27. Financial instruments

27.1. Principles of financial risk management

The Group is exposed to the following categories of risk related to financial instruments:

• credit risk;
• liquidity risk;
• commodity risk;
• currency risk;
• interest rate risk.

This note presents information on the Group’s exposure to each of the aforementioned risks as well as the risk and capital management objectives, policy and procedures.

Development of the general guidelines and rules of the risk management policy is the responsibility of the Management Board of the Parent.

Financial risk management in the Group is based on a formalized, integrated risk management system described in the dedicated policies, procedures and methodologies for risk management.

Risk is managed on an ongoing basis. Risks are analyzed in connection with the impact of the external environment as well as changes in the structure and activities of the Group. Taking these into consideration, the steps are undertaken aimed at mitigation of the risk or its transfer outside the Group.

27.2. Credit risk

Credit risk is the risk of financial losses which may be incurred if a counterparty or a customer being a party to a financial instrument fails to meet its contractual obligations.

Credit risk is mainly related to debt collection. The key factors that affect the occurrence of credit risk at the Company include:

• a substantial number of small customers resulting in an increase in the costs incurred to monitor debt collection;
• the necessity to supply electricity to budgetary units facing financial difficulties;
• legal requirements defining the principles for electricity supply suspension as a result of default on payment.

The Management Board applies a credit policy which provides monitoring exposure to credit risk on an ongoing basis and undertakes actions for risk minimization. The main tool for credit risk management is the analysis of the creditworthiness of most relevant partners of Enea S.A. under the terms of the contract with a counterparty are subject to appropriate structuring (terms of payment, any collateral contract, etc.).

The table below presents the structure of the assets illustrating the exposure of the Enea Group to credit risk:

The credit risk relating to receivables differs for individual market segments in which the Group carries out its business activities:

• electricity and distribution service sales to individual customers – a considerable amount of past due receivables. Although they do not represent a serious threat to the Group’s financial position, measures aimed at their reduction have been undertaken. Steps aimed at improvement of the collection process have been taken involving development of new and update of the existing manuals and principles of collection and cooperation with professional entities. The collection process starts 20-25 days after the payment deadline. Thanks to unified collection policy, including soft collection, the entity is able to shorten the collection period and avoid long-lasting and quite ineffective hard collections, i.e. enforcement by court or a bailiff. Court or bailiff’s collections are applied to cases whose value is higher than the cost-benefit ratio for debt collection;
• sales of electricity and distribution services to business, key and strategic clients, where overdue receivables are lower than in the segment of individual clients. Because of the much smaller number of customers in these segments, the principles of collection are based mainly on soft collection. Activities related to the soft collection are taken no later than 6 days after the payment deadline, and as a rule do not last longer than 30 days after the payment deadline;
• other receivables – compared to the above segments the amounts of past due receivables are immaterial.

A key role in the debt collection process is played by employees of the Debt Collection Department. They monitor the debt collection process and attempt to collect past due receivables through direct contact with the customer. Enea also works in the field of debt collection with specialized external entities, supporting the activities of the Company in the area of so-called hard bad debt collection.

The Group monitors the amount of past due receivables on an ongoing basis and in justified cases files legal complaints and recognizes appropriate impairment losses.

27.3. Liquidity risk

The liquidity risk is the risk that the Group will be unable to meet its financial obligations at due date.

The objective of the liquidity risk management carried out by the Group is to reduce the probability of loss the ability to repay liabilities. In particular, the policy assumes ensuring the ability to effectively address liquidity crises, i.e. periods of an increased demand for liquid assets.

The policy assumes ensuring available cash sufficient to repay liabilities in the course of standard operations and to continue undisturbed business operations in time of liquidity crisis in the period necessary to implement emergency financing plan which allows to increase liquidity without delay.

Liquidity management focuses on a detailed analysis of the receivables collection scheme debtors’ days ratio and the ongoing monitoring of bank accounts. The financial surpluses are invested in current assets in the form of term deposits. The Group diversifies sources of external financing and investments to ensure stability of financing. The Group also diversifies investments of surplus cash to mitigate concentration risk. The effectiveness of investment process is monitored on an ongoing basis.

Enea S.A. has undertaken actions toward concentration of liquidity management between entities within the Group. In order to finance current operations and optimize the process of managing liquidity, entities within the Group comprising introduction of a cash pooling in key entities participating in Enea Tax Group and expended intra-group bonds issue programmes resulting in an increase of cash effectiveness within the Group.

Taking into account ongoing risk management as well as the market and financial position of the Group it may be concluded that its liquidity risk remains at a minimum level.

Additionally, the Group manages its liquidity risk by maintaining open and unused credit facilities, which amounted to PLN 700 000 thousand as at 31 December 2016 and PLN 550 000 thousand as at the date of these consolidated financial statements.

The Group’s financial assets and liabilities by maturity are presented in the table below:

27.4. Commodity risk

Commodity risk is related to possible changes in revenue/cash flows generated by the Group resulting, in particular, from fluctuations in commodity prices and changing demand for products/services offered. The objective of commodity risk management is to maintain the risk exposure within an acceptable level while optimizing the return on risk.

One of the key aspects of the commodity risk results from the fact that being an energy company operating based on an electricity trading license, the entity is required to submit electricity tariffs for the G-tariff groups for approval. The Company purchases energy at market prices and calculates its tariff based on costs regarded as legitimate by the President of the Energy Regulatory Office as well as margins (for electricity trading) planned to be earned in the subsequent tariff period. Therefore, during the tariff period the Group’s possibility to transfer adverse changes in its operating costs to electricity customers is limited. A tariff adjustment request may be filed to the President of the Energy Regulatory Office only in the event of a dramatic rise in costs for reasons that are beyond the Group’s control.

Commodity risk management in the scope of pricing is based on continuous monitoring of an open position in trading (both with regard to securing the volume of retail sales, and to proprietary trading) and measurement - using value at risk tools - of the level of risk of possible electricity price fluctuation with respect to such an open position in trading. An appropriate risk mitigation technique in this case is to close an item that generates excessive (grater than accepted) value of potential loss. The management model is based in this case on a system of value limits (VaR limits) setting the maximum value of the open position, which is the carrier of the commodity risk (price risk).

Commodity risk management in terms of volumetric involves using scenario methods, optimizing the planning processes and control of commercial activities which allows possibly the most accurate way to estimate expected volumes of electricity and related goods that are traded.

Moreover, independently from mentioned above, the Enea applies the management principles defined by the strategic regulation (so-called Wholesale Trading Procedure), defining the operating methods related to optimization of Enea's trading position with the primary purpose of minimizing the risk of taking actions contrary to the market trends, taking account of the efficiency aspect in the context of that trend (achieving better results than the market average.

27.5. Curreny risk

The exposure of the Group to currency risk is presented below.

The currency risk is related to possible changes in cash flows generated by the Group resulting from fluctuations in the currencies exchange rates in which such cash flows are denominated.

The Enea Group is exposed in particular to currency risk arising from necessity to purchase CO2 emission rights, as well as in connection with the purchase of particular fuels (biomass), certain capital expenditures and realized contracts for the services provided by contractors, whose market prices/costs are denominated in EUR.

Currency risk is hedged mainly with currency forward contracts. The purpose of the activities aimed at hedging currency risk is guaranteeing a specific value in PLN of the future revenues and, in particular, expenditures - incurred as a result of purchases of CO2 emission rights, or investment works.

Safety measures are implemented based on Policy management of currency risk and interest rate risk applied in Enea Group.

Lubelski Węgiel Bogdanka S.A. enters into specific transactions denominated in foreign currencies, which brings about a risk of exchange rate fluctuations. The Company is mainly exposed to the risk of changes in EUR/PLN and USD/PLN exchange rates. During 2016 no significant foreign exchange transactions were entered into., however, in this year appeard the relatively high value of sales denominated in foreign currency USD and EUR.

Significant foreign exchange transactions were entered into in previous years, before 2015 - in connection with the purchase of specialized equipment and machinery. However, due to the completion of the intensified investment process, no such transactions are expected in the near future.

The risk is managed within the approved procedures using the foreign currency forward contracts. LWB applies hedge accounting for future cash flows. The aim of the LWB’s hedge operations against changes in the exchange rate of EUR/PLN and USD/PLN is to ensure a specific level in PLN of future expenditures in EUR, which will be incurred in connection with the future investments and to guarantee a specified level of future proceeds in USD/EUR received in relation with the realized sales.

27.6. Interest rate risk

The interest rate risk, the Group is exposed to, results from credit facilities and loans as well as bond issue programmes taken by Enea. The Group tends to apply variable interest correlated with market (interbank) rates.

Due to the applied by the Group model of financing, interest rate risk is identified and managed (quantified, hedged) at the level of the Parent company.

Safety measures in the area of interest rate are carried out based on Currency risk and interest rate risk management policy in Enea Group. As at 31 December 2016 Enea Group has liabilities resulting from loans, borrowings and debt securities of PLN 6 724 546 thousand. The above mentioned debt has been secured by interest rate risk hedging transactions (IRS) in 65%.

The table below, presents financial assets and liabilities by fixed and variable interest rates, showing the Group’s sensitivity to interest rate risk:

Cash deposited in bank is presented within fixed rate instruments.

Effective interest rates applicable to variable rate assets and liabilities are presented in the table below:

The effective interest rates presented in the table above are determined as the weighted average of interest rates.

The table below presents the impact of interest rate changes on the Group’s net results. The impact of interest rate on bank loans, borrowings and debt securities is presented net of IRS effect.

27.7. Mangement of founding sources

The key assumption of the Group in management of funding sources is maintaining optimal liabilities structure to reduce the cost of funding operations, secure credit rating at the investment level and sources of funding for operating and investing activities of the Group. Activities conducted in this area also tend to ensure the financial security of the Group and rewarding value for shareholders. When optimizing the structure of liabilities by applying financial leverage it is also important to maintain a strong capital base being a foundation for building confidence of investors, creditors and market. The Group monitors its capital using the debt ratio and the return on equity ratio. Its objective is to ensure increase of capital effectiveness together with maintaining the capital at the safe level.

27.8. Fair value

The table below presents fair values as compared to carrying amounts:

Financial assets available for sale include shares in unrelated parties for which the ratio of interest in equity is lower than 20%. The positions comprises also shares in PGE EJ1 Sp. o.o. in the amount of PLN 26 902 thousand for which there is no quoted market price in an active market and whose fair value - because of the initial phase of the company's activity – is based on incurred cost.

Derivatives comprise the valuation of interest rate hedging transactions (Interest Rate Swap). The fair value of derivatives is determined by calculating the net present value based on two yield curves, i.e. the curve to determine the discount factor and curve used to estimate future rates of variable reference rates.

Current financial assets measured at fair value through profit or loss include an investment portfolio managed by a company specialized in professional cash management. The fair value of the investment portfolio is estimated based on market quotations.

The table below presents the analysis of financial instruments measured at fair value and classified into the following three levels:

Level 1 – fair value based on stock exchange prices (unadjusted) offered for identical assets or liabilities in active markets,

Level 2 – fair value determined based on market observations instead of market quotations (e.g. direct or indirect reference to similar instruments traded in the market),

Level 3 – fair value determined using various valuation methods, but not based on any observable market information.