Exelon 2014 Annual Report Download - page 69

reclassified to results of operations when the forecasted purchase or sale of the energy commodity occurs, or becomes probable of
not occurring. None of Constellation’s designated cash flow hedges for commodity transactions prior to the Constellation merger
were re-designated as cash flow hedges. The effect of this decision is that all economic hedges for commodities are recorded at fair
value through earnings for the combined company. In addition, for energy-related derivatives entered into for proprietary trading
purposes, changes in the fair value of the derivatives are recognized in earnings each period. For economic hedges that are not
designated for hedge accounting for ComEd, PECO and BGE, changes in the fair value each period are recorded as a regulatory
asset or liability.
Normal Purchases and Normal Sales Exception. As part of Generation’s energy marketing business, Generation enters into
contracts to buy and sell energy to meet the requirements of its customers. These contracts include short-term and long-term
commitments to purchase and sell energy and energy-related products in the retail and wholesale markets with the intent and ability
to deliver or take delivery. While some of these contracts are considered derivative financial instruments under the authoritative
guidance, certain of these qualifying transactions have been designated as normal purchases and normal sales and are thus not
required to be recorded at fair value, but rather on an accrual basis of accounting. Determining whether a contract qualifies for the
normal purchases and normal sales exception requires that management exercise judgment on whether the contract will physically
deliver and requires that management ensure compliance with all of the associated qualification and documentation requirements.
Revenues and expenses on contracts that qualify as normal purchases and normal sales are recognized when the underlying
physical transaction is completed. Contracts which qualify for the normal purchases and normal sales exception are those for which
physical delivery is probable, quantities are expected to be used or sold in the normal course of business over a reasonable period
of time and is not financially settled on a net basis. The contracts that ComEd has entered into with suppliers as part of ComEd’s
energy procurement process, PECO’s full requirement contracts and block contracts under the PAPUC-approved DSP program,
most of PECO’s natural gas supply agreements and all of BGE’s full requirement contracts and natural gas supply agreements that
are derivatives qualify for the normal purchases and normal sales exception.
Commodity Contracts. Identification of a commodity contract as an economic hedge requires Generation to determine that the
contract is in accordance with the RMP. Generation reassesses its economic hedges on a regular basis to determine if they continue
to be within the guidelines of the RMP.
As a part of accounting for derivatives, the Registrants make estimates and assumptions concerning future commodity prices, load
requirements, interest rates, the timing of future transactions and their probable cash flows, the fair value of contracts and the
expected changes in the fair value in deciding whether or not to enter into derivative transactions, and in determining the initial
accounting treatment for derivative transactions. In accordance with the authoritative guidance for fair value measurements, the
Registrants categorize these derivatives under a fair value hierarchy that prioritizes the inputs to valuation techniques used to
measure fair value. Derivative contracts are traded in both exchange-based and non-exchange-based markets. Exchange-based
derivatives that are valued using unadjusted quoted prices in active markets are categorized in Level 1 in the fair value hierarchy.
Certain derivatives’ pricing is verified using indicative price quotations available through brokers or over-the-counter, on-line
exchanges are categorized in Level 2. These price quotations reflect the average of the bid-ask mid-point prices and are obtained
from sources that the Registrants believe provide the most liquid market for the commodity. The price quotations are reviewed and
corroborated to ensure the prices are observable and representative of an orderly transaction between market participants. This
includes consideration of actual transaction volumes, market delivery points, bid-ask spreads and contract duration. The Registrant’s
derivatives are traded predominately at liquid trading points. The remaining derivative contracts are valued using the Black model, an
industry standard option valuation model. The Black model takes into account inputs such as contract terms, including maturity, and
market parameters, and assumptions of the future prices of energy, interest rates, volatility, credit worthiness and credit spread. For
derivatives that trade in liquid markets, such as generic forwards, swaps and options, the model inputs are generally observable.
Such instruments are categorized in Level 2. For derivatives that trade in less liquid markets with limited pricing information, the
model inputs generally would include both observable and unobservable inputs. In instances where observable data is unavailable,
consideration is given to the assumptions that market participants would use in valuing the asset or liability. This includes
assumptions about market risks such as liquidity, volatility and contract duration. Such instruments are categorized in Level 3 as the
model inputs generally are not observable. The Registrants consider nonperformance risk, including credit risk in the valuation of
derivative contracts categorized in Level 1, 2 and 3, including both historical and current market data in its assessment of
nonperformance risk, including credit risk. The impacts of credit and nonperformance risk to date have generally not been material to
the financial statements.
Interest Rate and Foreign Exchange Derivative Instruments. The Registrants may utilize fixed-to-floating interest rate swaps,
which are typically designated as fair value hedges, as a means to achieve the targeted level of variable-rate debt as a percent of
total debt. Additionally, the Registrants may use forward-starting interest rate swaps and treasury rate locks to lock in interest-rate
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