Ørsted A/S – Annual report – 31 December 2018
Industry: utilities, energy
Management’s review (extract)
1.6 Business performance
Description of business performance
In 2011, we introduced an alternative performance measure, business performance, as a supplement to the financial statements prepared in accordance with IFRS. The business performance results reflect our internal risk management and show the results for the period under review. Under the business performance principle, the value of the hedging transaction is deferred and recognised for the period in which the hedged risk materialises. This is illustrated in the example overleaf.
Our reason for introducing the business performance principle in 2011 was:
– that we could not achieve the same timing of recognition of our commercial exposure and hedging contracts in accordance with the IFRS rules, for example with respect to option premiums and certain commercial fixed-price contracts, and
– that there was a high risk that the hedging contracts were not consistent with the IFRS hedge accounting rules, requiring us to recognise the hedging contracts at market value with value adjustments via the income statement, whereas our commercial exposure is accrued.
Our risk management is described in note 7.1 ‘Market risks’.
Business performance – background
We hedge market risks for up to five years with the aim of stabilising our cash flows and create certainty about our finances. With a view to ensuring transparency, we want the financial impact of the hedging transactions to be reflected in the financial reporting simultaneously with the hedged exposure (for example sales of power). We can normally achieve this by applying the IFRS rules on hedge accounting. For energy companies, it is, however, sometimes difficult to ensure simultaneity. This is due to the fact that hedging instruments are not always available which precisely match the exposure which must be hedged, or that there is no sufficiently liquid market available. Consequently, some hedging takes place in alternative markets or subject to alternative time horizons. For example, power generation in Denmark is to some extent hedged by financial contracts for nearby trading areas, such as the European Energy Exchange (EEX) in Germany and Nord Pool in Scandinavia. These areas normally develop relatively uniformly over time compared to Denmark.
This hedging method means that only some of the financial hedging transactions comply with the IFRS rules on hedge accounting even though the financial risk has been reduced. In case of non-compliance, under IFRS the hedging transactions must be recognised in the income statement on a regular basis. This may give rise to considerable fluctuations in the income statement, as the effects of the hedging and for example the sale of power are not recognised in the same period.
Consequently, we have decided not to apply the IFRS rules on hedge accounting to transactions hedging energy prices and associated currency risks. Value adjustments of these hedges are therefore recognised in the income statement in accordance with IFRS.
In the income statement, the business performance results are shown alongside the IFRS results. In the income statement, the difference between the two performance measures is shown in a separate column, ‘Adjustments’. Two types of contracts are included in the business performance principle:
– hedging contracts concerning energy and related currencies
– commercial contracts concerning energy recognised at market value (typically fixed-price physical gas and power contracts).
When we use hedging instruments which do not fully correspond to the underlying risk, any difference between the hedging instruments and the underlying risk is recognised immediately in the income statement. See note 7.3 ‘Energy trading portfolio’. The accounting treatment under business performance is otherwise identical to the accounting treatment under IFRS. Our balance sheet, cash flows and equity are consequently not affected. The accounting treatment of our hedging contracts according to IFRS and business performance is summarised in the table below.
Expected impact on business performance
EBITDA from energy and currency hedging
At 31 December 2018, a loss of DKK 1,849 million has been deferred (2017: loss of DKK 812 million), which will affect business performance EBITDA in subsequent years. Of the total deferred loss, a loss of DKK 1,470 million is expected on business performance EBITDA in 2019 (2017: DKK 159 million loss in 2018).
Power prices rose in 2018, which means that the market value of the hedges has fallen as we are selling power. The decrease in the deferred gain on currency hedging is primarily attributable to the transfer of gains to the income statement in 2018 as a consequence of the hedged transactions having occurred.
Explanation of the business performance principle
In year 1, we enter into a contract hedging the price risk associated with Offshore’s generation of 1,000GWh in year 5 at GBP 52,000 per GWh. This ensures a total revenue of GBP 52 million. In year 5, the cost of power has decreased to GBP 45,000 per GWh, which means that the hedging contract has a positive market value of GBP 7 million (a hedged price of GBP 52,000 per GWh minus the spot price of GBP 45,000 per GWh). This means that we ensure that the total income, including the hedging transaction, is still GBP 52 million. The income of GBP 52 million consists of a gain from the hedging contract of GBP 7 million and GBP 45 million from the sale of 1,000GWh at a spot price of GBP 45,000 per GWh. The financial impact of the hedging transaction in years 1-5 is shown in the table. Under the business performance principle, the hedging transaction is recognised in the income statement in year 5, i.e. at the same time as the hedged contract with a positive market value of GBP 7 million. The value development is, however, recognised continuously in the income statement according to IFRS. Upon the expiry of the contract in year 5, the total effect on results over the period is the same under the IFRS and the business performance principle. Only the timing differs. The business performance principle ensures simultaneity of recognition of the underlying exposure and the hedging contract.
Difference between IFRS and business performance for the year
The value adjustment in respect of future periods totalled DKK -1,734 million (2017: DKK -138 million) and reversal of deferred gains (losses) recognised according to business performance in 2018 totalled DKK 196 million (2017: DKK 193 million).
Market value adjustments for the year of hedging contracts
2018 was mainly affected by losses on the hedging of power as a result of rising prices, due to a selling position and hedging of oil as a result of lower prices due to a purchase position.
Deferred gains (losses) from previous periods
In 2018, a loss of DKK 196 million was recognised in business performance EBITDA, but as the loss was recognised in IFRS EBITDA in a previous period, the gain was reversed in the ‘Adjustments’ column in the income statement. The loss was primarily attributable to the hedging of power and gas, partly reduced by gains on hedging of oil and currency.