Derivative Instruments and Hedging Activities (EME, Midwest Generation)

EME and Midwest Generation use derivative instruments to reduce their 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 and Midwest Generation do 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 and Midwest Generation'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 and Midwest Generation's consolidated balance sheets as derivative assets or liabilities with offsetting changes in fair value, to the extent effective, recognized in AOCI 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. The results of derivative activities are recorded in cash flows from operating activities on the consolidated statements of cash flows.

Derivative instruments that are utilized by EME 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.

Where EME's and Midwest Generation's derivative instruments are subject to a master netting agreement or contain collateral deposit requirements and the criteria of authoritative guidance are met, EME presents its derivative assets and liabilities on a net basis on its consolidated balance sheets. EME's and Midwest Generation's master netting agreements allow for the right of offset for contracts with physical settlement. They do not allow for cross commodity settlement unless all positions are liquidated.

Since EME's and Midwest Generation's 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 and brokers. The amount of margin and collateral deposits generally varies based on changes in fair value of the related positions. Future changes in power prices could expose EME and Midwest Generation to additional collateral postings.

EME's and Midwest Generation's approach to trading and risk management depends, in part, on the ability to use clearing brokers to enter into market transactions. As a result of their financial position, EME and Midwest Generation have limited access to enter into such transactions and have been subject to increased initial collateral and margin requirements. There is no assurance that EME and Midwest Generation will continue to be able to utilize clearing brokers. If EME and Midwest Generation become unable to utilize clearing brokers, they may seek to execute bilateral transactions with third parties which could be unavailable on commercially reasonable terms or at all.

Notional Volumes of Derivative Instruments

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



				June 30, 2013
				Cash Flow Hedges			Economic Hedges				Trading Activities
Commodity	Instrument	Classification	Unit of Measure	Midwest Generation	Other EME Sub- sidiaries	EME	Midwest Generation	Other EME Sub- sidiaries	EME		Other EME Sub- sidiaries
Electricity	Forwards/ Futures	Sales, net	GWh¹	1,816	—	1,816	19	29	48	²	—
Electricity	Forwards/ Futures	Purchases, net	GWh	—	—	—	—	—	—		334
Electricity	Congestion	Purchases, net	GWh	—	—	—	—	151	151	⁴	296,064	⁴
Fuel oil	Forwards/Futures	Sales, net	barrels	—	—	—	—	—	—		45,000
Weather	Forwards/ Futures	Purchases, net	CDD¹	—	—	—	—	—	—		20,000



				December 31, 2012
				Cash Flow Hedges			Economic Hedges				Trading Activities
Commodity	Instrument	Classification	Unit of Measure	Midwest Generation	Other EME Sub- sidiaries	EME	Midwest Generation	Other EME Sub- sidiaries	EME		Other EME Sub- sidiaries
Electricity	Forwards/Futures	Sales, net	GWh	3,615	—	3,615	1	47	48	²	—
Electricity	Forwards/Futures	Purchases, net	GWh	—	—	—	—	—	—		492
Electricity	Capacity	Purchases, net	GW-Day¹	—	—	—	—	—	—		60	³
Electricity	Congestion	Purchases, net	GWh	—	—	—	—	263	263	⁴	268,529	⁴
Natural gas	Forwards/Futures	Sales, net	bcf¹	—	—	—	—	—	—		9.9


¹	gigawatt-hours (GWh); gigawatts-day (GW-Day); billion cubic feet (bcf); cooling degree day (CDD).


²	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.


³	Hedge transactions for capacity result from bilateral trades. Capacity sold in the PJM Interconnection, LLC Reliability Pricing Model (PJM RPM) auction is not accounted for as a derivative.


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.

EME

Interest Rate Risk Management

EME mitigates the risk of interest rate fluctuations for a number of its project financings by arranging for fixed rate financing or variable rate financing with interest rate swaps, interest rate options, or other hedging mechanisms.

Through June 30, 2013, as a result of the Chapter 11 Cases and the short-term forbearance agreements that had been executed with the lenders and the EME subsidiary borrowers, EME could no longer conclude it was probable that the future interest payments associated with the Viento II Financing would occur. Accordingly, the cash flow hedges associated with these interest rate swaps were prospectively discontinued. EME recorded unrealized gains of $4 million and $5 million during the three and six months ended June 30, 2013, respectively, in interest expense on the consolidated statements of operations representing changes in the fair value of discontinued interest rate swaps. In July 2013, the Viento II Financing was amended to remove the uncertainty around future interest payments. For additional information, see Note 5—Debt and Credit Agreements.

The following table summarizes EME's interest rate swaps:



				Notional Value (in millions)
	Effective Date	Expiration Date	Fixed Swap Rate Paid	June 30, 2013		December 31, 2012
Project Financing
Viento Funding II	June 2009	June 2016	3.18%	$	55	$	65
Viento Funding II	March 2011	December 2020	3.42%	108		108
Cedro Hill	December 2010	December 2025	4.29%	108		112
Laredo Ridge	March 2011	March 2026	3.46%	63		64
Tapestry	December 2011	December 2021	2.21%	184		189
Broken Bow	December 2012	December 2013	0.83%	46		47
Crofton Bluffs	December 2012	December 2013	0.78%	24		24
Walnut Creek Energy¹	November 2011	May 2013	0.81%	—		181
Walnut Creek Energy¹	June 2013	May 2023	3.54%	398		—
WCEP Holdings¹	July 2011	May 2013	0.79%	—		26
WCEP Holdings¹	June 2013	May 2023	4.00%	48		—
Forward Starting Swaps
Broken Bow	December 2013	December 2027	2.96%	45		45
Crofton Bluffs	December 2013	December 2027	2.75%	23		23
Tapestry	December 2021	December 2029	3.57%	60		60


¹	During the second quarter of 2013, the existing interest rate swaps for the Walnut Creek Project expired and, in conjunction with the conversion to term loans, the forward starting swaps became effective.

Summary of Derivative Instruments

The following table summarizes EME's derivative instruments, including amounts offset by collateral and under master netting agreements:



	June 30, 2013
	Short Term							Long Term
(in millions)	Gross		Netting and Collateral			Subtotal		Gross		Netting and Collateral			Subtotal		Net
Assets
Electricity contracts	$	135	$	(94	)	$	41	$	43	$	(21	)	$	22	$	63
Natural gas contracts	27		(27		)	—		3		(3		)	—		—
Coal contracts	1		(1		)	—		—		—			—		—
Total assets	$	163	$	(122	)	$	41	$	46	$	(24	)	$	22	$	63
Liabilities
Electricity contracts	$	96	$	(96	)	$	—	$	20	$	(20	)	$	—	$	—
Natural gas contracts	25		(25		)	—		3		(3		)	—		—
Coal contracts	1		(1		)	—		—		—			—		—
Total derivatives subject to a master netting agreement	$	122	$	(122	)	$	—	$	23	$	(23	)	$	—	$	—
Total derivatives not subject to a master netting agreement¹	—		—			—		68		—			68		68
Total liabilities	$	122	$	(122	)	$	—	$	91	$	(23	)	$	68	$	68

¹EME's interest rate swaps are not subject to master netting agreements and do not require EME to post collateral.



	December 31, 2012
	Short Term							Long Term
(in millions)	Gross		Netting and Collateral			Subtotal		Gross		Netting and Collateral			Subtotal		Net
Assets
Electricity contracts	$	120	$	(67	)	$	53	$	52	$	(15	)	$	37	$	90
Natural gas contracts	33		(33		)	—		1		(1		)	—		—
Coal contracts	2		(2		)	—		—		—			—		—
Total assets	$	155	$	(102	)	$	53	$	53	$	(16	)	$	37	$	90
Liabilities
Electricity contracts	$	71	$	(71	)	$	—	$	15	$	(15	)	$	—	$	—
Natural gas contracts	36		(36		)	—		1		(1		)	—		—
Coal contracts	2		(2		)	—		—		—			—		—
Total derivatives subject to a master netting agreement	$	109	$	(109	)	$	—	$	16	$	(16	)	$	—	$	—
Total derivatives not subject to a master netting agreement¹	—		—			—		118		—			118		118
Total liabilities	$	109	$	(109	)	$	—	$	134	$	(16	)	$	118	$	118


¹	EME's interest rate swaps are not subject to master netting agreements and do not require EME to post collateral.

EME's subsidiaries have posted $89 million and $61 million cash margin in the aggregate with various counterparties at June 30, 2013 and December 31, 2012, respectively, to support hedging and trading activities. The cash margin posted is required by counterparties as an initial collateral deposit and cannot be offset against the fair value of open contracts except in the event of default. EME's exposure is composed of $65 million and $44 million of net accounts receivable at June 30, 2013 and December 31, 2012, respectively. For positions subject to a master netting agreement, EME is in a net asset position, and in the event of default, cash collateral would be returned to EME. EME did not have any collateral received from counterparties as of June 30, 2013 and December 31, 2012.

Income Statement Impact of Derivative Instruments

The following table provides the cash flow hedge activity as part of EME's AOCI:



	Six Months Ended June 30,
	2013						2012
(in millions)	Commodity Contracts			Interest Rate Contracts			Commodity Contracts			Interest Rate Contracts
Beginning of period derivative gains (losses)	$	(1	)	$	(118	)	$	35		$	(90	)
Effective portion of changes in fair value	(3		)	44			19			(24		)
Reclassification to operating revenues	1			—			(33		)	—
Reclassification to interest expense	—			2			—			—
End of period derivative gains (losses)¹	$	(3	)	$	(72	)	$	21		$	(114	)


¹	Unrealized derivative gains (losses) are before income taxes. Amounts recorded in AOCI include commodity and interest rate contracts. For additional information, see Note 11—Accumulated Other Comprehensive Loss.

EME recorded net gains (losses) of $(1) million and none during the second quarter of 2013 and 2012, respectively, and $(1) million and $1 million during the six months ended June 30, 2013 and 2012, respectively, in operating revenues on the consolidated statements of operations representing the amount of cash flow hedge ineffectiveness. EME also reclassified $2 million of unrealized losses in AOCI to interest expense on the consolidated statements of operations in the six months ended June 30, 2013 due to the discontinuation of the Viento II interest rate swaps.

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



		Three Months Ended June 30,						Six Months Ended June 30,
(in millions)	Income Statement Location	2013			2012			2013			2012
Economic hedges	Operating revenues	$	(2	)	$	6		$	(2	)	$	17
	Fuel	—			(6		)	—			(1		)
Trading activities	Operating revenues	13			30			42			50

Midwest Generation

Summary of Derivative Instruments

The following table summarizes Midwest Generation's commodity short-term derivative instruments for non-trading purposes, including amounts offset by collateral and under master netting agreements:



	June 30, 2013							December 31, 2012
(in millions)	Gross		Netting and Collateral			Net		Gross		Netting and Collateral			Net
Assets
Electricity contracts	$	10	$	(9	)	$	1	$	12	$	(10	)	$	2
Liabilities
Electricity contracts	$	14	$	(9	)	$	5	$	13	$	(10	)	$	3

Midwest Generation does not have any long-term derivative assets and liabilities at June 30, 2013 and December 31, 2012.

Income Statement Impact of Derivative Instruments

The following table provides the cash flow hedge activity as part of Midwest Generation's AOCI:



	Six Months Ended June 30,
(in millions)	2013			2012
Beginning of period derivative gains (losses)	$	(2	)	$	34
Effective portion of changes in fair value	(3		)	20
Reclassification to operating revenues	1			(31		)
End of period derivative gains (losses)¹	$	(4	)	$	23


¹	Unrealized derivative gains (losses) are before income taxes. Amounts recorded in AOCI include commodity contracts. For additional information, see Note 11—Accumulated Other Comprehensive Loss.

Midwest Generation recorded net gains (losses) of $(1) million and $1 million during the second quarter of 2013 and 2012, respectively, and $(1) million and $2 million during the six months ended June 30, 2013 and 2012, 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 from derivative instruments used for non-trading purposes on the consolidated statements of operations is presented below:



(in millions)	Income Statement Location	Three Months Ended June 30,						Six Months Ended June 30,
(in millions)	Income Statement Location	2013			2012			2013			2012
Economic hedges	Operating revenues	$	(2	)	$	5		$	(2	)	$	16
	Fuel	—			(6		)	—			(1		)