Allegheny Power 2014 Annual Report Download - page 108

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93
9. FAIR VALUE MEASUREMENTS
RECURRING FAIR VALUE MEASUREMENTS
Authoritative accounting guidance establishes a fair value hierarchy that prioritizes the inputs used to measure fair value. This
hierarchy gives the highest priority to Level 1 measurements and the lowest priority to Level 3 measurements. The three levels of
the fair value hierarchy and a description of the valuation techniques are as follows:
Level 1 - Quoted prices for identical instruments in active market
Level 2 - Quoted prices for similar instruments in active market
- Quoted prices for identical or similar instruments in markets that are not active
- Model-derived valuations for which all significant inputs are observable market data
Models are primarily industry-standard models that consider various assumptions, including quoted forward prices
for commodities, time value, volatility factors and current market and contractual prices for the underlying
instruments, as well as other relevant economic measures.
Level 3 - Valuation inputs are unobservable and significant to the fair value measurement
FirstEnergy produces a long-term power and capacity price forecast annually with periodic updates as market
conditions change. When underlying prices are not observable, prices from the long-term price forecast, which has
been reviewed and approved by FirstEnergy's Risk Policy Committee, are used to measure fair value. A more
detailed description of FirstEnergy's valuation process for FTRs and NUGs are as follows:
FTRs are financial instruments that entitle the holder to a stream of revenues (or charges) based on the hourly day-
ahead congestion price differences across transmission paths. FTRs are acquired by FirstEnergy in the annual,
monthly and long-term RTO auctions and are initially recorded using the auction clearing price less cost. After initial
recognition, FTRs' carrying values are periodically adjusted to fair value using a mark-to-model methodology, which
approximates market. The primary inputs into the model, which are generally less observable than objective sources,
are the most recent RTO auction clearing prices and the FTRs' remaining hours. The model calculates the fair value
by multiplying the most recent auction clearing price by the remaining FTR hours less the prorated FTR cost.
Generally, significant increases or decreases in inputs in isolation could result in a higher or lower fair value
measurement. See Note 10, Derivative Instruments, for additional information regarding FirstEnergy's FTRs.
NUG contracts represent purchase power agreements with third-party non-utility generators that are transacted to
satisfy certain obligations under PURPA. NUG contract carrying values are recorded at fair value and adjusted
periodically using a mark-to-model methodology, which approximates market. The primary unobservable inputs
into the model are regional power prices and generation MWH. Pricing for the NUG contracts is a combination of
market prices for the current year and next three years based on observable data and internal models using historical
trends and market data for the remaining years under contract. The internal models use forecasted energy purchase
prices as an input when prices are not defined by the contract. Forecasted market prices are based on ICE quotes
and management assumptions. Generation MWH reflects data provided by contractual arrangements and historical
trends. The model calculates the fair value by multiplying the prices by the generation MWH. Generally, significant
increases or decreases in inputs in isolation could result in a higher or lower fair value measurement.
FirstEnergy primarily applies the market approach for recurring fair value measurements using the best information available.
Accordingly, FirstEnergy maximizes the use of observable inputs and minimizes the use of unobservable inputs. There were no
changes in valuation methodologies used as of December 31, 2014, from those used as of December 31, 2013. The determination
of the fair value measures takes into consideration various factors, including but not limited to, counterparty credit risk and the
impact of credit enhancements (such as cash deposits, LOCs and priority interests). The impact of these forms of risk was not
significant to the fair value measurements.