10.11 Derivative financial instruments

Accounting policies

Derivative instruments used by the Group to hedge against currency risk include in particular FX forwards. The Group also uses commodity swaps to hedge its exposure to commodity and petroleum product price risk, and in the case of sale of products at fixed prices with an embedded option it uses commodity options. The Group uses futures contracts to manage its exposure to prices of carbon dioxide (CO2) emission allowances, In order to hedge the interest rate risk, the Group permits use of interest rate swaps (IRSs) and forward rate agreements (FRAs). Such financial derivatives are measured at fair value in line with the fair value hierarchy.

Based on the fair value measurement methods applied, the Group classifies its individual financial assets and liabilities according to the following levels (fair value hierarchy):

• Level 1: Financial assets and liabilities whose fair values are measured directly on the basis of quoted prices (used without adjustment) from active markets for identical assets or liabilities.
• Level 2: Financial assets and liabilities whose fair values are measured using measurement models when all significant input data is observable on the market either directly (unadjusted market prices) or indirectly (data based on market prices).
• Level 3: Financial assets and liabilities whose fair values are measured using measurement models when the input data is not based on observable market data (unobservable input data).

Derivatives outside the hedge accounting are classified as: financial assets measured at fair value through profit or loss and financial liabilities measured at fair value through profit or loss, and are measured at fair value with gains and losses on changes in fair value recognised in profit or loss.

The fair value of commodity swaps is established by reference to discounted cash flows connected with the transactions, calculated on the basis of the difference between the average market price and the transaction price. The fair value is established on the basis of prices quoted on active markets, as provided by an external consultancy. (Level 2 in the fair value hierarchy).

Fair value of commodity options is established by reference to cash flows connected with the transactions, calculated on the basis of the difference between the option premium paid and the current market price of the option. The fair value is established on the basis of prices quoted on active markets provided by an external consultancy (Level 2 in the fair value hierarchy).

The fair value of spots, forwards and currency swaps in the case of Grupa LOTOS S.A. is established by reference to future discounted cash flows from the transactions, calculated on the basis of the difference between the forward rate and the transaction price. The forward rate is calculated on the basis of the fixing rate quotations of the National Bank of Poland and the interest rate curve implied in FX swaps (Level 2 in the fair value hierarchy).

The fair value of FRAs in the case of Grupa LOTOS S.A. is established by reference to future discounted cash flows connected with the transactions, calculated on the basis of the difference between the forward rate and the transaction price. The forward rate is calculated using the zero-coupon interest rate curve based on 6M or 3M LIBOR, depending on the type of transaction (Level 2 in the fair value hierarchy). The fair value of FRAs held by LOTOS Asfalt Sp. z o.o. is presented based on the information provided by the banks which are counterparties to those transactions (Level 2 in the fair value hierarchy).

The fair value of futures hedging the risk of prices of carbon dioxide (CO2) emission allowances is determined based on the difference between the market price quoted on the valuation date by the Intercontinental Exchange (ICE) and the transaction price. (Level 1 in the fair value hierarchy).

The fair value of derivative instruments does not take into account counterparty risk or the Group’s own credit risk. Analysis showed that the credit value adjustment (CVA) accounting for counterparty credit risk and the debit value adjustment (DVA) accounting for the Group’s credit risk would have no material effect on the measurement results. The effect of credit risk on the fair value of derivative instruments was analysed using conservative assumptions. A method estimating CVA as the hypothetical cost to purchase credit default swaps (CDS) for the projected exposure of derivatives entered into with a given counterparty was used for this purpose. The exposure forecast is made based on the current level of forward prices without taking into account their volatility. If no CDS are published on the market for a given entity, unsecured bond spreads over government bonds are used first, or, if no such spreads are published, Fitch, S&P and Moody’s ratings are used to determine the hypothetical CDS level.

To manage the risk related to carbon dioxide emission allowances, the Group assesses, on a case-by-case basis, the risk of expected deficit of emission allowances allocated free of charge under the carbon emission reduction system and manages the risk of changes in the price of emission allowance traded on an active market.

In the statement of financial position, financial derivatives are presented separately as either current or non-current, depending on the expected time of realisation of assets and liabilities. If their amount is immaterial, they are recognised under other assets and liabilities.

The Group applies hedge accounting. Changes in the fair value of derivative financial instruments designated to hedge cash flows, to the extent representing an effective hedge, are charged directly to other comprehensive income. For more information on hedge accounting, see Note 10.8.3.

For description of objectives and policies of financial risk management, see Note 11.2.
For classification of derivative financial instruments by fair value hierarchy, see Note 11.1.2.
For analysis of sensitivity of the derivative financial instruments to the risk of movements in commodity and petroleum product prices, see Note 11.2.1.1. For analysis of sensitivity of the derivative financial instruments to the risk of movements in prices of carbon dioxide (CO2) emission allowances, see Note 11.2.2.1.
For currency risk sensitivity analysis of the derivative financial instruments, see Note 11.2.3.1. For interest rate sensitivity analysis of the derivative financial instruments, see Note 11.2.4.1.
For information on contractual maturities of the derivative financial instruments, see Note 11.2.5.
For information on maximum credit risk exposure of the derivative financial instruments (financial assets), see Note 11.2.6.