10-Q 1 eme2012q3.htm 10-Q EME 2012 Q3
 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
_______________________

FORM 10-Q
(Mark one)
 
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended September 30, 2012
 
or
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from __________ to __________
Commission File Number 333-68630

_______________________

EDISON MISSION ENERGY
(Exact name of registrant as specified in its charter)
Delaware
(State or other jurisdiction of incorporation
or organization)
95-4031807
(I.R.S. Employer Identification No.)
3 MacArthur Place, Suite 100
Santa Ana, California
(Address of principal executive offices)
92707
(Zip Code)

Registrant's telephone number, including area code: (714) 513-8000
_______________________

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES x NO o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). YES NO o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer o
 
Accelerated filer o
 
Non-accelerated filer x
 
Smaller reporting company o
 
 
 
 
(Do not check if a smaller reporting company)
 
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES NO x
Number of shares outstanding of the registrant's Common Stock as of November 1, 2012: 100 shares (all shares held by an affiliate of the registrant).
 





TABLE OF CONTENTS

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

i


 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

ii



iii



















(This page has been left blank intentionally.)

iv


GLOSSARY
When the following terms and abbreviations appear in the text of this report, they have the meanings indicated below.
2010 Tax Relief Act
Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010
ACI
activated carbon injection
AOI
adjusted operating income (loss)
ARO(s)
asset retirement obligation(s)
BACT
best available control technology
BART
best available retrofit technology
bcf
billion cubic feet
Big 4
Kern River, Midway-Sunset, Sycamore and Watson natural gas power projects
Btu
British thermal units
CAA
Clean Air Act
CAIR
Clean Air Interstate Rule
CAMR
Clean Air Mercury Rule
CARB
California Air Resources Board
CO2
carbon dioxide
coal plants
Midwest Generation coal plants and Homer City electric generating station
Commonwealth Edison
Commonwealth Edison Company
CPS
Combined Pollutant Standard
CPUC
California Public Utilities Commission
CSAPR
Cross-State Air Pollution Rule
EIA
Energy Information Administration
EME
Edison Mission Energy
EMMT
Edison Mission Marketing & Trading, Inc.
ERCOT
Electric Reliability Council of Texas
FASB
Financial Accounting Standards Board
FERC
Federal Energy Regulatory Commission
FGD
flue gas desulfurization
FPA
Federal Power Act
GAAP
United States generally accepted accounting principles
GECC
General Electric Capital Corporation
GHG
greenhouse gas
GWh
gigawatt-hours
Homer City
EME Homer City Generation L.P.
Homer City MTA
Master Transaction Agreement between EME Homer City Generation L.P. and General Electric Capital Corporation
Illinois EPA
Illinois Environmental Protection Agency
ISO(s)
independent system operator(s)
Lehman
Lehman Brothers Commodity Services, Inc. and Lehman Brothers Holdings, Inc.
LIBOR
London Interbank Offered Rate
MATS
Mercury and Air Toxics Standards
Midwest Generation
Midwest Generation, LLC

v


MISO
Midwest Independent Transmission System Operator
MMBtu
million British thermal units
Moody's
Moody's Investors Service, Inc.
MW
megawatts
MWh
megawatt-hours
NAAQS
National Ambient Air Quality Standard(s)
NAPP
Northern Appalachian
NERC
North American Electric Reliability Corporation
NID
Novel Integrated Desulfurization
NOX
nitrogen oxide
NSR
New Source Review
NYISO
New York Independent System Operator
PADEP
Pennsylvania Department of Environmental Protection
PG&E
Pacific Gas & Electric Company
PJM
PJM Interconnection, LLC
PRB
Powder River Basin
PSD
Prevention of Significant Deterioration
RPM
Reliability Pricing Model
RTO(s)
regional transmission organization(s)
S&P
Standard & Poor's Ratings Services
SCE
Southern California Edison Company
SIP(s)
state implementation plan(s)
SNCR
selective non-catalytic reduction
SO2
sulfur dioxide
US EPA
United States Environmental Protection Agency
U.S. Treasury grants
Cash grants, under the American Recovery and Reinvestment Act of 2009
VIE(s)
variable interest entity(ies)



vi


PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS

EDISON MISSION ENERGY AND SUBSIDIARIES
 

CONSOLIDATED STATEMENTS OF OPERATIONS
(in millions, unaudited)
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2012
 
2011
 
2012
 
2011
Operating Revenues
$
340

 
$
437

 
$
1,007

 
$
1,272

Operating Expenses
 
 
 
 
 
 
 
Fuel
187

 
161

 
458

 
402

Plant operations
105

 
115

 
389

 
450

Plant operating leases
19

 
19

 
56

 
56

Depreciation and amortization
66

 
73

 
202

 
213

Loss on disposal and asset impairments
1

 

 
5

 
8

Administrative and general
33

 
39

 
114

 
124

Professional fees related to potential reorganization
7

 

 
9

 

Total operating expenses
418

 
407

 
1,233

 
1,253

Operating income (loss)
(78
)
 
30

 
(226
)
 
19

Other Income (Expense)
 
 
 
 
 
 
 
Equity in income from unconsolidated affiliates
25

 
55

 
42

 
67

Dividend income
1

 
1

 
12

 
29

Interest income
1

 

 
1

 
1

Interest expense
(83
)
 
(81
)
 
(253
)
 
(241
)
Other income, net
1

 
1

 
1

 
6

Total other expense
(55
)
 
(24
)
 
(197
)
 
(138
)
Income (loss) from continuing operations before income taxes
(133
)
 
6

 
(423
)
 
(119
)
Benefit for income taxes
47

 
12

 
204

 
103

Income (Loss) From Continuing Operations
(86
)
 
18

 
(219
)
 
(16
)
Income (Loss) from Operations of Discontinued Subsidiaries, net of tax (Note 13)
(76
)
 
15

 
(129
)
 
(3
)
Net Income (Loss)
(162
)
 
33

 
(348
)
 
(19
)
Net (Income) Loss Attributable to Noncontrolling Interests (Note 3)
(5
)
 
1

 
(12
)
 
1

Net Income (Loss) Attributable to Edison Mission Energy Common Shareholder
$
(167
)
 
$
34

 
$
(360
)
 
$
(18
)
Amounts Attributable to Edison Mission Energy Common Shareholder
 
 
 
 
 
 
 
Income (loss) from continuing operations, net of tax
$
(91
)
 
$
19

 
$
(231
)
 
$
(15
)
Income (loss) from discontinued operations, net of tax
(76
)
 
15

 
(129
)
 
(3
)
Net Income (Loss) Attributable to Edison Mission Energy Common Shareholder
$
(167
)
 
$
34

 
$
(360
)
 
$
(18
)

The accompanying notes are an integral part of these consolidated financial statements.
1


EDISON MISSION ENERGY AND SUBSIDIARIES
 

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(in millions, unaudited)

 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2012
 
2011
 
2012
 
2011
Net Income (Loss)
$
(162
)
 
$
33

 
$
(348
)
 
$
(19
)
Other comprehensive income (loss), net of tax
 
 
 
 
 
 
 
Pension and postretirement benefits other than pensions
 
 
 
 
 
 
 
Net gain adjustment, net of tax

 

 
1

 

Amortization of net loss and prior service adjustment included in expense, net of tax
2

 
1

 
3

 
2

Unrealized losses on derivatives qualified as cash flow hedges
 
 
 
 
 
 
 
Unrealized holding losses arising during the periods, net of income tax benefit of $11 and $19 for the three months and $13 and $24 for the nine months ended September 30, 2012 and 2011, respectively
(16
)
 
(30
)
 
(19
)
 
(38
)
Reclassification adjustments included in net income (loss), net of income tax expense (benefit) of $1 and $0 for the three months and $(12) and $(12) for the nine months ended September 30, 2012 and 2011, respectively
1

 

 
(19
)
 
(17
)
Other comprehensive loss, net of tax
(13
)
 
(29
)
 
(34
)
 
(53
)
Comprehensive Income (Loss)
(175
)
 
4

 
(382
)
 
(72
)
Comprehensive (Income) Loss Attributable to Noncontrolling Interests
(5
)
 
1

 
(12
)
 
1

Comprehensive Income (Loss) Attributable to Edison Mission Energy Common Shareholder
$
(180
)
 
$
5

 
$
(394
)
 
$
(71
)


The accompanying notes are an integral part of these consolidated financial statements.
2


EDISON MISSION ENERGY AND SUBSIDIARIES
 

CONSOLIDATED BALANCE SHEETS
(in millions, unaudited)

 
September 30,
2012
 
December 31,
2011
Assets
 
 
 
Current Assets
 
 
 
Cash and cash equivalents
$
698

 
$
1,221

Accounts receivable—trade
71

 
107

Receivables from affiliates
78

 
4

Inventory
171

 
169

Derivative assets
39

 
40

Restricted cash and cash equivalents
116

 
103

Margin and collateral deposits
79

 
41

Prepaid expenses and other
63

 
49

Assets of discontinued operations
61

 
207

Total current assets
1,376

 
1,941

Investments in Unconsolidated Affiliates
542

 
523

Property, Plant and Equipment, less accumulated depreciation of $1,495 and $1,295 at respective dates
4,471

 
4,472

Other Assets
 
 
 
Deferred financing costs
64

 
71

Long-term derivative assets
43

 
62

Restricted deposits
87

 
22

Rent payments in excess of levelized rent expense under plant operating leases
855

 
760

Deferred taxes
483

 
205

Other long-term assets
250

 
222

Total other assets
1,782

 
1,342

Assets of Discontinued Operations

 
45

Total Assets
$
8,171

 
$
8,323


EDISON MISSION ENERGY AND SUBSIDIARIES
 

CONSOLIDATED BALANCE SHEETS
(in millions, except share and per share amounts, unaudited)

 
September 30,
2012
 
December 31,
2011
Liabilities and Shareholder's Equity
 
 
 
Current Liabilities
 
 
 
Accounts payable
$
44

 
$
78

Payables to affiliates
2

 
187

Accrued liabilities
105

 
163

Derivative liabilities
1

 
1

Interest payable
102

 
33

Deferred taxes
3

 
2

Current portion of long-term debt
566

 
57

Short-term debt
21

 

Liabilities of discontinued operations
61

 
27

Total current liabilities
905

 
548

Long-term debt net of current portion
4,480

 
4,855

Deferred revenues
555

 
530

Long-term derivative liabilities
125

 
90

Other long-term liabilities
624

 
627

Liabilities of Discontinued Operations

 
9

Total Liabilities
6,689

 
6,659

Commitments and Contingencies (Notes 5, 6, 9 and 10)

 

Equity
 
 
 
Common stock, par value $0.01 per share (10,000 shares authorized; 100 shares issued and outstanding at each date)
64

 
64

Additional paid-in capital
1,313

 
1,327

Retained earnings (deficit)
(9
)
 
365

Accumulated other comprehensive loss
(128
)
 
(94
)
Total Edison Mission Energy common shareholder's equity
1,240

 
1,662

Noncontrolling Interests
242

 
2

Total Equity
1,482

 
1,664

Total Liabilities and Equity
$
8,171

 
$
8,323




The accompanying notes are an integral part of these consolidated financial statements.
3


EDISON MISSION ENERGY AND SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF CASH FLOWS (in millions, unaudited)
 
Nine Months Ended September 30,
 
2012
 
2011
Cash Flows From Operating Activities
 
 
 
Net loss
$
(348
)
 
$
(19
)
Adjustments to reconcile loss to net cash used in operating activities:
 
 
 
Equity in income from unconsolidated affiliates
(42
)
 
(67
)
Distributions from unconsolidated affiliates
15

 
52

Depreciation and amortization
219

 
227

Deferred taxes and tax credits
(215
)
 
(143
)
Loss on disposal and asset impairments
5

 
8

Proceeds from U.S. Treasury grants
44

 
310

Changes in operating assets and liabilities:
 
 
 
(Increase) decrease in margin and collateral deposits
(38
)
 
15

(Increase) decrease in receivables
(38
)
 
252

Increase in inventory
(2
)
 
(17
)
Increase in prepaid expenses and other
(16
)
 
(27
)
Increase in restricted cash and cash equivalents
(2
)
 
(12
)
Increase in rent payments in excess of levelized rent expense
(95
)
 
(96
)
(Decrease) increase in payables and other current liabilities
(42
)
 
33

Increase in interest payable
77

 
72

Decrease in derivative assets and liabilities
(9
)
 
(7
)
(Increase) decrease in other operating—assets
(3
)
 
15

Decrease in other operating—liabilities
(45
)
 
(35
)
Operating cash flow from continuing operations
(535
)
 
561

Operating cash flow from discontinued operations, net
(5
)
 
(14
)
Net cash (used in) provided by operating activities
(540
)
 
547

Cash Flows From Financing Activities
 
 
 
Borrowings on long-term debt
154

 
168

Payments on debt
(31
)
 
(85
)
Borrowings under short-term debt
21

 
32

Cash contributions from noncontrolling interests
242

 

Cash dividends to noncontrolling interests
(14
)
 

Payments to affiliates related to stock-based awards
(14
)
 
(6
)
Excess tax benefits related to stock-based exercises
3

 
1

Financing costs
(7
)
 
(18
)
Net cash provided by financing activities from continuing operations
354

 
92

Cash Flows From Investing Activities
 
 
 
Capital expenditures
(266
)
 
(446
)
Proceeds from return of capital and loan repayments and sale of assets
8

 
15

Proceeds from settlement of insurance claims
1

 

Purchase of interest of acquired companies

 
(3
)
Investments in and loans to unconsolidated affiliates

 
(10
)
(Increase) decrease in restricted deposits and restricted cash and cash equivalents
(76
)
 
4

Investments in other assets
(9
)
 
(29
)
Investing cash flows from continuing operations
(342
)
 
(469
)
Investing cash flows from discontinued operations, net
(19
)
 
(10
)
Net cash used in investing activities
(361
)
 
(479
)
Net (decrease) increase in cash and cash equivalents from continuing operations
(523
)
 
184

Cash and cash equivalents at beginning of period from continuing operations
1,221

 
947

Cash and cash equivalents at end of period from continuing operations
$
698

 
$
1,131

 
 
 
 
Net decrease in cash and cash equivalents from discontinued operations
$
(24
)
 
$
(24
)
Cash and cash equivalents at beginning of period from discontinued operations
79

 
128

Cash and cash equivalents at end of period from discontinued operations
$
55

 
$
104


The accompanying notes are an integral part of these consolidated financial statements.
4


EDISON MISSION ENERGY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2012
(Unaudited)

Note 1. Summary of Significant Accounting Policies
Liquidity and Restructuring Activities
At September 30, 2012, Edison Mission Energy (EME), and its subsidiaries without contractual dividend restrictions, had corporate cash and cash equivalents of $627 million, which includes Midwest Generation, LLC's (Midwest Generation) cash and cash equivalents of $142 million. At September 30, 2012, EME had $3.7 billion of unsecured notes outstanding, $500 million of which mature in June 2013.
EME continues to experience operating losses due to low realized energy and capacity prices, high fuel costs and low generation at the Midwest Generation plants. Forward market prices indicate that these trends are expected to continue for a number of years. As a result, EME expects that it will incur further reductions in cash flow and losses in the current year and in subsequent years. A continuation of these adverse trends coupled with pending debt maturities and the need to retrofit its Midwest Generation plants to comply with governmental regulations will exhaust EME's liquidity. Consequently, EME has been considering all options available to it, including potential sales of assets, restructuring, reorganization of its capital structure, or conservation of cash that would be applied otherwise to the payment of obligations.
In June 2012, EME entered into non-disclosure and engagement agreements with advisors representing holders of a majority in principal amount of its unsecured bonds for the purpose of engaging in discussions with such advisors and Edison International regarding EME's financial condition. In October 2012, EME and Edison International entered into non-disclosure agreements with certain of the clients of such advisors to facilitate further discussions. Discussions with the bondholders' advisors have been ongoing. In addition, EME and Midwest Generation have entered into a non-disclosure agreement with an advisor representing a majority in principal amount of Midwest Generation's senior lease obligation bonds.
Based on current projections, EME is not expected to have sufficient liquidity to repay the $500 million debt obligation due in June 2013. On November 15, 2012, $97 million of interest payments are due on unsecured EME bonds maturing in 2017, 2019 and 2027, and there is no assurance payment will be made. EME's unsecured bonds generally provide for a 30-day grace period for interest payments. EME's failure to pay indebtedness under its unsecured bonds will likely result in EME's filing for protection under Chapter 11 of the U.S. Bankruptcy Code, which would trigger cross defaults under EME's guarantee of the lease obligations of Midwest Generation, as well as Midwest Generation's own obligations under the lease and under instruments governing the senior lease obligation bonds, and which could potentially give rise to counterparty rights and remedies under other documents.
Bankruptcy proceedings could lead to a change of control of EME, which would, among other things, result in the termination of EME's tax-allocation agreement. At September 30, 2012, EME had recognized $635 million of net tax benefits based on continued ownership by Edison International and inclusion of EME in the consolidated income tax returns of Edison International and its subsidiaries. If realization is unlikely, EME would record a valuation allowance to reduce the carrying value of these assets and record a material charge against earnings. The termination of the tax-allocation agreement could adversely affect EME's long-term liquidity because realization of the value of tax benefits generated by EME could be deferred until such time that EME, or a subsequent owner of EME, had the ability to utilize such benefits. There is no assurance as to when, or whether, this might occur.
The accompanying consolidated financial statements have been prepared assuming that EME will continue as a going concern. Financial statements prepared on this basis assume the realization of assets and the satisfaction of liabilities in the normal course of business for the 12-month period following the date of these financial statements. There is no assurance that EME will be able to continue as a going concern.
Basis of Presentation
EME's significant accounting policies were described in "Note 1. Summary of Significant Accounting Policies" on page 68 of EME's annual report on Form 10-K for the year ended December 31, 2011. EME follows the same accounting policies for interim reporting purposes, with the exception of accounting principles adopted as of January 1, 2012, as discussed below in "—New Accounting Guidance." This quarterly report should be read in conjunction with such financial statements and notes.

5


In the opinion of management, all adjustments, consisting of recurring accruals, have been made that are necessary to fairly state the consolidated financial position and results of operations and cash flows in accordance with accounting principles generally accepted in the United States of America (GAAP) for the periods covered by this quarterly report on Form 10-Q. The results of operations for the three- and nine-month periods ended September 30, 2012 are not necessarily indicative of the operating results for the full year. Except as indicated, amounts reflected in the notes to the consolidated financial statements relate to continuing operations of EME.
The December 31, 2011 condensed consolidated balance sheet data was derived from audited financial statements, but does not include all disclosures required by GAAP.
Interim Financial Statements
On September 21, 2012, EME Homer City Generation L.P. (Homer City) and Homer City Generation L.P., an affiliate of General Electric Capital Corporation (GECC), entered into a Master Transaction Agreement (Homer City MTA) for the divestiture by Homer City of substantially all of its remaining assets and certain specified liabilities.
Beginning in the third quarter of 2012, Homer City met the definition of a discontinued operation and was classified separately in EME's consolidated financial statements. Previously issued financial statements have been restated to reflect discontinued operations reported subsequent to the original issuance date. For further information, see Note 13—Discontinued Operations. Except as indicated, amounts in the notes to the consolidated financial statements relate to continuing operations of EME.
The consolidated statement of cash flows for the nine months ended September 30, 2011 was revised to correct an error in the presentation of vendor financed property, plant and equipment in the amount of $21 million. This correction, to present the amount on a net rather than gross basis, decreased cash flows used in investing activities and cash flows provided by financing activities by this amount, but had no impact on the net change in cash and cash equivalents. Management believes the revision does not have a material impact on the prior year financial statements.
Cash Equivalents
Cash equivalents included money market funds totaling $630 million and $1.2 billion at September 30, 2012 and December 31, 2011, respectively. The carrying value of cash equivalents equals the fair value as all investments have original maturities of less than three months.
Restricted Cash and Cash Equivalents, and Restricted Deposits
Restricted cash and cash equivalents at September 30, 2012 and December 31, 2011 included $97 million received from a wind project financing that was held in escrow at those dates. At September 30, 2012, restricted deposits included $48 million to support outstanding letters of credit issued under EME's letter of credit facilities and $22 million related to normal banking operations.
Inventory
Inventory is stated at the lower of weighted-average cost or market. Inventory is recorded at actual cost when purchased and then expensed at weighted-average cost as used. Inventory consisted of the following:
(in millions)
September 30, 2012
 
December 31, 2011
Coal, fuel oil and other raw materials
$
119

 
$
120

Spare parts, materials and supplies
52

 
49

Total inventory
$
171

 
$
169

Allocation of Net Income or Losses to Investors in Certain Variable Interest Entities
Capistrano Wind Partners' partnership agreements contain complex allocation provisions for taxable income and losses, tax credits and cash distributions. EME allocates net income for this consolidated investment to third-party investors based on the Hypothetical Liquidation Book Value (HLBV) method. HLBV is a balance sheet oriented approach that calculates the change in the claims of each partner on the net assets of the investment at the beginning and end of each period. Each partner's claim is equal to the amount each party would receive or pay if the net assets of the investment were to liquidate at book value and the resulting cash was then distributed to investors in accordance with their respective liquidation preferences. EME reports

6


the net income (loss) attributable to the third-party investors as income (loss) attributable to noncontrolling interests in the consolidated statements of operations. For further information, see Note 3—Variable Interest Entities—Projects or Entities that are Consolidated—Capistrano Wind Equity Capital.
New Accounting Guidance
Accounting Guidance Adopted in 2012
Fair Value Measurement
In May 2011, the Financial Accounting Standards Board (FASB) issued an accounting standards update modifying the fair value measurement and disclosure guidance. This guidance prohibits grouping of financial instruments for purposes of fair value measurement and requires the value be based on the individual security. This amendment also results in new disclosures primarily related to Level 3 measurements including quantitative disclosure about unobservable inputs and assumptions, a description of the valuation processes and a narrative description of the sensitivity of the fair value to changes in unobservable inputs. EME adopted this guidance effective January 1, 2012. For further information, see Note 4—Fair Value Measurements.
Presentation of Comprehensive Income
In June 2011 and December 2011, the FASB issued accounting standards updates on the presentation of comprehensive income. An entity can elect to present items of net income and other comprehensive income in one continuous statement, referred to as the statement of comprehensive income, or in two separate but consecutive statements. EME adopted this guidance January 1, 2012 and elected to present two separate but consecutive statements. The adoption of these accounting standards updates did not change the items that constitute net income and other comprehensive income.
Accounting Guidance Not Yet Adopted
Offsetting Assets and Liabilities
In December 2011, the FASB issued an accounting standards update modifying the disclosure requirements about the nature of an entity's rights of offsetting assets and liabilities in the statement of financial position under master netting agreements and related arrangements associated with financial and derivative instruments. The guidance requires increased disclosure of the gross and net recognized assets and liabilities, collateral positions and narrative descriptions of setoff rights. EME will adopt this guidance effective January 1, 2013.


7


Note 2. Consolidated Statements of Changes in Equity
The following table provides the changes in equity for the nine months ended September 30, 2012:
 
EME Shareholder's Equity
 
 
 
 
(in millions)
Common Stock
 
Additional Paid-in Capital
 
Retained Earnings
 
Accumulated Other Comprehensive Loss
 
Non-controlling interest
 
Total Equity
Balance at December 31, 2011
$
64

 
$
1,327

 
$
365

 
$
(94
)
 
$
2

 
$
1,664

Net income (loss)

 

 
(360
)
 

 
12

 
(348
)
Other comprehensive loss

 

 

 
(34
)
 

 
(34
)
Payments to Edison International for stock purchases related to stock-based compensation

 

 
(14
)
 

 

 
(14
)
Other stock transactions, net

 
7

 

 

 

 
7

Contributions from noncontrolling interests1

 

 

 

 
242

 
242

Distributions to noncontrolling interests

 

 

 

 
(14
)
 
(14
)
Transfers of assets to Capistrano Wind Partners2

 
(21
)
 

 

 

 
(21
)
Balance at September 30, 2012
$
64

 
$
1,313

 
$
(9
)
 
$
(128
)
 
$
242

 
$
1,482

1 
Funds contributed by third-party investors related to the Capistrano Wind equity capital raise are reported in noncontrolling interest. For further information, see Note 3—Variable Interest Entities—Projects or Entities that are Consolidated—Capistrano Wind Equity Capital.
2 
Additional paid in capital was reduced by $21 million during the nine months ended September 30, 2012 due to a new tax basis in the assets transferred to Capistrano Wind Partners. For further information, see Note 3—Variable Interest Entities—Projects or Entities that are Consolidated—Capistrano Wind Equity Capital.
The following table provides the changes in equity for the nine months ended September 30, 2011:
 
EME Shareholder's Equity
 
 
 
 
(in millions)
Common Stock
 
Additional Paid-in Capital
 
Retained Earnings
 
Accumulated Other Comprehensive Loss
 
Non-controlling interest
 
Total Equity
Balance at December 31, 2010
$
64

 
$
1,336

 
$
1,448

 
$
(31
)
 
$
4

 
$
2,821

Net loss

 

 
(18
)
 

 
(1
)
 
(19
)
Other comprehensive loss

 

 

 
(53
)
 

 
(53
)
Payments to Edison International for stock purchases related to stock-based compensation

 

 
(4
)
 

 

 
(4
)
Excess tax benefits related to stock option exercises

 
1

 

 

 

 
1

Other stock transactions, net

 
3

 

 

 

 
3

Purchase of noncontrolling interest1

 
(14
)
 

 

 
(1
)
 
(15
)
Balance at September 30, 2011
$
64

 
$
1,326

 
$
1,426

 
$
(84
)
 
$
2

 
$
2,734

1 
During the nine months ended September 30, 2011, EME purchased the remaining interests in Pinnacle Wind Force, LLC, and Broken Bow I, LLC and all assets of the Crofton Bluffs project. All three projects are now 100% owned by EME. The purchases of the noncontrolling interests were accounted for as equity transactions between controlling and noncontrolling interest holders.


8


Note 3. Variable Interest Entities
Projects or Entities that are Consolidated
At September 30, 2012 and December 31, 2011, EME consolidated 16 and 13 projects, respectively, with a total generating capacity of 861 MW and 570 MW, respectively, that have noncontrolling interests held by others. Projects consolidated at September 30, 2012 increased from the projects consolidated at December 31, 2011, due to the Capistrano Wind equity capital transaction as discussed below. In determining that EME was the primary beneficiary of the projects that are consolidated, key factors considered were EME's ability to direct commercial and operating activities and EME's obligation to absorb losses of the variable interest entities.
The following table presents summarized financial information of the projects that were consolidated by EME:
(in millions)
September 30,
2012
 
December 31,
2011
Current assets
$
71

 
$
36

Net property, plant and equipment
1,090

 
675

Other long-term assets
73

 
5

Total assets
$
1,234

 
$
716

Current liabilities
$
40

 
$
28

Long-term debt net of current portion
172

 
57

Deferred revenues
172

 
69

Long-term derivative liabilities
23

 

Other long-term liabilities
38

 
22

Total liabilities
$
445

 
$
176

Noncontrolling interests
$
242

 
$
2

Assets serving as collateral for the debt obligations had a carrying value of $467 million and $136 million at September 30, 2012 and December 31, 2011, respectively, and primarily consist of property, plant and equipment.
Capistrano Wind Equity Capital
On February 13, 2012, Edison Mission Wind Inc. (Edison Mission Wind) sold its indirect equity interests in the Cedro Hill wind project (150 MW in Texas), the Mountain Wind Power I project (61 MW in Wyoming) and the Mountain Wind Power II project (80 MW in Wyoming) to a new venture, Capistrano Wind Partners. Outside investors provided $238 million of the funding. Capistrano Wind Partners also agreed to acquire the Broken Bow I wind project (80 MW in Nebraska) and the Crofton Bluffs wind project (40 MW in Nebraska) for consideration expected to include $140 million from the same outside investors upon the satisfaction of specified conditions, including commencement of commercial operation and conversion of project debt financing to term loans. In March 2012, EME received a distribution of the proceeds from outside investors, which was used for general corporate purposes. Through their ownership of Capistrano Wind Holdings, an indirect subsidiary of EME, Edison Mission Wind, and EME's parent company, Mission Energy Holding Company (MEHC), own 100% of the Class A equity interests in Capistrano Wind Partners, and the Class B preferred equity interests are held by outside investors. Under the terms of the formation documents, preferred equity interests receive 100% of the cash available for distribution, up to a scheduled amount to target a certain return and thereafter cash distributions are shared. Cash available for distribution includes 90% of the tax benefits realized by MEHC and contributed to Capistrano Wind Partners.
Edison Mission Wind retains indirect beneficial ownership of the common equity in the projects, net of a $4 million preferred investment made by MEHC, a note receivable of $107 million from the sale of the project companies, and retains responsibilities for managing the operations of Capistrano Wind Holdings and its projects, and accordingly, EME will continue to consolidate these projects. The $238 million contributed by the third-party interests and the $4 million preferred investment made by MEHC are reflected in noncontrolling interests on EME's consolidated balance sheet at September 30, 2012. This transaction was accounted for as a transfer among entities under common control and, therefore, resulted in no change in the book basis of the transferred assets. However, the transaction triggered a taxable gain and new tax basis in the assets with a corresponding adjustment to deferred taxes and a reduction to equity of $21 million.


9


Note 4. Fair Value Measurements
Recurring Fair Value Measurements
Fair value is defined as 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 (referred to as an "exit price"). Fair value of an asset or liability considers assumptions that market participants would use in pricing the asset or liability, including assumptions about nonperformance risk, which was not material as of September 30, 2012 and December 31, 2011.
Assets and liabilities are categorized into a three-level fair value hierarchy based on valuation inputs used to determine fair value. The hierarchy gives the highest priority to unadjusted quoted market prices in active markets for identical assets and liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements).
The following table sets forth assets and liabilities that were accounted for at fair value by level within the fair value hierarchy:
 
September 30, 2012
(in millions)
Level 1
 
Level 2
 
Level 3
 
Netting and
Collateral1
 
Total
Assets at Fair Value
 
 
 
 
 
 
 
 
 
Money market funds2
$
630

 
$

 
$

 
$

 
$
630

Derivative contracts
 
 
 
 
 
 
 
 
 
Electricity
$

 
$
84

 
$
39

 
$
(41
)
 
$
82

Natural gas
1

 

 

 
(1
)
 

Fuel oil
2

 

 

 
(2
)
 

Total derivative contracts
3

 
84

 
39

 
(44
)
 
82

Total assets
$
633

 
$
84

 
$
39

 
$
(44
)
 
$
712

Liabilities at Fair Value
 
 
 
 
 
 
 
 
 
Derivative contracts
 
 
 
 
 
 
 
 
 
Electricity
$

 
$
8

 
$
8

 
$
(15
)
 
$
1

Natural gas
1

 

 

 
(1
)
 

Interest rate contracts

 
125

 

 

 
125

Total liabilities
$
1

 
$
133

 
$
8

 
$
(16
)
 
$
126



10


 
December 31, 2011
(in millions)
Level 1
 
Level 2
 
Level 3
 
Netting and
Collateral1
 
Total
Assets at Fair Value
 
 
 
 
 
 
 
 
 
Money market funds2
$
1,179

 
$

 
$

 
$

 
$
1,179

Derivative contracts
 
 
 
 
 
 
 
 
 
Electricity
$

 
$
65

 
$
95

 
$
(58
)
 
$
102

Natural gas
4

 

 

 
(4
)
 

Fuel oil
4

 

 

 
(4
)
 

Total derivative contracts
8

 
65

 
95

 
(66
)
 
102

Total assets
$
1,187

 
$
65

 
$
95

 
$
(66
)
 
$
1,281

Liabilities at Fair Value
 
 
 
 
 
 
 
 
 
Derivative contracts
 
 
 
 
 
 
 
 
 
Electricity
$

 
$
5

 
$
12

 
$
(16
)
 
$
1

Interest rate contracts

 
90

 

 

 
90

Total liabilities
$

 
$
95

 
$
12

 
$
(16
)
 
$
91

1 
Represents cash collateral and the impact of netting across the levels of the fair value hierarchy. Netting among positions classified within the same level is included in that level.
2 
Money market funds are included in cash and cash equivalents and in restricted cash and cash equivalents on EME's consolidated balance sheets.
The following table sets forth a summary of changes in the fair value of Level 3 net derivative assets and liabilities:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
(in millions)
2012
 
2011
 
2012
 
2011
Fair value of net assets at beginning of period
$
41

 
$
84

 
$
83

 
$
91

Total realized/unrealized gains (losses)
 
 
 
 
 
 
 
Included in earnings1
12

 
(4
)
 
20

 
14

Included in accumulated other comprehensive income (loss)2
(1
)
 
1

 
1

 
(2
)
Purchases
8

 
5

 
27

 
16

Settlements
(29
)
 
(6
)
 
(49
)
 
(37
)
Transfers out of Level 33

 

 
(51
)
 
(2
)
Fair value of net assets at end of period
$
31

 
$
80

 
$
31

 
$
80

Change during the period in unrealized gains (losses) related to assets and liabilities held at end of period1
$
(7
)
 
$

 
$

 
$
7

1 
Reported in operating revenues on EME's consolidated statements of operations.
2 
Included in reclassification adjustments in EME's consolidated statement of other comprehensive loss.
3 
Transfers out of Level 3 into Level 2 occurred due to significant observable inputs becoming available as the transactions near maturity.
The fair value of transfers in and out of each level is determined at the end of each reporting period. There were no transfers between Levels 1 and 2 during the three and nine months ended September 30, 2012 and 2011.

11


Valuation Techniques Used to Determine Fair Value
Level 1
The fair value of Level 1 assets and liabilities is determined using unadjusted quoted prices in active markets that are available at the measurement date for identical assets and liabilities. This level includes exchange-traded derivatives and money market funds.
Level 2
The fair value of Level 2 assets and liabilities is determined using the income approach by obtaining quoted prices for similar assets and liabilities in active markets and inputs that are observable, either directly or indirectly, for substantially the full term of the instrument. This level includes over-the-counter derivatives and interest rate swaps.
Over-the-counter derivative contracts are valued using standard pricing models to determine the net present value of estimated future cash flows. Inputs to the pricing models include forward published or posted clearing prices from exchanges (New York Mercantile Exchange and Intercontinental Exchange) for similar instruments and discount rates. A primary price source that best represents trade activity for each market is used to develop observable forward market prices in determining the fair value of these positions. Broker quotes, prices from exchanges or comparison to executed trades are used to validate and corroborate the primary price source. These price quotations reflect mid-market prices (average of bid and ask) and are obtained from sources believed to provide the most liquid market for the commodity.
Level 3
The fair value of Level 3 assets and liabilities is determined using the income approach through various models and techniques that require significant unobservable inputs. This level includes over-the-counter options and derivative contracts that trade infrequently, such as congestion revenue rights and long-term power agreements.
Assumptions are made in order to value derivative contracts in which observable inputs are not available. Changes in fair value are based on changes to forward market prices, including extrapolation of short-term observable inputs into forecasted prices for illiquid forward periods. In circumstances where fair value cannot be verified with observable market transactions, it is possible that a different valuation model could produce a materially different estimate of fair value. Modeling methodologies, inputs and techniques are reviewed and assessed as markets continue to develop and more pricing information becomes available and the fair value is adjusted when it is concluded that a change in inputs or techniques would result in a new valuation that better reflects the fair value of those derivative contracts.
Level 3 Valuation Process
The process of determining fair value is the responsibility of the risk management department, which reports to the chief financial officer. This department obtains observable and unobservable inputs through broker quotes, exchanges and internal valuation techniques and uses both standard and proprietary models to determine fair value. Each reporting period, the risk management and key finance departments collaborate to determine the appropriate fair value methodologies and classifications for each derivative. Inputs are validated for reasonableness by comparison against prior prices, other broker quotes and volatility fluctuation thresholds. Inputs used and valuations are reviewed period-over-period and compared with market conditions to determine reasonableness.
The following table sets forth the valuation techniques and significant unobservable inputs used to determine fair value for Level 3 assets and liabilities at September 30, 2012:
 
Fair Value
(in millions)
 
Valuation Techniques
 
Significant Unobservable Input
 
Range
 
 
 
Assets
 
Liabilities
 
Weighted Average
Electricity
 
 
 
 
 
 
 
 
 
Congestion contracts
$
62

 
 
$
24

 
 
Latest auction pricing
 
Congestion prices
 
$(5.39) - $11.87
 
$0.13
Power contracts
12

 
 
19

 
 
Discounted cash flows
 
Power prices
 
$18.25 - $51.83
 
$40.68
Netting
(35
)
 
 
(35
)
 
 
 
 
 
 
 
 
 
Total
$
39

 
 
$
8

 
 
 
 
 
 
 
 
 

12


Level 3 Fair Value Sensitivity
For congestion contracts, generally, an increase (decrease) in congestion prices in the last auction relative to the contract price will increase (decrease) fair value. For power contracts, generally, an increase (decrease) in long-term forward power prices at illiquid locations relative to the contract price will increase (decrease) fair value.
Fair Value of Long-term Debt
The carrying amounts and fair values of EME's long-term debt were as follows:
 
September 30, 2012
 
December 31, 2011
(in millions)
Carrying
Amount
 
Fair Value
 
Carrying
Amount
 
Fair Value
Long-term debt, including current portion
$
5,046

 
$
3,420

 
$
4,912

 
$
3,716

In assessing the fair value of EME's long-term debt, EME primarily uses quoted market prices, except for floating-rate debt for which the carrying amounts were considered a reasonable estimate of fair value. The fair value of EME's long-term debt is classified as Level 2.The fair value of long-term debt may vary materially under different valuation approaches, including discounted cash flows, depending on underlying assumptions and discount rates.

Note 5. Debt and Credit Agreements
2012 Project Financings
Broken Bow and Crofton Bluffs
Effective March 30, 2012, EME, through its subsidiaries, Broken Bow Wind, LLC and Crofton Bluffs Wind, LLC, completed two nonrecourse financings of its interests in the Broken Bow and Crofton Bluffs wind projects. The financings included construction loans totaling $79 million that are required to be converted to 15-year amortizing term loans by March 31, 2013, subject to meeting specified conditions, $13.1 million letter of credit facilities and $5.5 million working capital facilities.
Interest under the construction and term loans will accrue at London Interbank Offered Rate (LIBOR) plus 2.875%, with the term loan rate increasing 0.125% after the third, sixth, ninth, and twelfth years. Pursuant to the financing agreements, on April 2, 2012 and April 17, 2012, EME's subsidiaries entered into forward starting interest rate swap agreements at 0.8275% and 0.7825%, respectively, to hedge the majority of the variable interest rate debt beginning December 31, 2012 through December 31, 2013 and at 2.96% and 2.7475%, respectively, to hedge the majority of the variable interest rate debt beginning December 31, 2013 through December 31, 2027.
Upon conversion to a term loan, distributions from such subsidiaries are subject to compliance with the terms and conditions of their financing agreements, including a 12-month historic debt service coverage ratio test as specified in the agreements of at least 1.20 to 1.00.
As of September 30, 2012, $21 million and $6 million were outstanding under the construction loans included in short-term debt on EME's consolidated balance sheet, and letters of credit facilities, respectively.
2011 Project Financings
Tapestry Wind
In December 2011, EME, through its subsidiary, Tapestry Wind, LLC, completed a nonrecourse financing of its interests in the Taloga, Buffalo Bear and Pinnacle wind projects. A total of $97 million of cash proceeds received from the $214 million 10-year partially amortizing term loan was deposited into an escrow account as of December 31, 2011. On February 22, 2012, a neighbor of the Pinnacle project filed a formal complaint with the West Virginia Public Service Commission regarding, among other things, noise emissions and shadow flicker and requested that the Commission order the project to shut down at night due to alleged noise emissions. This complaint was dismissed on June 1, 2012. On June 27, 2012 and on July 3, 2012, nearly identical complaints were filed with the West Virginia Public Service Commission by two other neighbors and were subsequently dismissed. In addition, on June 25, 2012, each of the three neighbors filed separate civil complaints in the Circuit Court of Mineral County, West Virginia against Pinnacle Wind, LLC, EME, Edison Mission Operations and Maintenance, Inc., and other non-affiliated defendants. The civil complaints allege, among other things, that the noise emissions and shadow flicker from the Pinnacle wind farm constitute a nuisance and seek compensatory damages, punitive damages and other equitable relief. The complaints have been dismissed without prejudice. The release of the loan proceeds in escrow is subject to final resolution of the complaints or further due diligence from the lenders.

13


Big Sky Turbine Financing
In October 2009, EME, through its subsidiary, Big Sky Wind, LLC (Big Sky), entered into turbine financing arrangements with the turbine manufacturer, totaling approximately $206 million for wind turbine purchase obligations related to the 240 MW Big Sky wind project. The loan has a five-year final maturity, however, specific events, including project performance, may trigger earlier repayment which could occur as early as February 2013. Big Sky is currently involved in a dispute with the lender/turbine manufacturer around whether certain latent defects existing in the turbine equipment would preclude the early repayment provisions. The loan is secured by a leasehold mortgage on the project's real property assets, a pledge of all other collateral of the Big Sky wind project, as well as a cash reserve account into which one-third of distributable cash flow, if any, of the Big Sky wind project is to be deposited on a monthly basis. The loan is also secured by pledges of Big Sky's direct and indirect ownership interests in the project, but is non-recourse to EME.
Big Sky will need to arrange alternative financing, if available, to repay the loan at maturity or reach agreement with the lender to extend the maturity date of the loan as EME does not plan to make an investment in the project and is under no obligation to do so. If these efforts are unsuccessful, the lender may foreclose on the project resulting in a write off of the entire investment in the project. At September 30, 2012, EME's net investment in the Big Sky wind project was $130 million.
Credit Facilities and Letters of Credit
In February 2012, EME terminated its $564 million revolving credit facility. Midwest Generation's $500 million credit facility expired in June 2012 as per its terms. In the first quarter of 2012, EME completed a $100 million letter of credit facility for EME's general corporate needs and for its projects, which expires on June 30, 2014. Letters of credit issued under this facility are secured by cash collateral at least equal to the issued amount.
At September 30, 2012, letters of credit under EME's and its subsidiaries' credit facilities aggregated $154 million. EME had $51 million of cash collateral supporting its letters of credit, which were scheduled to expire as follows: $48 million in 2013 and $3 million in 2014. In addition, EME's subsidiaries' credit facilities aggregated $103 million and were scheduled to expire as follows: $2 million in 2012, $49 million in 2013, $21 million in 2017, $18 million in 2018, and $13 million in 2021. Standby letters of credit include $30 million issued in connection with the power purchase agreement with Southern California Edison Company, an affiliate of EME, under the Walnut Creek credit facility. Certain letters of credit are subject to automatic annual renewal provisions.

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, 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.

14


Notional Volumes of Derivative Instruments
The following table summarizes the notional volumes of derivatives used for hedging and trading activities:
September 30, 2012
 
 
 
 
 
 
 
 
Hedging Activities
 
Trading
Activities
 
Commodity
 
Instrument
 
Classification
 
Unit of
Measure
 
Cash Flow
Hedges
 
Economic
Hedges
 
 
Electricity
 
Forwards/Futures
 
Sales, net
 
GWh
 
5,644


58

2 

  
Electricity
 
Forwards/Futures
 
Purchases, net
 
GWh
 




550


Electricity
 
Capacity
 
Purchases, net
 
GW-Day
 




97

1 
Electricity
 
Congestion
 
Purchases, net
 
GWh
 

  
241

3 
281,251

3 
Natural gas
 
Forwards/Futures
 
Sales, net
 
bcf
 




0.4


Fuel oil
 
Forwards/Futures
 
Sales, net
 
barrels
 

  

  
100,000

  
Fuel oil
 
Forwards/Futures
 
Purchases, net
 
barrels
 


120,000




At September 30, 2012, EME had interest rate contracts with notional values totaling $727 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, at September 30, 2012, EME had forward starting interest rate contracts with notional values totaling $641 million that will convert floating rate LIBOR-based debt to fixed rates ranging from 0.7825% to 4.0025%. These contracts have effective dates beginning December 2012 through December 2021 and expire December 2013 through December 2029.
December 31, 2011
 
 
 
 
 
 
 
 
Hedging Activities
  
Trading
Activities
  
Commodity
 
Instrument
 
Classification
 
Unit of
Measure
 
Cash Flow
Hedges
  
Economic
Hedges
  
  
Electricity
 
Forwards/Futures
 
Sales, net
 
GWh
 
8,320

 
335

2 

  
Electricity
 
Forwards/Futures
 
Purchases, net
 
GWh
 

 

 
2,926

  
Electricity
 
Capacity
 
Sales, net
 
GW-Day
 
61

1 

  

 
Electricity
 
Capacity
 
Purchases, net
 
GW-Day
 

 

  
184

1 
Electricity
 
Congestion
 
Purchases, net
 
GWh
 

  
1,261

3 
230,798

3 
Natural gas
 
Forwards/Futures
 
Sales, net
 
bcf
 

  

  
0.2

  
Fuel oil
 
Forwards/Futures
 
Purchases, net
 
barrels
 

  
240,000

  

  
1 
EME's 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.
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 
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, 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.

15


Fair Value of Derivative Instruments
The following table summarizes the fair value of derivative instruments reflected on EME's consolidated balance sheets:
September 30, 2012
 
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
 
 
 
 
 
 
 
 
 
 
 
 
 
Commodity contracts
$
14

 
$
2

 
$
16

 
$
9

 
$
1

 
$
10

 
$
6

Interest rate contracts

 

 

 

 
125

 
125

 
(125
)
Economic hedges
25

 
1

 
26

 
23

 
1

 
24

 
2

Trading activities
321

 
145

 
466

 
265

 
98

 
363

 
103

 
360

 
148

 
508

 
297

 
225

 
522

 
(14
)
Netting and collateral received1
(321
)
 
(105
)
 
(426
)
 
(296
)
 
(100
)
 
(396
)
 
(30
)
Total
$
39

 
$
43

 
$
82

 
$
1

 
$
125

 
$
126

 
$
(44
)
December 31, 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
 
 
 
 
 
 
 
 
 
 
 
 
 
Commodity contracts
$
40

 
$
1

 
$
41

 
$
2

 
$

 
$
2

 
$
39

Interest rate contracts

 

 

 

 
90

 
90

 
(90
)
Economic hedges
24

 

 
24

 
20

 

 
20

 
4

Trading activities
277

 
142

 
419

 
232

 
79

 
311

 
108

 
341

 
143

 
484

 
254

 
169

 
423

 
61

Netting and collateral received1
(301
)
 
(81
)
 
(382
)
 
(253
)
 
(79
)
 
(332
)
 
(50
)
Total
$
40

 
$
62

 
$
102

 
$
1

 
$
90

 
$
91

 
$
11

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,
 
 
 
2012
 
2011
 
 
(in millions)
Commodity Contracts
 
Interest Rate Contracts
 
Commodity Contracts
 
Interest Rate Contracts
 
Income Statement
Location
Beginning of period derivative gains (losses)
$
35

 
$
(90
)
 
$
43

 
$
(16
)
 
 
Effective portion of changes in fair value
3

 
(35
)
 
2

 
(64
)
 
 
Reclassification to earnings
(31
)
 

 
(29
)
 

 
Operating revenues
End of period derivative gains (losses)
$
7

 
$
(125
)
 
$
16

 
$
(80
)
 
 
1 
Unrealized derivative gains (losses) are before income taxes. The after-tax amounts recorded in accumulated other comprehensive loss at September 30, 2012 and 2011 for commodity and interest rate contracts were $7 million and $(79) million, and $10 million and $(49) million, respectively.

16


For additional information, see Note 11—Accumulated Other Comprehensive Loss.
EME recorded gains (losses) of $(2) million and $2 million during the three months ended September 30, 2012 and 2011, respectively, and gains of none and $2 million during the nine months ended September 30, 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 (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,
(in millions)
Income Statement Location
2012
 
2011
 
2012
 
2011
Economic hedges
Operating revenues
$
8

 
$
(3
)
 
$
25

 
$
5

 
Fuel
3

 
(3
)
 
2

 
1

Trading activities
Operating revenues
22

 
11

 
72

 
68

Margin and Collateral Deposits
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 and brokers. The amount of margin and collateral deposits generally varies based on changes in fair value of the related positions.
EME’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 its financial position, EME has limited access to enter into such transactions and has been subject to increased initial collateral and margin requirements. There is no assurance that EME will continue to be able to utilize clearing brokers. If EME becomes unable to utilize clearing brokers, it may seek to execute bilateral transactions with third parties which could be unavailable on commercially reasonable terms or at all.
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. Future increases in power prices could expose EME, Midwest Generation or Edison Mission Marketing & Trading, Inc. (EMMT) to additional collateral postings. The following table summarizes margin and collateral deposits provided to and received from counterparties:
(in millions)
September 30,
2012
 
December 31,
2011
Collateral provided to counterparties
 
 
 
 
 
 
 
Offset against derivative liabilities
 
$
10

 
 
 
$
2

 
Reflected in margin and collateral deposits
 
79

 
 
 
41

 
Collateral received from counterparties
 
 
 
 
 
 
 
Offset against derivative assets
 
39

 
 
 
53

 


17


Note 7. Income Taxes
Effective Tax Rate
The table below provides a reconciliation of income tax expense (benefit) computed at the federal statutory income tax rate to the income tax benefit:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
(in millions)
2012
 
2011
 
2012
 
2011
Income (loss) from continuing operations before income taxes
$
(133
)
 
$
6

 
$
(423
)
 
$
(119
)
Provision (benefit) for income taxes at federal statutory rate of 35%
$
(47
)
 
$
2

 
$
(148
)
 
$
(41
)
Increase (decrease) in income tax from
 
 
 
 
 
 
 
State tax - net of federal benefit
14

 
(2
)
 
(4
)
 
(9
)
Production tax credits, net
(12