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.

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 AOCI. 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 these 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 AOCI with subsequent reclassification to earnings in the period during which the hedged forecasted transaction affects earnings.

Total net unamortized gains included in AOCI associated with de-designated cash flow hedges totaled $15 million and $19 million as of June 30, 2012 and December 31, 2011, respectively. Since the forecasted transactions remain probable of occurring, these amounts will be amortized into earnings over the life of the hedging instruments. Reclassifications from AOCI into other operating expenses were $1 million and $14 million during the three months ended June 30, 2012 and 2011, respectively, and $4 million and $19 million during the six months ended June 30, 2012 and 2011, respectively. Approximately $9 million is expected to be amortized to income 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 June 30, 2012, no forward starting swap agreements accounted for as a cash flow hedge were outstanding. Total unamortized losses included in AOCI associated with prior interest rate cash flow hedges totaled $74 million as of June 30, 2012. Based on current estimates, approximately $9 million will be amortized to interest expense during the next twelve months. Reclassifications from AOCI into interest expense totaled $2 million and $3 million during the three months ended June 30, 2012 and 2011, respectively, and $5 million and $6 million during the six months ended June 30, 2012 and 2011, respectively.

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 June 30, 2012, 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 $91 million as of June 30, 2012. Based on current estimates, approximately $23 million will be amortized to interest expense during the next twelve months. Reclassifications from long-term debt into interest expense totaled approximately $6 million during the three months ended June 30, 2012 and 2011, and $11 million during the six months ended June 30, 2012 and 2011.

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 for use 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.

As of June 30, 2012, FirstEnergy’s net asset position under commodity derivative contracts was $78 million, which related to FES and AE Supply positions. Under these commodity derivative contracts, FES posted $34 million of collateral. Certain commodity derivative contracts include credit risk related contingent features that would require FES to post $12 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 June 30, 2012, an adverse 10% change in commodity prices would decrease net income by approximately $2 million during the next twelve months.

Interest Rate Swaps

FirstEnergy uses forward starting swap agreements to hedge a portion of the consolidated interest rate risk associated with issuances of fixed-rate, long-term debt securities of its subsidiaries. These derivatives are considered economic hedges, protecting against the risk of increases in future interest payments resulting from increases in benchmark U.S. Treasury rates between the date of hedge inception and the date of the debt issuance. During the three months ended June 30, 2012, FirstEnergy executed forward starting swap agreements expiring December 31, 2013, with sixteen separate counterparties for a combined notional value of $1.6 billion in order to lock in interest rates on planned debt issuances, which includes refinancings. The total portfolio of swaps carries a weighted average 10-year fixed rate of 2.315%. Changes in the fair value of the forward starting swap agreements are recorded in net income on a mark-to-market basis.

LCAPP

The LCAPP law was enacted in New Jersey during 2011 to promote the construction of qualified electric generation facilities. JCP&L maintains two LCAPP contracts, which are financially settled agreements that allow eligible generators to receive payments from, or make payments to, JCP&L pursuant to an annually calculated load-ratio share of the capacity produced by the generator based upon the annual forecasted peak demand as determined by PJM. During the second quarter of 2012, JCP&L began to account for these contracts as derivatives as a result of the generators clearing the 2015/2016 PJM RPM capacity auction. JCP&L expects to recover from its customers payments made to the generators and give credit to customers for payments from the generators under these contracts. As a result, the projected future obligations for the LCAPP contracts are reflected on the Consolidated Balance Sheets as derivative liabilities (assets) with a corresponding regulatory asset (liability). Since the LCAPP contracts are subject to regulatory accounting, changes in their fair value do not impact earnings.

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 on FirstEnergy’s Consolidated Balance Sheets:



Derivatives not designated as hedging instruments:
Derivative Assets					Derivative Liabilities
	Fair Value					Fair Value
	June 30, 2012		December 31, 2011			June 30, 2012			December 31, 2011
	(In millions)					(In millions)
Power Contracts					Power Contracts
Current Assets	$	232	$	185	Current Liabilities	$	(213	)	$	(196	)
Noncurrent Assets	106		79		Noncurrent Liabilities	(49		)	(51		)
FTRs					FTRs
Current Assets	12		1		Current Liabilities	(8		)	(22		)
Noncurrent Assets	—		—		Noncurrent Liabilities	(1		)	(1		)
NUGs	9		56		NUGs	(302		)	(349		)
LCAPP	—		—		LCAPP	(145		)	—
Interest Rate Swaps					Interest Rate Swaps
Noncurrent Assets	3		—		Noncurrent Liabilities	(23		)	—
Other					Other
Current Assets	4		—		Current Liabilities	(1		)	—
	$	366	$	321		$	(742	)	$	(619	)

The following table summarizes the volumes associated with FirstEnergy’s outstanding derivative transactions as of June 30, 2012:



	Purchases	Sales	Net		Units
	(In millions)
Power Contracts	29	40	(11	)	MWH
FTRs	82	—	82		MWH
Interest Rate Swaps	1,600	—	1,600		notional dollars
NUGs	22	—	22		MWH
LCAPP	408	—	408		MW
Natural Gas	26	—	26		Million BTUs

The effect of derivative instruments on the Consolidated Statements of Income during the three months ended June 30, 2012 and 2011, are summarized in the following tables:



	Three Months Ended June 30
	Power Contracts			FTRs			Interest Rate Swaps			Other			Total
	(In millions)
Derivatives in a Hedging Relationship

2012
Gain (Loss) Recognized in AOCI (Effective Portion)	$	1		$	—		$	—		$	—		$	1

2011
Gain (Loss) Recognized in AOCI (Effective Portion)	$	14		$	—		$	—		$	—		$	14

Derivatives Not in a Hedging Relationship

2012
Unrealized Gain (Loss) Recognized in:
Other Operating Expense	$	7		$	12		$	—		$	5		$	24
Interest Expense	—			—			(20		)	—			(20		)

Realized Gain (Loss) Reclassified to:
Purchased Power Expense	$	(104	)	$	—		$	—		$	—		$	(104	)
Revenues	95			5			—			—			100
Other Operating Expense	—			(18		)	—			—			(18		)
Fuel Expense	—			—			—			(1		)	(1		)
Interest Expense	—			—			—			—			—

2011
Unrealized Gain (Loss) Recognized in:
Purchased Power Expense	$	33		$	—		$	—		$	—		$	33
Revenues	(4		)	—			—			—			(4		)
Other Operating Expense	(34		)	11			—			—			(23		)
Interest Expense	—			—			—			—			—

Realized Gain (Loss) Reclassified to:
Purchased Power Expense	$	1		$	—		$	—		$	—		$	1
Revenues	(39		)	13			—			—			(26		)
Other Operating Expense	—			(40		)	—			—			(40		)
Interest Expense	—			—			—			—			—



	Six Months Ended June 30
	Power Contracts			FTRs			Interest Rate Swaps			Other			Total
	(In millions)
Derivatives in a Hedging Relationship

2012
Gain (Loss) Recognized in AOCI (Effective Portion)	$	(4	)	$	—		$	—		$	—		$	(4	)

2011
Gain (Loss) Recognized in AOCI (Effective Portion)	$	5		$	—		$	—		$	—		$	5
Effective Gain (Loss) Reclassified to:
Purchased Power Expense	16			—			—			—			16
Revenues	(12		)	—			—			—			(12		)
Fuel Expense	—			—			—			—			—

Derivatives Not in a Hedging Relationship

2012
Unrealized Gain (Loss) Recognized in:
Other Operating Expense	$	62		$	17		$	—		$	3		$	82
Interest Expense	—			—			(20		)	—			(20		)

Realized Gain (Loss) Reclassified to:
Purchased Power Expense	$	(221	)	$	—		$	—		$	—		$	(221	)
Revenues	206			11			—			—			217
Other Operating Expense	—			(41		)	—			—			(41		)
Fuel Expense	—			—			—			(1		)	(1		)
Interest Expense	—			—			—			—			—

2011
Unrealized Gain (Loss) Recognized in:
Purchased Power Expense	$	61		$	—		$	—		$	—		$	61
Revenues	(3		)	—			—			—			(3		)
Other Operating Expense	(54		)	12			1			—			(41		)
Interest Expense	—			—			—			—			—

Realized Gain (Loss) Reclassified to:
Purchased Power Expense	$	(36	)	$	—		$	—		$	—		$	(36	)
Revenues	(29		)	16			(1		)	—			(14		)
Other Operating Expense	—			(54		)	—			—			(54		)
Interest Expense	—			—			—			—			—

The unrealized and realized gains (losses) on FirstEnergy’s derivative instruments subject to regulatory accounting during the three and six months ended June 30, 2012 and 2011, are summarized in the following tables:



	Three Months Ended June 30
	NUGs			LCAPP			Regulated FTRs		Other		Total
	(In millions)
Derivatives Not in a Hedging Relationship with Regulatory Offset

2012
Unrealized Gain (Loss) to Derivative Instrument	$	(54	)	$	(145	)	$	—	$	—	$	(199	)
Realized Gain (Loss) to Derivative Instrument	61			—			5		—		66

2011
Unrealized Gain (Loss) to Derivative Instrument	$	(147	)	$	—		$	2	$	—	$	(145	)
Realized Gain (Loss) to Derivative Instrument	62			—			—		—		62



	Six Months Ended June 30
	NUGs			LCAPP			Regulated FTRs			Other		Total
	(In millions)
Derivatives Not in a Hedging Relationship with Regulatory Offset

2012
Unrealized Gain (Loss) to Derivative Instrument	$	(133	)	$	(145	)	$	(1	)	$	—	$	(279	)
Realized Gain (Loss) to Derivative Instrument	133			—			9			—		142

2011
Unrealized Gain (Loss) to Derivative Instrument	$	(236	)	$	—		$	2		$	—	$	(234	)
Realized Gain (Loss) to Derivative Instrument	134			—			(10		)	—		124

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 six months ended June 30, 2012 and 2011:



	Three Months Ended June 30
Derivatives Not in a Hedging Relationship with Regulatory Offset⁽¹⁾	NUGs			LCAPP			Regulated FTRs			Other		Total
	(In millions)
Outstanding net asset (liability) as of April 1, 2012	$	(300	)	$	—		$	(5	)	$	—	$	(305	)
Additions/Change in value of existing contracts	(54		)	(145		)	—			—		(199		)
Settled contracts	61			—			5			—		66
Outstanding net asset (liability) as of June 30, 2012	$	(293	)	$	(145	)	$	—		$	—	$	(438	)

Outstanding net asset (liability) as of April 1, 2011	$	(362	)	$	—		$	—		$	—	$	(362	)
Additions/Change in value of existing contracts	(147		)	—			2			—		(145		)
Settled contracts	62			—			—			—		62
Outstanding net asset (liability) as of June 30, 2011	$	(447	)	$	—		$	2		$	—	$	(445	)



	Six Months Ended June 30
Derivatives Not in a Hedging Relationship with Regulatory Offset⁽¹⁾	NUGs			LCAPP			Regulated FTRs			Other			Total
	(In millions)
Outstanding net asset (liability) as of January 1, 2012	$	(293	)	$	—		$	(8	)	$	—		$	(301	)
Additions/Change in value of existing contracts	(133		)	(145		)	(1		)	—			(279		)
Settled contracts	133			—			9			—			142
Outstanding net asset (liability) as of June 30, 2012	$	(293	)	$	(145	)	$	—		$	—		$	(438	)

Outstanding net asset (liability) as of January 1, 2011	$	(345	)	$	—		$	—		$	10		$	(335	)
Additions/Change in value of existing contracts	(236		)	—			2			—			(234		)
Settled contracts	134			—			—			(10		)	124
Outstanding net asset (liability) as of June 30, 2011	$	(447	)	$	—		$	2		$	—		$	(445	)


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