From Hedge Accounting to Strategic Hedging

Published: January 01, 2013

From Hedge Accounting to Strategic Hedging
Morten Buchgreitz
SVP and Group Treasurer, DONG Energy

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.

Risk profile

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.[[[PAGE]]]

In January 2011, we introduced a new three-column income statement to increase transparency and better reflect actual business performance. We stopped applying hedge accounting treatment, and instead accounted for mark-to-market movements from hedges and some physical deliveries directly in the profit & loss account. This increases volatility in the IFRS result, but only affects the timing of the accounting impact, without a real economic or cash flow effect. The new income statement splits the IFRS result into two sections: firstly, business performance i.e., results relating to the actual period, and secondly, adjustments i.e., mark-to-market movements not attributable to results during the period (figure 1). Over time the aggregate adjustments result in a zero amount, and the business performance plus adjustments equal the IFRS result.

Fig. 1 DONG Energy
Please click image to enlarge

The new presentation of the income statement has no impact on the cash flow statement, and better reflects the financial management and governance of the business. The presentation is in full compliance with IFRS rules, and is audited by our external auditors as part of our financial reporting process.

Managing expectations

Inevitably, however, we were concerned that a change in our financial reporting method would impact on our quarterly results, and therefore on our market and credit position. Although DONG is not a publicly listed company, we are the largest non-financial institution issuing bonds in Denmark, so it was very important that we retained market confidence. We therefore presented our dilemma and proposed solution to external credit analysts to gauge their reaction; similarly, we engaged with rating agencies. In fact, their response was very positive, but it was essential to explain our position and ensure external support.

Impact and outcomes

Adopting a new reporting strategy required changes to our systems, and new, strict procedures for registering transactions. We therefore undertook a migration project including technical specification and implementation, which was a significant task. However, our reporting is now considerably simpler, and our quarterly reporting is a far more rapid and straightforward process. We have also reduced our operational risks through greater visibility and simplicity. From a financial perspective, our hedging strategy is now business-led rather than accounting-led, which brings clear benefits. As our results are easier to understand, we need to provide less explanation to stakeholders, which in turn improves confidence. The change in our reporting had an impact on our results for the first two quarters, but then levelled out.[[[PAGE]]]

The change to our risk management strategy and the new reporting approach that we adopted as a result has been a major success for DONG. While we anticipated negative pushback to start with, the opposite was the case, and we have received considerable support and increased stakeholder confidence. In some respects, it may be easier for a privately held company such as DONG to adopt a new hedging approach than for a publicly listed company, as we have a smaller group of stakeholders, but it should be possible for a publicly listed company too. Transparency in financial reporting is essential for every company, and aligning external reporting with the way that the business is managed ensures greater visibility and credibility.

Morton Buchgreitz

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Article Last Updated: May 07, 2024

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