CAPITAL POWER CORPORATION Notes to the Consolidated Financial Statements (Tabular amounts in millions of Canadian dollars, except share and per share amounts) There were no significant transfers between Level 1 and 2 for the years ended December 31, 2012 and 2011. 29. Financial instruments, continued: Fair value hierarchy, continued The Company classifies financial instruments in Level 3 of the fair value hierarchy when there is reliance on at least one significant unobservable input to the valuation model used to determine fair value. In addition to these unobservable inputs, the valuation model for Level 3 instruments also relies on a number of inputs that are observable either directly or indirectly. Accordingly, the unrealized gains and losses shown below include changes in the fair value related to both observable and unobservable inputs. The following table summarizes the changes in the fair value of financial instruments classified in level 3: 2012 2011 As at January 1 1 $ (1) $ 12 Unrealized and realized losses included in net income 2 (23) (13) Settlements 3 8 - As at December 31 $ (16) $ (1) Total unrealized losses for the year included in net income $ (15) $ (13) 1 The fair value of derivative instruments is presented on a net basis. 2 Gains and losses are recorded in revenues or energy purchases and fuel, as appropriate. 3 Relates to settlement of financial derivative instruments. All instruments classified as level 3 are derivative type instruments, which include financial and non-financial commodity contracts, financial commodity and transmission options, and credit derivatives. Gains and losses associated with Level 3 balances may not necessarily reflect the underlying exposures of the Company. As a result, unrealized gains and losses from Level 3 financial instruments are often offset by unrealized gains and losses on financial instruments that are classified in Levels 1 or 2. For the significant financial instruments, the Company performs a sensitivity analysis for fair value measurements classified as Level 3, substituting the unobservable inputs with one or more reasonably possible alternative assumptions, if available, to the valuation models. The sensitivity analyses reflected a negligible difference compared with the fair value used to record financial instruments classified in Level 3. The Company is exposed to a number of different financial risks, arising from business activities and its use of financial instruments, including market risk, credit risk and liquidity risk. The Company’s overall risk management process is designed to identify, manage and mitigate business risk which includes, among other risks, financial risk. Risk management is overseen by the Company’s executive team according to objectives, targets, and policies approved by the Capital Power Board of Directors. The executive team is comprised of a senior management group. Risk management strategies, policies, and limits are designed to help ensure the risk exposures are managed within the Company’s business objectives and risk tolerance. The Company’s financial risk management objective is to protect and limit the volatility in income and cash flow. Commodity price risk management and the associated credit risk management are carried out in accordance with the respective commodity, credit, and financial exposures risk management policies, as approved by the executive team and the Board of Directors. Financial risk management including foreign exchange risk, interest rate risk, liquidity risk, and the associated credit risk, is carried out by a centralized Treasury function, also in accordance with a financial risk management policy approved by the executive team and the Board. Capital Power’s Audit Committee of the Board of Directors, in its oversight role, monitors the assessment of risk management controls and procedures to ensure compliance with applicable policies. 30. Risk management: Risk management overview 120