CAPITAL POWER CORPORATION Notes to the Consolidated Financial Statements (Tabular amounts in millions of Canadian dollars, except share and per share amounts) 2. Significant accounting policies, continued: (i) Derivative instruments and hedging activities, continued: All derivative instruments, including embedded derivatives, are recorded at fair value on the statement of financial position as derivative financial instruments assets or derivative financial instruments liabilities except for embedded derivative instruments that are clearly and closely related to their host contract and the combined instrument is not measured at fair value. Any contract to buy or sell a non-financial item is not treated as a non-financial derivative if that contract was entered into and continues to be held for the purpose of the receipt or delivery of a non-financial item in accordance with the Company’s expected purchase, sale or usage requirements. The Company accounts separately for any embedded derivatives in any hybrid instruments issued or acquired. The Company does not account for foreign currency derivatives embedded in non-financial instrument host contracts when the currency that is commonly used in contracts to purchase or sell non-financial items in the economic environment is that currency in which the transaction takes place. All changes in the fair value of derivatives are recorded in net income unless cash flow hedge accounting is used, in which case changes in the fair value of the effective portion of the derivatives are recorded in other comprehensive income. The Company uses financial contracts-for-differences (or fixed-for-floating swaps) to hedge the Company’s exposure to fluctuations in electricity prices. Under these instruments, the Company agrees to exchange, with creditworthy or adequately secured counterparties, the difference between the variable or indexed price and the fixed price on a notional quantity of the underlying commodity for a specified timeframe. The Company uses non-financial forward delivery derivatives to manage the Company’s exposure to fluctuations in natural gas prices related to its natural gas customer contracts and obligations arising from its natural gas fired generation facilities. Under these instruments, the Company agrees to sell or purchase natural gas at a fixed price for delivery of a pre-determined quantity under a specified timeframe. Foreign exchange forward contracts are used by the Company to manage foreign exchange exposures, consisting mainly of U.S. dollar exposures, resulting from anticipated transactions denominated in foreign currencies. For transactions involving the development or acquisition of property, plant and equipment, when the real or anticipated transaction subsequently results in the recognition of a financial asset, the associated gains or losses on derivative instruments are included in the initial carrying amount of the asset acquired in the same period or periods in which the asset is acquired or constructed. The Company may use non-financial or financial commodity derivative trades which are transacted with the intent of benefiting from short-term actual or expected differences between their buying and selling prices or to lock in arbitrage opportunities. Such trades are recognized on a net basis in the Company’s revenues. The Company may use hedge accounting when there is a high degree of correlation between the risk in the item designated as being hedged (the hedged item) and the derivative instrument designated as a hedge (the hedging instrument). The Company documents all relationships between hedging instruments and hedged items at the hedge’s inception, including its risk management objectives and its assessment of the effectiveness of the hedging relationship on a retrospective and prospective basis. The Company uses cash flow hedges for certain of its anticipated transactions to reduce exposure to fluctuations in changes in commodity prices. In a cash flow hedging relationship, the effective portion of the change in the fair value of the hedging derivative is recognized in other comprehensive income, while the ineffective portion is recognized in energy revenues or energy purchases or fuel, as appropriate. The amounts recognized in other comprehensive income as cash flow hedging gains/losses are reclassified into net income in the same period or periods in which the hedged item occurs and is recorded in net income when it becomes probable that the hedged items will not occur. 84