Derivative Instruments and Hedging Activities

9 Months Ended

Sep. 30, 2011

Derivative Instruments and Hedging Activities

Derivative Instruments and Hedging Activities

Note 6. 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, and transmission rights. Additionally, EME's financial results can be affected by fluctuations in 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 with offsetting changes recorded on the consolidated statements of operations. For derivative instruments that qualify for hedge accounting treatment, the fair value is recognized, to the extent effective, on EME's consolidated balance sheets with offsetting changes in fair value recognized in accumulated other comprehensive loss until the related forecasted transaction occurs. 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 for trading purposes are measured at fair value and included on the consolidated balance sheets as derivative assets or liabilities. Changes in fair value are recognized in operating revenues on the consolidated statements of operations.

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:

September 30, 2011
				Hedging Activities
Commodity	Instrument	Classification	Unit of Measure	Cash Flow Hedges			Economic Hedges			Trading Activities
Electricity	Forwards/Futures	Sales	GWh		15,910	1		13,353	3		36,597
Electricity	Forwards/Futures	Purchases	GWh		101	1		13,230	3		42,429
Electricity	Capacity	Sales	MW-Day (in thousands)		134	2		—			12	2
Electricity	Capacity	Purchases	MW-Day (in thousands)		12	2		—			219	2
Electricity	Congestion	Sales	GWh		—			90	4		15,910	4
Electricity	Congestion	Purchases	GWh		—			4,023	4		253,688	4
Natural gas	Forwards/Futures	Sales	bcf		—			—			55.3
Natural gas	Forwards/Futures	Purchases	bcf		—			—			53.4
Fuel oil	Forwards/Futures	Sales	barrels		—			—			100,000
Fuel oil	Forwards/Futures	Purchases	barrels		—			240,000			140,000
Coal	Forwards/Futures	Sales	tons		—			—			1,485,000
Coal	Forwards/Futures	Purchases	tons		—			—			1,485,000

(in millions)
Instrument	Purpose	Type of Hedge	Notional Amount		Expiration Date
Accreting forward starting interest rate swap	Convert floating rate (1-month LIBOR) debt to fixed rate (0.8135%) debt	Cash flow	$	39	May 2013
Accreting interest rate swap	Convert floating rate (1-month LIBOR) debt to fixed rate (0.79%) debt	Cash flow		24	May 2013
Amortizing interest rate swap	Convert floating rate (6-month LIBOR) debt to fixed rate (3.175%) debt	Cash flow		84	June 2016
Amortizing interest rate swap	Convert floating rate (6-month LIBOR) debt to fixed rate (3.415%) debt	Cash flow		110	December 2020
Amortizing forward starting interest rate swap	Convert floating rate (3-month LIBOR) debt to fixed rate (3.5429%) debt	Cash flow		398	May 2023
Amortizing forward starting interest rate swap	Convert floating rate (3-month LIBOR) debt to fixed rate (4.0025%) debt	Cash flow		48	May 2023
Amortizing interest rate swap	Convert floating rate (3-month LIBOR) debt to fixed rate (4.29%) debt	Cash flow		119	December 2025
Amortizing interest rate swap	Convert floating rate (3-month LIBOR) debt to fixed rate (3.46%) debt	Cash flow		67	March 2026

December 31, 2010
				Hedging Activities
Commodity	Instrument	Classification	Unit of Measure	Cash Flow Hedges			Economic Hedges			Trading Activities
Electricity	Forwards/Futures	Sales	GWh		16,799	1		22,456	3		34,630
Electricity	Forwards/Futures	Purchases	GWh		408	1		22,931	3		37,669
Electricity	Capacity	Sales	MW-Day (in thousands)		190	2		—			136	2
Electricity	Capacity	Purchases	MW-Day (in thousands)		8	2		—			419	2
Electricity	Congestion	Sales	GWh		—			136	4		12,020	4
Electricity	Congestion	Purchases	GWh		—			1,143	4		187,689	4
Natural gas	Forwards/Futures	Sales	bcf		—			—			30.6
Natural gas	Forwards/Futures	Purchases	bcf		—			—			34.3
Fuel oil	Forwards/Futures	Sales	barrels		—			250,000			10,000
Fuel oil	Forwards/Futures	Purchases	barrels		—			490,000			10,000
Coal	Forwards/Futures	Sales	tons		—			—			2,630,500
Coal	Forwards/Futures	Purchases	tons		—			—			2,645,500

(in millions)
Instrument	Purpose	Type of Hedge	Notional Amount		Expiration Date
Amortizing interest rate swap	Convert floating rate (6-month LIBOR) debt to fixed rate (3.175%) debt	Cash flow	$	138	June 2016
Amortizing forward starting interest rate swap	Convert floating rate (3-month LIBOR) debt to fixed rate (4.29%) debt	Cash flow		122	December 2025
Amortizing forward starting interest rate swap	Convert floating rate (3-month LIBOR) debt to fixed rate (3.46%) debt	Cash flow		68	March 2026

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

EME also entered into transactions that adjust financial and physical positions, or day-ahead and real-time positions to reduce costs or increase gross margin. These positions largely offset each other. 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.

Fair Value of Derivative Instruments

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

September 30, 2011
		Derivative Assets									Derivative Liabilities
																				Net Assets (Liabilities)
(in millions)		Short-term			Long-term			Subtotal			Short-term			Long-term			Subtotal
Non-trading activities
	Cash flow hedges	$	34		$	8		$	42		$	16		$	90		$	106		$	(64	)
	Economic hedges		29			3			32			31			2			33			(1	)
Trading activities			132			102			234			96			37			133			101
			195			113			308			143			129			272			36
Netting and collateral received1			(163	)		(54	)		(217	)		(140	)		(49	)		(189	)		(28	)
Total		$	32		$	59		$	91		$	3		$	80		$	83		$	8

December 31, 2010
Non-trading activities
	Cash flow hedges	$	54		$	2		$	56		$	10		$	25		$	35		$	21
	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 Nine Months Ended September 30,
							Income Statement Location
(in millions)	2011			2010
Beginning of period derivative gains	$	27		$	175
Effective portion of changes in fair value		(62	)		102
Reclassification to net income		(29	)		(134	)	Operating revenues
End of period derivative gains (losses)	$	(64	)	$	143

¹

Unrealized derivative gains (losses) are before income taxes. The after-tax amounts recorded in accumulated other comprehensive income (loss) at September 30, 2011 and 2010 were $(39) million and $86 million, respectively.

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

The portion of a cash flow hedge that does not offset the change in the value of the transaction being hedged, which is commonly referred to as the ineffective portion, is immediately recognized in earnings. EME recorded net gains of $4 million during each of the third quarters of 2011 and 2010 and $6 million and $5 million during the nine months ended September 30, 2011 and 2010, 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:

		Three Months Ended September 30,					Nine Months Ended September 30,
	Income Statement Location
(in millions)		2011			2010		2011		2010
Economic hedges	Operating revenues	$	(6	)	$	7	$	20	$	—
	Fuel		(3	)		2		1		—
Trading activities	Operating revenues		11			28		68		108

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 Edison Mission Marketing & Trading, Inc. (EMMT) to additional collateral postings.

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 cash 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:

(in millions)		September 30, 2011		December 31, 2010
Collateral provided to counterparties
	Offset against derivative liabilities	$	2	$	4
	Reflected in margin and collateral deposits		44		59
Collateral received from counterparties
	Offset against derivative assets		30		52