Item 7A. Quantitative and Qualitative Disclosures About Market Risk

We are exposed to risks associated with natural gas prices, interest rates and credit. Natural gas price risk is defined as the potential loss that we may incur as a result of changes in the fair value of natural gas. Interest rate risk results from our portfolio of debt and equity instruments that we issue to provide financing and liquidity for our business. Credit risk results from the extension of credit throughout all aspects of our business but is particularly concentrated at Atlanta Gas Light in distribution operations and in wholesale services.

Our Risk Management Committee (RMC) is responsible for establishing the overall risk management policies and monitoring compliance with, and adherence to, the terms within these policies, including approval and authorization levels and delegation of these levels. Our RMC consists of members of senior management who monitor open natural gas price risk positions and other types of risk, corporate exposures, credit exposures and overall results of our risk management activities. It is chaired by our chief risk officer, who is responsible for ensuring that appropriate reporting mechanisms exist for the RMC to perform its monitoring functions. Our risk management activities and related accounting treatments are described in further detail in Note 2.

Natural Gas Price Risk

Retail Energy Operations SouthStar’s use of derivative instruments is governed by a risk management policy, approved and monitored by its Finance and Risk Management Committee, which prohibits the use of derivatives for speculative purposes.

Energy Marketing and Risk Management Activities SouthStar routinely utilizes various types of derivative financial instruments to mitigate certain natural gas price and weather risk inherent in the natural gas industry. This includes the active management of storage positions through a variety of hedging transactions for the purpose of managing exposures arising from changing natural gas prices. SouthStar uses these hedging instruments to lock in economic margins (as spreads between wholesale and retail natural gas prices widen between periods) and thereby minimize its exposure to declining operating margins.

We have designated a portion of SouthStar’s derivative transactions as cash flow hedges in accordance with authoritative guidance related to derivatives and hedging. We record derivative gains or losses arising from cash flow hedges in OCI and reclassify them into earnings as cost of gas in our consolidated statement of income in the same period as the underlying hedged transaction occurs and is recorded in earnings. We record any hedge ineffectiveness, defined as when the gains or losses on the hedging instrument do not offset and are greater than the losses or gains on the hedged item, in cost of gas in our consolidated statement of income in the period in which the ineffectiveness occurs. SouthStar currently hasminimal hedge ineffectiveness.We have not designated the remainder of SouthStar’s derivative instruments as hedges under the guidance and, accordingly, we record changes in their fair value in earnings as cost of gas in our consolidated statements of income in the period of change.

SouthStar recorded a net unrealized gain related to changes in the fair value of derivative instruments utilized in its energy marketing and riskmanagement activities of $20million during 2009, unrealized losses of $27 million during 2008 and $7 million during 2007. The following tables illustrate the change in the net fair value of the derivative financial instruments during 2009, 2008 and 2007 and provide details of the net fair value of derivative financial instruments outstanding as of December 31, 2009, 2008 and 2007.

In millions
2009
2008
2007
Net fair value of derivative
financial instruments outstanding
at beginning of period
$(17)
$ 10
$ 17
Derivative financial instruments
realized or otherwise settled
during period
19
(10)
(17)
Change in net fair value of derivative
financial instruments
1
(17)
10
Net fair value of derivative financial
instruments outstanding at
end of period(1)
3
(17)
10
Netting of cash collateral
18
31
3
Cash collateral and net fair value
of derivative financial instruments
outstanding at end of period(1)
$ 21
$ 14
$ 13

(1) Net fair value of derivative financial instruments outstanding includes $2 million premium and associated intrinsic value at December 31, 2009, $4 million at December 31, 2008 and $5 million at December 31, 2007 associated with weather derivatives.

The sources of SouthStar’s net fair value of its natural gasrelated derivative financial instruments at December 31, 2009, are as follows.

In millions
Prices actively quoted (Level 1)(1)
Significant other observable inputs (Level 2)(2)
Mature through 2010(3)
$1
$2

(1) Valued using NYMEX futures prices.
(2) Values primarily related to weather derivative transactions that are valued on an intrinsic basis in accordance with authoritative guidance related to financial instruments as based on heating degree days. Additionally, includes values associated with basis transactions that represent the commodity from NYMEX delivery point to the contract delivery point. These transactions are based on quotes obtained either through electronic trading platforms or directly from brokers.
(3) Excludes cash collateral amounts.


SouthStar routinely utilizes various types of financial and other instruments to mitigate certain commodity price and weather risks inherent in the natural gas industry. These instruments include a variety of exchange-traded and OTC energy contracts, such as forward contracts, futures contracts, options contracts and swap agreements. The following tables include the fair values and average values of SouthStar’s derivative instruments as of the dates indicated. SouthStar bases the average values on monthly averages for the 12 months ended December 31, 2009 and 2008.

 
Derivative financial instruments average fair values at December 31,
In millions
2009(1)
2008(1)
Asset
$13
$17
Liability
19
12

(1) Excludes cash collateral amounts.

 
Derivative financial instruments fair values netted with cash collateral at December 31,
In millions
2009
2008
2007
Asset
$21
$16
$13
Liability
2


Value-at-risk A 95% confidence interval is used to evaluate VaR exposure. A 95% confidence interval means that over the holding period, an actual loss in portfolio value is not expected to exceed the calculated VaR more than 5% of the time. We calculate VaR based on the variance-covariance technique. This technique requires several assumptions for the basis of the calculation, such as price distribution, price volatility, confidence interval and holding period. Our VaR may not be comparable to a similarly titled measure of another company because, although VaR is a common metric in the energy industry, there is no established industry standard for calculating VaR or for the assumptions underlying such calculations. SouthStar’s portfolio of positions for 2009, 2008 and 2007, had annual average 1-day holding period VaRs of less than $100,000, and its high, low and period end 1-day holding period VaR were immaterial.

Wholesale Services Sequent routinely uses various types of derivative financial instruments to mitigate certain natural gas price risks inherent in the natural gas industry. These instruments include a variety of exchange-traded and OTC energy contracts, such as forward contracts, futures contracts, options contracts and financial swap agreements.

Energy Marketing and Risk Management Activities We account for derivative transactions in connection with Sequent’s energy marketing activities on a fair value basis in accordance with authoritative guidance related to derivatives and hedging.We record derivative energy commodity contracts (including both physical transactions and financial instruments) at fair value, with unrealized gains or losses from changes in fair value reflected in our earnings in the period of change.

Sequent’s energy-trading contracts are recorded on an accrual basis and its derivatives are recorded at fair value under authoritative guidance related to derivatives and hedging.

Sequent experienced a $36 million increase in the net fair value of its outstanding contracts during 2009 and $25 million during 2008 and a $62 million decrease in the net fair value of its outstanding contracts during 2007, due to changes in the fair value of derivative financial instruments utilized in its energy marketing and risk management activities and contract settlements and new business contracts acquired in 2009. The following tables illustrate the change in the net fair value of Sequent’s derivative financial instruments during 2009, 2008 and 2007 and provide details of the net fair value of contracts outstanding as of December 31, 2009, 2008 and 2007.

In millions
2009
2008
2007
Net fair value of derivative financial
instruments outstanding at
beginning of period
$ 82
$ 57
$ 119
Derivative financial instruments
realized or otherwise settled
during period
(73)
(49)
(102)
Net fair value of derivative financial
instruments acquired during period
50
Change in net fair value of derivative
financial instruments
59
74
40
Net fair value of derivative financial
instruments outstanding at
end of period
118
82
57
Netting of cash collateral
39
97
(9)
Cash collateral and net fair value
of derivative financial instruments
outstanding at end of period
$157
$179
$ 48


The sources of Sequent’s net fair value at December 31, 2009, are as follows.

In millions
Prices actively quoted (Level 1) (1)
Significant other observable inputs (Level 2) (2)
Mature through 2010
$(4)
$ 82
Mature 2011 – 2012
2
25
Mature 2013 – 2015
1
12
Total derivative financial instruments (3)
$(1)
$119

(1) Valued using NYMEX futures prices.
(2) Valued using basis transactions that represent the cost to transport natural gas from a NYMEX delivery point to the contract delivery point. These transactions are based on quotes obtained either through electronic trading platforms or directly from brokers.
(3) Excludes cash collateral amounts.


The following tables include the cash collateral fair values and average values of Sequent’s energy marketing and risk management assets and liabilities as of December 31, 2009 and 2008. Sequent bases the average values on monthly averages for the 12 months ended December 31, 2009 and 2008.

 
Derivative financial instruments average fair values at December 31, 
In millions
2009(1)
2008(1)
Asset
$170
$96
Liability
68
45

(1) Excludes cash collateral amounts.

 
Derivative financial instruments fair values netted with cash collateral at December 31,
In millions
2009
2008
2007
Asset
$208
$206
$61
Liability
51
27
13


Value-at-risk Sequent’s open exposure is managed in accordance with established policies that limit market risk and require daily reporting of potential financial exposure to senior management, including the chief risk officer. Because Sequent generally manages physical gas assets and economically protects its positions by hedging in the futures markets, its open exposure is generally immaterial, permitting Sequent to operate within relatively low VaR limits. Sequent employs daily risk testing, using both VaR and stress testing, to evaluate the risks of its open positions.

Sequent’s management actively monitors open commodity positions and the resulting VaR. Sequent continues to maintain a relatively matched book, where its total buy volume is close to its sell volume, with minimal open natural gas price risk. Based on a 95% confidence interval and employing a 1-day holding period for all positions, Sequent’s portfolio of positions for the 12 months ended December 31, 2009, 2008 and 2007 had the following VaRs.

In millions
2009
2008
2007
Period end
$2.4
$2.5
$1.2
12-month average
1.8
1.8
1.3
High
3.3
3.1
2.3
Low
0.7
0.8
0.7


Energy Investments In 2009, Golden Triangle Storage began using derivative financial instruments to reduce its exposure during the construction of the storage caverns to the risk of changes with the price of natural gas that will be purchased in future periods for pad gas, which includes volumes of non-working natural gas used to maintain the operational integrity of the caverns. As of December 31, 2009, Golden Triangle Storage had locked-in the price of approximately 68% of the required pad gas for the first storage cavern or 2 Bcf and the associated fair value of the derivative financial instruments was immaterial.

Interest Rate Risk

Interest rate fluctuations expose our variable-rate debt to changes in interest expense and cash flows. Our policy is to manage interest expense using a combination of fixed-rate and variable-rate debt. Based on $762 million of variable-rate debt, which includes $601 million of our variable-rate short-term debt and $161 million of variable-rate gas facility revenue bonds outstanding at December 31, 2009, a 100 basis point change in market interest rates from 0.4%to 1.4%would have resulted in an increase in pretax interest expense of $8 million on an annualized basis.

Credit Risk

Distribution Operations Atlanta Gas Light has a concentration of credit risk as it bills nine certificated and active Marketers and one regulated natural gas provider responsible for offering natural gas to low-income customers and customers unable to get natural gas service from other Marketers in Georgia for its services. The credit risk exposure to Marketers varies with the time of the year, with exposure at its lowest in the nonpeak summer months and highest in the peak winter months. Marketers are responsible for the retail sale of natural gas to end-use customers in Georgia. These retail functions include customer service, billing, collections, and the purchase and sale of the natural gas commodity. The provisions of Atlanta Gas Light’s tariff allow Atlanta Gas Light to obtain security support in an amount equal to a minimum of two times a Marketer’s highest month’s estimated bill from Atlanta Gas Light. For 2009, the four largest Marketers based on customer count, which includes SouthStar, accounted for approximately 31% of our consolidated operating margin and 44% of distribution operations’ operating margin.

Several factors are designed to mitigate our risks from the increased concentration of credit that has resulted from deregulation. In addition to the security support described above, Atlanta Gas Light bills intrastate delivery service to Marketers in advance rather than in arrears. We accept credit support in the form of cash deposits, letters of credit/surety bonds from acceptable issuers and corporate guarantees from investment-grade entities. The RMC reviews on a monthly basis the adequacy of credit support coverage, credit rating profiles of credit support providers and payment status of each Marketer.We believe that adequate policies and procedures have been put in place to properly quantify, manage and report on Atlanta Gas Light’s credit risk exposure to Marketers.

Atlanta Gas Light also faces potential credit risk in connection with assignments of interstate pipeline transportation and storage capacity to Marketers. Although Atlanta Gas Light assigns this capacity to Marketers, in the event that a Marketer fails to pay the interstate pipelines for the capacity, the interstate pipelines would in all likelihood seek repayment from Atlanta Gas Light.

Retail Energy Operations SouthStar obtains credit scores for its firm residential and small commercial customers using a national credit reporting agency, enrolling only those customers that meet or exceed SouthStar’s credit threshold.

SouthStar considers potential interruptible and large commercial customers based on a review of publicly available financial statements and review of commercially available credit reports. Prior to entering into a physical transaction, SouthStar also assigns physical wholesale counterparties an internal credit rating and credit limit based on the counterparties’ Moody’s, S&P and Fitch ratings, commercially available credit reports and audited financial statements.

Wholesale Services Sequent has established credit policies to determine and monitor the creditworthiness of counterparties, as well as the quality of pledged collateral. Sequent also utilizes master netting agreements whenever possible to mitigate exposure to counterparty credit risk. When Sequent is engaged in more than one outstanding derivative transaction with the same counterparty and it also has a legally enforceable netting agreement with that counterparty, the “net” mark-to-market exposure represents the netting of the positive and negative exposures with that counterparty and a reasonable measure of Sequent’s credit risk. Sequent also uses other netting agreements with certain counterparties with whom it conducts significant transactions. Master netting agreements enable Sequent to net certain assets and liabilities by counterparty. Sequent also nets across product lines and against cash collateral provided the master netting and cash collateral agreements include such provisions.

Additionally, Sequent may require counterparties to pledge additional collateral when deemed necessary. Sequent conducts credit evaluations and obtains appropriate internal approvals for its counterparty’s line of credit before any transaction with the counterparty is executed. Inmost cases, the counterpartymust have an investment grade rating, which includes a minimum long-term debt rating of Baa3 from Moody’s and BBB- from S&P. Generally, Sequent requires credit enhancements by way of guaranty, cash deposit or letter of credit for transaction counterparties that do not have investment grade ratings.

Sequent, which provides services to retail marketers and utility and industrial customers, also has a concentration of credit risk as measured by its 30-day receivable exposure plus forward exposure.

As of December 31, 2009, Sequent’s top 20 counterparties represented approximately 58% of the total counterparty exposure of $534 million, derived by adding together the top 20 counterparties’ exposures and dividing by the total of Sequent’s counterparties’ exposures. As of December 31, 2009, Sequent’s counterparties, or the counterparties’ guarantors, had a weighted average S&P equivalent credit rating of A-, which is consistent with the prior year. The S&P equivalent credit rating is determined by a process of converting the lower of the S&P or Moody’s ratings to an internal rating ranging from 9 to 1, with 9 being equivalent to AAA/Aaa by S&P and Moody’s and 1 being D or Default by S&P and Moody’s. A counterparty that does not have an external rating is assigned an internal rating based on the strength of the financial ratios of that counterparty. To arrive at the weighted average credit rating, each counterparty is assigned an internal ratio, which is multiplied by their credit exposure and summed for all counterparties. The sum is divided by the aggregate total counterparties’ exposures, and this numeric value is then converted to an S&P equivalent. There were no credit defaults with Sequent’s counterparties. The following table shows Sequent’s third-party natural gas contracts receivable and payable positions.

 
As of December 31, Gross receivables
In millions
2009
2008
Netting agreements in place:
Counterparty is investment grade
$483
$398
Counterparty is non-investment grade
12
15
Counterparty has no external rating
106
129
No netting agreements in place:
Counterparty is investment grade
14
7
Counterparty is non-investment grade
Amount recorded on statements of financial position
$615
$549


 
As of December 31, Gross payables
In millions
2009
2008
Netting agreements in place:
Counterparty is investment grade
$277
$266
Counterparty is non-investment grade
34
41
Counterparty has no external rating
207
228
No netting agreements in place:
Counterparty is investment grade
6
4
Counterparty is non-investment grade
Amount recorded on statements of financial position
$524
$539


Sequent has certain trade and credit contracts that have explicit minimum credit rating requirements. These credit rating requirements typically give counterparties the right to suspend or terminate credit if our credit ratings are downgraded to noninvestment grade status. Under such circumstances, Sequent would need to post collateral to continue transacting business with some of its counterparties. If such collateral were not posted, Sequent’s ability to continue transacting business with these counterparties would be impaired. If our credit ratings had been downgraded to non-investment grade status, the required amounts to satisfy potential collateral demands under such agreements between Sequent and its counterparties would have totaled $25 million at December 31, 2009, which would not have a material impact to our consolidated results of operations, cash flows or financial condition.