(17) DISCONTINUED OPERATIONS

On March 21, 2013, Pepco Energy Services entered into an agreement whereby a third party assumed all of the rights and obligations of the remaining retail natural gas supply customer contracts, and the associated supply obligations, gas inventory and derivative contracts. The transaction was completed on April 1, 2013. The agreement eliminated the retail natural gas supply business from the ongoing operations of Pepco Energy Services effective April 1, 2013 and Pepco Energy Services will not have significant continuing involvement in the retail natural gas supply business thereafter. As a result, PHI commenced reporting the results of operations of Pepco Energy Services’ retail natural gas supply business in discontinued operations in all periods presented in the accompanying consolidated statements of income. Further, certain assets and liabilities of Pepco Energy Services’ retail natural gas supply business are reported as held for sale as of each date presented in the accompanying consolidated balance sheets. Upon completion of the transaction, Pepco Energy Services received $8 million of collateral that it had pledged against its retail natural gas supply derivatives.

Operating Results

The operating results for the retail natural gas supply business of Pepco Energy Services are as follows:


	Three Months Ended March 31,
	2013			2012
	*(millions of dollars)*
Income from operations of discontinued operations, net of income taxes	$	2		$	5
Unrealized losses associated with retail natural gas supply contracts, net of income taxes		(2	)		—

Income From Discontinued Operations, Net of Income Taxes	$	—		$	5

Unrealized losses associated with retail natural gas supply contracts, net of income taxes includes unrealized derivative losses that were previously included in AOCL and were reclassified to income upon entering into the March 21, 2013 agreement, because PHI determined that the hedged forecasted purchases of supply for retail natural gas customers were probable not to occur. Accordingly, during the first quarter of 2013, PHI recognized $4 million of pre-tax unrealized derivative losses ($2 million after tax) that previously were included in AOCL as cash flow hedges. As a result of the completion of the transaction in the second quarter of 2013, PHI expects to record a pre-tax gain of approximately $8 million ($5 million after tax).

Balance Sheet Information

As March 31, 2013 and December 31, 2012, the retail natural gas supply business of Pepco Energy Services had inventory assets of less than $1 million and $1 million, respectively, and gross derivative liabilities of $8 million and $12 million, respectively, exclusive of the collateral pledged by Pepco Energy Services against the derivative liabilities. The fair value of the derivative liabilities were considered level 1 within the fair value hierarchy.

Derivative Instruments and Hedging Activities

Derivatives were used by the retail natural gas supply business of Pepco Energy Services to hedge commodity price risk.

The retail natural gas supply business of Pepco Energy Services entered into energy commodity contracts in the form of natural gas futures, swaps, options and forward contracts to hedge commodity price risk in connection with the purchase of physical natural gas for distribution to customers. The primary risk management objective was to manage the spread between retail sales commitments and the cost of supply used to service those commitments to ensure stable cash flows and lock in favorable prices and margins when they became available.

Commodity contracts held by the retail natural gas supply business of Pepco Energy Services that were not designated for hedge accounting, did not qualify for hedge accounting, or did not meet the requirements for normal purchase and normal sale accounting, were marked to market through current earnings. Forward contracts that met the requirements for normal purchase and normal sale accounting were recorded on an accrual basis.

The tables below identify the balance sheet location and fair values of the retail natural gas supply business’ derivative instruments as of March 31, 2013 and December 31, 2012:


	As of March 31, 2013
Balance Sheet Caption	Derivatives Designated as Hedging Instruments			Other Derivative Instruments			Gross Derivative Instruments			Effects of Cash Collateral and Netting		Net Derivative Instruments
							*(millions of dollars)*
Derivative liabilities (current liabilities)	$	—		$	(7	)	$	(7	)	$	7	$	—
Derivative liabilities (non-current liabilities)		—			(1	)		(1	)		1		—

Net Derivative liability	$	—		$	(8	)	$	(8	)	$	8	$	—


	As of December 31, 2012
Balance Sheet Caption	Derivatives Designated as Hedging Instruments (a)			Other Derivative Instruments			Gross Derivative Instruments			Effects of Cash Collateral and Netting		Net Derivative Instruments
	*(millions of dollars)*
Derivative liabilities (current liabilities)	$	(5	)	$	(5	)	$	(10	)	$	10	$	—
Derivative liabilities (non-current liabilities)		(1	)		(1	)		(2	)		2		—

Net Derivative (liability) asset	$	(6	)	$	(6	)	$	(12	)	$	12	$	—

(a)	Amounts included in Derivatives Designated as Hedging Instruments primarily consist of derivatives that were designated as cash flow hedges prior to Pepco Energy Services’ election to discontinue cash flow hedge accounting for these derivatives.

Under FASB guidance on the offsetting of balance sheet accounts (ASC 210-20), the retail natural gas supply business of Pepco Energy Services offsets the fair value amounts recognized for derivative instruments and the fair value amounts recognized for related collateral positions executed with the same counterparty under master netting agreements. No derivative assets or liabilities were available to be offset under master netting arrangements as of March 31, 2013 and December 31, 2012. The amount of cash collateral that was offset against these derivative positions is as follows:


	March 31, 2013		December 31, 2012
	*(millions of dollars)*
Cash collateral pledged to counterparties with the right to reclaim (a)	$	8	$	12

(a)	Includes cash deposits on commodity brokerage accounts.

As of March 31, 2013 and December 31, 2012, all cash collateral pledged by the retail gas business related to derivative instruments accounted for at fair value was entitled to offset under master netting agreements.

Derivatives Designated as Hedging Instruments

Cash Flow Hedges

For energy commodity contracts that are designated and qualify as cash flow hedges, the effective portion of the gain or loss on the derivative is reported as a component of AOCL and is reclassified into income in the same period or periods during which the hedged transactions affect income. Gains and losses on the derivative that are related to hedge ineffectiveness or the forecasted hedged transaction being probable not to occur are recognized in income. The retail natural gas supply business of Pepco Energy Services had elected to no longer apply cash flow hedge accounting to its natural gas derivatives. Amounts included in AOCL for these cash flow hedges as of March 31, 2013 and 2012 represent net losses on derivatives prior to the election to discontinue cash flow hedge accounting less amounts reclassified into income as the hedged transactions occurred or because the hedged transactions were deemed probable not to occur. Gains or losses on these derivatives after the election to discontinue cash flow hedge accounting were recognized in income.

The cash flow hedge activity during the three months ended March 31, 2013 and 2012 is provided in the tables below:


	Three Months Ended March 31,
	2013		2012
	*(millions of dollars)*
Amount of net pre-tax loss arising during the period included in Accumulated Other Comprehensive Loss	$	—	$	—

Amount of net pre-tax loss reclassified into income:
Effective portion:
Income from Discontinued Operations, Net of Income Taxes		1		6
Ineffective portion: (a)
Income from Discontinued Operations, Net of Income Taxes		4		—

Total net pre-tax loss reclassified into Income from Discontinued Operations, Net of Income Taxes		5		6

Net pre-tax gain on commodity derivatives included in Accumulated Other Comprehensive Loss	$	5	$	6

(a)

Included in the table above is a loss of $4 million for the three months ended March 31, 2013, which was reclassified from AOCL to Income from Discontinued Operations, Net of Income Taxes because the forecasted hedged transactions were deemed probable not to occur. For the three months ended March 31, 2012, no amounts were reclassified from AOCL to Income from Discontinued Operations, Net of Income Taxes because the forecasted hedged transactions were deemed probable not to occur.

Cash Flow Hedges Included in Accumulated Other Comprehensive Loss

Cash flow hedges are marked to market on the balance sheet with corresponding adjustments to AOCL for effective cash flow hedges. As of March 31, 2013, all of the losses in AOCL that were associated with derivatives that the retail natural gas supply business of Pepco Energy Services had previously designated as cash flow hedges have been reclassified to income. The table below provides details regarding effective cash flow hedges included in the retail natural gas supply business of Pepco Energy Services’ balance sheets as of March 31, 2012. Although the retail natural gas supply business of Pepco Energy Services elected to no longer apply cash flow hedge accounting to its derivatives prior to March 31, 2012, gains or losses previously deferred in AOCL prior to the decision to discontinue cash flow hedge accounting remained in AOCL until the hedged forecasted transaction occurred unless it was deemed probable that the hedged forecasted transaction would not occur. The data in the following tables indicate the cumulative net loss after-tax related to effective cash flow hedges by contract type included in AOCL, the portion of AOCL expected to be reclassified to income during the next 12 months, and the maximum hedge or deferral term:


Contracts	As of March 31, 2012				Maximum Term
Contracts	Accumulated Other Comprehensive Loss After-tax		Portion Expected to be Reclassified to Income during the Next 12 Months		Maximum Term
	*(millions of dollars)*
Energy commodity (a)	$	10	$	7		26 months

Total	$	10	$	7

(a)

The unrealized derivative losses recorded in AOCL relate to forecasted physical natural gas purchases which are used to supply retail natural gas contracts that are in gain positions and subject to accrual accounting. Under accrual accounting, no asset is recorded on the retail natural gas supply business of Pepco Energy Services’ balance sheet and the purchase cost is not recognized until the period of distribution.

Other Derivative Activity

The retail natural gas supply business of Pepco Energy Services held certain derivatives that were not in hedge accounting relationships and were not designated as normal purchases or normal sales. These derivatives were recorded at fair value on the balance sheet with the gain or loss for changes in fair value recorded through Income from Discontinued Operations, Net of Income Taxes.

For the three months ended March 31, 2013 and 2012, the amount of the derivative gain (loss) for the retail natural gas supply business of Pepco Energy Services recognized in Income from Discontinued Operations, Net of Income Taxes is provided in the table below:


	Three Months Ended March 31,
	2013			2012
	*(millions of dollars)*
Reclassification of mark-to-market to realized on settlement of contracts	$	2		$	8
Unrealized mark-to-market loss		(3	)		(6	)

Total net (loss) gain	$	(1	)	$	2

As of March 31, 2013 and December 31, 2012, the retail natural gas supply business of Pepco Energy Services had the following net outstanding commodity forward contract quantities and net position on derivatives that did not qualify for hedge accounting:

March 31, 2013

December 31, 2012

Commodity

Quantity

Net Position

Quantity

Net Position

Natural gas (MMBtu)

2,047,500

Long

2,867,500

Long