12 DECEMBER 2006

NEW ZEALAND GAZETTE, No. 169

4893

Note to and Forming Part of the Financial Statements

For the year ended 30 June 2006

POWERCO

ELECTRICITY DIVISION

2 DERIVATIVE FINANCIAL INSTRUMENTS

a) Powerco Limited enters into NZD floating to fixed interest rate swap agreements to reduce the impact of changes in floating interest rates on its borrowings and thus reduce variability in cash flows. Fixed to floating instruments are entered into in order to hedge the changes in fair value of fixed rate NZD debt. Powerco Limited also utilises Cross Currency interest rate swaps to hedge against the variations in interest costs and fair value of the USD Private placement debt.

Derivative instruments are initially recognised at fair value on the contract date and subsequently measured at their fair value on each balance sheet. The method of recognising the resulting gain or loss depends on whether the derivative is designated as a hedging instrument, and if so, the nature of the item being hedged. The Group designates certain derivatives as either (i) hedges of highly probable forecast transactions (cash flow hedges), or (ii) hedges of the fair value of recognised assets or liabilities or a firm commitment (fair value hedges).

The Group documents, at the inception of the hedge transaction, the relationship between hedging instruments and hedged items, as well as its risk management objective and hedging strategy. The Group also documents its assessment, both at hedge inception and on an ongoing basis, of whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items.

(i) Cash flow hedges
The effective portion of changes in the fair value of derivatives that are designated and qualify as cash flow hedges are recognised in equity. The gain or loss relating to the ineffective portion is recognised immediately in the Income Statement. Amounts accumulated in equity are transferred to the Income Statement in the same period in which the hedged item affects the Income Statement.

When a hedging instrument expires or is sold, or when a hedge no longer meets the criteria for hedge accounting, any cumulative gain or loss existing in equity at that time remains in equity and is recognised when the forecast transaction is ultimately recognised in the Income Statement. When a forecast transaction is no longer expected to occur, the cumulative gain or loss that was reported in equity is immediately transferred to the Income Statement.

(ii) Fair value hedges
Changes in the fair value of derivatives that are designated and qualify as fair value hedges are recorded in the Income Statement, together with any changes in the fair value of the hedged risk.

(iii) Derivatives that do not qualify for hedge accounting
Certain derivative instruments are undertaken as hedges of economic exposures but do not qualify for hedge accounting. Changes in the fair value of any derivative instruments that do not qualify for hedge accounting are recognised immediately in the Income Statement.

The fair value of financial instruments are determined by reference to the market quoted rates.

All derivative instruments are carried on balance sheet at their fair values. Movements on the hedging reserve are shown in the Statement of Shareholders’ Equity.

The Group holds the following financial instruments:

1. Interest rate swaps
   The Group receives New Zealand fixed interest rates and pays New Zealand dollar floating interest rates. The hedge is a fair value hedge and was entered into on terms matched to the underlying obligation.
   The nominal value of the hedge is $252,000,000 (2005: $252,000,000)
   The fair value of the hedge is -$6,426,693 (2005: -$4,528,454)

2. US Cross Currency Interest rate swaps
   The Group receives US dollar fixed interest and pays NZ dollar floating interest. The hedge is both a fair value hedge and hedges the movements in currency that would affect interest payments and final repayment at maturity; these were entered into at terms to match the underlying obligation.
   The nominal value of the hedge is $211,871,532 (2005: $211,871,532)
   The fair value of the hedge is -$21,075,924 (2005: -$28,986,452)

3. Interest rate swaps
   The Group receives NZ dollar floating interest rates and pays NZ dollar fixed interest. The hedge is to fix the variable floating obligations efficiently as per the hedge policy and the treasury policy and is on matched terms. The hedge is a cash flow hedge.
   The nominal value of the hedge is $180,000,000 (2005: $180,000,000)
   The fair value of the hedge is -$2,004,023 (2005: -$4,503,380)

4. Interest rate swap
   To swap back fixed New Zealand dollar debt converted to floating back to fixed debt. The swap is used to match the interest rate profile in accordance with the Board strategy and is on matched terms. Hedge accounting is not applied to these swaps.
   The nominal value of the hedge is $357,840,000 (2005: $451,440,000)
   The fair value of the hedge is $926,822 (2005: -$3,624,895)

5. Interest rate swap
   To convert floating New Zealand debt from US dollar fixed debt to fixed New Zealand dollar debt. The swap is used to modify the debt profile in accordance with the Board strategy and is on matched terms. Hedge accounting is not applied to these swaps.
   The nominal value of the hedge is $399,600,000 (2005: $566,960,000)
   The fair value of the hedge is -$188,886 (2005: -$233,618)

6. Interest rate swaps
   To unwind floating to fixed swaps which existed when the hedging policy was changed. These are to cancel previous interest rate swaps and match the terms of those including termination date and rolls. Hedge accounting is not applied to these swaps.
   The nominal value of the swap is $57,600,000 (2005: $169,200,000)
   The fair value of the swap is -$633,376 (2005: $1,431,150)