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About This FAM
| Responsible Agency: | Government Accounting - Finance |
| Issued: | July 2008 |
| Last Updated: | July 2008 |
1. Introduction
The Financial Administration Act Sections 57.1 and 107(c.2) permit the Government to manage the price risk inherent in petroleum product purchases through a variety of derivative instruments. Further legislative requirements are found in the Financial Agreements and Transactions (Petroleum Product Derivatives) Regulations.
The Revolving Fund Act, Section 4(1) permits the financial settlement of agreements referred to in Section 57(1) of the Financial Administration Act. Therefore, the relevant legislation will permit the Petroleum Products Division (PPD), Department of Public Works and Services (PWS), to manage and account for the petroleum risk management program within the Petroleum Products Revolving Fund.
This policy gives additional direction on the Financial Agreements and Transactions (Petroleum Product Derivatives) Regulations.
In addition to the Financial Agreements and Transactions (Petroleum Product Derivatives) Regulations, this policy is also broadly based on the Committee of Sponsoring Organizations of the Treadway Commission’s (COSO) Internal Control Issues in Derivatives Usage, which addresses the business control systems needed when using derivative financial assets.
Background
In 1972, the Government established the PPD to provide petroleum fuel sales to communities in the Northwest Territories not served by the private sector. Commercial suppliers contracted by the PPD deliver petroleum products to communities in the Northwest Territories not served by all season roads. At the time of delivery, the Rack or Spot Market Price determines the price of PPD’s fuel purchases. Spot petroleum market prices frequently change and recent history shows that despite inevitable market fluctuations prices seem to be on a long-term rise.
Since 2004, the causes of increasing end product petroleum prices include:
- Natural disasters (e.g., hurricanes) interfering with production, refining, and distribution;
- Political uncertainty in the Middle East;
- Shortages in refining capacity caused in part by rising environmental regulations in the United States and a lag in construction following over-construction in the 1970s and 1980s;
- In continuing to identify additional sources of oil, exploration is taking place in locations which are more costly. As well, a rise in production from other than conventional sources of oil, such as Alberta’s oil sands, have increased the cost of production.
Governments in Canada are using derivatives. Strategies involving derivatives commonly seek to offset the risk that a future period will bring an adverse change in the price of commodities such as fuel, foreign currency exchange rates, or interest rates on debt. Entering into a derivative contract changes the economic position of an entity, transforming risk but not eliminating it. Instead, a host of new risks associated with derivative positions arise including market risk, basis or correlation risk, settlement risk, and operational risk.
2. Definitions
| “agreement” | An agreement referred to in section 57.1 of the Financial Administration Act (Financial Agreements and Transactions (Petroleum Product Derivatives) Regulations) |
| “counterparty” | The party on the other side of a transaction. (COSO. Internal Control Issues in Derivatives Usage. 1996. Jersey City, NJ) |
| “derivative” |
A financial instrument or other contract within the scope of Canadian Institute of Chartered Accountants (CICA) Handbook Section 3855 with all three of the following characteristics:
|
| “financial instrument” | Any contract that gives rise to a financial asset of one party and a financial liability or equity instrument of another party. (CICA Section 3855.19(a)) |
| “hedge” | Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract.5. |
| “spot market” | A commodities or securities market in which goods are sold for cash and delivered immediately. Contracts bought and sold on these markets are immediately effective6. |
3. Policy
The objectives of this policy through its Directives and guidelines are to elaborate and clarify the application of Sections 57.1 and 107(c.2) of the Financial Administration Act and the Financial Agreements and Transactions (Petroleum Product Derivatives) Regulations to ensure that:
- business exposures to risk from petroleum purchasing and sales activities have been identified and are capable of being controlled (e.g.: setting acceptable limits to the divergence of the Edmonton Rack price and the Nymex price for heating oil).
- derivative financial instruments may only be used to manage business risk of petroleum product purchases used for resale within the limits specified by this policy and manage exposures that have been identified through the risk identification and assessment process.
- derivative financial instruments cannot be used for activities that increase risk to the Government of the Northwest Territories, such as trading, speculation, or any other purpose in which the objective is to generate profits. Financial activities in the context of this policy are considered speculative if they increase risk, if their purposes have no relation to the objectives of this policy, or they do not intend or expect to reduce the business risks which have been identified.
- roles, responsibilities, and accountabilities are clearly specified and appropriate in relation to control standards.
4. Directives
| 4.1 |
Authority to Enter into Petroleum Derivatives Transactions Under the authority of Section 3 of the Financial Agreements and Transactions (Petroleum Product Derivatives) Regulations, the Deputy Minister of Finance or his or her delegate have the sole authority to enter into agreements and settle related transactions referred to in Section 57.1 of the Financial Administration Act. |
| 4.2 |
Annual Hedging Strategy PWS management shall submit an annual Hedging Strategy and revisions to the Petroleum Product Derivatives Risk Management Committee (the Committee) as the Committee directs. The Committee will review and approve the Strategy and any revisions thereafter. |
| 4.3 | Unauthorized Uses |
| 4.3.1 |
Unusual and Complex Transactions Complex derivatives transactions are prohibited if they are not essential to accomplishing the objectives specified by this policy or if they cannot be readily valued and determined to be effective in reducing risk (e.g., counter hedging). |
| 4.3.2 |
Accounting-motivated Transactions Derivative transactions that are primarily motivated by accounting implications and do not reduce economic risk exposure are considered inappropriate and are prohibited. |
| 4.4 |
Operating Limitations The total amount of petroleum fuel swap contracts outstanding for the purposes of hedging at any point in time shall not exceed the total amount of petroleum products anticipated and forecasted to be purchased by the Government of the Northwest Territories and its entities and shall not exceed an eighteen-month period. |
| 4.5 |
Counterparty Risk The Deputy Minister of Finance shall ensure that counterparty risk is managed appropriately including regard to requirements of Financial Administration Act and the Financial Agreements and Transactions (Petroleum Product Derivatives) Regulations. |
| 4.6 |
Risk Identification The Deputy Minister of Finance shall ensure that an appropriate risk management system is in place to identify, manage, and monitor internal and external risk associated with derivative transactions. This requirement includes the requirement to ensure adequate processes are implemented, maintained, and improved over time to identify and mitigate exposures to risk from fuel swap instruments and hedging strategies. |
| 4.7 |
Assessing Risk and Reporting Performance The Deputy Minister of PWS shall develop and implement a method for assessing and for reporting risk and performance that is associated with using derivatives within their operations when developing their Hedging Strategy. It must be generally understandable by non-financial executives, decision-makers, and other stakeholders and is mathematically rigorous. The Hedging Strategy is submitted to the Committee and performance against the Strategy shall be reported to the Financial Management Board on an annual basis and included in the Committee’s report to the Minister of Finance. |
| 4.8 |
Derivative Contracting Operations The Deputy Ministers of Finance and PWS shall develop, implement, and maintain adequate systems of internal control and accounting over the derivative contracting operations in their respective departments and co-ordinate control and accounting processes to ensure effective control is in place for the overall derivative contracting operations between their departments. In this regard, clear functional separation between the trading (front office), monitoring (middle office, including the Petroleum Product Risk Management Committee), and back-office processing, control, and accounting must be maintained. Within each function it must be ensured that, in handling business transactions, activities (which are mutually incompatible) are carried out by different persons. |
| 4.9 |
Departmental Monitoring The risks arising from trading activities shall be monitored in a timely fashion by both the Departments of Finance and PWS by managers independent of the trading operations. The Chair of the Committee must be informed immediately of any serious violations of internal control and unusual business practices. |
| 4.10 |
Petroleum Product Derivatives Risk Management Committee (Middle Office) In accordance with Section 6 of the Financial Agreements and Transactions (Petroleum Product Derivatives) Regulations, the Petroleum Product Derivatives Risk Management Committee is established. The Deputy Minister of Finance will act as Chair of the Committee, which will include at least three members selected by the respective department heads from PWS, Finance and the Financial Management Board Secretariat (FMBS) The members and the Chair of the Committee must be completely arms-length from the operational activities associated with taking derivatives positions for petroleum products. The Chair of the Committee shall report annually to the Minister of Finance on the results and effectiveness of the hedging strategy. The deputy heads of the Departments of Finance, PWS, and FMBS shall jointly establish the Terms of Reference for the Committee. In general, the Committee reviews and approves the annual risk management strategy and any revisions to it and regularly monitors the derivative contracting activities related to petroleum products risk management activities. |
| 4.11 |
Supporting Control and Information Systems The Departments of Finance and PWS respectively will ensure that adequate control and information systems are in place to support the derivatives activities, considering the nature, size, and complexity of the derivative contracts being used. With respect to Financial Administration Act Section 12(2)(c)(ii), the Departments of Finance and PWS must obtain the Comptroller General’s approval for all new or substantially revised systems of control and information systems as derivative transactions are considered public property under that definition in the Financial Administration Act. Section 61 of the Financial Administration Act also requires, in addition to subsection 12(2)(b), that Deputy Ministers maintain adequate records of public property administered by them. |
5. Guidelines
| 5.1 | The Departments of Finance and PWS should consult authoritative control literature including the Committee of Sponsoring Organizations of the Treadway Commission’s (COSO) Internal Control Issues in Derivatives Usage. |
6 . Authorities and References
- Financial Administration Act, Sections 4, 12, 13(2), 13(3), 57.1, 105(f) and 107(c.2);
- FAM Policy 2324 – Accounting for Petroleum Product Hedges;
- Financial Agreements and Transactions (Petroleum Product Derivatives) Regulations;
- Internal Control Issues in Derivatives Usage, 1996 COSO; and
- Revolving Fund Act, Section 4(1).
7 . Consequences from Failure to Comply
Failure to comply with policies and directives of the Financial Administration Manual may result in actions under Part X of the Financial Administration Act. The Government of the Northwest Territories may seek legal remedy in the Territorial Courts.