From Hedge Accounting to Strategic Hedging
by Morten Buchgreitz, SVP and Group Treasurer, DONG Energy
Hedge accounting under IFRS 39 or FAS 133, with future iterations, has created issues for many companies as they seek to balance the risk management needs of the business with the requirements for hedge accounting treatment. In this article, Morten Buchgreitz, SVP and Group Treasurer of DONG Energy discusses how the company made the decision to abandon hedge accounting in favour of a hedging strategy that was more closely aligned to the needs of the business, and income reporting that better reflected actual business performance.
As an energy company, our business is highly capital-intensive with long-term (i.e., 30-40 year) investment horizons. We therefore take a long-term view of both profitability and risk. We evaluate our exposure to a wide range of regulatory, operational, environmental and financial risks. The way that we measure and manage these risks is driven by regulation in many cases, and we also need to be sensitive to reputational and competition risk, and public and scientific opinion on issues such as climate change.
Our Group Risk Management department establishes the risk policy for the group, and consolidates reporting from across the business. Energy trading takes place in a separate department. The consolidated energy risk is transferred to them, and they manage this within defined limits. Treasury manages the remaining financial risks for which we use two systems: we use SunGard Quantum and SunGard QRisk for FX and interest rate management, Endur Openlink for energy risk management and a proprietary system for consolidated risk management.
Approach to hedging
From a financial risk management perspective, our profitability is impacted enormously by changes in FX and commodity prices, so we hedge both short- and medium-term exposures (up to five years). Beyond this, it is more difficult to hedge as there is decreasing liquidity in the market. Until two years ago, we applied hedge accounting to our FX and commodity risk hedging. The value of our hedge transactions is typically very large, so it would have had a major impact on our financial results if we had not been able to apply hedge accounting rules.
Over time, however, we have adopted a more integrated approach to risk management, and we now evaluate our risks on a portfolio basis. As a result, we started to hedge our positions on a net basis as opposed to hedging individual exposures, which made it more difficult to apply hedge accounting treatment. In addition, some markets are less liquid than others, which affected efficiency testing. We realised that we were making our hedging decisions in order to achieve hedge accounting treatment, as opposed to managing our risk in the best way possible, which could be detrimental to the business. We therefore needed to re-examine our hedging and hedge accounting strategy to realign it with our business needs.
Reassessing business performance reporting
We embarked on a project to evaluate new reporting methodologies: in particular what the impact on our business would be if we did not apply hedge accounting, and we designed new methods for business performance reporting. We also engaged our external auditors to review our proposed strategy, which was a valuable and constructive part of the process. Our auditors had reviewed our financial transactions on a quarterly basis, and recognised the difficulties that we were experiencing in applying hedge accounting treatment. They could therefore see the advantages of a new approach that focused on simplicity and transparency.