(14) FAIR VALUE DISCLOSURES

Financial Instruments Measured at Fair Value on a Recurring Basis

PHI applies FASB guidance on fair value measurement and disclosures (ASC 820) that established a framework for measuring fair value and expanded disclosures about fair value measurements. As defined in the guidance, fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). PHI utilizes market data or assumptions that market participants would use in pricing the asset or liability, including assumptions about risk and the risks inherent in the inputs to the valuation technique. These inputs can be readily observable, market corroborated or generally unobservable. Accordingly, PHI utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. The guidance establishes a fair value hierarchy that prioritizes the inputs used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (level 1) and the lowest priority to unobservable inputs (level 3).

The following tables set forth, by level within the fair value hierarchy, PHI’s financial assets and liabilities that were accounted for at fair value on a recurring basis as of December 31, 2013 and 2012. As required by the guidance, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. PHI’s assessment of the significance of a particular input to the fair value measurement requires the exercise of judgment, and may affect the valuation of fair value assets and liabilities and their placement within the fair value hierarchy levels.


	Fair Value Measurements at December 31, 2013
Description	Total		Quoted Prices in Active Markets for Identical Instruments (Level 1) (a)		Significant Other Observable Inputs (Level 2) (a)		Significant Unobservable Inputs (Level 3)
	*(millions of dollars)*
ASSETS
Derivative instruments (b)
Natural gas (c)	$	1	$	1	$	—	$	—
Restricted cash and cash equivalents
Treasury fund		34		34		—		—
Executive deferred compensation plan assets
Money market funds		15		15		—		—
Life insurance contracts		66		—		47		19

	$	116	$	50	$	47	$	19

LIABILITIES
Executive deferred compensation plan liabilities
Life insurance contracts	$	30	$	—	$	30	$	—

	$	30	$	—	$	30	$

(a)	There were no transfers of instruments between level 1 and level 2 valuation categories during the year ended December 31, 2013.

(b)	The fair values of derivative assets and liabilities reflect netting by counterparty before the impact of collateral.

(c)	Represents natural gas swaps purchased by DPL as part of a natural gas hedging program approved by the DPSC.


	Fair Value Measurements at December 31, 2012
Description	Total		Quoted Prices in Active Markets for Identical Instruments (Level 1) (a)		Significant Other Observable Inputs (Level 2) (a)		Significant Unobservable Inputs (Level 3)
	*(millions of dollars)*
ASSETS
Derivative instruments (b)
Capacity (d)	$	8	$	—	$	—	$	8
Restricted cash equivalents
Treasury fund		27		27		—		—
Executive deferred compensation plan assets
Money market funds		17		17		—		—
Life insurance contracts		60		—		42		18

	$	112	$	44	$	42	$	26

LIABILITIES
Derivative instruments (b)
Natural gas (c)	$	4	$	—	$	—	$	4
Capacity (d)		11		—		—		11
Executive deferred compensation plan liabilities
Life insurance contracts		28		—		28		—

	$	43	$	—	$	28	$	15

(a)	There were no transfers of instruments between level 1 and level 2 valuation categories during the year ended December 31, 2012.

(b)	The fair values of derivative assets and liabilities reflect netting by counterparty before the impact of collateral.

(c)	Represents natural gas options purchased by DPL as part of a natural gas hedging program approved by the DPSC.

(d)	Represents derivatives associated with the ACE SOCAs.

PHI classifies its fair value balances in the fair value hierarchy based on the observability of the inputs used in the fair value calculation as follows:

Level 1 – Quoted prices are available in active markets for identical assets or liabilities as of the reporting date. Active markets are those in which transactions for the asset or liability occur in sufficient frequency and volume to provide pricing information on an ongoing basis, such as the New York Mercantile Exchange (NYMEX).

Level 2 – Pricing inputs are other than quoted prices in active markets included in level 1, which are either directly or indirectly observable as of the reporting date. Level 2 includes those financial instruments that are valued using broker quotes in liquid markets and other observable data. Level 2 also includes those financial instruments that are valued using methodologies that have been corroborated by observable market data through correlation or by other means. Significant assumptions are observable in the marketplace throughout the full term of the instrument and can be derived from observable data or are supported by observable levels at which transactions are executed in the marketplace.

Executive deferred compensation plan assets and liabilities categorized as level 2 consist of life insurance policies and certain employment agreement obligations. The life insurance policies are categorized as level 2 assets because they are valued based on the assets underlying the policies, which consist of short-term cash equivalents and fixed income securities that are priced using observable market data and can be liquidated for the value of the underlying assets as of December 31, 2013. The level 2 liability associated with the life insurance policies represents a deferred compensation obligation, the value of which is tracked via underlying insurance sub-accounts. The sub-accounts are designed to mirror existing mutual funds and money market funds that are observable and actively traded.

The value of certain employment agreement obligations (which are included with life insurance contracts in the tables above) is derived using a discounted cash flow valuation technique. The discounted cash flow calculations are based on a known and certain stream of payments to be made over time that are discounted to determine their net present value. The primary variable input, the discount rate, is based on market-corroborated and observable published rates. These obligations have been classified as level 2 within the fair value hierarchy because the payment streams represent contractually known and certain amounts and the discount rate is based on published, observable data.

Level 3 – Pricing inputs that are significant and generally less observable than those from objective sources. Level 3 includes those financial instruments that are valued using models or other valuation methodologies.

Derivative instruments categorized as level 3 include natural gas options used by DPL as part of a natural gas hedging program approved by the DPSC and capacity under the SOCAs entered into by ACE:

•

DPL applies a Black-Scholes model to value its options with inputs, such as forward price curves, contract prices, contract volumes, the risk-free rate and implied volatility factors that are based on a range of historical NYMEX option prices. DPL maintains valuation policies and procedures and reviews the validity and relevance of the inputs used to estimate the fair value of its options. As of December 31, 2013, all of these contracts classified as level 3 derivative instruments have settled.

•

ACE used a discounted cash flow methodology to estimate the fair value of the capacity derivatives embedded in the SOCAs. ACE utilized an external valuation specialist to estimate annual zonal PJM capacity prices through the 2030-2031 auction. The capacity price forecast was based on various assumptions that impact the cost of constructing new generation facilities, including zonal load forecasts, zonal fuel and energy prices, generation capacity and transmission planning, and environmental legislation and regulation. ACE reviewed the assumptions and resulting capacity price forecast for reasonableness. ACE used the capacity price forecast to estimate future cash flows. A significant change in the forecasted prices would have a significant impact on the estimated fair value of the SOCAs. ACE employed a discount rate reflective of the estimated weighted average cost of capital for merchant generation companies since payments under the SOCAs are contingent on providing generation capacity. As further discussed in Note (7), “Regulatory Matters,” ACE derecognized the derivative assets and derivative liabilities related to the SOCAs in the fourth quarter of 2013.

The tables below summarize the primary unobservable inputs used to determine the fair value of PHI’s level 3 instruments and the range of values that could be used for those inputs as of December 31, 2012:


Type of Instrument	Fair Value at December 31, 2012			Valuation Technique	Unobservable Input	Range
	*(millions of dollars)*
Natural gas options	$	(4	)	Option model	Volatility factor	1.57 - 2.00
Capacity contracts, net		(3	)	Discounted cash flow	Discount rate	5% - 9%

PHI used values within these ranges as part of its fair value estimates. A significant change in any of the unobservable inputs within these ranges would have an insignificant impact on the reported fair value as of December 31, 2012.

Executive deferred compensation plan assets include certain life insurance policies that are valued using the cash surrender value of the policies, net of loans against those policies. The cash surrender values do not represent a quoted price in an active market; therefore, those inputs are unobservable and the policies are categorized as level 3. Cash surrender values are provided by third parties and reviewed by PHI for reasonableness.

Reconciliations of the beginning and ending balances of PHI’s fair value measurements using significant unobservable inputs (Level 3) for the years ended December 31, 2013 and 2012 are shown below:


	Year Ended December 31, 2013									Year Ended December 31, 2012
	Natural Gas			Life Insurance Contracts			Capacity			Natural Gas			Life Insurance Contracts			Capacity
	*(millions of dollars)*									*(millions of dollars)*
Balance as of January 1	$	(4	)	$	18		$	(3	)	$	(15	)	$	17		$	—
Total gains (losses) (realized and unrealized):
Included in income		—			4			—			—			4			—
Included in accumulated other comprehensive loss		—			—			—			—			—			—
Included in regulatory liabilities		—			—			3			(2	)		—			(3	)
Purchases		—			—			—			—			—			—
Issuances		—			(3	)		—			—			(3	)		—
Settlements		4			—			—			13			—			—
Transfers in (out) of level 3		—			—			—			—			—			—

Balance as of December 31	$	—		$	19		$	—		$	(4	)	$	18		$	(3	)

The breakdown of realized and unrealized gains or (losses) on level 3 instruments included in income as a component of Other income or Other operation and maintenance expense for the periods below were as follows:


	Year Ended December 31,
	2013		2012
	*(millions of dollars)*
Total net gains included in income for the period	$	4	$	4

Change in unrealized gains relating to assets still held at reporting date	$	4	$	4

Other Financial Instruments

The estimated fair values of PHI’s Long-term debt instruments that are measured at amortized cost in PHI’s consolidated financial statements and the associated level of the estimates within the fair value hierarchy as of December 31, 2013 and 2012 are shown in the tables below. As required by the fair value measurement guidance, debt instruments are classified in their entirety within the fair value hierarchy based on the lowest level of input that is significant to the fair value measurement. PHI’s assessment of the significance of a particular input to the fair value measurement requires the exercise of judgment, which may affect the valuation of fair value debt instruments and their placement within the fair value hierarchy levels.

The fair value of Long-term debt and Transition Bonds categorized as level 2 is based on a blend of quoted prices for the debt and quoted prices for similar debt on the measurement date. The blend places more weight on current pricing information when determining the final fair value measurement. The fair value information is provided by brokers, and PHI reviews the methodologies and results.

The fair value of Long-term debt categorized as level 3 is based on a discounted cash flow methodology using observable inputs, such as the U.S. Treasury yield, and unobservable inputs, such as credit spreads, because quoted prices for the debt or similar debt in active markets were insufficient. The Long-term project funding represents debt instruments issued by Pepco Energy Services related to its energy savings contracts. Long-term project funding is categorized as level 3 because PHI concluded that the amortized cost carrying amounts for these instruments approximates fair value, which does not represent a quoted price in an active market.


	Fair Value Measurements at December 31, 2013
Description	Total		Quoted Prices in Active Markets for Identical Instruments (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	*(millions of dollars)*
LIABILITIES
Debt instruments
Long-term debt (a)	$	4,850	$	—	$	4,289	$	561
Transition Bonds (b)		284		—		284		—
Long-term project funding		12		—		—		12

	$	5,146	$	—	$	4,573	$	573

(a)	The carrying amount for Long-term debt is $4,456 million as of December 31, 2013.

(b)	The carrying amount for Transition Bonds, including amounts due within one year, is $255 million as of December 31, 2013.


	Fair Value Measurements at December 31, 2012
Description	Total		Quoted Prices in Active Markets for Identical Instruments (Level 1) (a)		Significant Other Observable Inputs (Level 2) (a)		Significant Unobservable Inputs (Level 3)
	*(millions of dollars)*
LIABILITIES
Debt instruments
Long-term debt (b)	$	5,004	$	—	$	4,517	$	487
Transition Bonds (c)		341		—		341		—
Long-term project funding		13		—		—		13

	$	5,358	$	—	$	4,858	$	500

(a)	Certain debt instruments that were categorized as level 1 at December 31, 2012, have been reclassified as level 2 to conform to the current period presentation.

(b)	The carrying amount for Long-term debt is $4,177 million as of December 31, 2012.

(c)	The carrying amount for Transition Bonds, including amounts due within one year, is $295 million as of December 31, 2012.

The carrying amounts of all other financial instruments in the accompanying consolidated financial statements approximate fair value.

Fair Value Disclosures

(11) FAIR VALUE DISCLOSURES

Financial Instruments Measured at Fair Value on a Recurring Basis

Pepco applies FASB guidance on fair value measurement and disclosures (ASC 820) that established a framework for measuring fair value and expanded disclosures about fair value measurements. As defined in the guidance, fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). Pepco utilizes market data or assumptions that market participants would use in pricing the asset or liability, including assumptions about risk and the risks inherent in the inputs to the valuation technique. These inputs can be readily observable, market corroborated or generally unobservable. Accordingly, Pepco utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. The guidance establishes a fair value hierarchy that prioritizes the inputs used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (level 1) and the lowest priority to unobservable inputs (level 3).

The following tables set forth, by level within the fair value hierarchy, Pepco’s financial assets and liabilities that were accounted for at fair value on a recurring basis as of December 31, 2013 and 2012. As required by the guidance, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. Pepco’s assessment of the significance of a particular input to the fair value measurement requires the exercise of judgment, and may affect the valuation of fair value assets and liabilities and their placement within the fair value hierarchy levels.


	Fair Value Measurements at December 31, 2013
Description	Total		Quoted Prices in Active Markets for Identical Instruments (Level 1) (a)		Significant Other Observable Inputs (Level 2) (a)		Significant Unobservable Inputs (Level 3)
	*(millions of dollars)*
ASSETS
Restricted cash equivalents
Treasury fund	$	3	$	3	$	—	$	—
Executive deferred compensation plan assets
Money market funds		13		13		—		—
Life insurance contracts		61		—		43		18

	$	77	$	16	$	43	$	18

LIABILITIES
Executive deferred compensation plan liabilities
Life insurance contracts	$	7	$	—	$	7	$	—

	$	7	$	—	$	7	$	—

(a)	There were no transfers of instruments between level 1 and level 2 valuation categories during the year ended December 31, 2013.


	Fair Value Measurements at December 31, 2012
Description	Total		Quoted Prices in Active Markets for Identical Instruments (Level 1) (a)		Significant Other Observable Inputs (Level 2) (a)		Significant Unobservable Inputs (Level 3)
	*(millions of dollars)*
ASSETS
Executive deferred compensation plan assets
Money market funds	$	15	$	15	$	—	$	—
Life insurance contracts		56		—		38		18

	$	71	$	15	$	38	$	18

LIABILITIES
Executive deferred compensation plan liabilities
Life insurance contracts	$	9	$	—	$	9	$	—

	$	9	$	—	$	9	$	—

(a)	There were no transfers of instruments between level 1 and level 2 valuation categories during the year ended December 31, 2012.

Pepco classifies its fair value balances in the fair value hierarchy based on the observability of the inputs used in the fair value calculation as follows:

Level 1 – Quoted prices are available in active markets for identical assets or liabilities as of the reporting date. Active markets are those in which transactions for the asset or liability occur in sufficient frequency and volume to provide pricing information on an ongoing basis.

Level 2 – Pricing inputs are other than quoted prices in active markets included in level 1, which are either directly or indirectly observable as of the reporting date. Level 2 includes those financial instruments that are valued using broker quotes in liquid markets and other observable data. Level 2 also includes those financial instruments that are valued using methodologies that have been corroborated by observable market data through correlation or by other means. Significant assumptions are observable in the marketplace throughout the full term of the instrument and can be derived from observable data or are supported by observable levels at which transactions are executed in the marketplace.

Executive deferred compensation plan assets and liabilities categorized as level 2 consist of life insurance policies and certain employment agreement obligations. The life insurance policies are categorized as level 2 assets because they are valued based on the assets underlying the policies, which consist of short-term cash equivalents and fixed income securities that are priced using observable market data and can be liquidated for the value of the underlying assets as of December 31, 2013. The level 2 liability associated with the life insurance policies represents a deferred compensation obligation, the value of which is tracked via underlying insurance sub-accounts. The sub-accounts are designed to mirror existing mutual funds and money market funds that are observable and actively traded.

The value of certain employment agreement obligations (which are included in life insurance contracts in the tables above) is derived using a discounted cash flow valuation technique. The discounted cash flow calculations are based on a known and certain stream of payments to be made over time that are discounted to determine their net present value. The primary variable input, the discount rate, is based on market-corroborated and observable published rates. These obligations have been classified as level 2 within the fair value hierarchy because the payment streams represent contractually known and certain amounts and the discount rate is based on published, observable data.

Level 3 – Pricing inputs that are significant and generally less observable than those from objective sources. Level 3 includes those financial instruments that are valued using models or other valuation methodologies.

Executive deferred compensation plan assets include certain life insurance policies that are valued using the cash surrender value of the policies, net of loans against those policies. The cash surrender values do not represent a quoted price in an active market; therefore, those inputs are unobservable and the policies are categorized as level 3. Cash surrender values are provided by third parties and reviewed by Pepco for reasonableness.

Reconciliations of the beginning and ending balances of Pepco’s fair value measurements using significant unobservable inputs (Level 3) for the years ended December 31, 2013 and 2012 are shown below.


	Life Insurance Contracts
	Year Ended December 31,
	2013			2012
	*(millions of dollars)*
Balance as of January 1	$	18		$	17
Total gains (losses) (realized and unrealized):
Included in income		4			4
Included in accumulated other comprehensive loss		—			—
Purchases		—			—
Issuances		(3	)		(3	)
Settlements		(1	)		—
Transfers in (out) of level 3		—			—

Balance as of December 31	$	18		$	18

The breakdown of realized and unrealized gains on level 3 instruments included in income as a component of Other operation and maintenance expense for the periods below were as follows:


	Year Ended December 31,
	2013		2012
	*(millions of dollars)*
Total gains included in income for the period	$	4	$	4

Change in unrealized gains relating to assets still held at reporting date	$	4	$	4

Other Financial Instruments

The estimated fair values of Pepco’s Long-term debt instruments that are measured at amortized cost in Pepco’s financial statements and the associated level of the estimates within the fair value hierarchy as of December 31, 2013 and 2012 are shown in the tables below. As required by the fair value measurement guidance, debt instruments are classified in their entirety within the fair value hierarchy based on the lowest level of input that is significant to the fair value measurement. Pepco’s assessment of the significance of a particular input to the fair value measurement requires the exercise of judgment, which may affect the valuation of fair value debt instruments and their placement within the fair value hierarchy levels.

The fair value of Long-term debt categorized as level 2 is based on a blend of quoted prices for the debt and quoted prices for similar debt on the measurement date. The blend places more weight on current pricing information when determining the final fair value measurement. The fair value information is provided by brokers and Pepco reviews the methodologies and results.


	Fair Value Measurements at December 31, 2013
Description	Total		Quoted Prices in Active Markets for Identical Instruments (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	*(millions of dollars)*
LIABILITIES
Debt instruments
Long-term debt (a)	$	2,127	$	—	$	2,127	$	—

	$	2,127	$	—	$	2,127	$	—

(a)	The carrying amount for Long-term debt is $1,899 million as of December 31, 2013.


	Fair Value Measurements at December 31, 2012
Description	Total		Quoted Prices in Active Markets for Identical Instruments (Level 1)(a)		Significant Other Observable Inputs (Level 2)(a)		Significant Unobservable Inputs (Level 3)
	*(millions of dollars)*
LIABILITIES
Debt instruments
Long-term debt (b)	$	2,160	$	—	$	2,160	$	—

	$	2,160	$	—	$	2,160	$	—

(a)	Certain debt instruments that were categorized as level 1 at December 31, 2012, have been reclassified as level 2 to conform to the current period presentation.

(b)	The carrying amount for Long-term debt is $1,701 million as of December 31, 2012.

The carrying amount of all other financial instruments in the accompanying financial statements approximate fair value.

Fair Value Disclosures

(13) FAIR VALUE DISCLOSURES

Financial Instruments Measured at Fair Value on a Recurring Basis

DPL applies FASB guidance on fair value measurement and disclosures (ASC 820) that established a framework for measuring fair value and expanded disclosures about fair value measurements. As defined in the guidance, fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). DPL utilizes market data or assumptions that market participants would use in pricing the asset or liability, including assumptions about risk and the risks inherent in the inputs to the valuation technique. These inputs can be readily observable, market corroborated or generally unobservable. Accordingly, DPL utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. The guidance establishes a fair value hierarchy that prioritizes the inputs used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (level 1) and the lowest priority to unobservable inputs (level 3).

The following tables set forth, by level within the fair value hierarchy, DPL’s financial assets and liabilities that were accounted for at fair value on a recurring basis as of December 31, 2013 and 2012. As required by the guidance, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. DPL’s assessment of the significance of a particular input to the fair value measurement requires the exercise of judgment, and may affect the valuation of fair value assets and liabilities and their placement within the fair value hierarchy levels.


	Fair Value Measurements at December 31, 2013
Description	Total		Quoted Prices in Active Markets for Identical Instruments (Level 1) (a)		Significant Other Observable Inputs (Level 2) (a)		Significant Unobservable Inputs (Level 3)
	*(millions of dollars)*
ASSETS
Derivative instruments (b)
Natural gas (c)	$	1	$	1	$	—	$	—
Executive deferred compensation plan assets
Money market funds		1		1		—		—
Life insurance contracts		1		—		—		1

	$	3	$	2	$	—	$	1

LIABILITIES
Executive deferred compensation plan assets
Life insurance contracts	$	1	$	—	$	1	$	—

	$	1	$	—	$	1	$	—

(a)	There were no transfers of instruments between level 1 and level 2 valuation categories during the year ended December 31, 2013.

(b)	The fair value of derivative assets reflect netting by counterparty before the impact of collateral.

(c)	Represents natural gas swaps purchased by DPL as part of a natural gas hedging program approved by the DPSC.


	Fair Value Measurements at December 31, 2012
Description	Total		Quoted Prices in Active Markets for Identical Instruments (Level 1) (a)		Significant Other Observable Inputs (Level 2) (a)		Significant Unobservable Inputs (Level 3)
	*(millions of dollars)*
ASSETS
Executive deferred compensation plan assets
Money market funds	$	2	$	2	$	—	$	—
Life insurance contracts		1		—		—		1

	$	3	$	2	$	—	$	1

LIABILITIES
Derivative instruments (b)
Natural gas (c)	$	4	$	—	$	—	$	4

	$	4	$	—	$	—	$	4

(a)	There were no transfers of instruments between level 1 and level 2 valuation categories during the year ended December 31, 2012.

(b)	The fair value of derivative liabilities reflect netting by counterparty before the impact of collateral.

(c)	Represents natural gas options purchased by DPL as part of a natural gas hedging program approved by the DPSC.

DPL classifies its fair value balances in the fair value hierarchy based on the observability of the inputs used in the fair value calculation as follows:

Level 1 – Quoted prices are available in active markets for identical assets or liabilities as of the reporting date. Active markets are those in which transactions for the asset or liability occur in sufficient frequency and volume to provide pricing information on an ongoing basis, such as the New York Mercantile Exchange (NYMEX).

Level 2 – Pricing inputs are other than quoted prices in active markets included in level 1, which are either directly or indirectly observable as of the reporting date. Level 2 includes those financial instruments that are valued using broker quotes in liquid markets and other observable data. Level 2 also includes those financial instruments that are valued using methodologies that have been corroborated by observable market data through correlation or by other means. Significant assumptions are observable in the marketplace throughout the full term of the instrument and can be derived from observable data or are supported by observable levels at which transactions are executed in the marketplace.

Level 2 executive deferred compensation plan liabilities associated with the life insurance policies represent a deferred compensation obligation, the value of which is tracked via underlying insurance sub-accounts. The sub-accounts are designed to mirror existing mutual funds and money market funds that are observable and actively traded.

Level 3 – Pricing inputs that are significant and generally less observable than those from objective sources. Level 3 includes those financial instruments that are valued using models or other valuation methodologies.

Derivative instruments categorized as level 3 represent natural gas options used by DPL as part of a natural gas hedging program approved by the DPSC. DPL applies a Black-Scholes model to value its options with inputs, such as forward price curves, contract prices, contract volumes, the risk-free rate and implied volatility factors that are based on a range of historical NYMEX option prices. DPL maintains valuation policies and procedures and reviews the validity and relevance of the inputs used to estimate the fair value of its options. As of December 31, 2013, all of these contracts classified as level 3 derivative instruments have settled.

The table below summarizes the primary unobservable input used to determine the fair value of DPL’s level 3 instruments and the range of values that could be used for the input as of December 31, 2012:

Type of Instrument

Fair Value at
December 31, 2012

Valuation Technique

Unobservable Input

Range

(millions of dollars)

Natural gas options

$

(4

)

Option model

Volatility factor

1.57 – 2.00

DPL used values within this range as part of its fair value estimates. A significant change in the unobservable input within this range would have an insignificant impact on the reported fair value as of December 31, 2012.

Executive deferred compensation plan assets include certain life insurance policies that are valued using the cash surrender value of the policies, net of loans against those policies. The cash surrender values do not represent a quoted price in an active market; therefore, those inputs are unobservable and the policies are categorized as level 3. Cash surrender values are provided by third parties and reviewed by DPL for reasonableness.

Reconciliations of the beginning and ending balances of DPL’s fair value measurements using significant unobservable inputs (Level 3) for the years ended December 31, 2013 and 2012 are shown below:


	Year Ended December 31, 2013					Year Ended December 31, 2012
	Natural Gas			Life Insurance Contracts		Natural Gas			Life Insurance Contracts
	*(millions of dollars)*
Balance as of January 1	$	(4	)	$	1	$	(15	)	$	1
Total gains (losses) (realized and unrealized):
Included in income		—			—		—			—
Included in accumulated other comprehensive loss		—			—		—			—
Included in regulatory liabilities		—			—		(2	)		—
Purchases		—			—		—			—
Issuances		—			—		—			—
Settlements		4			—		13			—
Transfers in (out) of Level 3		—			—		—			—

Balance as of December 31	$	—		$	1	$	(4	)	$	1

Other Financial Instruments

The estimated fair values of DPL’s Long-term debt instruments that are measured at amortized cost in DPL’s financial statements and the associated level of the estimates within the fair value hierarchy as of December 31, 2013 and 2012 are shown in the tables below. As required by the fair value measurement guidance, debt instruments are classified in their entirety within the fair value hierarchy based on the lowest level of input that is significant to the fair value measurement. DPL’s assessment of the significance of a particular input to the fair value measurement requires the exercise of judgment, which may affect the valuation of fair value debt instruments and their placement within the fair value hierarchy levels.

The fair value of Long-term debt categorized as level 2 is based on a blend of quoted prices for the debt and quoted prices for similar debt on the measurement date. The blend places more weight on current pricing information when determining the final fair value measurement. The fair value information is provided by brokers and DPL reviews the methodologies and results.

The fair value of Long-term debt categorized as level 3 is based on a discounted cash flow methodology using observable inputs, such as the U.S. Treasury yield, and unobservable inputs, such as credit spreads, because quoted prices for the debt or similar debt in active markets were insufficient.


	Fair Value Measurements at December 31, 2013
Description	Total		Quoted Prices in Active Markets for Identical Instruments (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	*(millions of dollars)*
LIABILITIES
Debt instruments
Long-term debt (a)	$	960	$	—	$	850	$	110

	$	960	$	—	$	850	$	110

(a)	The carrying amount for Long-term debt is $967 million as of December 31, 2013.


	Fair Value Measurements at December 31, 2012
Description	Total		Quoted Prices in Active Markets for Identical Instruments (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	*(millions of dollars)*
LIABILITIES
Debt instruments
Long-term debt (a)	$	990	$	—	$	877	$	113

	$	990	$	—	$	877	$	113

(a)	The carrying amount for Long-term debt is $917 million as of December 31, 2012.

The carrying amounts of all other financial instruments in the accompanying financial statements approximate fair value.

Fair Value Disclosures

(12) FAIR VALUE DISCLOSURES

Financial Instruments Measured at Fair Value on a Recurring Basis

ACE applies FASB guidance on fair value measurement and disclosures (ASC 820) that established a framework for measuring fair value and expanded disclosures about fair value measurements. As defined in the guidance, fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). ACE utilizes market data or assumptions that market participants would use in pricing the asset or liability, including assumptions about risk and the risks inherent in the inputs to the valuation technique. These inputs can be readily observable, market corroborated, or generally unobservable. Accordingly, ACE utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. The guidance establishes a fair value hierarchy that prioritizes the inputs used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (level 1) and the lowest priority to unobservable inputs (level 3).

The following tables set forth by level within the fair value hierarchy ACE’s financial assets and liabilities that were accounted for at fair value on a recurring basis as of December 31, 2013 and 2012. As required by the guidance, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. ACE’s assessment of the significance of a particular input to the fair value measurement requires the exercise of judgment, and may affect the valuation of fair value assets and liabilities and their placement within the fair value hierarchy levels.


	Fair Value Measurements at December 31, 2013
Description	Total		Quoted Prices in Active Markets for Identical Instruments (Level 1) (a)		Significant Other Observable Inputs (Level 2) (a)		Significant Unobservable Inputs (Level 3)
	*(millions of dollars)*
ASSETS
Restricted cash equivalents
Treasury fund	$	24	$	24	$	—	$	—

	$	24	$	24	$	—	$	—

(a)	There were no transfers of instruments between level 1 and level 2 valuation categories during the year ended December 31, 2013.


	Fair Value Measurements at December 31, 2012
Description	Total		Quoted Prices in Active Markets for Identical Instruments (Level 1) (a)		Significant Other Observable Inputs (Level 2) (a)		Significant Unobservable Inputs (Level 3)
	*(millions of dollars)*
ASSETS
Derivative instruments (b)
Capacity (c)	$	8	$	—	$	—	$	8
Restricted cash equivalents
Treasury fund		27		27		—		—

	$	35	$	27	$	—	$	8

LIABILITIES
Derivative instruments (b)
Capacity (c)	$	11	$	—	$	—	$	11
Executive deferred compensation plan liabilities
Life insurance contracts		1		—		1		—

	$	12	$	—	$	1	$	11

(a)	There were no transfers of instruments between level 1 and level 2 valuation categories during the year ended December 31, 2012.

(b)	The fair value of derivative assets and liabilities reflect netting by counterparty before the impact of collateral.

(c)	Represents derivatives associated with ACE SOCAs.

ACE classifies its fair value balances in the fair value hierarchy based on the observability of the inputs used in the fair value calculation as follows:

Level 1 – Quoted prices are available in active markets for identical assets or liabilities as of the reporting date. Active markets are those in which transactions for the asset or liability occur in sufficient frequency and volume to provide pricing information on an ongoing basis.

Level 2 – Pricing inputs are other than quoted prices in active markets included in level 1, which are either directly or indirectly observable as of the reporting date. Level 2 includes those financial instruments that are valued using broker quotes in liquid markets and other observable data. Level 2 also includes those financial instruments that are valued using methodologies that have been corroborated by observable market data through correlation or by other means. Significant assumptions are observable in the marketplace throughout the full term of the instrument and can be derived from observable data or are supported by observable levels at which transactions are executed in the marketplace.

The level 2 liability associated with the life insurance policies represents a deferred compensation obligation, the value of which is tracked via underlying insurance sub-accounts. The sub-accounts are designed to mirror existing mutual funds and money market funds that are observable and actively traded.

Level 3 – Pricing inputs that are significant and generally less observable than those from objective sources. Level 3 includes those financial instruments that are valued using models or other valuation methodologies.

Derivative instruments categorized as level 3 represent capacity under the SOCAs entered into by ACE.

ACE used a discounted cash flow methodology to estimate the fair value of the capacity derivatives embedded in the SOCAs. ACE utilized an external consulting firm to estimate annual zonal PJM capacity prices through the 2030-2031 auction. The capacity price forecast was based on various assumptions that impact the cost of constructing new generation facilities, including zonal load forecasts, zonal fuel and energy prices, generation capacity and transmission planning, and environmental legislation and regulation. ACE reviewed the assumptions and resulting capacity price forecast for reasonableness. ACE used the capacity price forecast to estimate future cash flows. A significant change in the forecasted prices would have a significant impact on the estimated fair value of the SOCAs. ACE employed a discount rate reflective of the estimated weighted average cost of capital for merchant generation companies since payments under the SOCAs are contingent on providing generation capacity. As further discussed in Note (6), “Regulatory Matters,” ACE derecognized the derivative assets and derivative liabilities related to the SOCAs in the fourth quarter of 2013.

The table below summarizes the primary unobservable input used to determine the fair value of ACE’s level 3 instruments and the range of values that could be used for the input as of December 31, 2012:

Type of Instrument

Fair Value at
December 31, 2012

Valuation Technique

Unobservable Input

Range

(millions of dollars)

Capacity contracts, net

$

(3

)

Discounted cash flow

Discount rate

5% - 9%

ACE used a value within this range as part of its fair value estimates. A significant change in the unobservable input within this range would have an insignificant impact on the reported fair value as of December 31, 2012.

A reconciliation of the beginning and ending balances of ACE’s fair value measurements using significant unobservable inputs (level 3) for the years ended December 31, 2013 and 2012 are shown below:


	Capacity
	Year Ended December 31,
	2013			2012
	*(millions of dollars)*			*(millions of dollars)*
Balance as of January 1	$	(3	)	$	—
Total gains (losses) (realized and unrealized):
Included in income		—			—
Included in accumulated other comprehensive loss		—			—
Included in regulatory liabilities and regulatory assets		3			(3	)
Purchases		—			—
Issuances		—			—
Settlements		—			—
Transfers in (out) of level 3		—			—

Balance as of December 31	$	—		$	(3	)

Other Financial Instruments

The estimated fair values of ACE’s Long-term debt instruments that are measured at amortized cost in ACE’s consolidated financial statements and the associated level of the estimates within the fair value hierarchy as of December 31, 2013 and 2012 are shown in the table below. As required by the fair value measurement guidance, debt instruments are classified in their entirety within the fair value hierarchy based on the lowest level of input that is significant to the fair value measurement. ACE’s assessment of the significance of a particular input to the fair value measurement requires the exercise of judgment, which may affect the valuation of fair value debt instruments and their placement within the fair value hierarchy levels.

The fair value of Long-term debt and Transition Bonds categorized as level 2 is based on a blend of quoted prices for the debt and quoted prices for similar debt on the measurement date. The blend places more weight on current pricing information when determining the final fair value measurement. The fair value information is provided by brokers and ACE reviews the methodologies and results.

The fair value of Long-term debt categorized as level 3 is based on a discounted cash flow methodology using observable inputs, such as the U.S. Treasury yield, and unobservable inputs, such as credit spreads, because quoted prices for the debt or similar debt in active markets were insufficient.


	Fair Value Measurements at December 31, 2013
Description	Total		Quoted Prices in Active Markets for Identical Instruments (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	*(millions of dollars)*
LIABILITIES
Debt instruments
Long-term debt (a)	$	959	$	—	$	744	$	215
Transition Bonds (b)		285		—		285		—

	$	1,244	$	—	$	1,029	$	215

(a)	The carrying amount for Long-term debt is $860 million as of December 31, 2013.

(b)	The carrying amount for Transition Bonds, including amounts due within one year, is $255 million as of December 31, 2013.


	Fair Value Measurements at December 31, 2012
Description	Total		Quoted Prices in Active Markets for Identical Instruments (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	*(millions of dollars)*
LIABILITIES
Debt instruments
Long-term debt (a)	$	1,016	$	—	$	884	$	132
Transition Bonds (b)		341		—		341		—

	$	1,357	$	—	$	1,225	$	132

(a)	The carrying amount for Long-term debt is $829 million as of December 31, 2012.

(b)	The carrying amount for Transition Bonds, including amounts due within one year, is $295 million as of December 31, 2012.

The carrying amounts of all other financial instruments in the accompanying consolidated financial statements approximate fair value.