Constellation Energy Group 10-Q 2009
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QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
For The Quarterly Period Ended June 30, 2009
100 CONSTELLATION WAY, BALTIMORE,
2 CENTER PLAZA, 110 WEST FAYETTE STREET BALTIMORE,
Indicate by check mark whether the registrants (1) have 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, and (2) have been subject to such filing requirements for the past 90 days. Yes ý No o
Indicate by check mark whether Constellation Energy Group, Inc. 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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ý No o
Indicate by check mark whether Baltimore Gas and Electric Company 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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o
Indicate by check mark whether Constellation Energy Group, Inc. is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See
definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether Baltimore Gas and Electric Company is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See
definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether Constellation Energy Group, Inc. is a shell company (as defined in Rule 12b-2 of the Exchange Act) Yes o No ý
Indicate by check mark whether Baltimore Gas and Electric Company is a shell company (as defined in Rule 12b-2 of the Exchange Act) Yes o No ý
Common Stock, without par value 200,630,389 shares outstanding
Baltimore Gas and Electric Company meets the conditions set forth in General Instruction H(1)(a) and (b) of Form 10-Q and is therefore filing this form in the reduced disclosure format.
Table of Contents
Constellation Energy Group, Inc. and Subsidiaries
Constellation Energy Group, Inc. and Subsidiaries
See Notes to Consolidated Financial Statements.
Constellation Energy Group, Inc. and Subsidiaries
CONSOLIDATED BALANCE SHEETS
Constellation Energy Group, Inc. and Subsidiaries
Constellation Energy Group, Inc. and Subsidiaries
See Notes to Consolidated Financial Statements.
Baltimore Gas and Electric Company and Subsidiaries
See Notes to Consolidated Financial Statements.
Baltimore Gas and Electric Company and Subsidiaries
CONSOLIDATED BALANCE SHEETS
Baltimore Gas and Electric Company and Subsidiaries
Baltimore Gas and Electric Company and Subsidiaries
Various factors can have a significant impact on our results for interim periods. This means that the results for this quarter are not necessarily indicative of future quarters or full year results given the seasonality of our business.
Our interim financial statements on the previous pages reflect all adjustments that management believes are necessary for the fair statement of the results of operations for the interim periods presented. These adjustments are of a normal recurring nature.
We have evaluated events or transactions that occurred after June 30, 2009 for inclusion in these financial statements through August 7, 2009, the date these financial statements were issued.
Basis of Presentation
This Quarterly Report on Form 10-Q is a combined report of Constellation Energy Group, Inc. (Constellation Energy) and Baltimore Gas and Electric Company (BGE). References in this report to "we" and "our" are to Constellation Energy and its subsidiaries, collectively. References in this report to the "regulated business(es)" are to BGE.
We have reclassified certain prior-period amounts:
We discuss our adoption of SFAS No. 160 in more detail on page 41.
We also made the following reclassifications:
Investment Agreement with EDF Group
On December 17, 2008, we entered into an Investment Agreement with EDF Group and related entities (EDF) under which EDF will purchase from us a 49.99% membership interest in our nuclear generation and operation business for $4.5 billion (subject to certain adjustments). We discuss the Investment Agreement with EDF in more detail in Note 15 of our 2008 Annual Report on Form 10-K.
Merger Termination and Strategic Alternatives Costs
We incurred costs during the quarter and six months ended June 30, 2009 related to the terminated merger agreement with MidAmerican Energy Holdings Company (MidAmerican), the conversion of our Series A Preferred Stock, the transactions related to EDF, and other strategic alternatives costs. These costs totaled $4.0 million pre-tax and $46.3 million pre-tax for the quarter and six months ended June 30, 2009, respectively, and primarily relate to the first quarter of 2009 write-off of the unamortized debt discount associated with the 14% Senior Notes (Senior Notes) that were repaid in full to MidAmerican in January 2009.
Variable Interest Entities
As of June 30, 2009, we consolidated three variable interest entities (VIE) in which we were the primary beneficiary, and we had significant interests in seven VIEs for which we did not have controlling financial interests and, accordingly, were not the primary beneficiary. We discuss our VIEs in more detail in Note 4 of our 2008 Annual Report on Form 10-K.
Consolidated Variable Interest Entities
In 2007, BGE formed RSB BondCo LLC (BondCo), a special purpose bankruptcy-remote limited liability company, to acquire and hold rate stabilization property and to issue and service bonds secured by the rate stabilization property. In June 2007, BondCo purchased rate stabilization property from BGE, including the right to
assess, collect, and receive non-bypassable rate stabilization charges payable by all residential electric customers of BGE. These charges are being assessed in order to recover previously incurred power purchase costs that BGE deferred pursuant to Senate Bill 1. We discuss Senate Bill 1 in more detail in Management's Discussion and Analysis section of our 2008 Annual Report on Form 10-K.
BGE determined that BondCo is a VIE for which it is the primary beneficiary. As a result, BGE, and we, consolidated BondCo.
The BondCo assets are restricted and can only be used to settle the obligations of BondCo. Further, BGE is required to remit all payments it receives from customers for rate stabilization charges to BondCo. During the quarter and six months ended June 30, 2009, BGE remitted $17.6 million and $42.1 million, respectively, to BondCo.
BGE did not provide any additional financial support to BondCo during the quarter and six months ended June 30, 2009. Further, BGE does not have any contractual commitments or obligations to provide additional financial support to BondCo unless additional rate stabilization bonds are issued. The BondCo creditors do not have any recourse to the general credit of BGE in the event the rate stabilization charges are not sufficient to cover the bond principal and interest payments of BondCo.
During the second quarter of 2009, our retail gas customer supply operation formed two new entities and combined them with our existing retail gas customer supply operation into a retail gas entity group for the purpose of entering into a collateralized gas supply agreement (GSA) with a third party gas supplier. While we own 100% of these entities, we determined that the retail gas entity group is a VIE because we provide additional credit support to the gas supplier in the form of a letter of credit and a parental guarantee. We are the primary beneficiary of the retail gas entity group; accordingly, we consolidate the retail gas entity group as a VIE, including the existing retail gas customer supply operation, which we formerly consolidated as a voting interest entity.
The gas supply arrangement is collateralized as follows:
Other than credit support provided by the parental guarantee and the letter of credit, we do not have any contractual or other obligations to provide additional financial support to the retail gas entity group. The retail gas entity group creditors do not have any recourse to our general credit. Finally, we did not provide any financial support to the retail gas entity group during the quarter ended June 30, 2009, other than the initial equity contribution, parental guarantee and the letter of credit.
The carrying amounts and classification of the above consolidated VIEs' assets and liabilities included in our consolidated financial statements at June 30, 2009 are as follows:
All of the assets in the table above are restricted for settlement of the VIE obligations and all of the liabilities in the table above can only be settled using VIE resources.
We also consolidate a retail power supply VIE for which we became the primary beneficiary in 2008 as a result of a modification to its contractual arrangements that changed the allocation of the economic risks and rewards of the VIE among the variable interest holders. The consolidation of this VIE did not have a material impact on our financial results or financial condition.
Unconsolidated Variable Interest Entities
As of June 30, 2009, we had significant interests in seven VIEs for which we were not the primary beneficiary. We have not provided any material financial or other support to these entities during the quarter and six months ended June 30, 2009.
The nature of these entities and our involvement with them are described in the following table:
We discuss the nature of our involvement with the power contract monetization VIEs in detail in Note 4 of our 2008 Annual Report on Form 10-K.
The following is summary information available as of June 30, 2009 about these entities:
Our maximum exposure to loss is the loss that we would incur in the unlikely event that our interests in all of these entities were to become worthless and we were required to fund the full amount of all guarantees associated with these entities. Our maximum exposure to loss as of June 30, 2009 consists of the following:
We assess the risk of a loss equal to our maximum exposure to be remote and, accordingly have not recognized a liability associated with any portion of the maximum exposure to loss. In addition, there are no agreements with, or commitments by, third parties that would affect the fair value or risk of our variable interests in these variable interest entities.
Impairment Losses and Other Costs
Available for Sale Securities
We evaluated certain of our investments in equity securities during the six months ended June 30, 2009. The investments we evaluated included our nuclear decommissioning trust fund assets and other marketable securities. We record an impairment charge if an investment has experienced a decline in fair value to a level less than our carrying value and the decline is "other than temporary."
In making this determination, we evaluate the reasons for an investment's decline in value, the extent and duration of that decline, and factors that indicate whether and when the value will recover. For securities held in our nuclear decommissioning trust fund for which the market value is below book value, the decline in fair value is considered other than temporary and we write them down to fair value. We discuss our impairment policy for our nuclear decommissioning trust fund assets and other marketable securities in more detail in Note 1 to our 2008 Annual Report on Form 10-K.
The fair values of certain of our marketable securities and certain of the securities held in our nuclear decommissioning trust fund declined below book value. As a result, we recorded a $1.9 million pre-tax impairment charge for the quarter ended June 30, 2009 and a $62.4 million pre-tax impairment charge for the six months ended June 30, 2009 for our nuclear decommissioning trust fund assets in the "Other income (expense)" line in our Consolidated Statements of Income (Loss). In addition, we recorded all other changes in the fair value of our nuclear decommissioning trust fund assets that are not impaired in other comprehensive (loss) income. We also recorded an impairment charge of $0.5 million for other marketable securities during the six months ended June 30, 2009.
The estimates we utilize in evaluating impairment of our available for sale securities require judgment and the evaluation of economic and other factors that are subject to variation, and the impact of such variations could be material.
Equity Method Investments
Shipping Joint Venture
We record an impairment if an equity method investment has experienced a decline in fair value to a level less than our carrying value and the decline is "other than temporary." During the quarter ended June 30, 2009, we contemplated several potential courses of action together with our partner relating to the strategic direction of our shipping joint venture and our continuing involvement. This led to a decision to explore a plan to sell our 50% interest to a party related to our joint venture partner for negligible proceeds. During July 2009, a definitive purchase and sale agreement was executed between the parties and we expect the transaction to close in the third quarter of 2009. Upon completion, we will have no further continuing involvement associated with the activities of the joint venture.
As a result of the events that occurred during the second quarter of 2009, it became apparent that a decline in fair value to a level below the carrying value existed and that this decline was "other than temporary." As such, we recorded a pre-tax impairment charge of $59.0 million associated with our equity investment in our shipping joint venture within the "Impairment losses and other costs" line in our Consolidated Statements of Income (Loss), and reported the charge in our merchant energy business results for the second quarter of 2009.
Constellation Energy Partners LLC
As of March 31, 2009, the fair value of our investment in Constellation Energy Partners LLC (CEP) based upon its closing unit price was $10.0 million, which was lower than its carrying value of $24.0 million.
The decline in fair value of our investment in CEP reflected a number of other factors, including:
As a result of evaluating these factors, we determined that the decline in the value of our investment is other than temporary. Therefore, we recorded a $14.0 million pre-tax impairment charge at March 31, 2009 to write-down our investment to fair value. We recorded this charge in "Impairment losses and other costs" in our Consolidated Statements of Income (Loss). We did not record an impairment charge in the second quarter of 2009. To the extent that the market price of our investment declines further in future quarters, we may record additional write-downs if we determine that those additional declines are other than temporary.
During the quarter and six months ended June 30, 2009, we recorded $8.2 million and $22.3 million pre-tax charges, respectively, in the "Impairment losses and other costs" line in our Consolidated Statements of Income (Loss) primarily related to certain long-lived assets that ceased to be used in connection with the divestiture of a majority of our international commodities operation and our Houston-based gas trading operation as well as the write-off of an uncollectible advance to an affiliate.
Workforce Reduction Costs
We incurred workforce reduction costs during the six months ended June 30, 2009 primarily related to the divestiture of a majority of our international commodities operation as well as some smaller restructurings elsewhere in our organization. We recognized an $11.2 million pre-tax charge during the six months ended June 30, 2009 related to the elimination of approximately 180 positions. We expect these restructurings will be completed within the next 12 months. The following table summarizes the status of the involuntary severance liability at June 30, 2009:
We also incurred costs related to workforce reduction efforts initiated across all of our operations in 2008.
The following table summarizes the status of this involuntary severance liability at June 30, 2009:
We discuss our 2008 workforce reduction costs in more detail in Note 2 of our 2008 Annual Report on Form 10-K.
Earnings Per Share
Basic earnings per common share (EPS) is computed by dividing earnings applicable to common stock by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution of common stock equivalent shares that could occur if securities or other contracts to issue common stock were exercised or converted into common stock.
Our dilutive common stock equivalent shares consist of stock options and other stock-based compensation awards. The following table presents stock options that were not dilutive and were excluded from the computation of diluted EPS in each period, as well as the dilutive common stock equivalent shares:
As a result of the Company incurring a loss for the six months ended June 30, 2009, dilutive common stock equivalent shares were not included in calculating diluted EPS.
We issued to MidAmerican 19,897,322 shares of Constellation Energy's common stock upon the conversion of the Series A Preferred Stock, which happened upon the termination of the merger agreement with MidAmerican on December 17, 2008. We discuss the conversion feature of the Series A Preferred Stock in more detail in Note 9 of our 2008 Annual Report on Form 10-K. These additional shares impacted our earnings per share for the quarter and six months ended June 30, 2009.
Accretion of Asset Retirement Obligations
We discuss our asset retirement obligations in more detail in Note 1 of our 2008 Annual Report on Form 10-K. The change in our "Asset retirement obligations" liability during 2009 was as follows:
In 2009, we continued to implement many of the strategic initiatives we identified in 2008 to improve liquidity and reduce our business risk. We discuss these initiatives in the Strategy section of our 2008 Annual Report on Form 10-K.
The transactions to sell a majority of our international commodities, our Houston-based gas trading and other operations were structured in two parts:
Under the TRS, we entered into offsetting trades with the buyers that matched the terms of the remaining third party contracts for which we were unable to complete assignment to the buyers as of the transaction dates. This structure transferred the risks associated with changes in commodity prices as of the transaction dates to the buyers in all instances. However, the trades under the TRS are newly executed transactions, and we remain the principal under both the unassigned third party trades and the matching trades with the buyers under the TRS with no right of either financial or legal offset. We continue to pursue the assignment of these remaining contracts to the buyers.
The matching contracts under the TRS include both derivatives and non-derivatives and were executed at prices that differed from market prices at closing, which resulted in a net cash payment to/from the buyers. We recorded the underlying contracts at fair value on a gross basis as assets or liabilities in our Consolidated Balance Sheets depending on whether the contract prices were above- or below-market prices at closing. As a result, the derivative contracts have been included in "Derivative Assets and Liabilities" and the nonderivative contracts have been included in "Unamortized Energy Contract Assets and Liabilities." The derivative
contracts are subject to mark-to-market accounting until they are realized or assigned. The nonderivative contracts will be amortized into earnings as the underlying contracts are realized, or sooner if those contracts are assigned.
We record the cash proceeds we pay or receive at the inception of energy purchase and sale contracts based upon whether the contracts are in-the-money or out-of-the-money as follows:
After inception, we record the cash flows from all energy purchase and sale contracts as operating activities, except for out-of-the-money derivative contracts that were liabilities at inception. We record the ongoing cash flows from these out-of-the-money derivative contracts as financing activities, regardless of whether they are purchase or sale contracts.
International Commodities Operation
In January 2009, we entered into a definitive agreement to sell a majority of our international commodities operation. We completed this transaction on March 23, 2009 and recognized the following impacts during the six months ended June 30, 2009:
We removed the contracts that were assigned from our balance sheet, paid the buyer approximately $90 million, and reflected the impact of this payment on our working capital in the operating activities section of our Consolidated Statements of Cash Flows.
The net cash payment to the buyer upon completion of the TRS was $2.5 million. As part of the consideration, we acquired matching nonderivative contracts that resulted in a net liability of approximately $75 million, which will be amortized into earnings as the underlying contracts are realized, or sooner if the original nonderivative contracts are assigned.
We have reflected the contracts under the TRS on a gross basis in cash flows from investing and financing activities in our Consolidated Statements of Cash Flows as follows:
In addition to the March 23, 2009 transaction for a majority of our international commodities operation, on June 30, 2009 we completed the sale of a uranium market participant that we owned. We received cash proceeds of approximately $43 million and recorded a $27.2 million loss on this sale. This loss from our merchant energy segment is included in the "Net (loss) gain on divestitures" line in our Consolidated Statements of Income (Loss).
Houston-Based Gas and Other Trading Operations
On February 3, 2009, we entered into a definitive agreement to sell our Houston-based gas trading operation. We transferred control of this operation on April 1, 2009. In addition, in the second quarter of 2009 we also sold certain other trading operations. In total, we received proceeds of approximately $56 million, and recorded a $102.4 million net loss on these sales in the quarter ended June 30, 2009. The net loss on sale primarily relates to nonderivative accrual contracts, which were not recorded on our Consolidated Balance Sheet, the cost associated with disposing of an entire portfolio and not merely individual contracts, and the cost of capital, including contingent capital, to support the operation.
The matching derivative and nonderivative transactions under the TRS discussed above were executed at prices that differed from market prices at closing. As a result, we record the ongoing cash flows related to the out-of-the-money derivative contracts that were liabilities at inception as financing cash flows in accordance with SFAS No. 149. This resulted in cash outflows related to financing activities of $378.0 million and $695.4 million in our
Consolidated Statements of Cash Flows for the quarter and six months ended June 30, 2009, respectively, associated with derivative liabilities that were out-of-the-money.
The net cash receipt from the buyers upon completion of the TRS was $91.9 million in the second quarter of 2009. We have reflected these contracts on a gross basis in cash flows from investing and financing activities in our Consolidated Statements of Cash Flows as follows:
In addition, we incurred other costs of $1.5 million and $5.5 million for the quarter and six months ended June 30, 2009, respectively, related to leasehold improvements, furniture, computer hardware and software costs, which are recorded as part of "Impairment losses and other costs" on our Consolidated Statements of Income (Loss).
On April 1, 2009, we executed an agreement with the buyer of our Houston-based gas trading operation under which the buyer will provide us with the gas supply needed to support our retail gas customer supply business through March 31, 2011. This agreement was structured such that our requirements to post collateral are reduced. The supplier has liens on the assets of the retail gas supply business as well as our investment in the stock of these entities to secure our obligations under the gas supply agreement. In connection with this agreement, we posted approximately $160 million of collateral. This was subsequently reduced to $100 million. The initial $160 million posted represents approximately 25 percent of the previous collateral requirements to support this operation. We discuss the impact of the gas supply agreement on our retail gas customer supply business in more detail on page 12.
Investments Classified as Available-for-Sale
We classify the following investments as available-for-sale:
This means we do not expect to hold these investments to maturity, and we do not consider them trading securities. We record these investments at fair value on our Consolidated Balance Sheets.
We show the fair values, gross unrealized gains and losses, and adjusted cost basis for all of our available-for-sale securities in the following tables. We use specific identification to determine cost in computing realized gains and losses.
The unrealized gains in the preceding table consist primarily of $143.2 million at June 30, 2009 associated with the nuclear decommissioning trust funds.
The investments in our nuclear decommissioning trust funds are managed by third parties who have independent discretion over the purchases and sales of securities. We recognize impairments for any of these investments for which the fair value declines below our book value. We recognized $1.9 million and $62.4 million in pre-tax impairment losses on our nuclear decommissioning trust investments during the quarter and six months ended June 30, 2009, respectively. These impairments are included as part of gross realized losses in the following table.
Gross and net realized gains and losses on available-for-sale securities were as follows:
The corporate debt securities, U.S. Government agency obligations, and state municipal bonds mature on the following schedule:
Information by Operating Segment
Our reportable operating segments areMerchant Energy, Regulated Electric, and Regulated Gas:
Our remaining nonregulated businesses:
Prior to June 30, 2009, our merchant energy business segment included additional activities that have been divested as part of our strategy to improve our liquidity and reduce our business risk. The divested activities include:
Additionally, we entered into an Investment Agreement with EDF on December 17, 2008. See Note 15 of our 2008 Annual Report on Form 10-K for more detail on the Investment Agreement with EDF.
We believe that the successful execution of these initiatives, as well as our other initiatives that we have undertaken to reduce risk in our merchant energy business, have reduced our exposure to activities that require contingent capital support and improved our liquidity. In turn, the results for our merchant energy business segment will be materially different from prior periods. We discuss these strategies and their effect on liquidity in Note 8 of our 2008 Annual Report on Form 10-K.
Our Merchant Energy, Regulated Electric, and Regulated Gas reportable segments are strategic businesses based principally upon regulations, products, and services that require different technologies and marketing strategies. We evaluate the performance of these segments based on net income. We account for intersegment revenues using market prices. A summary of information by operating segment is shown in the table below.
Certain prior-period amounts have been reclassified to conform with the current period's presentation.
Our merchant energy business operating results for the quarter and six months ended June 30, 2009 include the following after-tax charges:
Our Holding Company and Other Nonregulated businesses operating results for the quarter and six months ended June 30, 2009 reflect impairment losses and other costs of $3.2 million after-tax.
Total assets decreased approximately $2.3 billion during the six months ended June 30, 2009. The decrease primarily relates to:
Our allowance for uncollectible accounts receivable increased $19.6 million from December 31, 2008 to June 30, 2009. This increase is primarily attributable to our regulated electric and gas businesses. In the second quarter of 2009, the Maryland PSC issued a ruling which delayed BGE's ability to terminate service to customers with arrearages and offered those customers the option to enter into extended payment plans.
Pension and Postretirement Benefits
We show the components of net periodic pension benefit cost in the following table:
1 BGE's portion of our net periodic pension benefit cost, excluding amounts capitalized, was $4.9 million for the quarter ended June 30, 2009 and $4.2 million for the quarter ended June 30, 2008. BGE's portion of our net periodic pension benefit cost, excluding amounts capitalized, was $9.9 million for the six months ended June 30, 2009 and $8.7 million for the six months ended June 30, 2008. Net periodic pension benefit costs exclude settlement charges of $7.7 million in the quarter and six months ended June 30, 2009.
We show the components of net periodic postretirement benefit cost in the following table:
1 BGE's portion of our net periodic postretirement benefit cost, excluding amounts capitalized, was $3.5 million for the quarter ended June 30, 2009 and $4.0 million for the quarter ended June 30, 2008. BGE's portion of our net periodic postretirement benefit costs, excluding amounts capitalized, was $6.7 million for the six months ended June 30, 2009 and $7.7 million for the six months ended June 30, 2008.
Our non-qualified pension plans and our postretirement benefit programs are not funded; however, we have trust assets securing certain executive pension benefits. We estimate that we will incur approximately $22 million in pension benefit payments for our non-qualified pension plans and approximately $30 million for retiree health and life insurance benefit payments during 2009. As of June 30, 2009, we contributed $297 million to our qualified pension plans. We contributed an additional $20 million in July 2009.
Credit Facilities and Short-term Borrowings
Our short-term borrowings may include bank loans, commercial paper, and bank lines of credit. Short-term borrowings mature within one year from the date of issuance. We pay commitment fees to banks for providing us lines of credit. When we borrow under the lines of credit, we pay market interest rates.
Constellation Energy had bank and other lines of credit under committed unsecured credit facilities totaling $5.6 billion at June 30, 2009 for short-term financial needs. We enter into these facilities to ensure adequate liquidity to support our operations.
Our liquidity requirements are funded with credit facilities and cash. We fund our short-term working capital needs with existing cash and with our credit facilities, which support direct cash borrowings and the issuance of commercial paper, if available. We also use our credit facilities to support the issuance of letters of credit, primarily for our merchant energy business.
These facilities can issue letters of credit, commercial paper, if available, and/or cash borrowings up to approximately $5.6 billion as shown below. As of June 30, 2009, we had approximately $2.8 billion in letters of credit issued against those facilities.
We have also included in the table below the pro forma effect on our credit facilities, which are reduced or terminated upon the closing of the transactions contemplated by the Investment Agreement with EDF, which is expected to occur in the fourth quarter of 2009:
1 Size of facility may be reduced by proceeds received from certain securities offerings or asset sales.
BGE has a $400.0 million five-year revolving credit facility expiring in 2011. BGE can borrow directly from the banks, use the facility to allow commercial paper to be issued, if available, or issue letters of credit. As of June 30, 2009, BGE had $0.5 million in letters of credit issued under this facility.
In addition, at June 30, 2009, BGE had $339.9 million in commercial paper outstanding.
Net Available Liquidity
The following table provides a summary of our net available liquidity at June 30, 2009:
Other Sources of Liquidity
In December 2008, we executed an Investment Agreement with EDF that includes an asset put arrangement that provides us with an option at any time through December 31, 2010 (or the termination of the Investment Agreement by EDF if we breach that agreement) to sell certain non-nuclear generation assets, at pre-agreed prices, to EDF for aggregate proceeds of no more than $2 billion pre-tax, or approximately $1.4 billion after-tax. The amount of after-tax proceeds will be impacted by the assets actually sold and the related tax impacts at that time. Exercise of the put arrangement is conditioned upon the receipt of regulatory approvals and third-party consents, the absence of any material liens on such assets, and the absence of a material adverse effect, as defined in the Investment Agreement. During April 2009, we received regulatory approvals and consents for the majority of the assets covered by the put arrangement. As of June 30, 2009, we have approximately $1.1 billion after-tax of liquidity available through the put arrangement. We expect to receive regulatory approval for an additional asset in the first quarter of 2010, which will increase the net after-tax
liquidity from the put arrangement to approximately $1.4 billion.
We are actively seeking to increase available liquidity and to reduce our business risk. Specifically, we are reducing capital spending and ongoing expenses, scaling down the expected variability in long-term earnings and short-term collateral usage, and limiting our exposure to business activities that require contingent capital support. During 2009, we made progress on several other initiatives as discussed in more detail in the Divestitures section beginning on page 15 and the Variable Interest Entities section on page 12. As of June 30, 2009 we have realized substantially all of the $1 billion of the net reduction in collateral that was expected from the divestiture of these operations.
We believe that the actions that we have taken and our current net available liquidity will be sufficient to support the ongoing liquidity requirements over the next 12 months. Our liquidity projections include assumptions for commodity price changes, which are subject to significant volatility, and we are exposed to certain operational risks that could have a significant impact on our liquidity.
Credit Facility Compliance and Covenants
The credit facilities of Constellation Energy and BGE have limited material adverse change clauses, none of which would prohibit draws under the existing facilities.
Certain credit facilities of Constellation Energy contain a provision requiring Constellation Energy to maintain a ratio of debt to capitalization equal to or less than 65%. At June 30, 2009, the debt to capitalization ratio as defined in the credit agreements was 51%.
Under our $3.85 billion and $1.23 billion credit facilities, we will be required to grant a lien on certain of our generating facilities and pledge our ownership interests in our nuclear business to the lenders upon the earlier of (i) the closing of the Investment Agreement with EDF or (ii) the date on which both the Investment Agreement is terminated and our Standard & Poors (S&P) or Fitch senior unsecured debt credit rating is below BBB- or our Moody's senior unsecured debt credit rating is below Baa3.
Our $1.23 billion credit facility requires us to maintain consolidated earnings before interest, taxes, depreciation, and amortization to consolidated interest expense ratio of at least 2.75 when our S&P senior unsecured debt rating is BBB- or lower and our Moody's senior unsecured debt rating is Baa3 or lower. Compliance with the covenant is not required as of July 31, 2009 as S&P's senior unsecured debt rating is above BBB-.
The credit agreement of BGE contains a provision requiring BGE to maintain a ratio of debt to capitalization equal to or less than 65%. At June 30, 2009, the debt to capitalization ratio for BGE as defined in this credit agreement was 52%.
We compute the income tax (benefit) expense for each quarter based on the estimated annual effective tax rate for the year. The effective tax rate was 78.3% and 60.4% for the quarter and six months ended June 30, 2009, respectively, compared to 38.0% and 36.1% for the same periods of 2008. The higher effective tax rate for the quarter and six months ended June 30, 2009 reflects the impact of unfavorable nondeductible adjustments (primarily related to nondeductible dividends on the Series B Preferred Stock and the write-off of the unamortized debt discount on the Senior Notes) in relation to the lower estimated 2009 taxable income (primarily attributable to losses on the divestiture of a majority of our international commodities and our Houston-based gas trading operations).
The BGE effective tax rate was 39.8% and 39.6% for the quarter and six months ended June 30, 2009, respectively, compared to 33.1% and 36.7% for the same periods of 2008. This reflects the impact of the lower 2008 taxable income related to the Maryland settlement agreement, which increased the relative impact of favorable permanent tax adjustments on BGE's 2008 effective tax rate.
Unrecognized Tax Benefits
The following table summarizes the change in unrecognized tax benefits during 2009 and our total unrecognized tax benefits at June 30, 2009:
1 BGE's portion of our total unrecognized tax benefits at June 30, 2009 was $3.9 million.
Increases in current year and reductions in prior year tax positions are primarily due to unrecognized tax benefits for repair and depreciation deductions measured at amounts
consistent with prior IRS examination results and state income tax accruals. Statutes of limitations lapsed for 2003 and 2004 tax positions related to Maryland taxes on the gas plant sale that occurred in 2006.
If the total amount of unrecognized tax benefits of $184.1 million were ultimately realized, our income tax expense would decrease by approximately $158 million. However, the $158 million includes state tax refund claims of approximately $48 million that have been disallowed by tax authorities and we believe that there is a remote likelihood of ultimately realizing any benefit from these refund claim amounts. These state refund claims may be resolved by December 31, 2009. For this reason, we believe it is reasonably possible that reductions to our total unrecognized tax benefits in the range of $40 to $50 million may occur by June 30, 2010, although these reductions are not expected to materially impact income tax expense.
Interest and penalties recorded in our Consolidated Statements of Income (Loss) as tax expense relating to liabilities for unrecognized tax benefits were as follows:
Accrued interest and penalties recognized in our Consolidated Balance Sheets were $11.0 million, of which BGE's portion was $0.8 million at June 30, 2009, and $10.3 million, of which BGE's portion was $0.7 million at December 31, 2008.
Taxes Other Than Income Taxes
BGE collects from certain customers franchise and other taxes that are levied by state or local governments on the sale or distribution of gas and electricity. We include these types of taxes in "Taxes other than income taxes" in our Consolidated Statements of Income (Loss). Some of these taxes are imposed on the customer and others are imposed on BGE. We account for the taxes imposed on the customer on a net basis, which means we do not recognize revenue and an offsetting tax expense for the taxes collected from customers. We account for the taxes imposed on BGE on a gross basis, which means we recognize revenue for the taxes collected from customers. Accordingly, we record the taxes accounted for on a gross basis as revenues in the accompanying Consolidated Statements of Income (Loss) for BGE as follows:
Our guarantees do not represent incremental Constellation Energy obligations; rather they primarily represent parental guarantees of subsidiary obligations. The following table summarizes the maximum exposure by guarantor based on the stated limit of our outstanding guarantees:
At June 30, 2009, Constellation Energy had a total of $14.1 billion in guarantees outstanding related to loans, credit facilities, and contractual performance of certain of its subsidiaries as described below.
expenses and obligations to safely operate and maintain the plants.
Commitments and Contingencies
We have made substantial commitments in connection with our merchant energy, regulated electric and gas, and other nonregulated businesses. These commitments relate to:
Our merchant energy business enters into various long-term contracts for the procurement and delivery of fuels to supply our generating plant requirements. In most cases, our contracts contain provisions for price escalations, minimum purchase levels, and other financial commitments. These contracts expire in various years between 2009 and 2028. In addition, our merchant energy business enters into long-term contracts for the capacity and transmission rights for the delivery of energy to meet our physical obligations to our customers. These contracts expire in various years between 2009 and 2030.
Our merchant energy business also has committed to long-term service agreements and other purchase commitments for our plants.
Our regulated electric business enters into various long-term contracts for the procurement of electricity. As of June 30, 2009, these contracts expire during 2009, 2010, and 2011 and represent BGE's estimated requirements for residential customers as follows:
The cost of power under these contracts is recoverable under the Provider of Last Resort agreement reached with the Maryland PSC.
Our regulated gas business enters into various long-term contracts for the procurement, transportation, and storage of gas. Our regulated gas business has gas procurement contracts that expire between 2009 and 2011, and transportation and storage contracts that expire between 2012 and 2027. The cost of gas under these contracts is recoverable under BGE's gas cost adjustment clause discussed in Note 1 of our 2008 Annual Report on Form 10-K.
Our other nonregulated businesses have committed to gas purchases, as well as to contribute additional capital for construction programs and joint ventures in which they have an interest.
We have also committed to long-term service agreements and other obligations related to our information technology systems.
At June 30, 2009, the total amount of commitments was $4,973.4 million. These commitments are primarily related to our merchant energy business.
We enter into long-term power sales contracts in connection with our load-serving activities. We also enter into long-term power sales contracts associated with certain of our power plants. Our load-serving power sales contracts extend for terms through 2019 and provide for the sale of energy to electricity distribution utilities and certain retail customers. Our power sales contracts associated with power plants we own extend for terms into 2015 and provide for the sale of all or a portion of the actual output of certain of our power plants. Substantially all long-term contracts were executed at pricing that approximated market rates, including profit margin, at the time of execution.
In the normal course of business, we are involved in various legal proceedings. We discuss the significant matters below.
Merger with MidAmerican
Beginning September 18, 2008, seven shareholders of Constellation Energy filed lawsuits in the Circuit Court for Baltimore City, Maryland challenging the then-pending merger with MidAmerican. Four similar suits were filed by other shareholders of Constellation Energy in the United States District Court for the District of Maryland.
The lawsuits claim that the merger consideration was inadequate and did not maximize value for shareholders, that the sales process leading up to the merger was
unreasonably short and procedurally flawed, and that unreasonable deal protection devices were agreed to in order to ward off competing bids and coerce shareholders into accepting the merger. The federal lawsuits also assert that the conversion of the Preferred Stock issued to MidAmerican into debt is not permitted under Maryland law. The lawsuits seek declaratory judgments establishing the unenforceability of the merger based on the alleged breaches of duty, injunctive relief to enjoin the merger, rescission of the merger or rescissory damages, the imposition of a constructive trust in favor of shareholders of any benefits received by the individual members of the Board of Directors of Constellation Energy, and reasonable costs and expenses, including attorney's fees.
The termination of the MidAmerican merger renders moot the claims attempting to enjoin the merger with MidAmerican. One of the federal merger cases was voluntarily dismissed on December 31, 2008. The other federal merger cases filed in the United States District Court for the District of Maryland were dismissed as moot on May 27, 2009. We believe there are meritorious defenses to the remaining claims or requests for relief. However, we are unable at this time to determine the ultimate outcome of these lawsuits or their possible effect on our financial results.
Securities Class Action
Three federal securities class action lawsuits have been filed in the United States District Courts for the Southern District of New York and the District of Maryland between September 2008 and November 2008. The cases were filed on behalf of a proposed class of persons who acquired publicly traded securities, including the Series A Junior Subordinated Debentures (Debentures), of Constellation Energy between January 30, 2008 and September 16, 2008, and who acquired Debentures in an offering completed in June 2008. The securities class actions generally allege that Constellation Energy, a number of its present or former officers or directors, and the underwriters violated the securities laws by issuing a false and misleading registration statement and prospectus in connection with Constellation Energy's June 27, 2008 offering of Debentures. The securities class actions also allege that Constellation Energy issued false or misleading statements or was aware of material undisclosed information which contradicted public statements including in connection with its announcements of financial results for 2007, the fourth quarter of 2007, the first quarter of 2008 and the second quarter of 2008 and the filing of its first quarter 2008 Form 10-Q. The securities class actions seek, among other things, certification of the cases as class actions, compensatory damages, reasonable costs and expenses, including counsel fees, and rescission damages.
The Southern District of New York granted the defendants' motion to transfer the two securities class actions filed there to the District of Maryland, and the actions have since been transferred for coordination with the securities class action filed there. On June 18, 2009, the court appointed a lead plaintiff, who we expect to file a consolidated amended complaint. We are unable at this time to determine the ultimate outcome of the securities class actions or their possible effect on our, or BGE's financial results.
In the fall of 2008, multiple class action lawsuits were filed in the United States District Courts for the District of Maryland and the Southern District of New York against Constellation Energy; Mayo A. Shattuck III, Constellation Energy's Chairman of the Board, President and Chief Executive Officer; and others in their roles as fiduciaries of the Constellation Energy Employee Savings Plan. The actions, which have been consolidated into one action in Maryland (the Consolidated Action), allege that the defendants, in violation of various sections of ERISA, breached their fiduciary duties to prudently and loyally manage Constellation Energy Savings Plan's assets by designating Constellation Energy common stock as an investment, by failing to properly provide accurate information about the investment, by failing to avoid conflicts of interest, by failing to properly monitor the investment and by failing to properly monitor other fiduciaries. The plaintiffs seek to compel the defendants to reimburse the plaintiffs and the Constellation Energy Savings Plan for all losses resulting from the defendants' breaches of fiduciary duty, to impose a constructive trust on any unjust enrichment, to award actual damages with pre- and post-judgment interest, to award appropriate equitable relief including injunction and restitution and to award costs and expenses, including attorneys' fees. We are unable at this time to determine the ultimate outcome of the Consolidated Action or its possible effects on our, or BGE's, financial results.
Since September 2002, BGE, Constellation Energy, and several other defendants have been involved in numerous actions filed in the Circuit Court for Baltimore City, Maryland alleging mercury poisoning from several sources, including coal plants formerly owned by BGE. The plants are now owned by a subsidiary of Constellation Energy. In addition to BGE and Constellation Energy, approximately 11 other defendants, consisting of pharmaceutical
companies, manufacturers of vaccines, and manufacturers of Thimerosal have been sued. Approximately 70 cases, involving claims related to approximately 132 children, have been filed to date, with each claimant seeking $20 million in compensatory damages, plus punitive damages, from us.
In rulings applicable to all but three of the cases, involving claims related to approximately 47 children, the Circuit Court for Baltimore City dismissed with prejudice all claims against BGE and Constellation Energy. Plaintiffs may attempt to pursue appeals of the rulings in favor of BGE and Constellation Energy once the cases are finally concluded as to all defendants. We believe that we have meritorious defenses and intend to defend the remaining actions vigorously. However, we cannot predict the timing, or outcome, of these cases, or their possible effect on our, or BGE's, financial results.
Since 1993, BGE and certain Constellation Energy subsidiaries have been involved in several actions concerning asbestos. The actions are based upon the theory of "premises liability," alleging that BGE and Constellation Energy knew of and exposed individuals to an asbestos hazard. In addition to BGE and Constellation Energy, numerous other parties are defendants in these cases.
Approximately 512 individuals who were never employees of BGE or Constellation Energy have pending claims each seeking several million dollars in compensatory and punitive damages. Cross-claims and third-party claims brought by other defendants may also be filed against BGE and Constellation Energy in these actions. To date, most asbestos claims which have been resolved have been dismissed or resolved without any payment and a small minority have been resolved for amounts that were not material to our financial results.
BGE and Constellation Energy do not know the specific facts necessary to estimate their potential liability for these claims. The specific facts we do not know include:
Until the relevant facts are determined, we are unable to estimate what our, or BGE's, liability might be. Although insurance and hold harmless agreements from contractors who employed the plaintiffs may cover a portion of any awards in the actions, the potential effect on our, or BGE's, financial results could be material.
Solid and Hazardous Waste
In 1999, the EPA proposed to add the 68th Street Dump in Baltimore, Maryland to the Superfund National Priorities List, which is its list of sites targeted for clean-up and enforcement, and sent a general notice letter to BGE and 19 other parties identifying them as potentially liable parties at the site. In March 2004, we and other potentially responsible parties formed the 68th Street Coalition and entered into consent order negotiations with the EPA to investigate clean-up options for the site under the Superfund Alternative Sites Program. In May 2006, a settlement among the EPA and 19 of the potentially responsible parties, including BGE, with respect to investigation of the site became effective. The settlement requires the potentially responsible parties, over the course of several years, to identify contamination at the site and recommend clean-up options. BGE is fully indemnified by a wholly owned subsidiary of Constellation Energy for costs related to this settlement, as well as any clean-up costs. The clean-up costs will not be known until the investigation is closer to completion. However, those costs could have a material effect on our financial results.
In May 2007, a subsidiary of Constellation Energy entered into a consent decree with the Maryland Department of the Environment to resolve alleged violations of air quality opacity standards at three fossil fuel plants in Maryland. The consent decree requires the subsidiary to pay a $100,000 penalty, provide $100,000 to a supplemental environmental project, and install technology to control emissions from those plants.
In January 2009, the EPA issued a notice of violation (NOV) to a subsidiary of Constellation Energy, as well as the other owners and the operator of the Keystone coal-fired power plant in Shelocta, Pennsylvania. We hold an approximately 21% interest in the Keystone plant. The NOV alleges that the plant performed various capital projects beginning in 1984 without complying with the new source review permitting requirements of the Clean Air Act. The EPA also contends that the alleged failure to comply with those requirements are continuing violations under the plant's air permits. The EPA could seek civil penalties under the Clean Air Act for the alleged violations.
The owners and operator of the Keystone plant are investigating the allegations and have entered into discussions with the EPA. We believe there are meritorious defenses to the allegations contained in the NOV. However, we cannot predict the outcome of this proceeding and it is not possible to determine our actual liability, if any, at this time.
In October 2007, a subsidiary of Constellation Energy entered into a consent decree with the Maryland Department of the Environment relating to groundwater contamination at a third party facility that was licensed to accept fly ash, a byproduct generated by our coal-fired plants. The consent decree requires the payment of a $1.0 million penalty, remediation of groundwater contamination resulting from the ash placement operations at the site, replacement of drinking water supplies in the vicinity of the site, and monitoring of groundwater conditions. We recorded a liability in our Consolidated Balance Sheets of approximately $7.9 million, which includes the $1 million penalty and our estimate of probable costs to remediate contamination, replace drinking water supplies, monitor groundwater conditions, and otherwise comply with the consent decree. We have paid approximately $4.1 million of these costs as of June 30, 2009, resulting in a remaining liability at June 30, 2009 of $3.8 million. We estimate that it is reasonably possible that we could incur additional costs of up to approximately $10 million more than the liability that we accrued.
We discuss our nuclear and non-nuclear insurance programs in Note 12 of our 2008 Annual Report on Form 10-K.
Nature of Our Business and Associated Risks
Our business activities primarily include our merchant energy business and our regulated electric and gas business. Our merchant energy business includes:
Our regulated electric and gas businesses engage in electricity and gas transmission and distribution activities in Central Maryland at prices set by the Maryland PSC that are generally designed to recover our costs, including purchased fuel and energy. Substantially all of our risk management activities involving derivatives occur outside our regulated businesses.
In carrying out our merchant energy business activities, we purchase and sell power, fuel, and other energy-related commodities in competitive markets. These activities expose us to significant risks, including market risk from price volatility for energy commodities and the credit risks of counterparties with which we enter into contracts. The sources of these risks include, but are not limited to, the following:
Objectives and Strategies for Using Derivatives
Risk Management Activities
To lower our exposure to the risk of unfavorable fluctuations in commodity prices, interest rates, and foreign currency rates, we routinely enter into derivative contracts, such as fixed-price forward physical purchase and sales contracts, futures, financial swaps, and option contracts traded in the over-the-counter markets or on exchanges, for hedging purposes. The objectives for entering into such hedging transactions primarily include:
Non-Risk Management Activities
In addition to the use of derivatives for risk management purposes, we also enter into derivative contracts for trading purposes primarily to achieve the following objectives:
The accounting requirements for derivatives requires recognition of all qualifying derivative instruments on the balance sheet at fair value as either assets or liabilities.
We must evaluate new and existing transactions and agreements to determine whether they are derivatives, for which there are several possible accounting treatments. Mark-to-market is required as the default accounting treatment for all derivatives unless they qualify, and we specifically designate them, for one of the other accounting treatments. Derivatives designated for any of the elective accounting treatments must meet specific, restrictive criteria, both at the time of designation and on an ongoing basis. The permissible accounting treatments include:
We discuss our accounting policies for derivatives and hedging activities and their impacts on our financial statements in Note 1 to our 2008 Annual Report on Form 10-K.
We elect NPNS accounting for derivative contracts that provide for the purchase or sale of a physical commodity that will be delivered in quantities expected to be used or sold over a reasonable period in the normal course of business. Once we elect NPNS classification for a given contract, we cannot subsequently change the election and treat the contract as a derivative using mark-to-market or hedge accounting.
Cash Flow Hedging
We generally elect cash flow hedge accounting for most of the derivatives that we use to hedge market price risk for our physical energy delivery activities because hedge accounting more closely aligns the timing of earnings recognition and cash flows for the underlying business activities. Management monitors the potential impacts of commodity price changes and, where appropriate, may enter into or close out (via offsetting transactions) derivative transactions designated as cash flow hedges.
Commodity Cash Flow Hedges
Our merchant energy business has designated fixed-price forward contracts as cash-flow hedges of forecasted sales of energy and forecasted purchases of fuel and energy for the years 2009 through 2016. Our merchant energy business had net unrealized pre-tax losses on these cash-flow hedges recorded in "Accumulated other comprehensive loss" of $1,845.3 million at June 30, 2009 and $2,614.9 million at December 31, 2008.
We expect to reclassify $1,326.2 million of net pre-tax losses on cash-flow hedges from "Accumulated other comprehensive loss" into earnings during the next twelve months based on market prices at June 30, 2009. However, the actual amount reclassified into earnings could vary from the amounts recorded at June 30, 2009, due to future changes in market prices.
When we determine that a forecasted transaction originally hedged has become probable of not occurring, we reclassify net unrealized gains or losses associated with those hedges from "Accumulated other comprehensive loss" to earnings. We recognized in earnings the following pre-tax amounts on such contracts:
The pre-tax loss reclassified in 2009 resulted from the sale of a majority of our international commodities operation and our termination of certain contracts as part of our efforts to improve liquidity and reduce risk. The forecasted transactions associated with previously designated cash-flow hedge contracts were deemed probable of not occurring.
Interest Rate Swaps Designated as Cash Flow Hedges
We use interest rate swaps designated as cash flow hedges to manage our interest rate exposures associated with new debt issuances and to manage our exposure to fluctuations in interest rates on variable rate debt. The effective portion of gains and losses on these interest rate cash flow hedges, net of associated deferred income tax effects, is recorded in "Accumulated other comprehensive loss" in our Consolidated Statements of Comprehensive Income (Loss). We reclassify gains and losses on the hedges from "Accumulated other comprehensive loss" into "Interest expense" in our Consolidated Statements of Income (Loss) during the periods in which the interest payments being hedged occur.
Accumulated other comprehensive loss includes net unrealized pre-tax gains on interest rate cash-flow hedges of prior debt issuances totaling $12.1 million at June 30, 2009 and $12.0 million at December 31, 2008. We expect to reclassify $1.9 million of pre-tax net gains on these cash-flow hedges from "Accumulated other comprehensive loss" into "Interest expense" during the next twelve months. We had no hedge ineffectiveness on these swaps.
Fair Value Hedging
We elect fair value hedge accounting for a limited portion of our derivative contracts including certain interest rate swaps and certain forward contracts and price and basis swaps associated with natural gas fuel in storage. The objectives for electing fair value hedging in these situations are to manage our exposure, to optimize the mix of our fixed and floating-rate debt, and to hedge the value of our natural gas in storage. We did not have any fair value hedges related to the value of our natural gas in storage during the second quarter of 2009.
Interest Rate Swaps Designated as Fair Value Hedges
We use interest rate swaps designated as fair value hedges to optimize the mix of fixed and floating-rate debt. We record any gains or losses on swaps that qualify for fair value hedge accounting treatment, as well as changes in the fair value of the debt being hedged, in "Interest expense." We record changes in fair value of the swaps in "Derivative assets and liabilities" and changes in the fair value of the debt in "Long-term debt" in our Consolidated Balance Sheets. In addition, we record the difference between interest on hedged fixed-rate debt and floating-rate swaps in "Interest expense" in the periods that the swaps settle.
During 2004, we entered into interest rate swaps qualifying as fair value hedges relating to $450 million of our fixed-rate debt maturing in 2012 and 2015, and converted this notional amount of debt to floating-rate. The fair value of these hedges was an unrealized gain of $40.4 million at June 30, 2009 and $55.9 million at December 31, 2008 and was recorded as an increase in our "Derivative assets" and an increase in our "Long-term debt." We had no hedge ineffectiveness on these interest rate swaps. On July 15, 2009, we terminated an interest rate swap relating to $50 million of the $450 million of our fixed-rate debt and received approximately $4.5 million in cash. This transaction will be recorded in the third quarter of 2009.
For all categories of derivative instruments designated in hedging relationships, we recorded in earnings the following pre-tax gains (losses) related to hedge ineffectiveness:
In addition, we did not recognize any gain or loss during the quarter or six months ended June 30, 2009 and 2008 relating to changes in value for the portion of our fair value hedges excluded from our hedge effectiveness assessment.
We generally apply mark-to-market accounting for risk management and trading activities for which changes in fair value more closely reflect the economic performance of the underlying business activity. However, we also use mark-to-market accounting for derivatives related to the following physical energy delivery activities:
Effective January 1, 2009, we adopted SFAS No. 161, Disclosures About Derivative Instruments and Hedging Activities, (SFAS No. 161). SFAS No. 161 does not change the accounting for derivatives; rather, it requires expanded disclosure about derivative instruments and hedging activities regarding:
Balance Sheet Tables
We present our derivative assets and liabilities in our Consolidated Balance Sheets on a net basis, including cash collateral, whenever we have a legally enforceable master netting agreement with a counterparty to a derivative contract. We use master netting agreements whenever possible to manage and substantially reduce our potential counterparty credit risk. The net presentation in our Consolidated Balance Sheets reflects our actual credit exposure after giving effect to the beneficial effects of these agreements and cash collateral, and our credit risk is reduced further by other forms of collateral.
The following table provides information about the types of market risks we manage using derivatives. This table only includes derivatives and does not reflect the price risks we are hedging that arise from physical assets or nonderivative accrual contracts within our generating plants, customer supply, and global commodities activities.
As discussed more fully following the table, we present this information by disaggregating our net derivative assets and liabilities into gross components on a contract-by-contract basis before giving effect to the risk-reducing benefits of master netting arrangements and collateral. As a result, we must present each individual contract as an "asset value" if it is in the money or a "liability value" if it is out of the money, regardless of whether the individual contracts offset market or credit risks of other contracts in full or in part. Therefore, the gross amounts in this table do not reflect our actual economic or credit risk associated with derivatives. This gross presentation is intended only to show separately the various derivative contract types we use, such as commodities, interest rate, and foreign exchange.
In order to identify how our derivatives impact our financial position, at the bottom of the table we provide a reconciliation of the gross fair value components to the net fair value amounts as presented in the Fair Value Measurements section of this note and our Consolidated Balance Sheets.
The gross asset and liability values in the table below are segregated between those derivatives designated in qualifying hedge accounting relationships and those not designated in hedge accounting relationships. Derivatives not designated in hedging relationships include our retail gas customer supply operation, economic hedges of accrual activities, the international commodities and Houston-based gas trading operations that we have divested, and risk management and trading activities which we have substantially curtailed as part of our effort to reduce risk in our business. We use the end of period accounting designation to determine the classification for each derivative position.
1 Other commodity contracts include oil, freight, emission allowances, and weather contracts.
The magnitude of and changes in the gross derivatives components in this table do not indicate changes in the level of derivative activities, the level of market risk, or the level of credit risk. The primary factors affecting the magnitude of the gross amounts in the table are changes in commodity prices and the total number of contracts. If commodity prices change, the gross amounts could increase, even if the level of contracts stays the same, because separate presentation is required for contracts that are in the money from those that are out of the money. As a result, the gross amounts of even fully hedged positions could increase if prices change. Additionally, if the number of contracts increases, the gross amounts also could increase. Thus, the execution of new contracts to reduce economic risk could actually increase the gross amounts in the table because of the requirement to present the gross value of each individual contract separately.
The primary purpose of this table is to disaggregate the risks being managed using derivatives. In order to achieve this objective, we prepare this table by separating each individual derivative contract that is in the money from each contract that is out of the money and present such amounts on a gross basis, even for offsetting contracts that have identical quantities for the same commodity, location, and delivery period. We must also present these components excluding the substantive credit-risk reducing effects of master netting agreements and collateral. As a result, the gross "asset" and "liability" amounts for each contract type far exceed our actual economic exposure to commodity price risk and credit risk. Our actual economic exposure consists of the net derivative position combined with our nonderivative accrual contracts, such as those for load-serving, and our physical assets, such as our power plants. Our actual derivative credit risk exposure after master netting agreements and cash collateral is reflected in the net fair value amounts shown at the bottom of the table above. Our total economic and credit exposures, including derivatives, are managed in a comprehensive risk framework that includes risk measures such as economic value at risk, stress testing, and maximum potential credit exposure.
Gain and (Loss) Tables
The tables below summarize the gain and loss impacts of our derivative instruments segregated into the following categories:
The tables only include this information for derivatives and do not reflect the related gains or losses that arise from generation and generation-related assets, nonderivative accrual contracts, or NPNS contracts within our Generation, Customer Supply, and Global Commodities activities, other than fair value hedges, for which we separately show the gain or loss on the hedged asset or liability. As a result, for mark-to-market and cash-flow hedge derivatives, these tables only reflect the impact of derivatives themselves and therefore do not necessarily include all of the income statement impacts of the transactions for which derivatives are used to manage risk. For a more complete discussion of how derivatives affect our financial performance, see our accounting policy for Revenues, Fuel and Purchased Energy Expenses, and Derivatives and Hedging Activities in Note 1 to our 2008 Annual Report on Form 10-K.
The following table presents gains and losses on derivatives designated as cash flow hedges. As discussed more fully in our accounting policy, we record the effective portion of unrealized gains and losses on cash flow hedges in Accumulated Other Comprehensive Loss until the hedged forecasted transaction affects earnings. We record the ineffective portion of gains and losses on cash flow hedges in earnings as they occur. When the hedged forecasted transaction settles and is recorded in earnings, we reclassify the related amounts from Accumulated Other Comprehensive Loss into earnings, with the result that the combination of revenue or expense from the forecasted transaction and gain or loss from the hedge are recognized in earnings at a total amount equal to the hedged price. Accordingly, the amount of derivative gains and losses recorded in Accumulated Other Comprehensive Loss and reclassified from Accumulated Other Comprehensive Loss into earnings does not reflect the total economics of the hedged forecasted transactions. The total impact of our forecasted transactions and related hedges is reflected in our Consolidated Statements of Income (Loss).
1 Other commodity sale contracts include oil and freight contracts.
The following table presents gains and losses on derivatives designated as fair value hedges and, separately, the gains and losses on the hedged item. As discussed earlier, we record the unrealized gains and losses on fair value hedges as well as changes in the fair value of the hedged asset or liability in earnings as they occur. The difference between these amounts represents hedge ineffectiveness. Due to the sale of our Houston-based gas trading operation, we do not have any second quarter activity under fair value hedges related to gas contracts.
The following table presents gains and losses on mark-to-market derivatives, contracts that have not been designated as hedges for accounting purposes. As discussed more fully in Note 1 to our 2008 Annual Report on Form 10-K, we record the unrealized gains and losses on mark-to-market derivatives in earnings as they occur. While we use mark-to-market accounting for risk management and trading activities because changes in fair value more closely reflect the economic performance of the activity, we also use mark-to-market accounting for certain derivatives related to portions of our physical energy delivery activities. Accordingly, the total amount of gains and losses from mark-to-market derivatives does not necessarily reflect the total economics of related transactions.
1 Other commodity contracts for the quarter ended June 30, 2009 include oil, freight, weather, and emission allowances. For the six months ended June 30, 2009, other commodity contracts also include uranium.
In computing the amounts of derivative gains and losses in the above tables, we include the changes in fair values of derivative contracts up to the date of maturity or settlement of each contract. This approach facilitates a comparable presentation for both financial and physical derivative contracts. In addition, for cash flow hedges we include the impact of intra-quarter transactions (i.e., those that arise and settle within the same quarter) in both gains and losses recognized in Accumulated Other Comprehensive Loss and amounts reclassified from Accumulated Other Comprehensive Loss into earnings.
Volume of Derivative Activity
The volume of our derivatives activity is directly related to the fundamental nature and scope of our business and the risks we manage. We own or control electric generating
facilities, which exposes us to both power and fuel price risk; we serve electric and gas wholesale and retail customers within our customer supply business, which exposes us to electricity and natural gas price risk; and we provide risk management services and engage in trading activities, which can expose us to a variety of commodity price risks. We conduct our business activities throughout the United States and internationally. In order to manage the risks associated with these activities, we are required to be an active participant in the energy markets, and we routinely employ derivative instruments to conduct our business.
Derivative instruments provide an efficient and effective way to conduct our business and to manage the associated risks. We manage our generating resources and customer supply activities based upon established policies and limits, and we use derivatives to establish a portion of our hedges and to adjust the level of our hedges from time to time. Additionally, we engage in trading activities which enable us to execute hedging transactions in a cost-effective manner. We manage those activities based upon various risk measures, including position limits, economic value at risk (EVaR) and value at risk (VaR), and we use derivatives to establish and maintain those activities within the prescribed limits. We are also using derivatives to execute, control, and reduce the overall level of our trading positions and risk as well as to manage a portion of our interest rate risk associated with debt and our foreign currency risk from non-dollar denominated transactions. Accordingly, the use of derivative instruments is integral to the conduct of our business, and derivative instruments are an important tool through which we are able to manage and mitigate the risks that are inherent in our activities.
The following table presents information designed to provide insight into the overall volume of our derivatives usage. However, the volumes presented in this table are subject to a number of limitations and should only be used as an indication of the extent of our derivatives usage and the risks they are intended to manage.
First, the volume information is not a complete representation of our market price risk because it only includes derivative contracts. Accordingly, this table does not present a complete picture of our overall net economic exposure, and should not be interpreted as an indication of open or unhedged commodity positions, because the use of derivatives is only one of the means by which we engage in and manage the risks of our business. For example, the table does not include power or fuel quantities and risks arising from our physical assets, non-derivative contracts, and forecasted transactions that we manage using derivatives; a portion of these volumes reduce those risks. It also does not include volumes of commodities under nonderivative contracts that we use to serve customers or manage our risks. Our actual net economic exposure from our generating facilities and customer supply activities is reduced by derivatives, and the exposure from our trading activities is managed and controlled through the risk measures discussed above. Therefore, the information in the table below is only an indication of that portion of our business that we manage through derivatives and serves primarily to identify the extent of our derivatives activities and the types of risks that they are intended to manage.
Additionally, the disclosure of derivative quantities potentially could reveal commercially valuable or otherwise competitively sensitive information that could limit the effectiveness and profitability of our business activities. Therefore, in the table below, we have computed the derivative volumes for commodities by aggregating the absolute value of net open long (purchase) and short (sell) positions within commodities for each year. This provides an indication of the level of derivatives activity, but it does not indicate either the direction of our position (long or short), or the overall size of our position. We believe this presentation gives an appropriate indication of the level of derivatives activity without unnecessarily revealing the size and direction of our derivatives positions.
Finally, the volume information for commodity derivatives represents "delta equivalent" quantities, not gross notional amounts. We make use of different types of commodity derivative instruments such as forwards, futures, options, and swaps, and we believe that the delta equivalent quantity is the most relevant measure of the volume associated with these commodity derivatives. The delta-equivalent quantity represents a risk-adjusted notional quantity for each contract that takes into account the probability that an option will be exercised. Therefore, the volume information for commodity derivatives represents the delta equivalent quantity of those contracts, computed on the basis described above. For interest rate contracts and foreign currency contracts we have presented the notional amounts of such contracts in the table below.
The following table presents the volume of our derivative activities as of June 30, 2009, shown by contractual settlement year.
1 Amounts in the table are only intended to provide an indication of the level of derivatives activity and should not be interpreted as a measure of any derivative position or overall economic exposure to market risk. Quantities are expressed as "delta equivalents" on an absolute value basis by contract type by year. Additionally, quantities relate only to derivatives and do not include potentially offsetting quantities associated with physical assets and nonderivative accrual contracts.
In addition to the commodities in the tables above, we also hold derivative instruments related to weather and freight that are insignificant relative to the overall level of our derivative activity.
Credit-Risk Related Contingent Features
Certain of our derivative instruments contain provisions that would require additional collateral upon a credit-related event such as an adequate assurance provision or a credit rating decrease in the senior unsecured debt of Constellation Energy. The amount of collateral we could be required to post would be determined by the fair value of contracts containing such provisions that represent a net liability, after offset for the fair value of any asset contracts with the same counterparty under master netting agreements and any other collateral already posted. This collateral amount is a component of, and is not in addition to, the total collateral we could be required to post for all contracts upon a credit rating decrease.
The following table presents information related to these derivatives. Based on contractual provisions, we estimate that if Constellation Energy's senior unsecured debt were downgraded, our total contingent collateral obligation for derivatives in a net liability position was $0.3 billion as of June 30, 2009, which represents the additional collateral that we could be required to post with counterparties, including both cash collateral and letters of credit, in the event of a credit downgrade to below investment grade. These amounts are associated with net derivative liabilities totaling $1.5 billion after reflecting legally binding master netting agreements and collateral already posted.
Interpretations of SFAS No. 161 indicate that the gross fair value of derivatives in a net liability position that have credit-risk-related contingent features should be disclosed, and we present this amount in the first column in the table below. This gross fair value amount represents only the out-of-the-money contracts containing such features that are not fully collateralized by cash on a stand-alone basis. Thus, this amount does not reflect the offsetting fair value of in-the-money contracts under legally-binding master netting agreements with the same counterparty, as shown in the second column in the table. These in-the-money contracts would offset the amount of any gross liability that could be required to be collateralized, and as a result, the actual potential collateral requirements would be based upon the net fair value of derivatives containing such features, not the gross amount. The amount of any possible contingent collateral for such contracts in the event of a downgrade would be further reduced to the extent that we have already posted collateral related to the net liability.
Because the amount of any contingent collateral obligation would be based on the net fair value of all derivative contracts under each master netting agreement, we believe that the "net fair value of derivative contracts containing this feature" as shown in the table below is the most relevant measure of derivatives in a net liability position with credit-risk-related contingent features. This amount reflects the actual net liability upon which existing collateral postings are computed and upon which any additional contingent collateral obligation would be based.
1 Amount represents the gross fair value of out-of-the-money derivative contracts containing credit-risk-related
contingent features that are not fully collateralized by posted cash collateral on an individual, contract-by-contract basis ignoring the effects of master netting
Concentrations of Derivative-Related Credit Risk
Constellation Energy's wholesale and retail credit risk management policies establish the guidelines under which we extend unsecured credit to counterparties and customers. Based on the counterparty analysis and limits established by Constellation Energy, collateral or other security may be required to enter into transactions based on the potential exposure. Under most agreements we have entered into, collateral is in the form of cash or letters of credit. These forms of collateral are held by us and can be drawn upon should a counterparty default on its obligations under its agreement.
As a best practice, we enter into commodity master agreements and cross-commodity netting agreements in order to achieve the benefits of netting in terms of exposure and collateral capital reductions. Where beneficial to the risk profile of the company, we will seek credit protections that include upfront collateral, margining, material adverse change clauses (based on credit ratings downgrades or other financial ratios events), and adequate assurances clauses in our master agreements that can be utilized to request security from our counterparties in order to cover our potential risk of loss.
We consider a significant concentration of credit risk to be any single obligor or counterparty whose concentration exceeds 10% of total credit exposure. As of June 30, 2009, no single counterparty concentration comprises more than 10% of the total exposure of the portfolio, and no collection of counterparties based in a single country other than the United States comprises more than 10% of the total exposure of the portfolio.
Fair Value Measurements
SFAS No. 157, Fair Value Measurements, (SFAS No. 157) defines fair value, establishes a framework for measuring fair value, and requires certain disclosures about fair value measurements. Fair value is the price that we would receive to sell an asset or pay to transfer a liability in an orderly transaction between market participants at the measurement date (exit price).
SFAS No. 157 also creates a fair value hierarchy that prioritizes the inputs used to measure fair value. The three levels of the fair value hierarchy are as follows:
We determine the fair value of our assets and liabilities using unadjusted quoted prices in active markets (Level 1) or pricing inputs that are observable (Level 2) whenever that information is available. We use unobservable inputs (Level 3) to estimate fair value only when relevant observable inputs are not available.
We classify assets and liabilities within the fair value hierarchy based on the lowest level of input that is
significant to the fair value measurement of each individual asset and liability taken as a whole. We determine fair value for assets and liabilities classified as Level 1 by multiplying the market price by the quantity of the asset or liability. We primarily determine fair value measurements classified as Level 2 or Level 3 using the income valuation approach, which involves discounting estimated cash flows using assumptions that market participants would use in pricing the asset or liability.
We present all derivatives recorded at fair value net with the associated fair value cash collateral. This presentation of the net position reflects our credit exposure for our on-balance sheet positions but excludes the impact of any off-balance sheet positions and collateral. Examples of off-balance sheet positions and collateral include in-the-money accrual contracts for which the right of offset exists in the event of default and letters of credit. We discuss our letters of credit in more detail in the Financing Activities section.
BGE's assets and liabilities measured at fair value on a recurring basis are immaterial. Our merchant energy business segment's assets and liabilities measured at fair value on a recurring basis consist of the following:
* Represents the unrealized fair value of exchange traded derivatives, exclusive of cash margin posted.
Cash equivalents represent money market mutual funds which are included in "Cash and cash equivalents" and "Nuclear decommissioning trust funds" in the Consolidated Balance Sheets. Debt and equity securities primarily represent available-for-sale investments which are included in "Nuclear decommissioning trust funds" and "Other assets" in the Consolidated Balance Sheets. Derivative instruments represent unrealized amounts related to all derivative positions, including futures, forwards, swaps, and options. We classify exchange-listed contracts as part of "Accounts Receivable" in our Consolidated Balance Sheets. We classify the remainder of our derivative contracts as "Derivative assets" or "Derivative liabilities" in our Consolidated Balance Sheets.
The table below disaggregates our net derivative assets and liabilities on a gross contract-by-contract basis. Each individual asset or liability that is remeasured at fair value on a recurring basis is required to be presented in this table and classified, in its entirety, within the appropriate level in the fair value hierarchy. Therefore, the objective of this table is to provide information about how each individual derivative contract is valued within the fair value hierarchy, regardless of whether a particular contract is eligible for netting against other contracts or whether it has been collateralized.
The table below sets forth by level within the fair value hierarchy the gross components of the Company's assets and liabilities that were measured at fair value on a recurring basis as of June 30, 2009. These gross balances are intended solely to provide information on sources of inputs to fair value and proportions of fair value involving objective versus subjective valuations and do not represent either our actual credit exposure or net economic exposure.
* We present our derivative assets and liabilities in our Consolidated Balance Sheets on a net basis. We net derivative assets and liabilities, including cash collateral, when a legally enforceable master netting agreement exists between us and the counterparty to a derivative contract. At June 30, 2009, we included $193.4 million of cash collateral held and $133.4 million of cash collateral posted (excluding margin posted on exchange traded derivatives) in netting amounts in the above table.
The factors that cause changes in the gross components of the derivatives amounts in the table above are unrelated to the existence or level of actual market or credit risk from our operations. Thus, the gross components of the derivatives amounts in this table decreased from the corresponding amounts as of December 31, 2008, due to substantial changes in commodity prices and the decrease in the number of derivative contracts outstanding. We describe the primary factors that change the gross components below.
SFAS No. 157 requires us to prepare this table by separating each individual derivative contract that is in the money from each contract that is out of the money. It also requires us to ignore master netting agreements and collateral for our derivatives. As a result, the gross "asset" and "liability" amounts under each of the three fair value levels far exceed our actual economic exposure to commodity price risk and credit risk. Our actual economic exposure consists of the net derivative position combined with our nonderivative accrual contracts, such as those for load-serving, and our physical assets, such as our power plants. Our actual credit risk exposure is reflected in the net derivative asset and derivative liability amounts shown in the Total Net Fair Value column.
Increases and decreases in the gross components presented in each of the levels in this table also do not indicate changes in the level of derivative activities. Rather, the primary factors affecting the gross amounts are commodity prices and the total number of contracts. If commodity prices change, the gross amounts could increase, even if the level of contracts stays the same, because separate presentation is required for contracts that are in the money from those that are out of the money. As a result, even fully hedged positions could exhibit increases in the gross amounts if prices change. Additionally, if the number of contracts increases, the gross amounts also could increase. Thus, the execution of new contracts to reduce economic risk could actually increase the gross amounts in the table because of the required separation of contracts discussed above.
Cash equivalents are primarily comprised of exchange traded money market funds and money market mutual funds. These instruments are valued based upon unadjusted quoted prices in active markets and are classified within Level 1. Cash equivalents classified in Level 2 are held within our nuclear decommissioning trust funds and are valued based on fund share price, which is observable on a less frequent basis.
Debt and equity securities include trust assets securing certain executive benefits, other marketable securities, and our nuclear decommissioning trust funds. Trust assets securing certain executive benefits consist of mutual funds, which are valued based upon unadjusted quoted prices in active markets and are classified within Level 1. Our other marketable securities consist of marketable equity securities, which are valued based on unadjusted quoted prices in active markets and are classified within Level 1. Nuclear decommissioning trust funds consist of a number of different types of securities, including the following:
Derivative instruments include exchange-traded and bilateral contracts. Exchange-traded derivative contracts include futures and certain options. Bilateral derivative contracts include swaps, forwards, certain options and complex structured transactions. We utilize models to measure the fair value of bilateral derivative contracts. Generally, we use similar models to value similar instruments. Valuation models utilize various inputs, which include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, other observable inputs for the asset or liability, and market-corroborated inputs, which are inputs derived principally from or corroborated by observable market data by correlation or other means. However, the primary input to our valuation models is the forward commodity price. We have classified derivative contracts within the fair value hierarchy as follows:
In order to determine fair value, we utilize various inputs and factors including market data and assumptions that market participants would use in pricing assets or liabilities as well as assumptions about the risks inherent in the inputs to the valuation technique. The inputs and factors include:
The following table sets forth a reconciliation of changes in Level 3 fair value measurements:
Realized and unrealized gains (losses) are included primarily in "Nonregulated revenues" for our derivative contracts that are marked-to-market