-voltage cable network, or gas
and oil by using pipelines or tankers;
distribution of power and gas from the
transmission/transport system to the customer and/or
oil & gas, coal, ore etc by truck transportation;
wholesale/retail supply services to facilitate the
purchase and sale of the physical commodity (e.g.
marketing to customers, metering, billing);
trading and hedging trading in or hedging of the risks
inherent to the commodities.
The way in which companies organise the different
services varies significantly from one company to another.
Some companies with a service offering in, for example,
both generation of and trading in a commodity may
organise these services in separate legal entities under
the same parent company, where others organise these in
a single legal entity. Irrespective of the organisational
structure chosen, leading companies have established a
sound organisational structure that specifies individual
responsibilities and accountabilities for each of the
different services.
For companies that have integrated several of the above
services into one legal entity, the objective of establishing
clear roles and responsibilities is mostly accomplished by
the creation of separate departments/business units
which are responsible for one or several of the main areas
including marketing/retailing, production, optimising and
balancing (given the importance of this area for the
physical element of the commodity), trading and hedging,
and risk management. In practice, many different
solutions exist as to how to organise these
responsibilities. For instance, some companies organise
optimisation and balancing under the responsibility of
trading and have moved these functions into a separate
department away from the trading activities.
Among the leading companies there is a clear bias
towards independent risk management functions, with
corporate risk management established on central level,
responsible, amongst others, for consolidating the risks
across departments/business units and across
commodities (e.g. oil, gas, power), supported by a risk
service/middle office function on a decentralised level,
responsible for the individual risks within a
department/business unit. In these models risk
service/middle office functions report to corporate risk
management on policy compliance and risk reporting.
This is beneficial from an operational perspective yielding
improved control of risk activities, procedures and
routines as well as adherence to controlling limits on the
department/business unit level.
One of the challenges with an independent and de-
centralised risk management function is to ensure that
individual risk components on a department/business unit
level are also aggregated and monitored on a central
level, and that hedging programmes are fully integrated
with business activities such as sales and production.
The responsibility for the business units risks generally
remains with the business unit to ensure a proper
identification of risks arising, for example, from the
physical side of the business.

Leading companies have set up a risk management
infrastructure that monitors prices, volatilities, maturities,
volume variations and basis risks in a comprehensive
manner across all departments/business units and
commodities. They have ensured that adequate internal
processes have been established for transferring risks
from, for example, the production and marketing
departments to the trading and hedging department, in
order to properly manage the price risk embedded in both
production and customer sales. To achieve this, these
companies have developed appropriate mechanisms for
internal transfer pricing that properly transfer risks and
measure performance per department/business unit.
Given the importance of establishing an efficient structure
for performance measurement and reporting of risk
activities across business areas and commodities, leading
companies have implemented a book (or portfolio)
structure in support of the organisational structure. This
book structure reflects on a lower level the different roles
and responsibilities for each of the business areas and
commodities at a more granular level than the
departmental structure. It captures individual commodity
contract data and is used for identifying, measuring and
monitoring risks and returns of individual activities as well
as for providing information for consolidation across
business units and commodities.
Key differences between external and
internal reporting
As discussed earlier, the complexity and diversity of
stakeholders gives rise to a need for a wealth of financial
and operational performance data. The size of large
international companies can foster a culture of reporting
silos with different divisions and locations capturing and
disclosing varying types of data. Leading companies,
however, seek to instil a coherent reporting mind-set and
framework that promotes the importance of strong
reporting standards and procedures that preserve
reputation, share price, and the companys license to
operate. They also integrate all reporting functions
throughout the organisation, effectively eliminating
information silos where possible. The most effective
reporting frameworks broaden the types of data gathered,
providing consistent and timely disclosure of both
financial and operational data to management, regulators
and other stakeholders.
29
Although leading companies have integrated the data
gathering processes across the various reporting
functions, the ultimate information provided in their
external reporting may differ significantly from the
information in their internal reporting. An obvious reason
for this is that not all internal information is relevant or
appropriate for external stakeholders. Management uses
information primarily to manage the company, both its
historical performance and future goals and expectations,
but refrains from publishing competitively sensitive
information in external reporting. It is important to note
that IFRS 7 requires companies to base their external
reporting of financial instruments and financial risks on
the internal management reports provided to key
management. This may reduce the reporting gap to a
certain extent.
For the purpose of risk and performance measurement,
internal reporting includes information on actual and
expected prices, volatilities, actual quantities, volume
variations, maturities, basis risks and adherence to
internal limits across departments/business units and
commodities. This information enables management to
stay in control and monitor performance but is not
disclosed in external reporting.
Finally, differences between internal and external reporting
arise from the fact that external reporting is governed by
generally accepted accounting principles (GAAP), where
internal reporting is more a matter of company policy,
governance and culture and, indeed, sometimes better
reflects economic reality. The best example of this last
gap between internal and external reporting relates to
those instances where economic hedges do not receive
hedge accounting for technical reasons, resulting in a
timing mismatch in external reporting.
30 Embedding commodity risk management in
the organisation

Accounting A key issue is that commodity trading activities normally

The accounting risk within commodity risk management
mainly relates to financial instruments. Accounting for
financial instruments under International Financial
Reporting Standards (IFRS) as well as US GAAP can have
a major impact on a companys financial statements. This
external reporting is often not identical with a companys
internal reporting and may require full understanding of
accounting and reconciliation between both reporting
streams. The three major areas related to commodity
trading activities are: derivatives; embedded derivatives;
and hedge accounting.
Derivatives
Derivative financial instruments are commonly used within
commodity trading activities. Derivatives without physical
delivery of the underlying commodity are within the scope
of International Accounting Standard (IAS) 39 and
recorded at fair value with changes in fair value recorded
in income irrespectively of its use. For commodity
derivatives with a physical delivery of the underlying
commodity (such as oil, gas, electricity, coal, and carbon)
an assessment of the accounting is necessary.
do not distinguish contracts in the way that IFRS does.
Often portfolios for derivatives are created based on
economics and not accounting requirements. In an
extreme case a company may only have one portfolio for
all its derivatives. This has a major impact since, under
IFRS, similar contracts are accounted for in the same
manner. The book structure has an influence on the
accounting and, therefore, book structures should be
implemented to take account of the accounting impact.
These book structures should be in line with the
companys organisation and risk management. A common
book structure for a company is:
own use books for derivatives that are only used for
receipt or delivery of commodities in the normal course
of business (trading activities are not included);
trading books for pure speculation and other books for
optimisation and other activities that do not qualify as
own use.
Such book structures avoid contracts entered into in the
course of normal business (i.e. retail) being accounted for
as derivatives at fair value.

Contracts that are for an entitys own use are exempt

from the requirements. Thus, contracts for own use, that
were entered into and continue to be held for the purpose
of receipt or delivery of a non-financial item with a net
settlement through terms of the contract that permit either
party to settle it net in cash or another financial instrument
(IAS 39.6a), or where the commodity that is the subject of
the contract is readily convertible to cash (IAS 39.6 d), are
not within the scope of IAS 39. Contracts that qualify as a
written option (i.e. a volume flexibility for the counterparty
to the contract) for an underlying commodity that can be
net settled, must always be accounted for a derivative in
accordance with IAS 39.

Embedded derivatives
Long-term commodity purchase contracts frequently
contain an index pricing clause based on a commodity
other than the commodity deliverable under the contract.
Such contracts contain embedded derivatives that may
have to be separated and accounted for under IAS 39 as
a derivative. Examples are fuel prices that are linked to
the electricity price or other products or a pricing formula
that includes an inflation component.
Such price clauses must be separated if:
(a) the economic characteristics and risks of the
embedded derivative are not closely related to the
economic characteristics and risks of the host
contract;
(b) a separate instrument with the same terms as the
embedded derivative would meet the definition of a
derivative; and
(c) the hybrid (combined) instrument is not measured at
fair value with changes in fair value recognised in the
profit or loss (i.e. a derivative that is embedded in a
financial asset or financial liability at fair value through
profit or loss is not separated).
Such embedded derivatives that are not closely related
must be separated from the host contract and accounted
for at fair value with changes in fair value recognised in
the income statement.
Within commodity risk management such contracts are
often used as a natural hedge for certain assets, for
example a power plant. A power plant owner enters into
long-term electricity supply contracts with pricing clauses
mirroring the investment and generation costs of the
power plant. Such contracts are considered a natural
hedge of risks arising from such a power plant and,
therefore, reduce the exposure. From the accounting point
of view, generally the embedded derivatives are
accounted for at fair value but the power plant and the
future production is not, which creates income volatility.
A solution may be hedge accounting but this cannot be
achieved easily.
31
Hedge accounting
Hedging, as understood in risk management, is not hedge
accounting. The latter term reflects only the technique to
book relationships between a hedging instrument and a
hedged item. Hedge accounting can mitigate the volatility
of trading transactions. Practical experience of hedge
accounting has shown that complying with the
requirements can be onerous. Most hedge relationships in
hedge accounting are micro hedges rather than portfolio
hedges. Macro hedges, which are also common in
economic hedging, are not allowed under IAS 39. Two
main hurdles for hedge accounting are documentation
and measurement of effectiveness. Detailed formal
documentation must be in place at the inception of the
hedge relationship. This must cover, for example, the
hedged item, hedging instrument, hedged risk and
measurement of effectiveness. To apply hedge accounting
the prospective and retrospective effectiveness of a
hedge relationship must be between 80% and 120% and
must be assessed at least quarterly. This high hurdle for
hedge accounting is normally not applied in economic
hedges. Ineffectiveness resulting from hedge accounting
is always recorded in income.
Active commodity risk management, such as a dynamic
hedging strategy, requires hedges to be entered into and
derecognised frequently. To be able to meet all the
accounting requirements systems should be in place that
secure the timely documentation of all requirements. The
effectiveness tests are complex for dynamic hedging and
may also lead to additional ineffectiveness. For example,
a hedge relationship in a dynamic hedging environment
may arise upon purchasing a derivative at market
conditions. After a de-designation the company may
designate a derivative in a new hedge relationship at a
later date. At this time the derivative has conditions other
than actual market conditions and a fair value other than
zero. This may lead to additional ineffectiveness in the
accounting.
Weather derivatives
Weather derivatives are either insurance contracts and fall
into IFRS 4 or financial instruments and with the scope of
IAS 39. Contracts that require a payment only if a
particular level of the underlying climatic, geological, or
other physical variables adversely affects the contract
holder are insurance contracts. Payment is contingent on
changes in a physical variable that is specific to a party to
the contract. Contracts that require a payment based on a
specified level of the underlying variable, regardless of
whether there is an adverse effect on the contract holder,
are derivatives and are within IAS 39s scope. Derivatives
should be recognised at fair value with the changes in fair
value recognised in the income statement.
32 Embedding commodity risk management in
the organisation

Valuation Transportation/capacity pricing

Valuation of standard commodity contracts, for example
an electricity baseload forward contract with a duration
within the liquid market period, are generally not a major
issue for companies involved in commodity activities as
forward prices are available. More often, though, a
valuation is required for commodities in non-liquid
markets, for example developing markets in Eastern
Europe or gas markets in some central European states.
Sometimes, also, contracts may contain market inputs
that do not refer to available forward prices, for example
long-term gas contracts with indexation to a statistical
index such as heavy fuel oil (HEL). If no market quotes for
a commodity are available, companies mostly derive
forward prices from comparable commodities in a
different market with modifications as transportation.
In those cases the guidelines of IAS 39 or FAS 157, in
particular the fair value hierarchy, should be followed to
enable the contracts to be valued for accounting
purposes. Furthermore, when valuing a contract with
indices for which no forward prices are available,
companies have to come up with their own forecast for a
forward price of the indices within those contracts and
have to consider those inputs within their valuation
models. Approaches to derive a price-forecast vary in
practice and include such things as trend-analyses,
regression-analyses, monte-carlo-simulations, etc. If those
forecasts are used as an input into a valuation model for
accounting purposes, the method of deriving such
forecasts should be suitable and verifiable.
Pricing of transportation or capacity contracts within the
commodity industry continues to be a challenge. There
are generally no market prices available for capacity
contracts and the transportation is dependent on the
individual market structure for the underlying commodity.
A basis for determination of the transportation price
should be the price difference for the delivered commodity
between the different markets (i.e. the market price
difference between the local market where the commodity
is received and is delivered). Since transportation
capacities are normally limited and markets are not
perfect there is a value to the transportation capacities in
excess of the transportation services, making arbitrage
possible. Capacity contracts are mostly valued by
applying a marginal pricing model.
Valuation of EU emission allowance CER swaps
Due to the emergence of the CER market, companies
have entered into EU emission allowance (EUA)CER
swaps to make use of the existing market price
differences between EUAs and CERs. Irrespective of the
accounting issues, these swaps are comparable to a
basis swap. Some additional difficulties have to be borne
in mind when valuing such contracts, for example the
different risk levels between registered and unregistered
projects and the timescale beyond 2012. Alongside these
considerations are the risk of liquidity, the introduction of
ITL (International Transaction Log) and the credit risk of
the counterparty.

Credit risk in pricing

Credit risk from an accounting viewpoint has to be
considered when valuing a commodity contract and
should be considered when pricing a contract. Credit risk,
as with other valuation inputs, should be based on
assumptions from the perspective of an independent
market participant and not from the companys
perspective. This risk will not only be limited to the
customer side but will also be faced on the supplier side.
Common practice within the commodity industry is that
such a risk is not considered directly in the pricing but in
other ways (i.e. counterparty limits). In theory there should
be a price premium depending on the credit risk of the
counterparty. Thus, a counterparty with a better credit
standing would get a better price than a company with a
worse credit standing.

Tax
Cross-border trading and risk management transactions
within international oil and gas, power utilities and mining
groups must also be carefully structured from a tax
perspective, having particular regard to transfer pricing.
National governments will take a close look at whether
entities in their countries are generating adequate taxable
profits. Such adequacy will depend essentially on the
functions performed, risks borne and assets employed by
one entity compared to its trading partners. In addition,
business restructurings must be thoroughly planned as
more and more tax authorities are scrutinising taxes when
business functions are transferred abroad. If, for example,
a utilities group centralises its trading activities in a
location with a potentially favourable tax environment, tax
authorities in countries where such trading activities were
previously performed might assess exit charges as
compensation for the loss of the business function and
the future tax revenue connected therewith. Thus, state-
of-the-art transfer pricing planning becomes essential to
optimise the cross-border activities and to monitor risks.
If a new trading hub is established in a country with a
low tax regime, the profits generated by the trading
activities will become subject to income taxation in that
country. As a result, the trading profits will benefit from
lower tax rates which will reduce the groups effective tax
rate. However, after the decision has been made where to
locate or relocate the trading function, the company will
be faced with the question whether or not the trading
activities create a permanent establishment in another
country. They might, perhaps, do this by using a server
located in that other country or by employees working in
foreign offices with the consequence that the trading
function may come under the tax jurisdiction of that
country. Furthermore, any decision on the location or
relocation of the trading function has to take account
whether or not losses from trading with derivatives can be
offset against other income as, in some countries, the
utilisation of such losses is restricted for tax purposes.
33
In addition to income tax consequences, the VAT
treatment of cross-border trading and risk management
transactions adds another layer of complexity into tax
planning. In spite of the changes made by EU Directive
2003/92/EG to the EU Sixth VAT Directive, with respect to
the trade of electricity and natural gas in gaseous form,
the practical application of these new rules apparently are
still so complex and too narrow that the EU Commission
has presented a draft of a so-called technical Directive.
That Directive contains an article which will clarify the VAT
treatment of electricity and natural gas, but will also
expand the scope of the rules, for example with respect
to LNG, warmth and cold. The original plan was to pass
the technical directive in December 2007 and to have it
transposed into national law by 1 July 2008. However, the
procedure was delayed and the Commission hopes that it
will enter into force by the end of 2008.
All EU member states have agreed on the VAT treatment
of EU emission trading allowances, although actual
practice does not always follow agreed lines. There is
some likelihood that other forms of certificates will
eventually be treated likewise but this is far from certain.
While it can be said that there will be relative clarity about
the VAT treatment of the commodities themselves, this is
not true for the derivatives. Currently, it is not possible to
find two EU member states which treat the various
futures, forwards, options or swaps in the same way.
Hopefully, this will change when the EU proposals on the
VAT treatment of financial and insurance services have
been transformed into law. However, this will still take a
considerable amount of time. Currently, there is just a
draft for discussion purposes, not even a negotiated
draft.
34 How PwC can help

PwC has a global expert team dealing with commodity trading and risk management within the
oil and gas, power utilities and mining industries. We are able to support companies in all
aspects of commodity trading including the following.

Strategy and policy

Development of clear objectives for commodity risk management and trading within the company that are aligned
with the corporate risk capacity and risk appetite.
Development of clear policies and strategies for commodity trading and risk management.
Re-alignment of polcies and strategies with market changes and new developments.

Commodity trading operations

Design of organisation and processes.

Implementation of organisation and processes.
Improving effectiveness and efficiency of trading execution.
Testing/audit of trading control framework.

Trading systems

Support in selection of the best fit commodity trading system.

Implementation and customising of systems.
Testing of systems.

Compliance

Support in assessing regulatory requirements (e.g. MiFID, FSA).

Support in registration with national authorities (i.e. BaFin, FSA).
Review of compliance with regulatory requirements.

Governance

Support management in design of governance and control framework.

Support internal audit of trading activities.
Training for management, internal audit and other employees.

Accounting

Support in evaluation of accounting impact on new products.

Support in writing accounting guidelines, including tools.
Support in development of book structures in accordance with IAS 39/FAS133.
Training regarding accounting issues.

Taxes

Support on transfer pricing issues.

Support on VAT issues.

Corporate transactions

Revaluation of commodity trading positions.

Due diligence of commodity trading activities.
Valuation of commodity trading business and contracts.
 Contact us 35

Global contacts Territory contacts Indonesia

Rich Paterson
Global Energy, Utilities & Mining Leader
Telephone: +1 713 356 5579
Email: richard.paterson@us.pwc.com
Manfred Wiegand
Global Utilities Leader
Telephone: +49 201 438 1517
Email: manfred.wiegand@de.pwc.com
Tim Goldsmith
Global Mining Leader
Telephone: +61 3 8603 2016
Email: tim.goldsmith@au.pwc.com
Fred Cohen
Global Energy, Utilities & Mining
Advisory Leader
Telephone: +1 646 471 8252
Email: fred.cohen@us.pwc.com
James Koch
Global Energy, Utilities & Mining Tax Leader
Telephone: +1 713 356 4626
Email: james.koch@us.pwc.com
Folker Trepte
Utilities
Telephone: +49 89 5790 5530
Email: folker.trepte@de.pwc.com
Steve Johnson
Oil & Gas
Telephone: +44 20 780 40853
Email: steve.johnson@uk.pwc.com
Jud Roderick
Mining
Telephone: +61 3 8603 2978
Email: jud.p.roderick@au.pwc.com
Africa
Angola
Julian Ince
Telephone: +244 222 395004
Email: julian.ince@ao.pwc.com
Allan Dulany
Telephone: +244 222 395004
Email: allan.a.dulany@ao.pwc.com
Gabon
Elias Pungong
Telephone: +241 77 23 35
Email: elias.pungong@ga.pwc.com
Nigeria
Uyiosa Akpata
Telephone: +234 1 320 2101
Email: uyi.n.akpata@ng.pwc.com
Southern Africa
Stanley Subramoney
Telephone: +27 11 797 4380
Email: stanley.subramoney@za.pwc.com
Asia-Pacific
Australia
Derek Kidley
Telephone: +61 2 8266 9267
Email:derek.kidley@au.pwc.com
Jud Roderick
Telephone: +61 3 8603 2978
Email: jud.p.roderick@au.pwc.com
China
Gavin Chui
Telephone: +86 10 6533 2188
Email: gavin.chui@cn.pwc.com
India
Kameswara Rao
Telephone: +91 40 2330 0750
Email: kameswara.rao@in.pwc.com
William Deertz
Telephone: +62 21 521 3975
Email: william.deertz@id.pwc.com
Sacha Winzenried
Telephone: +62 21 528 90968
Email: sacha.winzenried@id.pwc.com
Mirza Diran
Telephone: +62 21 528 90950
Email: mirza.diran@id.pwc.com
Singapore
Robert Montgomery
Telephone: +65 6236 4178
Email: robert.montgomery@sg.pwc.com
Europe
Austria
Bernhard Haider
Telephone: +43 1 501 88 2900
Email: bernhard.haider@at.pwc.com
Erwin Smole
Telephone: +43 1 501 88 2928
Email: erwin.smole@at.pwc.com
Belgium
Bernard Gabriels
Telephone: +32 3 259 3304
Email: bernard.gabriels@pwc.be
Denmark
Per Timmermann
Telephone: +45 3945 3945
Email: per.timmermann@dk.pwc.com
Finland
Mauri Htnen
Telephone: +358 9 2280 1946
Email: mauri.hatonen@fi.pwc.com
France
Philippe Girault
Telephone: +33 1 5657 8897
Email: philippe.girault@fr.pwc.com
Vincent le Bellac
Telephone: + 33 1 5657 1402
Email: vincent.le.bellac@fr.pwc.com

Pascale Jean
Telephone: +33 1 5657 1159
Email: pascale.jean@fr.pwc.com
36 Contact us
Germany
Folker Trepte
Telephone: +49 89 5790 5530
Email: folker.trepte@de.pwc.com
Olaf Maulshagen
Telephone: + 49 211 981 1273
Email: olaf.maulshagen@de.pwc.com
Greece
Socrates Leptos-Bourgi
Telephone: +30 210 687 4693
Email: socrates.leptos.-.bourgi@gr.pwc.com
Ireland
Denis OConnor
Telephone: +353 1 792 6288
Email: denis.g.oconnor@ie.pwc.com
Italy
John McQuiston
Telephone: +390 6 57025 2439
Email: john.mcquiston@it.pwc.com
Netherlands
Aad Groenenboom
Telephone: +31 26 3712 509
Email: aad.groenenboom@nl.pwc.com
Fred Konings
Telephone: +31 70 342 6150
Email: fred.konings@nl.pwc.com
Pieter Veuger
Telephone: +31 20 568 6099
Email: pieter.veuger@nl.pwc.com
Arthur Kramer
Telephone: +31 70 342 6033
Email: arthur.kramer@nl.pwc.com
Norway
Staale Johansen
Telephone: +47 9526 0476
Email: staale.johansen@no.pwc.com
Ole Schei Martinsen
Telephone: +47 95 26 11 62
Email: ole.martinsen@no.pwc.com
Portugal
Luis Ferreira
Telephone: +351 213 599 296
Email: luis.s.ferreira@pt.pwc.com
Russia & Central and Eastern Europe
David Gray
Telephone: +7 495 967 6311
Email: dave.gray@ru.pwc.com
Peter Mitka
Telephone: +420 251 151 231
Email: peter.mitka@cz.pwc.com
Spain
Francisco Martinez
Telephone: +34 915 684 704
Email: francisco.martinez@es.pwc.com
Mariola Pina
Telephone: +34 915 684 145
Email: mariola.pina@es.pwc.com
Sweden
Lars Tvede-Jensen
Telephone: +46 8 555 33403
Email: lars.tvede-jensen@se.pwc.com
Switzerland
Ralf Schlaepfer
Telephone: +41 58 792 1620
Email: ralf.schlaepfer@ch.pwc.com
Iwan Ogink
Telephone: +41 58 792 2747
Email: iwan.ogink@ch.pwc.com
Rafic Mecattaf
Telephone: +41 58 792 1540
Email: rafic.mecattaf@ch.pwc.com
Turkey
Faruk Sabuncu
Telephone: +90 212 326 6082
Email: faruk.sabuncu@tr.pwc.com
Kaan Aksel
Telephone: +90 212 326 6060
Email: kaan.aksel@tr.pwc.com
United Kingdom
Ross Hunter
Telephone: +44 20 7804 4326
Email: ross.hunter@uk.pwc.com
Charles van den Arend
Telephone: +44 20 7804 4412
Email: charles.van.den.arend@uk.pwc.com
Middle East
Paul Suddaby
Telephone: +971 4 3043 451
Email: paul.suddaby@ae.pwc.com
Reinhard Schulz
Telephone: +971 2 694 6905
Email: reinhard.schulz@ae.pwc.com
The Americas
United States
Paul Keglevic
Telephone: +1 312 298 2029
Email: paul.keglevic@us.pwc.com
Mark Allan Smith
Telephone: +1 713 356 4233
Email: mark.allan.smith@us.pwc.com
Manish Kumar
Telephone: +1 713 356 4014
Email: manish.k.kumar@us.pwc.com
Tim Schutt
Telephone: +1 678 419 1472
Email: tim.schutt@us.pwc.com
Keith Considine
Telephone: +1 713 356 6832
Email: keith.considine@us.pwc.com
Canada
John Williamson
Telephone: +1 403 509 7507
Email: john.m.williamson@ca.pwc.com
Alistair Bryden
Telephone: +1 403 509 7354
Email: alistair.bryden@ca.pwc.com
Latin America
Jorge Bacher
Telephone: +54 11 4850 6801
Email: jorge.c.bacher@ar.pwc.com
Further information
Olesya Hatop
Global Energy, Utilities & Mining Marketing
Telephone: +49 201 438 1431
Email: olesya.hatop@de.pwc.com
PricewaterhouseCoopers (www.pwc.com) provides industry-focused assurance, tax
and advisory services to build public trust and enhance value for its clients and their
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PricewaterhouseCoopers International Limited, each of which is a separate and independent legal entity.