Derivative Instruments and Hedging Activities

12 Months Ended

Dec. 31, 2011

Derivative Instruments and Hedging Activities Disclosure [Abstract]

Derivative Instruments and Hedging Activities

Derivative Instruments and Hedging Activities

EME uses derivative instruments to reduce its exposure to market risks that arise from price fluctuations of electricity, capacity, fuel, emission allowances, transmission rights and interest rates. The derivative financial instruments vary in duration, ranging from a few days to several years, depending upon the instrument. To the extent that EME does not use derivative instruments to hedge these market risks, the unhedged portions will be subject to the risks and benefits of spot market price movements.

Risk management positions may be designated as cash flow hedges or economic hedges, which are derivatives that are not designated as cash flow hedges. Economic hedges are accounted for at fair value on EME's consolidated balance sheets as derivative assets or liabilities with offsetting changes recorded on the consolidated statements of operations. For derivative instruments that qualify for hedge accounting treatment, the fair value is recognized on EME's consolidated balance sheets as derivative assets or liabilities with offsetting changes in fair value, to the extent effective, recognized in accumulated other comprehensive loss until reclassified into earnings when the related forecasted transaction occurs. The portion of a cash flow hedge that does not offset the change in the fair value of the transaction being hedged, which is commonly referred to as the ineffective portion, is immediately recognized in earnings.

Derivative instruments that are utilized for trading purposes are measured at fair value and included on the consolidated balance sheets as derivative assets or liabilities, with offsetting changes recognized in operating revenues on the consolidated statements of operations.

The results of derivative activities are recorded in cash flows from operating activities on the consolidated statements of cash flows.

Where EME's derivative instruments are subject to a master netting agreement and the criteria of authoritative guidance are met, EME presents its derivative assets and liabilities on a net basis on its consolidated balance sheets.

Notional Volumes of Derivative Instruments

The following table summarizes the notional volumes of derivatives used for hedging and trading activities:

December 31, 2011
				Hedging Activities
Commodity	Instrument	Classification	Unit of Measure	Cash Flow Hedges		Economic Hedges		Trading Activities
Electricity	Forwards/Futures	Sales, net	GWh	8,320	1	425	3	—
Electricity	Forwards/Futures	Purchases, net	GWh	—		—		2,926
Electricity	Capacity	Sales, net	MW-Day (in thousands)	89	2	—		—
Electricity	Capacity	Purchases, net	MW-Day (in thousands)	—		—		184	2
Electricity	Congestion	Purchases, net	GWh	—		2,528	4	230,798	4
Natural gas	Forwards/Futures	Sales, net	bcf	—		—		0.2
Fuel oil	Forwards/Futures	Purchases, net	barrels	—		240,000		—

At December 31, 2011, EME had interest rate contracts with notional values totaling $644 million that converted floating rate LIBOR-based debt to fixed rates ranging from 0.79% to 4.29%. These contracts expire May 2013 through March 2026. In addition, EME had forward starting interest rate contracts with notional values totaling $506 million that will convert floating rate LIBOR-based debt to fixed rates of 3.5429%, 3.57% and 4.0025%. These contracts have effective dates of June 2013 and December 2021 and expire May 2023 and December 2029.

December 31, 2010
				Hedging Activities
Commodity	Instrument	Classification	Unit of Measure	Cash Flow Hedges		Economic Hedges		Trading Activities
Electricity	Forwards/Futures	Sales, net	GWh	16,391	1	—		—
Electricity	Forwards/Futures	Purchases, net	GWh	—		475	3	3,039
Electricity	Capacity	Sales, net	MW-Day (in thousands)	182	2	—		—
Electricity	Capacity	Purchases, net	MW-Day (in thousands)	—		—		283	2
Electricity	Congestion	Purchases, net	GWh	—		1,007	4	175,669	4
Natural gas	Forwards/Futures	Purchases, net	bcf	—		—		3.7
Fuel oil	Forwards/Futures	Purchases, net	barrels	—		240,000		—
Coal	Forwards/Futures	Purchases, net	tons	—		—		15,000

¹  EME's hedge products include forward and futures contracts that qualify for hedge accounting. This category excludes power contracts for the coal plants which meet the normal purchases and sales exception and are accounted for on the accrual method.

²  EME's hedge transactions for capacity result from bilateral trades. Capacity sold in the PJM Reliability Pricing Model (RPM) auction is not accounted for as a derivative.

³  These positions adjust financial and physical positions, or day-ahead and real-time positions, to reduce costs or increase gross margin. The net sales positions of these categories are primarily related to hedge transactions that are not designated as cash flow hedges.

⁴  Congestion contracts include financial transmission rights, transmission congestion contracts or congestion revenue rights. These positions are similar to a swap, where the buyer is entitled to receive a stream of revenues (or charges) based on the hourly day-ahead price differences between two locations.

At December 31, 2010, EME had interest rate contracts with notional values totaling $328 million that converted floating rate LIBOR-based debt to fixed rates ranging from 3.175% to 4.29%. These contracts expire June 2016 through March 2026.

Included in trading activities in the preceding table, EME shows net the volume of energy trading activities that are physically settled. Gross purchases and sales totaled 3,332 GWh, 3,944 GWh and 3,791 GWh during 2011, 2010 and 2009, respectively.

Fair Value of Derivative Instruments

The following table summarizes the fair value of derivative instruments reflected on EME's consolidated balance sheets:

December 31, 2011
	Derivative Assets									Derivative Liabilities
(in millions)	Short-term			Long-term			Subtotal			Short-term			Long-term			Subtotal			Net Assets (Liabilities)
Non-trading activities
Cash flow hedges
Commodity contracts	$	41		$	1		$	42		$	2		$	3		$	5		$	37
Interest rate contracts	—			—			—			—			90			90			(90		)
Economic hedges	31			1			32			26			1			27			5
Trading activities	276			142			418			232			79			311			107
	348			144			492			260			173			433			59
Netting and collateral received1	(308		)	(85		)	(393		)	(259		)	(83		)	(342		)	(51		)
Total	$	40		$	59		$	99		$	1		$	90		$	91		$	8

December 31, 2010
	Derivative Assets									Derivative Liabilities
(in millions)	Short-term			Long-term			Subtotal			Short-term			Long-term			Subtotal			Net Assets (Liabilities)
Non-trading activities
Cash flow hedges
Commodity contracts	$	54		$	2		$	56		$	10		$	9		$	19		$	37
Interest rate contracts	—			—			—			—			16			16			(16		)
Economic hedges	77			2			79			71			—			71			8
Trading activities	184			103			287			148			29			177			110
	315			107			422			229			54			283			139
Netting and collateral received1	(269		)	(37		)	(306		)	(223		)	(35		)	(258		)	(48		)
Total	$	46		$	70		$	116		$	6		$	19		$	25		$	91

¹  Netting of derivative receivables and derivative payables and the related cash collateral received and paid is permitted when a legally enforceable master netting agreement exists with a derivative counterparty.

Income Statement Impact of Derivative Instruments

The following table provides the cash flow hedge activity as part of accumulated other comprehensive loss:

	Cash Flow Hedge Activity1
	2011						2010
(in millions)	Commodity Contracts			Interest Rate Contracts			Commodity Contracts			Interest Rate Contracts			Income Statement Location
Beginning of period derivative gains (losses)	$	43		$	(16	)	$	177		$	(2	)
Effective portion of changes in fair value	55			(74		)	106			(14		)
Reclassification to earnings	(63		)	—			(240		)	—			Operating revenues
End of period derivative gains (losses)	$	35		$	(90	)	$	43		$	(16	)

¹  Unrealized derivative gains (losses) are before income taxes. The after-tax amounts recorded in accumulated other comprehensive loss at December 31, 2011 and 2010 for commodity and interest rate contracts were $21 million and $(55) million and $26 million and $(10) million, respectively.

For additional information, see Note 11—Accumulated Other Comprehensive Income (Loss).

EME recorded net gains (losses) of $11 million, $(4) million and $24 million in 2011, 2010 and 2009, respectively, in operating revenues on the consolidated statements of operations representing the amount of cash flow hedge ineffectiveness.

The effect of realized and unrealized gains (losses) from derivative instruments used for economic hedging and trading purposes on the consolidated statements of operations is presented below:

		Years Ended December 31,
(in millions)	Income Statement Location	2011		2010
Economic hedges	Operating revenues	$	21	$	8
	Fuel	3		2
Trading activities	Operating revenues	76		114

Energy Trading Derivative Instruments

The change in the fair value of energy trading derivative instruments was as follows:

(in millions)	2011			2010
Fair value of trading contracts at beginning of period	$	110		$	122
Net gains from energy trading activities	76			114
Amount realized from energy trading activities	(84		)	(131		)
Other changes in fair value	5			5
Fair value of trading contracts at end of period	$	107		$	110

Contingent Features

Certain derivative instruments contain margin and collateral deposit requirements. Since EME's and its subsidiaries' credit ratings are below investment grade, EME and its subsidiaries have provided collateral in the form of cash and letters of credit for the benefit of derivative counterparties. Future increases in power prices could expose EME, Midwest Generation or EMMT to additional collateral postings. Furthermore, EMMT has hedge contracts that do not require margin, but contain the right of each party to request additional credit support in the form of adequate assurance of performance in the case of adverse development affecting the other party.

Margin and Collateral Deposits

Margin and collateral deposits include cash deposited with counterparties and brokers as credit support under energy contracts. The amount of margin and collateral deposits generally varies based on changes in fair value of the related positions. EME nets counterparty receivables and payables where balances exist under master netting arrangements. EME presents the portion of its margin and collateral deposits netted with its derivative positions on its consolidated balance sheets. The following table summarizes margin and collateral deposits provided to and received from counterparties:

	December 31,
(in millions)	2011		2010
Collateral provided to counterparties
Offset against derivative liabilities	$	2	$	4
Reflected in margin and collateral deposits	41		59
Collateral received from counterparties
Offset against derivative assets	53		52

Commodity Price Risk Management

EME's merchant operations are exposed to commodity price risk, which reflects the potential impact of a change in the market value of a particular commodity. Commodity price risks are actively monitored, with oversight provided by a risk management committee, to ensure compliance with EME's risk management policies. EME uses estimates of the variability in gross margin to help identify, measure, monitor and control its overall market risk exposure and earnings volatility with respect to hedge positions at the coal plants and the merchant wind projects, and uses "value at risk" metrics to help identify, measure, monitor and control its overall risk exposure in respect to its trading positions. These measures allow management to aggregate overall commodity risk, compare risk on a consistent basis and identify changes in risk factors. Value at risk measures the possible loss, and variability in gross margin measures the potential change in value, of an asset or position, in each case over a given time interval, under normal market conditions, at a given confidence level. Given the inherent limitations of these measures and reliance on a single type of risk measurement tool, EME supplements these approaches with the use of stress testing and worst-case scenario analysis for key risk factors, as well as stop-loss triggers and volumetric exposure limits. When appropriate, EME manages the spread between the electric prices and fuel prices, and uses forward contracts, swaps, futures, or options contracts to achieve those objectives.

Interest Rate Risk Management

Interest rate changes affect the cost of capital needed to operate EME's projects. EME mitigates the risk of interest rate fluctuations by arranging for fixed rate financing or variable rate financing with interest rate swaps, interest rate options or other hedging mechanisms for a number of EME's project financings.

Credit Risk

In conducting EME's hedging and trading activities, EME enters into transactions with utilities, energy companies, financial institutions, and other companies, collectively referred to as counterparties. In the event a counterparty were to default on its trade obligation, EME would be exposed to the risk of possible loss associated with market price changes occurring since the original contract was executed if the nonperforming counterparty were unable to pay the resulting damages owed to EME. Further, EME would be exposed to the risk of non-payment of accounts receivable accrued for products delivered prior to the time a counterparty defaulted.

Credit risk is measured as the loss that EME would expect to incur if a counterparty failed to perform pursuant to the terms of its contractual obligations. To manage credit risk, EME evaluates the risk of potential defaults by counterparties. To mitigate credit risk from counterparties, master netting agreements are used whenever possible and counterparties may be required to pledge collateral when deemed necessary.

The majority of EME's consolidated wind projects and unconsolidated affiliates that own power plants sell power under power purchase agreements. Generally, each project or plant sells its output to one counterparty. A default by the counterparty, including a default as a result of a bankruptcy, would likely have a material adverse effect on the operations of the project or plant.

The majority of the coal for the coal plants is purchased from suppliers under contracts which may be for multiple years. None of the coal suppliers to the coal plants have investment grade credit ratings and, accordingly, EME may have limited recourse to collect damages in the event of default by a supplier.

The coal plants sell electric power generally into the PJM market by participating in PJM's capacity and energy markets or transacting in capacity and energy on a bilateral basis. Sales into PJM accounted for approximately 69%, 66% and 48% of EME's consolidated operating revenues for the years ended December 31, 2011, 2010 and 2009, respectively. Moody's Investors Service, Inc. (Moody's) rates PJM's debt Aa3. PJM, a regional transmission organization (RTO) with over 300 member companies, maintains its own credit risk policies and does not extend unsecured credit to non-investment grade companies. Losses resulting from a PJM member default are shared by all other members using a predetermined formula. At December 31, 2011 and 2010, EME's account receivable due from PJM was $62 million and $64 million, respectively.

For the years ended December 31, 2011 and 2010, a second customer, Constellation Energy Commodities Group, Inc. accounted for less than 10% and, in 2009, 16% of EME's consolidated operating revenues. Sales to Constellation are primarily generated from the coal plants and consist of energy sales under forward contracts. The contract with Constellation is guaranteed by Constellation Energy Group, Inc., which has a senior unsecured debt rating of BBB- by Standard & Poor's Ratings Services (S&P) and Baa3 by Moody's. At December 31, 2011 and 2010, EME's account receivable due from Constellation was $7 million and $32 million, respectively.