12. Derivatives, Hedges, Financial Instruments and Carbon Credits

Periodically, we have three classes of contracts that are accounted for on a fair value basis, which are commodities futures/forward contracts (“commodities contracts”), foreign exchange contracts and interest rate contracts as discussed below. All of these contracts are used as economic hedges for risk management purposes but are not designated as hedging instruments. In addition as discussed below, we are issued climate reserve tonnes (“carbon credits”), of which a certain portion of the carbon credits are to be sold and the proceeds given to Bayer. The assets for carbon credits are accounted for on a fair value basis as discussed below. Also, the contractual obligations to give the related proceeds to Bayer are accounted for on a fair value basis (as discussed below) unless we enter into a firm sales commitment to sell the carbon credits as discussed in Note 1 - Summary of Significant Accounting Policies. The valuations of these assets and liabilities were determined based on quoted market prices or, in instances where market quotes are not available, other valuation techniques or models used to estimate fair values.

The valuations of contracts classified as Level 1 are based on quoted prices in active markets for identical contracts. The valuations of contracts classified as Level 2 are based on quoted prices for similar contracts and valuation inputs other than quoted prices that are observable for these contracts. At December 31, 2014, the valuations of contracts classified as Level 2 related to certain futures/forward natural gas contracts, a foreign exchange contract and an interest rate swap contract. At December 31, 2013, the valuations of contracts classified as Level 2 related to an interest rate swap contract.

For the natural gas contracts, these contracts are valued using the prices pursuant to the terms of the contracts and using market information for futures/forward natural gas prices. At December 31, 2014, the valuation inputs included the contractual weighted-average cost of $3.24 per MMBtu and the estimated weighted-average market value of $2.99 per MMBtu.

For foreign exchange contracts, these contracts are valued using the foreign currency exchange rates pursuant to the terms of the contract and using market information for foreign currency exchange rates. The valuation inputs included the total contractual exchange rate of 1.27 and the total estimated market exchange rate of 1.22 (U.S. Dollar/Euro). For interest rate swap contracts, we utilize valuation software and market data from a third-party provider. These contracts are valued using a discounted cash flow model that calculates the present value of future cash flows pursuant to the terms of the contracts and using market information for forward interest-rate yield curves. At December 31, 2014, the valuation inputs included the contractual weighted-average pay rate of 3.23% and the estimated market weighted-average receive rate of 0.53%. No valuation input adjustments were considered necessary relating to nonperformance risk for the contracts as discussed above.

The valuations of assets and liabilities classified as Level 3 are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. At December 31, 2014 and 2013, the valuations ($2.50 and $1.00 per carbon credit, respectively) of the carbon credits and the contractual obligations associated with these carbon credits are classified as Level 3 and are based on the most recent sales transaction and reevaluated for market changes, if any, and on the range of ask/bid prices obtained from a broker adjusted for minimal market volume activity, respectively. The valuations are using undiscounted cash flows based on management’s assumption that the carbon credits would be sold and the associated contractual obligations would be extinguished in the near term. In addition, no valuation input adjustments were considered necessary relating to nonperformance risk for the carbon credits and associated contractual obligations.

Commodities Contracts

Raw materials for use in our manufacturing processes include copper used by our Climate Control Business and natural gas and platinum used by our Chemical Business. As part of our raw material price risk management, we periodically enter into futures/forward contracts for these materials, which contracts may be required to be accounted for on a mark-to-market basis. At December 31, 2014, our futures/forward copper contracts include 1,750,000 pounds of copper, extend through May 2015 at a weighted-average cost of $2.98 per pound. At December 31, 2013, we did not have any futures/forward copper contracts. At December 31, 2014, our futures/forward natural gas contracts (accounted for on a mark-to-market basis) include approximately 8,279,000 MMBtu of natural gas, extend through June 2016 at a weighted-average cost of $3.24 per MMBtu. At December 31, 2013, our futures/forward natural gas contracts include 1,530,000 MMBtu of natural gas, extend through October 2014 at a weighted-average cost of $3.98 per MMBtu. At December 31, 2014, our futures/forward platinum contracts include 3,000 ounces of platinum, extend through April 2015 at a weighted-average cost of $1,224.26 per ounce. At December 31, 2013, we did not have any futures/forward platinum contracts. The cash flows relating to these contracts are included in cash flows from continuing operating activities.

Foreign Exchange Contracts

One of our business operations purchases industrial machinery and related components from vendors outside of the United States. As part of our foreign currency risk management, we periodically enter into foreign exchange contracts, which set the U.S. Dollar/Euro exchange rates. At December 31, 2014, our foreign exchange contract was for the receipt of approximately 819,000 Euros through May 2015 at the contractual exchange rate of 1.27 (U.S. Dollar/Euro). At December 31, 2013, we did not have any foreign exchange contracts. These contracts are free-standing derivatives and are accounted for on a mark-to-market basis. The cash flows relating to these contracts are included in cash flows from continuing operating activities.

Interest Rate Contracts

As part of our interest rate risk management, we periodically purchase and/or enter into various interest rate contracts. In February 2011, we entered into an interest rate swap at no cost, which sets a fixed three-month LIBOR rate of 3.23% on a declining balance (from $23.8 million to $18.8 million) for the period beginning in April 2012 through March 2016. This contract is a free-standing derivative and is accounted for on a mark-to-market basis. During each of the three years ended December 31, 2014, no cash flows occurred relating to the purchase or sale of interest rate contracts. The cash flows associated with the interest rate swap payments are included in cash flows from continuing operating activities.

Carbon Credits and Associated Contractual Obligation

Periodically, we are issued carbon credits by the Climate Action Reserve in relation to a greenhouse gas reduction project (“Project”) performed at the Baytown Facility. Pursuant to the terms of the agreement with Bayer, a certain portion of the carbon credits are to be used to recover the costs of the Project, and any balance thereafter to be allocated between Bayer and EDN. We have no obligation to reimburse Bayer for their costs associated with the Project, except through the transfer or sale of the carbon credits when such credits are issued to us. The assets for carbon credits are accounted for on a fair value basis and the contractual obligations associated with these carbon credits are also accounted for on a fair value basis (unless we enter into a sales commitment to sell the carbon credits). At December 31, 2014 and 2013, we had approximately 1,112,000 and 1,284,000 carbon credits, respectively, all of which were subject to contractual obligations. The cash flows associated with the carbon credits and the associated contractual obligations are included in cash flows from continuing investing activities.

The following details our assets and liabilities that are measured at fair value on a recurring basis at December 31, 2014 and 2013:


			Fair Value Measurements at December 31, 2014 Using
Description	Total Fair Value at December 31, 2014		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total Fair Value at December 31, 2013
					(In Thousands)
Assets - Supplies, prepaid items and other:
Commodities contracts	$	—	$	—	$	—	$	—	$	31
Carbon credits		2,779		—		—		2,779		1,284

Total	$	2,779	$	—	$	—	$	2,779	$	1,315

Liabilities - Current and noncurrent accrued and other liabilities:
Commodities contracts	$	2,440	$	316	$	2,124	$	—	$	—
Contractual obligations - carbon credits		2,779		—		—		2,779		1,284
Interest rate contracts		671		—		671		—		1,240
Foreign exchange contracts		44		—		44		—		—

Total	$	5,934	$	316	$	2,839	$	2,779	$	2,524

None of our assets or liabilities measured at fair value on a recurring basis transferred between Level 1 and Level 2 classifications for the periods presented below except for certain futures/forward natural gas contracts (an asset with an estimated fair value of $31,000 at December 31, 2013) that were transferred from Level 1 to Level 2 since a portion of these contracts were expected to be settled on dates that quoted prices were not available. As a result, we are utilizing observable market data other than quoted prices to value these contracts. The classification transfer of the contracts was deemed to occur in the first quarter of 2014. In addition, the following is a reconciliation of the beginning and ending balances for assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3):


	Assets									Liabilities
	2014			2013			2012			2014			2013			2012
	(In Thousands)
Beginning balance	$	1,284		$	91		$	42		$	(1,284	)	$	(91	)	$	(42	)
Transfers into Level 3		—			—			—			—			—			—
Transfers out of Level 3		—			—			—			—			—			—
Total realized and unrealized gains (losses) included in earnings		3,089			1,233			876			(2,799	)		(1,233	)		(721	)
Purchases		—			—			—			—			—			—
Issuances		—			—			—			—			—			—
Sales		(1,594	)		(40	)		(827	)		—			—			—
Settlements		—			—			—			1,304			40			672

Ending balance	$	2,779		$	1,284		$	91		$	(2,779	)	$	(1,284	)	$	(91	)

Total gains (losses) for the period included in earnings attributed to the change in unrealized gains or losses on assets and liabilities still held at the reporting date	$	2,110		$	1,193		$	78		$	(2,110	)	$	(1,193	)	$	(78	)

Net gains (losses) included in earnings and the income statement classifications are as follows:


	2014			2013			2012
	(In Thousands)
Total net gains (losses) included in earnings:
Cost of sales - Undesignated commodities contracts	$	(1,198	)	$	(244	)	$	14
Cost of sales - Undesignated foreign exchange contracts		(49	)		—			(19	)
Other income - Carbon credits		3,089			1,233			876
Other expense - Contractual obligations relating to carbon credits		(2,799	)		(1,233	)		(721	)
Interest expense - Undesignated interest rate contracts		(71	)		(33	)		(523	)

Total net losses included in earnings	$	(1,028	)	$	(277	)	$	(373	)

At December 31, 2014 and 2013, we did not have any financial instruments with fair values significantly different from their carrying amounts, except for the Senior Secured Notes. At December 31, 2014, the estimated fair value of the Senior Secured Notes exceeded the carrying value by approximately $17 million based on a quoted price of 104.0. At December 31, 2013, the estimated fair value of the Senior Secured Notes exceeded the carrying by approximately $20 million based on a range of ask/bid prices (104.5 to 104.9). These valuations are classified as Level 2. The valuations of our other long-term debt agreements are classified as Level 3 and are based on valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. The fair value measurements of our other long-term debt agreements are valued using a discounted cash flow model that calculates the present value of future cash flows pursuant to the terms of the debt agreements and applies estimated current market interest rates. The estimated current market interest rates are based primarily on interest rates currently being offered on borrowings of similar amounts and terms. In addition, no valuation input adjustments were considered necessary relating to nonperformance risk for our debt agreements. The fair value of financial instruments is not indicative of the overall fair value of our assets and liabilities since financial instruments do not include all assets, including intangibles, and all liabilities. Also see discussions concerning certain assets and liabilities initially accounted for on a fair value basis under Note 8 - Asset Retirement Obligations.