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:

December 31, 2013

Economic Hedges

Trading Activities

Commodity

Instrument

Classification

Unit of

Measure

Midwest Generation

Other EME Sub- sidiaries

EME

Other EME Sub- sidiaries

Electricity

Forwards/Futures

Sales, net

GWh¹

170

177

—

Electricity

Forwards/Futures

Purchases, net

GWh

—

Electricity

Congestion

Purchases, net

GWh

—

⁴

262,188

⁴



				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-Day	—	—	—	—	—	—		60	³
Electricity	Congestion	Purchases, net	GWh	—	—	—	—	263	263	⁴	268,529	⁴
Natural gas	Forwards/Futures	Purchase, net	bcf	—	—	—	—	—	—		9.9


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


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 July 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 dedesignated. Unrealized gains of $6 million were recorded in interest expense on the consolidated statements of operations during the year ending December 31, 2013 from changes in the fair value of interest rate swaps. In conjunction with the amendment of the Viento II Financing in July 2013, EME entered into new interest rate swaps and re-designated the existing interest rate swaps as cash flow hedges. Interest rate swap termination fees of $6 million were recorded as reduction to derivative liabilities on the consolidated balance sheets. 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		December 31, 2013		December 31, 2012
Project Financing
Viento Funding II	June 2009	June 2016	3.18	%	48		65
Viento Funding II	March 2011	December 2020	3.42	%	30		108
Viento Funding II	July 2013	July 2023	3.03	%	103		—
Cedro Hill	December 2010	December 2025	4.29	%	106		112
Laredo Ridge	March 2011	March 2026	3.46	%	62		64
Tapestry	December 2011	December 2021	2.21	%	181		189
Broken Bow ¹	December 2012	December 2013	0.83	%	—		47
Broken Bow ¹	December 2013	December 2027	2.96	%	45		—
Crofton Bluffs¹	December 2012	December 2013	0.78	%	—		24
Crofton Bluffs¹	December 2013	December 2027	2.75	%	23		—
Walnut Creek Energy²	November 2011	May 2013	0.81	%	—		181
Walnut Creek Energy²	June 2013	May 2023	3.54	%	375		—
WCEP Holdings²	July 2011	May 2013	0.79	%	—		$	26
WCEP Holdings²	June 2013	May 2023	4.00	%	$	48	—
Forward Starting Swaps
Tapestry	December 2021	December 2029	3.57	%	60		60
Viento Funding II	July 2023	June 2028	4.99	%	65		—


¹	During the fourth quarter of 2013, the existing interest rate swaps for the Broken Bow and Crofton Bluffs projects expired and the forward starting swaps became effective.


²	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:



	December 31, 2013
	Short Term							Long Term
(in millions)	Gross		Netting and Collateral			Subtotal		Gross		Netting and Collateral			Subtotal		Net
Assets
Electricity contracts	$	81	$	(37	)	$	44	$	23	$	(10	)	$	13	$	57
Natural gas contracts	47		(47		)	—		4		(4		)	—		—
Total derivatives subject to a master netting agreement	128		(84		)	44		27		(14		)	13		57
Total derivatives not subject to a master netting agreement¹	—		—			—		5		—			5		5
Total assets	128		(84		)	44		32		(14		)	18		62
Liabilities
Electricity contracts	36		(36		)	—		9		(9		)	—		—
Natural gas contracts	46		(46		)	—		5		(5		)	—		—
Total derivatives subject to a master netting agreement	82		(82		)	—		14		(14		)	—		—
Total derivatives not subject to a master netting agreement¹	—		—			—		56		—			56		56
Total liabilities	$	82	$	(82	)	$	—	$	70	$	(14	)	$	56	$	56

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 $71 million and $61 million cash margin in the aggregate with various counterparties at December 31, 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 $43 million and $44 million of net accounts receivable at December 31, 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 December 31, 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:



	Years Ended December 31,
	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	(2	)	55		5		(28	)
Reclassification to operating revenues	3		—		(41	)	—
Reclassification to interest expense	—		5		—		—
End of period derivative gains (losses)¹	—		(58	)	(1	)	(118	)


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 losses of $1 million, none and $4 million in 2013, 2012 and 2011, respectively, in operating revenues on the consolidated statements of operations representing the amount of cash flow hedge ineffectiveness. EME also amortized $5 million of the deferred unrealized losses in AOCI related to the dedesignated Viento II interest rate hedge to interest expense on the consolidated statements of operations in 2013.

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:



		Years Ended December 31,
(in millions)	Income Statement Location	2013			2012
Economic hedges	Operating revenues	$	(9	)	$	31
	Fuel	—			2
	Interest expense, net	6			—
Trading activities	Operating revenues	75			68

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:



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

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

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



	Years Ended December 31,
(in millions)	2013		2012
Beginning of period derivative gains (losses)	(2	)	34
Effective portion of changes in fair value	(2	)	7
Reclassification to operating revenues	4		(43	)
End of period derivative gains (losses)¹	—		(2	)


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, none and $4 million in 2013, 2012 and 2011, 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	Years Ended December 31,
(in millions)	Income Statement Location	2013			2012
Economic hedges	Operating revenues	$	(9	)	$	31
	Fuel	—			2

Energy Trading Derivative Instruments (EME only)

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



(in millions)	2013			2012
Fair value of trading contracts at beginning of period	$	84		$	107
Net gains from energy trading activities	75			68
Amount realized from energy trading activities	(88		)	(93		)
Other changes in fair value	(12		)	2
Fair value of trading contracts at end of period	$	59		$	84

Commodity Price Risk Management

EME's and Midwest Generation'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.

Credit Risk

In conducting EME's hedging and trading activities and Midwest Generation's marketing activities, EMMT 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 and Midwest Generation 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 or Midwest Generation. Midwest Generation's agreement with EMMT transfers the risk of non-payment of accounts receivable from counterparties to EMMT; therefore, EMMT 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 Midwest Generation 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, Midwest Generation may have limited recourse to collect damages in the event of default by a supplier.

The Midwest Generation 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 100%, 92% and 81% of Midwest Generation's consolidated operating revenues for the years ended December 31, 2013, 2012 and 2011, respectively. Sales into PJM accounted for approximately 62%, 64% and 63% of EME's consolidated operating revenues for the years ended December 31, 2013, 2012 and 2011, 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, 2013 and 2012, EME's account receivable due from PJM was $32 million and $40 million, respectively.