6.2 Derivatives and hedge accounting The group uses financial derivatives to manage currency, interest rate and commodity price risks.
changes generated by the hedged items. Thereby the hedge ratio between the instrument and the cash flow is 1:1. Ineffectiveness may arise in the highly unlikely case that the forecasted cash flows are no longer expected to occur. Ineffectiveness can also occur in a situation where the hedging instrument with an appropriate maturity is not available in the market for the whole duration of the hedged item. Then the terms of the hedging instrument and the hedged item don't fully match, which causes minor ineffectiveness. There are no other significant sources of ineffectiveness that can reasonably be expected to take place. Ineffectiveness in electricity price hedges may arise in the highly unlikely case that the forecasted cash flows are no longer expected to occur. Ineffectiveness may also arise in case EPAD prices remained negative for a longer period of time, but considering historical price development UPM considers this scenario to be highly unlikely. Hedges of net investments in foreign subsidiaries The fair value changes of forward exchange contracts used in hedging net investments that reflect the change in spot exchange rates are recognised in other comprehensive income within translation reserve. Any gain or loss relating to the interest portion of forward exchange contracts is recognised immediately in the income statement under financial items. Gains and losses accumulated in equity are included in the income statement when the foreign operation is partially disposed of or sold. The hedging instrument is always made in the same currency as the hedged investment, hence the hedge ratio in net investment hedging is 1:1. For hedging of net investments, ineffectiveness may only arise in the highly unlikely situation where the hedged item is disposed or sold during the duration of the hedging instrument. Fair value hedges The group applies fair value hedge accounting for hedging fixed interest risk on debt. Changes in the fair value of derivatives that are designated and qualify as fair value hedges and that are prospectively highly effective are recorded in the income statement under financial items, along with any changes in the fair value of the hedged asset or liabilities that are attributable to the hedged risk. The carrying amounts of hedged items and the fair values of hedging instruments are included in interest-bearing assets or liabilities. Derivatives that are designated and qualify as fair value hedges mature at the same time as hedged items. If the hedge no longer meets the criteria for hedge accounting, the adjustment to the carrying amount of a hedged item for which the effective interest method is used is amortised to profit or loss over the expected period to maturity. Ineffectiveness in fair value hedge of fixed interest risk may arise in case of early redemption of such debt, which is hedged under fair value hedge accounting. The group has not recognised other significant sources of ineffectiveness that can reasonably be expected to take place. The group applies fair value hedge accounting also for hedging firm commitment of a purchase in foreign currency. The currency changes of the hedging instrument are recorded through profit and loss in financial items, until they are recognised as a part of the acquisition cost of a fixed asset.
Electricity price risk
Financial counterparty risk
UPM is hedging both sales of power production and power purchases consumed. Electricity prices rely on the balance of supply and demand and as the share of intermittent renewable energy sources grows in the energy system, the volatility in the electricity market increases. The group’s sensitivity to electricity market price is dependent on the electricity production and consumption levels and the hedging levels. The inherent price risks arise from the daily sales and purchases of electricity from the power market with spot prices, and the hedging objective is to reduce the earnings volatility that arises from electricity prices. UPM considers system (SYS) and electricity price area differential (EPAD) products perfect hedges for corresponding electricity price risk components in Finland. The components of electricity price risk in the Nordic power market are hedged by entering into System and EPAD electricity derivative contracts, mostly Nasdaq Commodities forwards, futures and options. System and EPAD prices are considered as separately identifiable and reliably measurable risk components in electricity sales and purchase contracts as well as in the hedging instruments, as a quoted price is available. Fair value changes of designated system and EPAD derivatives are offsetting electricity sales and purchase price changes. The share of SYS component covers approximately 80-90% and the share of EPAD component covers 10-20% of the changes in electricity sales and purchase prices. The electricity price risk in the Central European power market is hedged by entering into European electricity exchange futures. Products used for hedging hedge the entire price risk for the underlying price area. The time frame hedged has historically been approximately rolling 5 years. Hedging level has been typically higher for the nearest years and lower for the latter years. Hedging level for a certain year has historically varied between 0-80%. UPM constantly updates its electricity sales and consumption forecasts. The targeted hedging level is calculated based on the most recent available information about the sales and consumption of electricity. The group applies cash flow hedge accounting for the hedging relationships when it hedges its electricity price risk. In addition to hedging, the group is also trading electricity forwards and futures. As well as hedging, proprietary trading risks are monitored on a daily basis. Value-At-Risk levels are set to limit the maximum risk at any given time. Cumulative maximum loss is limited by stop-loss limits. Electricity derivatives price sensitivity Sensitivity analysis for financial electricity derivatives is based on position at the end of financial year. Sensitivities change over time as the overall hedging and trading positions change. Underlying physical positions are not included in the sensitivity analysis. Sensitivity analysis is calculated separately for the hedge accounted and non- hedge accounted volumes. In the analysis it is assumed that forward quotation in Nasdaq Commodities and EEX would change EUR 5/ MWh throughout the period UPM has derivatives. EUR 5/ MWh price sensitivity is estimated from historical market price movements in Nasdaq and EEX markets.
The financial instruments the group has agreed with banks and financial institutions contain an element of risk of the counterparties being unable to meet their obligations. According to the Group Treasury Policy derivative instruments and investments of cash funds may be made only with counterparties meeting certain creditworthiness criteria. The group minimises counterparty risk also by using a number of major banks and financial institutions. Creditworthiness of counterparties is constantly monitored by Treasury and Risk Management. Effect of IBOR reform and significant assumptions The Group’s risk exposure that is directly affected by the IBOR reform is fair value hedge accounting of long-term fixed-rate debt for changes in fair value attributable to USD LIBOR which is the current benchmark interest rate. Group currently has only few contracts which reference USD LIBOR and extend beyond 2021. Group oversees the IBOR transition and follows changes to ISDA and other market guidelines on effects of these changes to UPM’s contracts. In fair value hedging relationships, fair value for both the hedged item and hedging instrument is calculated with identical rate. Therefore no ineffectiveness is expected.
» Refer Note 6.1 Financial risk management.
All derivatives are initially and continuously recognised at fair value in the balance sheet. The fair value gain or loss is recognised through the income statement or other comprehensive income depending on whether the derivative is designated as a hedging instrument, and on the nature of the item being hedged. Certain derivatives are designated at inception either hedges of the fair value of recognised assets or liabilities or a firm commitment (fair value hedge), hedges of highly probable forecasted transactions (cash flow hedge), or hedges of net investments in foreign subsidiaries with other than the EUR as their functional currency (net investment hedge). Derivative fair values on the balance sheet are classified as non-current when the remaining maturity is more than 12 months and as current when the remaining maturity is less than 12 months. For hedge accounting purposes, UPM documents the relationship between the hedging instruments and hedged items, as well as the risk management objective and strategy for undertaking various hedge transactions at the inception date. This process includes linking all derivatives designated as hedges to specific assets and liabilities or to specific firm commitments or forecast transactions. The group also documents its assessment, both at the hedge inception and on an on- going basis, as to whether the hedge is highly effective in offsetting changes in fair values or cash flows of the hedged items. Certain derivatives, while considered to be economical hedges for UPM’s financial risk management purposes, do not qualify for hedge accounting. Such derivatives are recognised at fair value through the income statement in other operating income or under financial items. Cash flow hedges The effective portion of changes in the fair value of derivatives that are designated and qualify as cash flow hedges is recognised in other comprehensive income. Cost of hedging, meaning forward points of derivative forward contracts accounted as cash flow hedges, is recognised as a part of the hedging reserve. Amounts deferred in equity are transferred to the income statement and classified as income or expense in the same period as that in which the hedged item affects the income statement (for example, when the forecast external sale to the group that is hedged takes place). When the forecasted transaction that is hedged results in the recognition of a fixed asset, gains and losses previously deferred in equity are transferred from equity and included in the initial measurement of the acquisition cost and depreciated over the useful lives of the assets. When a hedging instrument expires or is sold, or when a hedge no longer meets hedge accounting criteria, any cumulative gain or loss existing in equity at that time remains in equity and is recognised when the committed or forecasted transaction is ultimately recognised in the income statement. However, if a forecasted transaction is no longer expected to occur, the cumulative gain or loss that was reported in equity is immediately recognised to the income statement. In currency cash flow hedging, the hedging instrument is made in the same currency as the hedged item and hence the fair value change of the hedging instrument are expected to effectively offset the fair value
+/– EUR 5/MWh in electricity forward quotations Effect on profit before tax