DERIVATIVE INSTRUMENTS

FirstEnergy is exposed to financial risks resulting from fluctuating interest rates and commodity prices, including prices for electricity, natural gas, coal and energy transmission. To manage the volatility relating to these exposures, FirstEnergy’s Risk Policy Committee, comprised of senior management, provides general management oversight for risk management activities throughout FirstEnergy. The Risk Policy Committee is responsible for promoting the effective design and implementation of sound risk management programs and oversees compliance with corporate risk management policies and established risk management practice. FirstEnergy also uses a variety of derivative instruments for risk management purposes including forward contracts, options, futures contracts and swaps. In addition to derivatives, FirstEnergy also enters into master netting agreements with certain third parties.

FirstEnergy accounts for derivative instruments on its Consolidated Balance Sheets at fair value unless they meet the normal purchases and normal sales criteria. Derivatives that meet those criteria are accounted for under the accrual method of accounting, and their effects are included in earnings at the time of contract performance. Changes in the fair value of derivative instruments that qualified and were designated as cash flow hedge instruments are recorded in AOCL. Changes in the fair value of derivative instruments that are not designated as cash flow hedge instruments are recorded in net income on a mark-to-market basis. FirstEnergy has contractual derivative agreements through December 2018.

Cash Flow Hedges

FirstEnergy has used cash flow hedges for risk management purposes to manage the volatility related to exposures associated with fluctuating interest rates and commodity prices. The effective portion of gains and losses on a derivative contract are reported as a component of AOCL with subsequent reclassification to earnings in the period during which the hedged forecasted transaction affects earnings.

As of December 31, 2010, commodity derivative contracts designated in cash flow hedging relationships were $104 million of assets and $101 million of liabilities. In February 2011, FirstEnergy elected to dedesignate all outstanding cash flow hedge relationships. Total net unamortized gains included in AOCL associated with dedesignated cash flow hedges totaled $12 million as of September 30, 2011. Since the forecasted transactions remain probable of occurring, these amounts will be amortized into earnings over the life of the hedging instruments. Reclassifications from AOCL into other operating expenses were less than $1 million and $19 million during the three months and nine months ended September 30, 2011, respectively. Approximately $1 million is expected to be amortized to expense during the next twelve months.

FirstEnergy has used forward starting swap agreements to hedge a portion of the consolidated interest rate risk associated with anticipated issuances of fixed-rate, long-term debt securities of its subsidiaries. These derivatives were treated as cash flow hedges, protecting against the risk of changes in future interest payments resulting from changes in benchmark U.S. Treasury rates between the date of hedge inception and the date of the debt issuance. As of September 30, 2011, no forward starting swap agreements were outstanding. Total unamortized losses included in AOCL associated with prior interest rate cash flow hedges totaled $81 million as of September 30, 2011. Based on current estimates, approximately $9 million will be amortized to interest expense during the next twelve months. Reclassifications from AOCL into interest expense totaled $3 million during the three months ended September 30, 2011, and 2010 and $9 million during the nine months ended September 30, 2011 and 2010.

Fair Value Hedges

FirstEnergy has used fixed-for-floating interest rate swap agreements to hedge a portion of the consolidated interest rate risk associated with the debt portfolio of its subsidiaries. These derivative instruments were treated as fair value hedges of fixed-rate, long-term debt issues, protecting against the risk of changes in the fair value of fixed-rate debt instruments due to lower interest rates. As of September 30, 2011, no fixed-for-floating interest rate swap agreements were outstanding.

Unamortized gains included in long-term debt associated with prior fixed-for-floating interest rate swap agreements totaled $107 million as of September 30, 2011. Based on current estimates, approximately $21 million will be amortized to interest expense during the next twelve months. Reclassifications from long-term debt into interest expense totaled approximately $5 million during the three months ended September 30, 2011 and 2010, respectively, and $16 million and $7 million during the nine months ended September 30, 2011 and 2010, respectively.

Commodity Derivatives

FirstEnergy uses both physically and financially settled derivatives to manage its exposure to volatility in commodity prices. Commodity derivatives are used for risk management purposes to hedge exposures when it makes economic sense to do so, including circumstances where the hedging relationship does not qualify for hedge accounting.

Electricity forwards are used to balance expected sales with expected generation and purchased power. Natural gas futures are entered into based on expected consumption of natural gas; primarily natural gas is used in FirstEnergy’s peaking units. Heating oil futures are entered into based on expected consumption of oil and the financial risk in FirstEnergy’s coal transportation contracts. Interest rate swaps include two interest rate swap agreements that expired during 2011 with an aggregate notional value of $200 million that were entered into during 2003 to substantially offset two existing interest rate swaps with the same counterparty. The 2003 agreements effectively locked in a net liability and substantially eliminated future income volatility from the interest rate swap positions but do not qualify for cash flow hedge accounting. Derivative instruments are not used in quantities greater than forecasted needs.

As of September 30, 2011, FirstEnergy’s net liability position under commodity derivative contracts was $41 million, which primarily related to FES positions. Under these commodity derivative contracts, FES posted $49 million and AE Supply posted $1 million in collateral. Certain commodity derivative contracts include credit risk related contingent features that would require FES to post $48 million of additional collateral if the credit rating for its debt were to fall below investment grade.

Based on commodity derivative contracts held as of September 30, 2011, an adverse 10% change in commodity prices would decrease net income by approximately $14 million during the next twelve months.

FTRs

FirstEnergy holds FTRs that generally represent an economic hedge of future congestion charges that will be incurred in connection with FirstEnergy’s load obligations. FirstEnergy acquires the majority of its FTRs in an annual auction through a self-scheduling process involving the use of ARRs allocated to members of an RTO that have load serving obligations and through the direct allocation of FTRs from the PJM RTO. The PJM RTO has a rule that allows directly allocated FTRs to be granted to LSEs in zones that have newly entered PJM. For the first two planning years, PJM permits the LSEs to request a direct allocation of FTRs in these new zones at no cost as opposed to receiving ARRs. The directly allocated FTRs differ from traditional FTRs in that the ownership of all or part of the FTRs may shift to another LSE if customers choose to shop with the other LSE.

The future obligations for the FTRs acquired at auction are reflected on the Consolidated Balance Sheets and have not been designated as cash flow hedge instruments. FirstEnergy initially records these FTRs at the auction price less the obligation due to the RTO, and subsequently adjusts the carrying value of remaining FTRs to their estimated fair value at the end of each accounting period prior to settlement. Changes in the fair value of FTRs held by FirstEnergy’s unregulated subsidiaries are included in other operating expenses as unrealized gains or losses. Unrealized gains or losses on FTRs held by FirstEnergy’s regulated subsidiaries are recorded as regulatory assets or liabilities. Directly allocated FTRs are accounted for under the accrual method of accounting, and their effects are included in earnings at the time of contract performance.

The following tables summarize the fair value of derivative instruments in FirstEnergy’s Consolidated Balance Sheets:



Derivatives not designated as hedging instruments:
Derivative Assets					Derivative Liabilities
	Fair Value					Fair Value
	September 30, 2011		December 31, 2010			September 30, 2011		December 31, 2010
	(In millions)					(In millions)
Power Contracts					Power Contracts
Current Assets	$	157	$	96	Current Liabilities	$	190	$	209
Noncurrent Assets	68		40		Noncurrent Liabilities	67		38
FTRs					FTRs
Current Assets	4		—		Current Liabilities	13		—
Noncurrent Assets	—		—		Noncurrent Liabilities	—		—
NUGs	59		122		NUGs	542		467
Interest Rate Swaps					Interest Rate Swaps
Current Assets	—		—		Current Liabilities	—		—
Noncurrent Assets	—		—		Noncurrent Liabilities	—		—
Other					Other
Current Assets	—		10		Current Liabilities	—		—
Noncurrent Assets	—		—		Noncurrent Liabilities	—		—
Total Derivatives Assets	$	288	$	268	Total Derivatives Liabilities	$	812	$	714

The following table summarizes the volumes associated with FirstEnergy’s outstanding derivative transactions as of September 30, 2011:



	Purchases	Sales	Net		Units
	(In thousands)
Power Contracts	34,956	49,696	(14,740	)	MWH
FTRs	45,730	27	45,703		MWH
NUGs	25,442	—	25,442		MWH

The effect of derivative instruments on the Consolidated Statements of Income during the three months and nine months ended September 30, 2011 and 2010, are summarized in the following tables:



	Three Months Ended September 30
	Power Contracts			FTRs			Interest Rate Swaps		Other			Total
	(In millions)
Derivatives in a Hedging Relationship
2011
Gain (Loss) Recognized in AOCL (Effective Portion)	$	—		$	—		$	—	$	—		$	—
Effective Gain (Loss) Reclassified to: ⁽¹⁾
Purchased Power Expense	—			—			—		—			—
Revenues	—			—			—		—			—
2010
Gain (Loss) Recognized in AOCL (Effective Portion)	$	(1	)	$	—		$	—	$	3		$	2
Effective Gain (Loss) Reclassified to:⁽¹⁾
Purchased Power Expense	5			—			—		—			5
Revenues	(7		)	—			—		—			(7		)
Fuel Expense	—			—			—		(4		)	(4		)

Derivatives Not in a Hedging Relationship
2011
Unrealized Gain (Loss) Recognized in:
Purchased Power Expense	$	27		$	—		$	—	$	—		$	27
Revenues	3			—			—		—			3
Other Operating Expense	(11		)	(15		)	1		—			(25		)
Realized Gain (Loss) Reclassified to:
Purchased Power Expense	(5		)	—			—		—			(5		)
Revenues	(40		)	30			—		—			(10		)
Other Operating Expense	—			(35		)	—		—			(35		)
2010
Unrealized Gain (Loss) Recognized in:
Purchased Power Expense	$	3		$	—		$	—	$	—		$	3
Realized Gain (Loss) Reclassified to:
Purchased Power Expense	(22		)	—			—		—			(22		)



Derivatives Not in a Hedging	Three Months Ended September 30
Relationship with Regulatory Offset⁽²⁾	NUGs			Other			Total
	(In millions)
2011
Unrealized Gain (Loss) to Derivative Instrument:	$	(89	)	$	(3	)	$	(92	)
Unrealized Gain (Loss) to Regulatory Assets:	89			3			92
Realized Gain (Loss) to Derivative Instrument:	53			(3		)	50
Realized Gain (Loss) to Regulatory Assets:	(53		)	3			(50		)
2010
Unrealized Gain (Loss) to Derivative Instrument:	$	(146	)	—			$	(146	)
Unrealized Gain (Loss) to Regulatory Assets:	146			—			146
Realized Gain (Loss) to Derivative Instrument:	63			—			63
Realized Gain (Loss) to Regulatory Assets:	(63		)	—			(63		)



	Nine Months Ended September 30
	Power Contracts			FTRs			Interest Rate Swaps		Other			Total
	(In millions)
Derivatives in a Hedging Relationship
2011
Gain (Loss) Recognized in AOCL (Effective Portion)	$	5		$	—		$	—	$	—		$	5
Effective Gain (Loss) Reclassified to: ⁽¹⁾
Purchased Power Expense	16			—			—		—			16
Revenues	(12		)	—			—		—			(12		)
2010
Gain (Loss) Recognized in AOCL (Effective Portion)	$	(3	)	$	—		$	—	$	10		$	7
Effective Gain (Loss) Reclassified to:⁽¹⁾
Purchased Power Expense	(2		)	—			—		—			(2		)
Revenues	(11		)	—			—		—			(11		)
Fuel Expense	—			—			—		(11		)	(11		)
Derivatives Not in a Hedging Relationship
2011
Unrealized Gain (Loss) Recognized in:
Purchased Power Expense	$	88		$	—		$	—	$	—		$	88
Revenues	(1		)	—			—		—			(1		)
Other Operating Expense	(65		)	(1		)	2		—			(64		)
Realized Gain (Loss) Reclassified to:
Purchased Power Expense	(41		)	—			—		—			(41		)
Revenues	(69		)	56			—		—			(13		)
Other Operating Expense	—			(122		)	—		—			(122		)
2010
Unrealized Gain (Loss) Recognized in:
Purchased Power Expense	$	42		$	—		$	—	$	—		$	42
Realized Gain (Loss) Reclassified to:
Purchased Power Expense	(71		)	—			—		—			(71		)



Derivatives Not in a Hedging	Nine Months Ended September 30,
Relationship with Regulatory Offset⁽²⁾	NUGs			Other			Total
	(In millions)
2011
Unrealized Gain (Loss) to Derivative Instrument:	$	(325	)	$	—		$	(325	)
Unrealized Gain (Loss) to Regulatory Assets:	325			—			325
Realized Gain (Loss) to Derivative Instrument:	187			(14		)	173
Realized Gain (Loss) to Regulatory Assets:	(187		)	14			(173		)
2010
Unrealized Gain (Loss) to Derivative Instrument:	$	(405	)	—			$	(405	)
Unrealized Gain (Loss) to Regulatory Assets:	405			—			405
Realized Gain (Loss) to Derivative Instrument:	209			(9		)	200
Realized Gain (Loss) to Regulatory Assets:	(209		)	9			(200		)


⁽¹⁾	The ineffective portion was immaterial.


⁽²⁾	Changes in the fair value of certain contracts are deferred for future recovery from (or refund to) customers.

The following table provides a reconciliation of changes in the fair value of certain contracts that are deferred for future recovery from (or credit to) customers during the three months and nine months ended September 30, 2011 and 2010:



	Three Months Ended September 30
Derivatives Not in a Hedging Relationship with Regulatory Offset⁽¹⁾	NUGs			Other			Total
	(In millions)
Outstanding net asset (liability) as of July 1, 2011	$	(447	)	$	2		$	(445	)
Additions/Change in value of existing contracts	(89		)	(3		)	(92		)
Settled contracts	53			(3		)	50
Outstanding net asset (liability) as of September 30, 2011	$	(483	)	$	(4	)	$	(487	)

Outstanding net asset (liability) as of July 1, 2010	$	(557	)	$	10		$	(547	)
Additions/Change in value of existing contracts	(146		)	—			(146		)
Settled contracts	63			—			63
Outstanding net asset (liability) as of September 30, 2010	$	(640	)	$	10		$	(630	)

	Nine Months Ended September 30
Derivatives Not in a Hedging Relationship with Regulatory Offset⁽¹⁾	NUGs			Other			Total
	(In millions)
Outstanding net asset (liability) as of January 1, 2011	$	(345	)	$	10		$	(335	)
Additions/Change in value of existing contracts	(325		)	—			(325		)
Settled contracts	187			(14		)	173
Outstanding net asset (liability) as of September 30, 2011	$	(483	)	$	(4	)	$	(487	)

Outstanding net asset (liability) as of January 1, 2010	$	(444	)	$	19		$	(425	)
Additions/Change in value of existing contracts	(405		)	—			(405		)
Settled contracts	209			(9		)	200
Outstanding net asset (liability) as of September 30, 2010	$	(640	)	$	10		$	(630	)


⁽¹⁾	Changes in the fair value of certain contracts are deferred for future recovery from (or refund to) customers.