Market risk is the risk that in the normal course of business we may experience a loss in value as a result of changes in market conditions that affect economic factors such as commodity prices, interest rates and counterparty credit. Our exposure to market risk is affected by a number of factors, including the size, duration and composition of our energy and financial portfolio, as well as the volatility and liquidity of markets. Instruments used to manage this exposure include interest rate swaps to hedge debt costs, as well as exchange-traded, over-the-counter contracts and other contractual arrangements to hedge commodity prices.
Risk Oversight
We manage the commodity price, counterparty credit and commodity-related operational risk related to the competitive energy business within limitations established by senior management and in accordance with overall risk management policies. Interest rate risk is managed centrally by our treasury function. Market risks are monitored by risk management groups that operate independently of the wholesale commercial operations, utilizing defined practices and analytical methodologies. These techniques measure the risk of change in value of the portfolio of contracts and the hypothetical effect on this value from changes in market conditions and include, but are not limited to, position reporting and review, Value at Risk (VaR) methodologies and stress test scenarios. Key risk control activities include, but are not limited to, transaction review and approval (including credit review), operational and market risk measurement, transaction authority oversight, validation of transaction capture, market price validation and reporting, and portfolio valuation and reporting, including mark-to-market valuation, VaR and other risk measurement metrics.
Vistra Energy has a risk management organization that enforces applicable risk limits, including the respective policies and procedures to ensure compliance with such limits, and evaluates the risks inherent in our businesses.
Commodity Price Risk
Our business is subject to the inherent risks of market fluctuations in the price of electricity, natural gas and other energy-related products it markets or purchases. We actively manage the portfolio of generation assets, fuel supply and retail sales load to mitigate the near-term impacts of these risks on results of operations. Similar to other participants in the market, we cannot fully manage the long-term value impact of structural declines or increases in natural gas and power prices.
In managing energy price risk, we enter into a variety of market transactions including, but not limited to, short- and long-term contracts for physical delivery, exchange-traded and over-the-counter financial contracts and bilateral contracts with customers. Activities include hedging, the structuring of long-term contractual arrangements and proprietary trading. We continuously monitor the valuation of identified risks and adjust positions based on current market conditions. We strive to use consistent assumptions regarding forward market price curves in evaluating and recording the effects of commodity price risk.
VaR Methodology — A VaR methodology is used to measure the amount of market risk that exists within the portfolio under a variety of market conditions. The resultant VaR produces an estimate of a portfolio's potential for loss given a specified confidence level and considers, among other things, market movements utilizing standard statistical techniques given historical and projected market prices and volatilities.
A Monte Carlo simulation methodology is used to calculate VaR and is considered by management to be the most effective way to estimate changes in a portfolio's value based on assumed market conditions for liquid markets. The use of this method requires a number of key assumptions, such as use of (i) an assumed confidence level; (ii) an assumed holding period (i.e., the time necessary for management action, such as to liquidate positions); and (iii) historical estimates of volatility and correlation data. The tables below detail certain VaR measures related to various portfolios of contracts.
VaR for Underlying Generation Assets and Energy-Related Contracts Subject to Mark-to-Market (MtM) Accounting — This measurement estimates the potential loss in fair value, due to changes in market conditions, of all underlying generation assets and contracts marked-to-market in net income (through the end of 2018), based on a 95% confidence level and an assumed holding period of 60 days.
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| Year Ended December 31, | | | | | | |
| 2017 | | | | 2016 | | |
| Month-end average VaR: | $ | 92 | | | $ | 65 | |
| Month-end high VaR: | $ | 140 | | | $ | 119 | |
| Month-end low VaR: | $ | 62 | | | $ | 30 | |
The increase in the month-end high VaR risk measure in 2017 reflected lower seasonal natural gas to power correlations in early 2017 and increased natural gas volatility.
Interest Rate Risk
The following table provides information concerning our financial instruments at December 31, 2017 and 2016 that are sensitive to changes in interest rates. Debt amounts consist of the Vistra Operations Credit Facilities. See Note 12 to the Financial Statements for further discussion of these financial instruments.
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| Expected Maturity Date | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| (millions of dollars, except percentages) | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| 2018 | | | | 2019 | | | | 2020 | | | | 2021 | | | | 2022 | | | | There-after | | | | 2017 Total Carrying Amount | | | | 2017 Total Fair Value | | | | 2016 Total Carrying Amount | | | | 2016 Total Fair Value | | |
| Long-term debt, including current maturities (a): | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Variable rate debt amount | $ | 39 | | | $ | 39 | | | $ | 39 | | | $ | 39 | | | $ | 39 | | | $ | 4,116 | | | $ | 4,311 | | | $ | 4,334 | | | $ | 4,500 | | | $ | 4,552 | |
| Average interest rate (b) | 3.98 | | % | | 3.98 | | % | | 3.98 | | % | | 3.98 | | % | | 3.98 | | % | | 3.98 | | % | | 3.98 | | % | | | | | | 4.78 | | % | | | | |
| Debt swapped to fixed (c): | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Notional amount | $ | — | | | $ | — | | | $ | — | | | $ | — | | | $ | — | | | $ | 3,000 | | | $ | 3,000 | | | | | | | $ | 3,000 | | | | | |
| Average pay rate | 4.59 | | % | | 4.59 | | % | | 4.59 | | % | | 4.59 | | % | | 4.59 | | % | | 4.59 | | % | | 4.59 | | % | | | | | | 5.82 | | % | | | | |
| Average receive rate | 4.11 | | % | | 4.11 | | % | | 4.11 | | % | | 4.11 | | % | | 4.11 | | % | | 4.11 | | % | | 4.11 | | % | | | | | | 4.52 | | % | | | | |
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| (a) | Capital leases, mandatorily redeemable preferred stock and the effects of unamortized premiums and discounts are excluded from the table. |
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| (b) | The weighted average interest rate presented is based on the rates in effect at December 31, 2017. |
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| (c) | Interest rate swaps became effective in January 2017 and have maturity dates through July 2023. |
At December 31, 2017, the potential reduction of annual pretax earnings over the next 12 months due to a one percentage-point (100 basis points) increase in floating interest rates on long-term debt totaled approximately $13 million, taking into account the interest rate swaps discussed in Note 12 to Financial Statements.
Credit Risk
Credit risk relates to the risk of loss associated with nonperformance by counterparties. We minimize credit risk by evaluating potential counterparties, monitoring ongoing counterparty risk and assessing overall portfolio risk. This includes review of counterparty financial condition, current and potential credit exposures, credit rating and other quantitative and qualitative credit criteria. We also employ certain risk mitigation practices, including utilization of standardized master agreements that provide for netting and setoff rights, as well as credit enhancements such as margin deposits and customer deposits, letters of credit, parental guarantees and surety bonds. See Note 16 to the Financial Statements for further discussion of this exposure.
Credit Exposure — Our gross credit exposure (excluding collateral impacts) associated with retail and wholesale trade accounts receivable and net derivative assets arising from commodity contracts and hedging and trading activities totaled $611 million at December 31, 2017.
At December 31, 2017, Retail Electricity segment credit exposure totaled $469 million, including $451 million of trade accounts receivable and $18 million related to derivative assets. Cash deposits and letters of credit held as collateral for these receivables totaled $44 million, resulting in a net exposure of $425 million. We believe the risk of material loss (after consideration of bad debt allowances) from nonperformance by these customers is unlikely based upon historical experience. Allowances for uncollectible accounts receivable are established for the potential loss from nonpayment by these customers based on historical experience, market or operational conditions and changes in the financial condition of large business customers.
At December 31, 2017, Wholesale Generation segment credit exposure totaled $142 million including $81 million related to derivative assets and $61 million of trade accounts receivable, after taking into account master netting agreement provisions but excluding collateral impacts.
Including collateral posted to us by counterparties, our net Wholesale Generation segment exposure was $136 million, substantially all of which is with investment grade customers as seen in the following table that presents the distribution of credit exposure at December 31, 2017. Credit collateral includes cash and letters of credit, but excludes other credit enhancements such as guarantees or liens on assets.
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| Exposure Before Credit Collateral | | | | Credit Collateral | | | | Net Exposure | | |
| Investment grade | $ | 132 | | | $ | — | | | $ | 132 | |
| Below investment grade or no rating | 10 | | | | 6 | | | | 4 | | |
| Totals | $ | 142 | | | $ | 6 | | | $ | 136 | |
Significant (10% or greater) concentration of credit exposure exists with three counterparties, which represented an aggregate $102 million, or 75%, of the total net exposure. We view exposure to these counterparties to be within an acceptable level of risk tolerance due to the counterparties' credit ratings, each of which is rated as investment grade, the counterparties' market role and deemed creditworthiness and the importance of our business relationship with the counterparties. An event of default by one or more counterparties could subsequently result in termination-related settlement payments that reduce available liquidity if amounts such as margin deposits are owed to the counterparties or delays in receipts of expected settlements owed to us.
Contracts classified as "normal" purchase or sale and non-derivative contractual commitments are not marked-to-market in the financial statements and are excluded from the detail above. Such contractual commitments may contain pricing that is favorable considering current market conditions and therefore represent economic risk if the counterparties do not perform.
At December 31, 2017, interest rate swap exposure in the Corporate and Other non-segment totaled $18 million. There are no collateral offsets. The counterparty credit rating is investment grade.
FORWARD-LOOKING STATEMENTS
This report and other presentations made by us contain "forward-looking statements." All statements, other than statements of historical facts, that are included in this report, or made in presentations, in response to questions or otherwise, that address activities, events or developments that may occur in the future, including such matters as activities related to our financial or operational projections, capital allocation, capital expenditures, liquidity, dividend policy, business strategy, competitive strengths, goals, future acquisitions or dispositions, development or operation of power generation assets, market and industry developments and the growth of our businesses and operations (often, but not always, through the use of words or phrases such as "intends," "plans," "will likely," "unlikely," "expected," "anticipated," "estimated," "should," "may," "projection," "target," "goal," "objective" and "outlook"), are forward-looking statements. Although we believe that in making any such forward-looking statement our expectations are based on reasonable assumptions, any such forward-looking statement involves uncertainties and risks and is qualified in its entirety by reference to the discussion under Item 1A. Risk Factors and Item 7., Management's Discussion and Analysis of Financial Condition and Results of Operations in this report and the following important factors, among others, that could cause our actual results to differ materially from those projected in or implied by such forward-looking statements:
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| • | the actions and decisions of regulatory authorities; |
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| • | prohibitions and other restrictions on our operations due to the terms of our agreements; |
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| • | prevailing governmental policies and regulatory actions, including those of the Texas Legislature, the Governor of Texas, the U.S. Congress, the FERC, the NERC, the TRE, the PUCT, the RCT, the NRC, the EPA, the TCEQ the MSHA and the CFTC, with respect to, among other things: |
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| ◦ | industry, market and rate structure; |
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| ◦ | purchased power and recovery of investments; |
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| ◦ | operations of nuclear generation facilities; |
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| ◦ | operations of fossil fueled generation facilities; |
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| ◦ | acquisition and disposal of assets and facilities; |
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| ◦ | development, construction and operation of facilities; |
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| ◦ | present or prospective wholesale and retail competition; |
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| ◦ | changes in tax laws and policies; |
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| ◦ | changes in and compliance with environmental and safety laws and policies, including National Ambient Air Quality Standards, the Cross-State Air Pollution Rule, the Mercury and Air Toxics Standard, regional haze program implementation and GHG and other climate change initiatives, and |
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| ◦ | clearing over-the-counter derivatives through exchanges and posting of cash collateral therewith; |
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| • | legal and administrative proceedings and settlements; |
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| • | general industry trends; |
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| • | economic conditions, including the impact of an economic downturn; |
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| • | weather conditions, including drought and limitations on access to water, and other natural phenomena, and acts of sabotage, wars or terrorist or cyber security threats or activities; |
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| • | our ability to collect trade receivables from counterparties; |
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| • | our ability to attract and retain profitable customers; |
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| • | our ability to profitably serve our customers; |
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| • | restrictions on competitive retail pricing; |
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| • | changes in wholesale electricity prices or energy commodity prices, including the price of natural gas; |
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| • | changes in prices of transportation of natural gas, coal, fuel oil and other refined products; |
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| • | changes in the ability of vendors to provide or deliver commodities as needed; |
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| • | changes in market heat rates in the ERCOT electricity market; |
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| • | our ability to effectively hedge against unfavorable commodity prices, including the price of natural gas, market heat rates and interest rates; |
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| • | population growth or decline, or changes in market supply or demand and demographic patterns, particularly in ERCOT; |
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| • | access to adequate transmission facilities to meet changing demands; |
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| • | changes in interest rates, commodity prices, rates of inflation or foreign exchange rates; |
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| • | changes in operating expenses, liquidity needs and capital expenditures; |
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| • | commercial bank market and capital market conditions and the potential impact of disruptions in U.S. and international credit markets; |
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| • | access to capital, the attractiveness of the cost and other terms of such capital and the success of financing and refinancing efforts, including availability of funds in capital markets; |
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| • | our ability to maintain prudent financial leverage; |
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| • | our ability to generate sufficient cash flow to make principal and interest payments in respect of, or refinance, our debt obligations: |
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| • | competition for new energy development and other business opportunities; |
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| • | our ability to successfully complete our solar generation project in a timely and cost-efficient manner or at all; |
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| • | inability of various counterparties to meet their obligations with respect to our financial instruments; |
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| • | changes in technology (including large scale electricity storage) used by and services offered by us; |
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| • | changes in electricity transmission that allow additional power generation to compete with our generation assets; |
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| • | our ability to attract and retain qualified employees; |
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| • | significant changes in our relationship with our employees, including the availability of qualified personnel, and the potential adverse effects if labor disputes or grievances were to occur; |
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| • | changes in assumptions used to estimate costs of providing employee benefits, including medical and dental benefits, pension and OPEB, and future funding requirements related thereto, including joint and several liability exposure under ERISA; |
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| • | hazards customary to the industry and the possibility that we may not have adequate insurance to cover losses resulting from such hazards; |
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| • | the impact of our obligations under the TRA; |
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| • | expectations regarding the Merger, including beliefs concerning stockholder and regulatory approvals; |
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| • | the occurrence of any event that could give rise to the termination of the Merger Agreement, including a termination of the Merger Agreement under circumstances that could require us to pay a termination fee; |
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| • | our ability to successfully integrate the businesses of Vistra Energy and Dynegy upon consummation of the Merger and our ability to successfully capture any projected synergies relating to the Merger, and |
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| • | actions by credit rating agencies. |
Any forward-looking statement speaks only at the date on which it is made, and, except as may be required by law, we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which it is made or to reflect the occurrence of unanticipated events or circumstances. New factors emerge from time to time, and it is not possible for us to predict them. In addition, we may be unable to assess the impact of any such event or condition or the extent to which any such event or condition, or combination of events or conditions, may cause results to differ materially from those contained in or implied by any forward-looking statement. As such, you should not unduly rely on such forward-looking statements.
INDUSTRY AND MARKET INFORMATION
Certain industry and market data and other statistical information used throughout this report are based on independent industry publications, government publications, reports by market research firms or other published independent sources, including certain data published by ERCOT, the PUCT and NYMEX. We did not commission any of these publications, reports or other sources. Some data is also based on good faith estimates, which are derived from our review of internal surveys, as well as the independent sources listed above. Industry publications, reports and other sources generally state that they have obtained information from sources believed to be reliable, but do not guarantee the accuracy and completeness of such information. While we believe that each of these studies, publications, reports and other sources is reliable, we have not independently investigated or verified the information contained or referred to therein and make no representation as to the accuracy or completeness of such information. Forecasts are particularly likely to be inaccurate, especially over long periods of time, and we do not know what assumptions were used in preparing such forecasts. Statements regarding industry and market data and other statistical information used throughout this report involve risks and uncertainties and are subject to change based on various factors.
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