Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The information required by this item is contained herein, as follows:
Registrants Page No.
Pepco Holdings 77
Pepco 107
DPL 120
ACE 125
ACE Funding 130
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MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
PEPCO HOLDINGS
OVERVIEW
Pepco Holdings is a diversified energy company that, through its operating
subsidiaries, is engaged in three principal areas of business operations:
regulated power delivery,
non-regulated competitive energy generation, marketing and supply, and
other non-regulated activities consisting primarily of investments in
energy-related assets.
The following is a description of each of PHI's areas of operation.
Power Delivery
The largest component of PHI's business is Power Delivery, which consists of
the transmission and distribution of electricity and the distribution of natural
gas. PHI's Power Delivery business is conducted by its subsidiaries Potomac
Electric Power Company (Pepco), Delmarva Power & Light Company (DPL) and
Atlantic City Electric Company (ACE), each of which is a regulated public
utility in the jurisdictions in which it serves customers. DPL and ACE conduct
their Power Delivery operations under the trade name Conectiv Power Delivery.
Competitive Energy
PHI's competitive energy business provides non-regulated generation,
marketing and supply of electricity and gas, and related energy management
services, in the mid-Atlantic region. PHI's competitive energy operations are
conducted through subsidiaries of Conectiv Energy Holding Company (collectively,
Conectiv Energy) and Pepco Energy Services and its subsidiaries (collectively,
Pepco Energy Services).
Other Non-Regulated
This component of PHI's business is conducted through its subsidiaries
Potomac Capital Investment Corporation (PCI) and Pepco Communications, Inc.
(Pepcom). PCI manages a portfolio of financial investments, which primarily
includes energy leveraged leases. During the second quarter of 2003, PHI
announced the discontinuation of further new investment activity by PCI. Pepco
Holdings, through Pepcom, holds a 50% interest in Starpower Communications, LLC
(Starpower), a joint venture with RCN Corporation (RCN), which owns the other
50%.
In the fourth quarter of 2003, Pepco Holdings recorded an impairment charge
which reduced the carrying value of Pepcom's investment in Starpower to $39.2
million. The amount of the impairment charge was based on Pepco Holdings' intent
to sell its investment and an assessment of the fair value of its investment at
December 31, 2003. On July 28, 2004, Pepcom entered into a contract with a third
party for the sale of its 50% interest in Starpower. Based on the sales price in
the contract and the related selling costs, Pepcom
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recorded an additional impairment charge of $11.2 million in the second quarter
of 2004 reducing the value of Pepco Holdings' equity investment in Starpower to
$28 million at June 30, 2004.
Under a right of first refusal provision in the Starpower joint venture
operating agreement between Pepcom and RCN, RCN has the right to match a third
party's offer and enter into an agreement to purchase Pepcom's interest in
Starpower within 60 days from the receipt of an offer notice from Pepcom.
On October 15, 2004, RCN notified Pepcom that it has elected to exercise its
right of first refusal to match the third party offer and to purchase Pepcom's
50% interest in Starpower. As a result of RCN's election to purchase Pepcom's
50% interest in Starpower, Pepcom will be required to pay a break up fee of $1
million to the third party with which Pepcom entered into the July 28, 2004
contract. This break up fee will be payable upon closing of the sale to RCN of
Pepcom's interest in Starpower.
The sale of Pepcom's interest in Starpower to RCN is subject to the receipt
of all necessary regulatory approvals. At this time, the completion date for the
sale has not been determined.
For additional information, refer to Item 7, Management's Discussion and
Analysis of Financial Condition and Results of Operations of PHI's Annual Report
on Form 10-K/A for the year ended December 31, 2003.
EARNINGS OVERVIEW
Three Months Ended September 30, 2004 and 2003 Results
The earnings of Pepco Holdings for the three months ended September 30, 2004,
were $111.0 million compared to $157.3 million for the corresponding period in
2003. A comparison of earnings for these periods, adjusted for supplemental
items, is as follows:
Pepco
For the Three Months Ended Conectiv Energy Other Corp. &
September 30, Power Delivery Energy Services Non-Regulated Other PHI Consolidated
(In Millions)
2004 Net Income/(Loss) $ 95.4 $19.8 $ 1.2 $ 9.5 $(14.9) $111.0
2004 Supplemental
Adjustments (a):
Bethlehem loan payment (b) - 7.7 - - - 7.7
2004 Adjusted $ 95.4 $27.5 $ 1.2 $ 9.5 $(14.9) $118.7
2003 Net Income/(Loss) $ 95.6 $23.1 $3.6 $50.4 $(15.4) $157.3
2003 Supplemental
Adjustments (a):
Mirant Receivable Reserve (c) 8.7 - - - - 8.7
Building sale gain (d) - - - (44.7) - (44.7)
2003 Adjusted $104.3 $ 23.1 $ 3.6 $ 5.7 $(15.4) $121.3
$ Variance for 2004 Adjusted
vs. 2003 Adjusted $ (8.9) $ 4.4 $(2.4) $ 3.8 $ 0.5 $(2.6)
(a) These adjustments, which are net of tax, represent non-GAAP financial information. Management
believes that the adjusted earnings amounts may be useful to investors because they show results
before giving effect to the adjustment items. This allows investors to compare earnings
information and make decisions without the impact of supplemental items.
(b) This amount represents the income statement impact of the expenses associated with the
pre-payment of the Bethlehem debt.
(c) This amount represents a reserve recorded against a delinquent receivable from Mirant.
(d) This amount represents a gain on the sale of the Edison Place office building.
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A summary of the factors contributing to the three months ended September 30,
2004 and 2003 earnings variances is as follows.
Power Delivery's third quarter 2004 earnings were $8.9 million lower than its
adjusted earnings for the corresponding 2003 period primarily due to the
unfavorable impact of lower earnings from ESS at Pepco of approximately $13.6
million and unfavorable cooler summer weather that resulted in approximately
$2.1 million lower T&D revenue, partially offset by $3.5 million net earnings
from ESS at Conectiv.
Conectiv Energy's third quarter 2004 adjusted earnings were $4.4 million
higher than the corresponding 2003 period due to favorable Provider of Last
Resort (POLR) margins and Power, Oil and Gas Marketing margins of $4.3 million,
and the recognition of an adjustment related to fuel supply contracts of $5.6
million, offset by lower generation output and margins resulting from milder
than normal weather ($4.3 million). In addition, interest expense was higher by
$.8 million and depreciation expense by $.5 million primarily because of the
completion of the Company's Bethlehem Power Plant.
Pepco Energy Services' third quarter 2004 earnings were $2.4 million lower
than its earnings for the corresponding 2003 period primarily due to lower run
time at its power plants resulting from mild summer weather.
Other Non-Regulated third quarter 2004 earnings were $3.8 million higher than
its adjusted earnings for the corresponding 2003 period primarily due to the
$1.4 million gain on the sale of PCI's final aircraft and $1.4 million in
reduced interest expense.
Corporate and Other's third quarter 2004 earnings were $.5 million higher
than its earnings for the corresponding period in 2003 primarily due to the fact
that software was fully amortized in early 2004.
Nine Months Ended September 30, 2004 and 2003 Results
The earnings of Pepco Holdings for the nine months ended September 30, 2004,
were $252.6 million compared to $175.5 million for the corresponding period in
2003. A comparison of earnings for these periods, adjusted for supplemental
items, is as follows:
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Pepco
For the Nine Months Ended Power Conectiv Energy Other Corp. & PHI
September 30, Delivery Energy Services Non-Regulated Other Consolidated
2004 Net Income/(Loss) $208.7 $49.4 $7.6 $36.5 $(49.6) $252.6
2004 Supplemental
Adjustments (a):
Starpower Impairment (b) - - - 7.3 - 7.3
Local Tax Benefit (c) (.8) - (1.5) (8.8) (2.0) (13.1)
Gain on disposition
associated with Vineland
co-generation facility (d) - (6.6) - - - (6.6)
Bethlehem loan payment (e) - 7.7 - - - 7.7
Gain on Vineland
distribution assets --
Condemnation Settlement (f) (8.6) - - - - (8.6)
2004 Adjusted $199.3 $50.5 $6.1 $35.0 $(51.6) $239.3
2003 Net Income/(Loss) $188.7 $(62.7) $1.3 $68.5 $(20.3) $175.5
2003 Supplemental
Adjustments (a):
Trading Losses (g) - 26.7 - - - 26.7
CT Cancellation (h) - 65.7 - - (34.6) 31.1
ACE New Jersey Deferral
Disallowance (i) 16.3 - - - - 16.3
ACE accrual reversal (j) (5.9) - - - - (5.9)
Mirant Receivable Reserve (k) 8.7 - - - - 8.7
Building Sale Gain (l) - - - (44.7) - (44.7)
2003 Adjusted $207.8 $ 29.7 $1.3 $23.8 $(54.9) $207.7
$ Variance for
2004 Adjusted vs.
2003 Adjusted $ (8.5) $ 20.8 $4.8 $11.2 $ 3.3 $ 31.6
(a) These adjustments, which are net of tax, represent non-GAAP financial information. Management
believes that the adjusted earnings amounts may be useful to investors because they show
results before giving effect to the adjustment items. This allows investors to compare
earnings information and make decisions without the impact of supplemental items.
(b) This amount represents an impairment charge used to reduce the value of the Starpower
investment to $28 million at June 30, 2004.
(c) In February 2004, a local jurisdiction issued final consolidated tax return regulations,
which were retroactive to 2001. These regulations have provided Pepco Holdings and its
affiliated subsidiaries doing business in this location with the necessary guidance to file a
consolidated income tax return. This allows Pepco Holdings' subsidiaries with taxable losses
to utilize those losses against tax liabilities of Pepco Holdings' companies with taxable
income. Pepco Holdings and its affected subsidiaries recorded the impact of the new
regulations in the first quarter of 2004 for the period 2001 through 2003.
(d) This amount represents the favorable impact at Conectiv Energy resulting from the disposition
of a joint venture associated with the Vineland co-generation facility.
(e) This amount represents the income statement impact of the expenses associated with the
pre-payment of the Bethlehem debt.
(f) This amount represents the favorable impact resulting from a gain on the condemnation
settlement associated with the transfer of Vineland distribution assets.
(g) This amount represents the unfavorable impact resulting from net trading losses prior to the
cessation of proprietary trading.
(h) This amount represents, for Conectiv Energy, the unfavorable impact related to the
cancellation of a CT contract to purchase combustion turbines and for Corp. & Other the
reversal of a purchase accounting fair value adjustment made on the date of the merger of
Pepco and Conectiv relating to this contract.
(i) This amount represents the unfavorable impact related to ACE's New Jersey deferral
disallowance.
(j) This amount represents the favorable impact related to ACE's accrual reversal.
(k) This amount represents a reserve recorded against a delinquent receivable from Mirant.
(l) This amount represents a gain on the sale of the Edison Place office building.
A summary of the factors contributing to the nine months ended September 30,
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2004 and 2003 adjusted earnings variances is as follows.
Power Delivery's year-to-date 2004 adjusted earnings were $8.5 million lower
than its adjusted earnings for the corresponding period in 2003 primarily due to
the unfavorable impact of lower earnings from ESS at Pepco of approximately
$33.6 million, partially offset by: (i) $20.4 million in regulated electric and
gas revenues due to sales growth and rate increases and (ii) $8.8 million in net
earnings from ESS at Conectiv.
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Conectiv Energy's year-to-date 2004 adjusted earnings were $20.8 million
higher than the corresponding 2003 period due to higher generation gross margins
of $19.7 million, which resulted primarily from fuel switching, hedging, and use
of power plant flexibility. Recognition of an adjustment related to fuel supply
contracts also helped to improve earnings this year. In addition, gross margins
from the provision of Provider of Last Resort (POLR) services improved due to an
increase in the average sales price and somewhat lower cost of goods. Power, Oil
and Gas Marketing benefited from lower cost of goods driven by mild summer
weather. In total, the fuel supply adjustment, POLR services, and Power, Oil and
Gas Marketing gross margins were $10 million higher than 2003. Several items
offsetting the positive variances included higher interest cost resulting from
the completion of the Bethlehem power plant ($4.2 million), higher depreciation
expense also associated with the Bethlehem plant ($3.2 million), and other ($4.0
million).
Pepco Energy Services' year to date 2004 adjusted earnings were $4.8 million
higher than its earnings for the corresponding period in 2003 due to improved
gross margins in the retail commodity business.
Other Non-Regulated year-to-date 2004 adjusted earnings were $11.2 million
higher than its adjusted earnings for the corresponding period in 2003 primarily
due to the $5.2 million gain on the sale of PCI's final three aircraft and from
$6.1 million in reduced interest expense.
Corporate and Other's year-to-date 2004 adjusted earnings were $3.3 million
higher than its adjusted earnings for the corresponding period in 2003 primarily
due to lower amortization associated with certain purchase accounting
adjustments and software which was fully amortized in early 2004. The items were
partially offset by higher intercompany net interest expense, which is offset in
the lines of businesses resulting in no effect on consolidated earnings.
CONSOLIDATED RESULTS OF OPERATIONS
The accompanying results of operations discussion is for the three months
ended September 30, 2004 compared to September 30, 2003.
Operating Revenue
PHI's operating revenue decreased by $84.1 million to $2,046.5 million for
the three months ended September 30, 2004, from $2,130.6 million for the
corresponding period in 2003. The decrease was primarily due to a decrease of
$146.4 million at Conectiv Energy that was partially offset by an increase of
$45.0 million at Power Delivery and an increase of $24.1 million at Pepco Energy
Services.
The increase in Power Delivery's operating revenue of $45.0 million is
primarily due to the following: (i) a $62.2 million increase in electricity
supply service revenue primarily of which $42.6 million is a result of lower
Pepco customer migration to alternative energy suppliers and $15.5 million is
related to ACE PJM interchange revenue and rate increases due to the higher
price of energy; partially offset by (ii) a $14.7 million decrease in other
revenue, primarily due to the expiration of DPL wholesale contracts. Delivery
sales were 14,028,000 MwH, compared to 14,190,000 MwH for the comparable period
in 2003. Cooling degree days decreased 8.9% for the three months ended
September 30, 2004 as compared to the same period in 2003. Gas sales were
2,220,000 mcf, compared to 2,527,000 mcf for the comparable period in
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2003 due to lower industrial customer sales as a result of economic conditions.
The table below shows the amount of Power Delivery operating revenue earned
that is subject to price regulation (regulated T&D electric and gas revenue and
electricity supply service revenue). Regulated T&D (Transmission and
Distribution) electric revenue includes revenue Power Delivery receives for
delivery of energy to its customers. Regulated gas revenue includes on-system
natural gas sales and the transportation of natural gas to customers.
Electricity supply service (ESS) also known as Standard Offer Service (SOS),
Basic Generation Service (BGS), and Provider of Last Resort (POLR) includes
revenue within the service areas of Power Delivery. Other electric revenue
includes work and services performed on behalf of customers including other
utilities; other gas revenue includes off-system gas sales; and the resale of
excess gas or system capacity.
Three Months Ended September 30, 2004 2003 Change
(Dollars in Millions)
Regulated T&D Electric Revenue $ 458.1 $ 462.1 $ (4.0)
Electricity Supply Service Revenue 814.3 752.1 62.2
Other Electric Revenue 16.3 28.6 (12.3)
Total Electric Operating Revenue 1,288.7 1,242.8 45.9
Regulated Gas Revenue 16.0 14.5 1.5
Other Gas Revenue 8.7 11.1 (2.4)
Total Gas Operating Revenue 24.7 25.6 (0.9)
Total Power Delivery Operating Revenue $1,313.4 $1,268.4 $ 45.0
The decrease in Conectiv Energy's operating revenue of $146.4 million is
primarily due to the following: a $44.8 million decrease in revenue from PJM due
primarily to a change in power scheduling procedures by Conectiv to schedule
power directly to DPL, a decrease of $88.9 million that related to the
implementation of EITF 03-11 on January 1, 2004, and a $12.7 million decrease
resulting primarily from a decrease in Power, Oil and Gas Marketing activities.
The impact of the decrease in operating revenue was substantially offset by
decreases in fuel and purchased energy expenses, discussed below.
The increase in Pepco Energy Services' operating revenue of $24.1 million is
primarily due to electricity sold to retail customers at higher prices than in
2003.
Operating Expenses
Fuel and Purchased Energy
PHI's fuel and purchased energy decreased $129.9 million to $1,197.3 million
for the three months ended September 30, 2004, from $1,327.2 million for the
corresponding period in 2003. The decrease was primarily due to a decrease of
$216.7 million at Conectiv Energy, partially offset by a $72.5 million increase
at Power Delivery and a $17.1 million increase at Pepco Energy Services.
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The increase in Power Delivery's fuel and purchased energy of $72.5 million
was primarily due to the following: (i) a $75.7 million increase in net energy
procurement due to higher sales of ESS; (ii) a $13.5 million increase in energy
procurement costs to provide ESS due to the TPA Settlement with Mirant (entered
into in November 2003) that increased the price of energy purchased from Mirant
(the TPA Settlement); partially offset by (iii) a $14.5 million reserve recorded
in September 2003 to reflect a potential exposure related to a pre-petition
receivable from Mirant Corp. for which Pepco filed a creditor's claim in the
bankruptcy proceedings. See the Regulatory and Other Matters - Relationship with
Mirant section herein for additional information related to Mirant.
The decrease in Conectiv Energy's fuel and purchased energy of $216.7 million
was primarily due to the following: a change in power scheduling procedures by
Conectiv to schedule power directly to DPL which resulted in a decrease of
approximately $17.0 million in expenses from PJM, a decrease of $88.9 million
related to the implementation of EITF 03-11 on January 1, 2004, and a decrease
of approximately $110.8 million primarily due to reduced Power, Oil and Gas
Marketing costs of goods sold from lower sales volume.
The increase in Pepco Energy Services' fuel and purchased energy of $17.1
million was primarily due to higher electricity supply costs associated with
sales to retail customers.
Other Operation and Maintenance
PHI's other operation and maintenance, which includes costs associated with
Conectiv Energy's petroleum division, increased $17.5 million to $348.1 million
for the three months ended September 30, 2004, from $330.6 million for the
corresponding period in 2003 primarily due to an increase of $17 million in
Conectiv Energy's cost of sales expense associated with its petroleum division
due to higher fuel costs. Additionally, higher electric system maintenance costs
of $3.7 million and other operating costs of $4.8 million in 2004 were partially
offset by $13.1 million in storm costs in 2003 primarily from Hurricane Isabel.
Other Taxes
PHI's other taxes increased by $9.9 million to $91.3 million for the three
months ended September 30, 2004, from $81.4 million for the corresponding period
in 2003 primarily due to an $8.9 million higher county surcharge (which is a
pass-through).
Deferred Electric Service Costs
Deferred electric service costs increased by $19.6 million to $18.7 million
for the three months ended September 30, 2004 from a $0.9 million credit to
operating expense for the corresponding period in 2003. The $19.6 million
increase represents a net over-recovery associated with non-utility generation
contracts (NUGs), market transition charge (MTC), BGS and other restructuring
items. Customers in New Jersey who do not choose a competitive supplier receive
default electricity supply from suppliers selected through auctions approved by
the NJBPU. ACE's rates for the recovery of these costs are reset annually. On
ACE's consolidated balance sheet a regulatory asset includes an under-recovery
of $110.9 million as of September 30, 2004. This amount is net of a $46.1
million reserve on previously disallowed items under appeal.
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Gain on Sale of Assets
PHI's gain on sale of assets decreased by $66.7 million for the three months
ended September 30, 2004 due to the fact that the corresponding period in 2003
included the $68.8 million gain on the sale of PCI's office building.
Other Income (Expenses)
PHI's other expenses (which is net of other income) increased $7.2 million to
$96.3 million for the three months ended September 30, 2004, from $89.1 million
for the corresponding period in 2003. The increase was primarily due to an
increase in interest expense of $12.8 million at Conectiv Energy from costs
associated with the pre-payment of debt related to the Bethlehem mid-merit
facility, partially offset by a $5.1 million decrease in PCI and Pepcom expenses
from reduced interest expense at PCI and decreased investment losses at Pepcom.
Income Tax Expense
PHI's effective tax rate for the three months ended September 30, 2004 was
38.9% as compared to the federal statutory rate of 35%. The major reasons for
this difference were state income taxes (net of federal benefit) and the
flow-through of certain book tax depreciation differences partially offset by
the flow-through of Deferred Investment Tax Credits and tax benefits related to
certain leveraged leases.
PHI's effective tax rate for the three months ended September 30, 2003 was
39.0% as compared to the federal statutory rate of 35%. The major reasons for
this difference were state income taxes (net of federal benefit) and the
flow-through of certain book tax depreciation differences partially offset by
the flow-through of Deferred Investment Tax Credits and tax benefits related to
certain leveraged leases.
The accompanying results of operations discussion is for the nine months
ended September 30, 2004 compared to September 30, 2003.
Operating Revenue
PHI's operating revenue decreased by $255.6 million to $5,502.1 million for
the nine months ended September 30, 2004, from $5,757.7 million for the
corresponding period in 2003. The decrease was primarily due to a decrease of
$536.9 million at Conectiv Energy, partially offset by a $272.3 million increase
by Power Delivery businesses.
The increase in Power Delivery's operating revenue of $272.3 million is
primarily due to the following: (i) a $229.3 million increase in ESS revenue
primarily of which $107.6 million is a result of lower customer migration to
alternative energy suppliers and $113.9 million is related to sales into the PJM
market and rate increases due to the higher price of energy; (ii) a $54.8
million increase in delivery revenue, of which $28.3 million is due to an
increase for a county surcharge which is a pass through; partially offset by
(iii) an $11.8 million decrease in other revenue primarily due to the expiration
of DPL wholesale contracts. For the nine months ended September 30, 2004,
delivery sales were 39,090,000 MwH, compared to 38,144,000 MwH for the
comparable period in 2003. Cooling degree days increased 12.5% and heating
degree days decreased 10.3% for the nine months ended September 30, 2004 as
compared to 2003. Gas sales were 15,357,000 mcf, compared to 17,006,000 mcf for
the comparable period in 2003.
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The table below shows the amount of Power Delivery operating revenue earned
that is subject to price regulation and its other electric and gas revenue.
Nine Months Ended September 30, 2004 2003 Change
(Dollars in Millions)
Regulated T&D Electric Revenue $1,219.0 $1,175.9 $ 43.1
Electricity Supply Service Revenue 1,981.9 1,752.6 229.3
Other Electric Revenue 51.1 80.7 (29.6)
Total Electric Operating Revenue 3,252.0 3,009.2 242.8
Regulated Gas Revenue 127.1 115.4 11.7
Other Gas Revenue 46.7 28.9 17.8
Total Gas Operating Revenue 173.8 144.3 29.5
Total Power Delivery Operating Revenue $3,425.8 $3,153.5 $272.3
The decrease of $536.9 million in Conectiv Energy's operating revenue is
primarily due to the following: a $220.5 million decrease in revenue from PJM
due primarily to a change in power scheduling procedures by Conectiv to schedule
power directly to DPL, a decrease of $192.5 million that related to the
implementation of EITF 03-11 on January 1, 2004. The remaining $123.9 million
decrease resulted primarily from a decrease in Power, Oil and Gas Marketing
activities, partially offset by an increase in operating revenues due to the
discontinuance of gas and electric trading which was recorded as a net loss in
2003 revenues and a net increase in generation and wholesale revenues. The
impact of the decrease in operating revenue was substantially offset by
decreases in fuel and purchased energy expenses.
Operating Expenses
Fuel and Purchased Energy
PHI's fuel and purchased energy decreased $485.5 million to $3,220.4 million
for the nine months ended September 30, 2004, from $3,705.9 million for the
corresponding period in 2003. The decrease was primarily due to a decrease of
$698.2 million at Conectiv Energy, partially offset by a $248.2 million increase
by Power Delivery.
Power Delivery's electric fuel and purchased energy costs increased by $248.2
million primarily due to the following: (i) a $183.9 million increase in net
energy procurement due to higher sales of ESS; (ii) a $71.1 million increase in
energy procurement costs to provide ESS due to the TPA Settlement with Mirant
(entered into in November 2003); (iii) a $26.2 million increase for gas
purchases; partially offset by (iv) an $18.5 million decrease in PJM
transmission costs and (v) a $14.5 million reserve recorded in September 2003 to
reflect a potential exposure related to a pre-petition receivable from Mirant
Corp. for which Pepco filed a creditor's claim in the bankruptcy proceedings.
See the Regulatory and Other Matters - Relationship with Mirant section herein
for additional information related to Mirant.
The decrease of $698.2 million in Conectiv Energy's fuel and purchased energy
costs was primarily due to the following: a change in power scheduling
procedures by Conectiv to schedule power directly to DPL which resulted in a
decrease of approximately $220.5 million in expenses from PJM, a decrease of
$192.5 million that related to the implementation of EITF 03-11 on January 1,
2004, and a decrease of approximately $265.6 million in cost of goods sold
primarily due to a reduction in Power, Oil and Gas Marketing sales volume.
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Depreciation and Amortization
Depreciation and amortization expenses increased by $15.5 million to $335.9
million for the nine months ended September 30, 2004 from $320.4 million for the
corresponding period in 2003 primarily due to increases in amortization for
bondable transition property and regulatory assets in Power Delivery's ACE
business.
Other Operation and Maintenance
PHI's other operation and maintenance, which includes costs associated with
Conectiv Energy's petroleum division, increased $43.1 million to $1,059.0
million for the nine months ended September 30, 2004 from $1,015.9 million for
the corresponding period in 2003 primarily due to an increase in Conectiv
Energy's cost of sales expense associated with its petroleum division due to
higher fuel costs. Additionally, higher electric system maintenance costs of
$11.1 million in 2004 were partially offset by $13.1 million in storm costs in
2003.
Other Taxes
Other taxes increased by $23.6 million to $227.5 million for the nine months
ended September 30, 2004 from $203.9 million for the corresponding period in
2003 primarily due to a $27.6 million higher county surcharge (which is a
pass-through) and $3.9 million higher gross receipts tax, partially offset by a
$8.3 million lower property tax adjustment.
Deferred Electric Service Costs
Deferred electric service costs increased by $27.1 million to $27.7 million
for the nine months ended September 30, 2004 from $.6 million for the nine
months ended September 30, 2003. The $27.1 million increase represents a net
over-recovery associated with NUGs, MTC, BGS and other restructuring items.
Additionally, the 2003 period contained a $27.5 million charge related to the
New Jersey deferral disallowance regarding the procurement of fuel and purchased
energy. Customers in New Jersey who do not choose a competitive supplier receive
default electricity supply from suppliers selected through auctions approved by
the NJBPU. ACE's rates for the recovery of these costs are reset annually. On
ACE's consolidated balance sheet the regulatory asset includes an under-recovery
of $110.9 million as of September 30, 2004. This amount is net of a $46.1
million reserve on previously disallowed items under appeal.
Impairment Losses
PHI's impairment loss decreased by $52.8 million during the nine months ended
September 30, 2004 as during the first quarter of 2003 PHI recorded an
impairment loss of $52.8 million related to the cancellation of a CT contract.
Gain on Sale of Assets
PHI's pre-tax gain on sale of assets decreased by $39.9 million during the
nine months ended September 30, 2004 as during this period PHI recorded $28.9
million in pre-tax asset gains versus $68.8 million in 2003. The $28.9 million
in 2004 primarily represents a $14.4 million pre-tax gain from the condemnation
settlement with the City of Vineland relating to the transfer of its
distribution assets and customer accounts during the second quarter of 2004, a
$6.6 million pre-tax gain on the sale of land and a $8.0 million pre-tax gain on
the sale of aircraft by PCI. The $68.8 million pre-tax gain in 2003 represents
the gain on the sale of PCI's office building.
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Other Income (Expenses)
PHI's other expense (which is net of other income) increased $19.7 million to
$264.1 million for the nine months ended September 30, 2004, from $244.4 million
for the corresponding period in 2003. The increase was primarily due to
increased interest expense at Conectiv Energy from costs associated with the
pre-payment of the Bethlehem debt.
Income Tax Expense
PHI's effective tax rate for the nine months ended September 30, 2004 was
35.5% as compared to the federal statutory rate of 35%. The major reasons for
this difference were state income taxes (net of federal benefit, including the
benefit associated with the retroactive adjustment for the issuance of final
consolidated return regulations by a local taxing authority, which is the
primary reason for the lower effective tax rate as compared to 2003) and the
flow-through of certain book tax depreciation differences partially offset by
the flow-through of Deferred Investment Tax Credits and tax benefits related to
certain leveraged leases.
PHI's effective tax rate for the nine months ended September 30, 2003 was
36.4% as compared to the federal statutory rate of 35%. The major reasons for
this difference were state income taxes (net of federal benefit) and the
flow-through of certain book tax depreciation differences partially offset by
the flow-through of Deferred Investment Tax Credits and tax benefits related to
certain leveraged leases.
CAPITAL RESOURCES AND LIQUIDITY
Capital Structure
The components of Pepco Holdings' capital structure, expressed as a
percentage of total capitalization (including short-term debt and current
maturities of long-term debt) is shown below as of September 30, 2004 and
December 31, 2003 (dollars in millions).
September 30, 2004 December 31, 2003
Common Shareholders' Equity $3,428.5 38.9% $3,003.3 34.7%
Preferred Stock of subsidiaries (a) 101.6 1.2% 108.2 1.2%
Debentures Issued to - -% 98.0 1.1%
Financing Trust (b)
Long-Term Debt (c) 5,089.2 57.7% 5,101.3 58.8%
Short-Term Debt (d) 196.5 2.2% 360.0 4.2%
Total $8,815.8 100.0% $8,670.8 100.0%
(a) Includes Mandatorily Redeemable Serial Preferred Stock, Serial Preferred
Stock, and Redeemable Serial Preferred Stock, which is accounted for as a
liability on the balance sheet.
(b) Represents debentures issued pursuant to financing trusts, including the
current portion.
(c) Excludes capital lease obligations and transition bonds issued by ACE
Funding. Includes first mortgage bonds, medium-term notes, other long-term
debt (other than debt issued by ACE Funding), current maturities of
long-term debt (other than debt issued by ACE Funding), and Variable Rate
Demand Bonds.
(d) Excludes current maturities of long-term debt, capital lease obligations
due within one year, and Variable Rate Demand Bonds.
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Issuance of Common Stock
In September 2004, Pepco Holdings sold 14,950,000 shares of common stock at
$19.25 per share. Proceeds received on the transaction, net of issuance costs of
$10.3 million, were $277.5 million. These proceeds, in combination with
short-term debt, were used to pre-pay in its entirety a term loan in the amount
of $335 million of Conectiv Bethlehem, LLC.
Financing Activity During the Three Months Ended September 30, 2004
In July 2004, Pepco Holdings, Pepco, DPL and ACE entered into a five-year
credit agreement with an aggregate borrowing limit of $650 million. This
agreement replaces a $550 million 364-day credit agreement that was entered into
on July 29, 2003. The respective companies also are parties to a three-year
credit agreement that was entered into in July 2003 and terminates in July 2006
with an aggregate borrowing limit of $550 million. Pepco Holdings' credit limit
under these agreements is $700 million and the credit limit of each of Pepco,
DPL and ACE is the lower of $300 million and the maximum amount of short-term
debt authorized by the applicable regulatory authority, except that the
aggregate amount of credit utilized by Pepco, DPL and ACE at any given time
under the agreements may not exceed $500 million. The credit agreements
primarily serve as a source of liquidity to support the commercial paper
programs of the respective companies. The companies can also borrow funds for
general corporate purposes and issue letters of credit under the Agreements. The
credit agreements contain customary financial and other covenants that, if not
satisfied, could result in the acceleration of repayment obligations under the
agreements or restrict the ability of the companies to borrow under the
agreements. Among these covenants is the requirement that each borrowing company
maintain a ratio of total indebtedness to total capitalization of 65% or less,
computed in accordance with the terms of the credit agreements. The credit
agreements also contain a number of customary events of default that could
result in the acceleration of repayment obligations under the agreements,
including (i) the failure of any borrowing company or any of its significant
subsidiaries to pay when due, or the acceleration of certain indebtedness under
other borrowing arrangements, (ii) certain bankruptcy events, judgments or
decrees against any borrowing company or its significant subsidiaries, and (iii)
a change in control (as defined in the credit agreements) of Pepco Holdings or
the failure of Pepco Holdings to own all of the voting stock of Pepco, DPL and
ACE.
Other Long-Term Financing
Set forth below is a summary of long-term financing activity during the
quarter ended September 30, 2004.
In July 2004, ACE Funding paid at maturity $4.0 million of 2.89% Transition
Bonds.
In August 2004, Pepco repurchased 65,000 shares of its $2.28 series, par
value $50.00 per share preferred stock at an average price of $45.50 per share.
In August 2004, on behalf of ACE, the Pollution Control Financing Authority
of Salem County, New Jersey issued $23.15 million of insured auction rate
tax-exempt bonds due 2029 and loaned the proceeds to ACE. ACE's obligations
under the insurance agreement are secured by a like amount of ACE First Mortgage
Bonds. In September 2004, ACE used the proceeds to redeem $23.15 million of
6.15% First Mortgage Bonds due 2029 at 102%.
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In August 2004, on behalf of ACE, the Pollution Control Financing Authority
of Cape May County, New Jersey issued $25 million of Series 2004A and $6.5
million of Series 2004B insured auction rate tax-exempt bonds due 2029 and
loaned the proceeds to ACE. ACE's obligations under the insurance agreement are
secured by a like amount of ACE First Mortgage Bonds. In November 2004, ACE used
the proceeds to redeem $25 million of 7.2% First Mortgage Bonds due 2029 at 102%
and $6.5 million of 7.0% First Mortgage Bonds due 2029 at 102%.
In September 2004, Conectiv Bethlehem prepaid its entire $335 million term
loan due 2006. Additionally, Conectiv Bethlehem paid $6.8 million to unwind an
interest rate swap agreement that had converted a portion of the variable
interest rate on the term loan balance to a fixed rate. Approximately $6.0
million in unamortized debt issuance costs related to the term loan were
expensed at the time of the loan repayment.
In September 2004, Pepco repurchased 16,400 shares of its $2.28 series
preferred stock, par value $50.00 per share, at an average price of $47.25 per
share.
In September 2004, Pepco redeemed $2.5 million, or 50,000 shares, of its
$3.40 Serial Preferred Stock Series of 1992 pursuant to mandatory sinking fund
provisions.
Financing Activity Subsequent to September 30, 2004
Set forth below is a summary of long-term financing activity subsequent to
September 30, 2004.
In October 2004, Pepco repurchased 84,502 shares of its $2.28 series
preferred stock, par value $50.00 per share, at an average price of $47.02 per
share.
In October 2004, ACE Funding paid at maturity $12.3 million 2.89% Transition
Bonds.
In October 2004, PCI paid at maturity $50 million of 7.97% Medium-Term Notes.
In October 2004, Pepco called for early redemption, at par, on December 1,
2004, all of the remaining 850,000 shares of its $3.40 Serial Preferred Stock
Series of 1992.
In November 2004, DPL redeemed at maturity $4.5 million of 8.3% Medium-Term
Notes.
Working Capital
At September 30, 2004, Pepco Holdings' current assets on a consolidated basis
totaled $1.8 billion, which consisted primarily of accounts receivable,
materials and supplies and cash and cash equivalents. Current liabilities
totaled $2.2 billion, of which $.9 billion was the current portion of long-term
debt and Variable Rate Demand Bonds, which have maturities ranging from 2007 to
2031. Excluding these amounts related to long-term debt, current assets of $1.8
billion exceeded current liabilities of $1.3 billion. At September 30, 2003,
current assets totaled $1.9 billion, which consisted primarily of accounts
receivable, materials and supplies, cash and cash equivalents and marketable
securities. Current liabilities totaled $2.4 billion, of which $.8 billion
consisted of the current portion of long-term debt, Variable Rate Demand Bonds,
which have maturities ranging from 2007 to 2031, and $.4 billion of short term
loans which were subsequently converted to long-term debt. Excluding these
amounts related to long-term debt, current assets of $1.9 billion exceeded
current liabilities of $1.6 billion.
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A detail of Pepco Holdings' $1.1 billion of short-term debt at September 30,
2004 is as follows:
As of September 30, 2004
($ in Millions)
ACE PHI
Type PHI Pepco DPL ACE Funding PES PCI Conectiv Consolidated
Variable Rate
Demand Bonds $ - $ - $104.8 $ 22.6 $ - $31.0 $ - $ - $ 158.4
Current Portion
of Long-Term Debt 200.0 100.0 7.2 71.5 31.9 .1 69.0 280.0 759.7
Commercial Paper 134.0 - - 62.5 - - - - 196.5
Total $334.0 $100.0 $112.0 $156.6 $31.9 $31.1 $69.0 $280.0 $1,114.6
Capital Requirements
Construction Expenditures
Pepco Holdings' construction expenditures for the nine months ended
September 30, 2004 totaled $357.0 million of which $340.6 million was related to
its Power Delivery businesses. The remainder was primarily related to Conectiv
Energy. The Power Delivery expenditures were primarily related to capital costs
associated with new customer services (customer driven), distribution
reliability, and transmission.
Dividends
On October 28, 2004, Pepco Holdings' Board of Directors declared a dividend
on common stock of 25 cents per share payable December 31, 2004, to shareholders
of record on December 10, 2004.
Third Party Guarantees, Indemnifications and
Off-Balance Sheet Arrangements
Pepco Holdings and certain of its subsidiaries have various financial and
performance guarantees and indemnification obligations which are entered into in
the normal course of business to facilitate commercial transactions with third
parties as discussed below.
As of September 30, 2004, Pepco Holdings and its subsidiaries were parties to
a variety of agreements pursuant to which they were guarantors for standby
letters of credit, performance residual value, and other commitments and
obligations. The fair value of these commitments and obligations was not
required to be recorded in Pepco Holdings' Consolidated Balance Sheets; however,
certain energy marketing obligations of Conectiv Energy were recorded. The
commitments and obligations, in millions of dollars, were as follows:
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Guarantor
PHI Conectiv PCI Total
Energy marketing obligations of
Conectiv Energy (1) $148.6 $ 1.3 $ - $149.9
Energy procurement obligations
of Pepco Energy Services (1) 5.0 - - 5.0
Standby letters of credit of
Pepco Holdings (2) 4.2 - - 4.2
Guaranteed lease residual values (3) - 6.4 - 6.4
Loan agreement (4) 13.1 - - 13.1
Construction performance guarantees (5) - 4.1 - 4.1
Other (6) 14.9 4.0 5.3 24.2
Total $185.8 $15.8 $5.3 $206.9
1. Pepco Holdings and Conectiv have contractual commitments for performance
and related payments of Conectiv Energy and Pepco Energy Services to
counterparties related to routine energy sales and procurement
obligations, including requirements under Basic Generation Service
contracts for ACE.
2. Pepco Holdings has issued standby letters of credit of $4.2 million on
behalf of subsidiaries' operations related to Conectiv Energy's
competitive energy activities and third party construction performance.
These standby letters of credit were put into place in order to allow the
subsidiaries the flexibility needed to conduct business with
counterparties without having to post substantial cash collateral. While
the exposure under these standby letters of credit is $4.2 million, Pepco
Holdings does not expect to fund the full amount.
3. Subsidiaries of Pepco Holdings have guaranteed residual values in excess
of fair value related to certain equipment and fleet vehicles held through
lease agreements. As of September 30, 2004, obligations under the
guarantees were approximately $6.4 million. Assets leased under agreements
subject to residual value guarantees are typically for periods ranging
from 2 years to 10 years. Historically, payments under the guarantees have
not been made by the guarantor as, under normal conditions, the contract
runs to full term at which time the residual value is minimal. As such,
Pepco Holdings believes the likelihood of requiring payment under the
guarantee is remote.
4. Pepco Holdings has issued a guarantee on the behalf of a subsidiary's 50%
unconsolidated investment in a limited liability company for repayment
borrowings under a loan agreement of approximately $13.1 million.
5. Conectiv has performance obligations of $4.1 million relating to
obligations to third party suppliers of equipment.
6. Other guarantees comprise:
Pepco Holdings has guaranteed payment of a bond issued by a
subsidiary of $14.9 million. Pepco Holdings does not expect to fund
the full amount of the exposure under the guarantee.
Conectiv has guaranteed a subsidiary building lease of $4.0
million. Conectiv does not expect to fund the full amount of the
exposure under the guarantee.
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PCI has guaranteed facility rental obligations related to contracts
entered into by Starpower Communications LLC. In addition, PCI has
agreed to indemnify RCN for 50% of any payments RCN makes under the
Starpower franchise and construction performance bonds. As of
September 30, 2004, the guarantees cover the remaining $3.2 million
in rental obligations and $2.1 million in franchise and
construction performance bonds issued.
Pepco Holdings and certain of its subsidiaries have entered into various
indemnification agreements related to purchase and sale agreements and other
types of contractual agreements with vendors and other third parties. These
indemnification agreements typically cover environmental, tax, litigation and
other matters, as well as breaches of representations, warranties and covenants
set forth in these agreements. Typically, claims may be made by third parties
under these indemnification agreements over various periods of time depending on
the nature of the claim. The maximum potential exposure under these
indemnification agreements can range from a specified dollar amount to an
unlimited amount depending on the nature of the claim and the particular
transaction. The total maximum potential amount of future payments under these
indemnification agreements is not estimable due to several factors, including
uncertainty as to whether or when claims may be made under these indemnities.
\
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Energy Contract Net Asset Activity
The following table provides detail on changes in the competitive energy
segments' net asset or liability position with respect to energy commodity
contracts from one period to the next:
Roll-forward of Mark-to-Market Energy Contract Net Assets
For the Nine Months Ended September 30, 2004
(Dollars are Pre-Tax and in Millions)(1)
Other
Energy
Proprietary Commodity
Trading (2) (3) Total
Total Marked-to-market (MTM) Energy Contract Net
Assets
at December 31, 2003 $ 11.0 $60.6 $ 71.6
Total change in unrealized fair value excluding
reclassification to realized at settlement of
contracts (0.2) 26.9 26.7
Reclassification to realized at settlement of
contracts (7.8) (31.1) (38.9)
Effective portion of changes in fair value -
recorded
in OCI - 14.9 14.9
Ineffective portion of charges in fair value -
recorded in earnings - (8.2) (8.2)
Changes in valuation techniques and assumptions - - -
Purchase/sale of existing contracts or portfolios
subject to MTM - - -
Total MTM Energy Contract Net Assets at
September 30, 2004 (a) $ 3.0 (4) $63.1 $ 66.1
(a) Detail of MTM Energy Contract Net Assets at September 30,
2004 (above) Total
Current Assets $136.0
Noncurrent Assets 30.5
Total MTM Energy Assets 166.5
Current Liabilities (73.0)
Noncurrent Liabilities (27.4)
Total MTM Energy Contract Liabilities (100.4)
Total MTM Energy Contract Net Assets $ 66.1
Notes:
(1) This table reflects $.3 million (pre-tax) of net assets that existed at the
time of the Pepco/Conectiv merger that are not reflected in PHI's
consolidated balance sheet as of September 30, 2004 due to purchase
accounting.
(2) Includes all remaining contracts held for proprietary trading.
(3) Includes all SFAS 133 hedge activity and non-proprietary trading activities
marked-to-market through earnings.
(4) This amount will not be materially sensitive to commodity price movements
because it represents positions that have been volumetrically offset almost
100% since the first quarter of 2003.
The following table provides the source of fair value information
(exchange-traded, provided by other external sources, or modeled internally)
used to determine the carrying amount of the competitive energy segments' total
mark-to-market energy contract net assets. The table also provides the maturity,
by year, of the competitive energy segments' mark-to-market energy contract net
assets, which indicates when the amounts will settle and either generate cash
for, or require payment of cash by, PHI.
PHI uses its best estimates to determine the fair value of the commodity and
derivative contracts that its competitive energy segments hold and sell. The
fair values in each category presented below reflect forward prices and
volatility factors as of September 30, 2004 and are subject to change as a
result of changes in these factors:
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Maturity and Source of Fair Value of Mark-to-Market
Energy Contract Net Assets
As of September 30, 2004
(Dollars are Pre-Tax and in Millions)(1)
Fair Value of Contracts at September 30, 2004
Maturities
Total
2007 and Fair
Source of Fair Value 2004 2005 2006 Beyond Value
Proprietary Trading (2)
Actively Quoted (i.e., exchange-traded)
prices (3) $ 1.8 $ 0.8 - - $ 2.6
Prices provided by other external sources
(4) .4 - - - .4
Modeled - - - - -
Total $ 2.2 $ 0.8 $ - $ - $ 3.0
Other Energy Commodity (5)
Actively Quoted (i.e., exchange-traded)
prices $18.1 $44.5 $3.3 $0.4 $66.3
Prices provided by other external sources
(4) (2.7) (31.0) 1.0 0.2 (32.5)
Modeled (6) .7 35.0 (6.4) - 29.3
Total $16.1 $48.5 $(2.1) $0.6 $63.1
Notes:
(1) This table reflects $.3 million (pre-tax) of net assets that existed at
the time of the Pepco/Conectiv merger that are not reflected in PHI's
consolidated balance sheet as of September 30, 2004 due to purchase
accounting.
(2) Includes all remaining contracts held for proprietary trading.
(3) The forward value of the trading contracts represents positions held
prior to the cessation of proprietary trading. The values were locked-in
during the exit from trading and will be realized during the normal
course of business through the year 2005.
(4) Prices provided by other external sources reflect information obtained
from over-the-counter brokers, industry services, or multiple-party
on-line platforms. As of March 2003, Conectiv Energy ceased all
proprietary trading activities; however, the market exposure under
certain contracts associated with proprietary trading activities was not
eliminated due to the illiquid market environment to execute such
elimination. These illiquid contracts will remain in place until they
are terminated and their values are realized.
(5) Includes all SFAS No. 133 hedge activity and non-trading activities
marked-to-market through AOCI or on the Income Statement as required. As
of the second quarter of 2003, this category also includes the
activities of the 24-Hour Power Desk.
(6) The modeled hedge position is a power swap for 50% of Conectiv Energy's
POLR obligation in the DPL territory. The model is used to approximate
the forward load quantities. Pricing is derived from the broker market.
Contractual Arrangements with Credit Rating Triggers or Margining Rights
Under certain contractual arrangements entered into by PHI's subsidiaries in
connection with competitive energy and other transactions, the affected company
may be required to provide cash collateral or letters of credit as security for
its contractual obligations if the credit ratings of the applicable company are
downgraded one or more levels. In the event of a downgrade, the amount required
to be posted would depend on the amount of the underlying contractual obligation
existing at the time of the downgrade. As of September 30, 2004, a one-level
downgrade in the credit rating of PHI and all of its affected subsidiaries would
have required PHI and such subsidiaries to provide aggregate cash collateral or
letters of credit of approximately up to $144 million. An additional amount of
approximately $176
94
million of aggregate cash collateral or letters of credit would have been
required in the event of subsequent downgrades to below investment grade.
Many of the contractual arrangements entered into by PHI's subsidiaries in
connection with competitive energy activities include margining rights pursuant
to which the PHI subsidiary or a counterparty may request collateral if the
market value of the contractual obligations reaches levels that are in excess of
the credit thresholds established in the applicable arrangements. Pursuant to
these margining rights, the affected PHI subsidiary may receive, or be required
to post, collateral due to energy price movements. As of September 30, 2004,
Pepco Holdings' subsidiaries that engaged in competitive energy activities were
in receipt of (a net holder of) cash collateral in the amount of $15.5 million
as recorded in connection with their competitive energy activities.
REGULATORY AND OTHER MATTERS
Relationship with Mirant Corporation
In 2000, Pepco sold substantially all of its electricity generation assets to
Mirant Corporation, formerly Southern Energy, Inc., pursuant to an Asset
Purchase and Sale Agreement. As part of the Asset Purchase and Sale Agreement,
Pepco entered into several ongoing contractual arrangements with Mirant and
certain of its subsidiaries (collectively, Mirant). On July 14, 2003, Mirant
Corporation and most of its subsidiaries filed a voluntary petition for
reorganization under Chapter 11 of the U.S. Bankruptcy Code in the U.S.
Bankruptcy Court for the Northern District of Texas (the Bankruptcy Court).
Depending on the outcome of the matters discussed below, the Mirant
bankruptcy could have a material adverse effect on the results of operations of
Pepco Holdings and Pepco. However, management currently believes that Pepco
Holdings and Pepco currently have sufficient cash, cash flow and borrowing
capacity under their credit facilities and in the capital markets to be able to
satisfy any additional cash requirements that have arisen or may arise due to
the Mirant bankruptcy. Accordingly, management does not anticipate that the
Mirant bankruptcy will impair the ability of Pepco Holdings or Pepco to fulfill
their contractual obligations or to fund projected capital expenditures. On this
basis, management currently does not believe that the Mirant bankruptcy will
have a material adverse effect on the financial condition of either company.
Transition Power Agreements
For a discussion of the Transition Power Agreements between Pepco and Mirant
and the amendment of these agreements in connection with the Mirant bankruptcy,
see Item 2, Management's Discussion and Analysis of Financial Condition and
Results of Operations - Regulatory and Other Matters - Relationship with Mirant
included in Pepco Holdings' Quarterly Report on Form 10-Q for the quarter ended
March 31, 2004.
Power Purchase Agreements
Under agreements with FirstEnergy Corp., formerly Ohio Edison (FirstEnergy),
and Allegheny Energy, Inc., both entered into in 1987, Pepco is obligated to
purchase from FirstEnergy 450 megawatts of capacity and energy annually through
December 2005 (the FirstEnergy PPA). Under an agreement with Panda-Brandywine
L.P. (Panda), entered into in 1991, Pepco is obligated to purchase from Panda
230 megawatts of capacity and energy
95
annually through 2021 (the Panda PPA). In each case, the purchase price is
substantially in excess of current market prices. As a part of the Asset
Purchase and Sale Agreement, Pepco entered into a "back-to-back" arrangement
with Mirant. Under this arrangement, Mirant is obligated, among other things, to
purchase from Pepco the capacity and energy that Pepco is obligated to purchase
under the FirstEnergy PPA and the Panda PPA at a price equal to the price Pepco
is obligated to pay under the PPAs (the PPA-Related Obligations).
Pepco Pre-Petition Claims
For a discussion of the claims that Pepco has filed against Mirant with
respect to amounts owed by Mirant to Pepco under the PPAs at the time of the
filing of Mirant's bankruptcy petition and the accounting treatment of these
claims, see Item 2, Management's Discussion and Analysis of Financial Condition
and Results of Operations - Regulatory and Other Matters - Relationship with
Mirant included in Pepco Holdings' Quarterly Report on Form 10-Q for the quarter
ended March 31, 2004.
Mirant's Attempt to Reject the PPA-Related Obligations
On August 28, 2003, Mirant filed with the Bankruptcy Court a motion seeking
authorization to reject its PPA-Related Obligations. Upon motions filed with the
U.S. District Court for the Northern District of Texas (the District Court) by
Pepco and the Federal Energy Regulatory Commission (FERC), in October 2003, the
District Court withdrew jurisdiction over the rejection proceedings from the
Bankruptcy Court. In December 2003, the District Court denied Mirant's motion to
reject the PPA-Related Obligations. The District Court's decision was appealed
by Mirant and The Official Committee of Unsecured Creditors of Mirant
Corporation in the U.S. Court of Appeals for the Fifth Circuit. On August 4,
2004, the Court of Appeals remanded the case to the District Court saying that
it has jurisdiction to rule on the merits of Mirant's rejection motion,
suggesting that in doing so the court apply a "more rigorous standard" than the
business judgment rule usually applied by bankruptcy courts in ruling on
rejection motions, and noting that there are other "important issues which must
still be resolved before a decision on the merits would be appropriate." On
October 4, 2004, the District Court issued an order stating that the District
Court will retain jurisdiction over the matter and invited parties to submit
comments on the appropriate standard to be applied in determining whether to
grant Mirant's rejection motion. All parties submitted comments. On November 3,
2004, the District Court issued an order stating that the Court concluded that
the "separate agreement" issue (i.e., whether the PPA-Related Obligations are
severable from the Asset Purchase and Sale Agreement) relating to the sale of
Pepco's generation assets should be resolved before the District Court deals
further with the issue of the standard to be applied in determining whether the
motion to reject should be granted. The order permits the parties to submit
further evidentiary material related to the separate agreement issue.
Pepco is exercising all available legal remedies and vigorously opposing
Mirant's attempt to reject the PPA-Related Obligations in order to protect the
interests of its customers and shareholders. While Pepco believes that it has
substantial legal bases to oppose the attempt to reject the agreements, the
outcome of Mirant's efforts to reject the PPA-Related Obligations is uncertain.
In accordance with the Bankruptcy Court's order, Mirant is continuing to
perform the PPA-Related Obligations pending the resolution of the ongoing
proceedings. However, if Mirant ultimately is successful in rejecting, and
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is otherwise permitted to stop performing the PPA-Related Obligations, Pepco
could be required to repay to Mirant, for the period beginning on the effective
date of the rejection (which date could be prior to the date of the court's
order and possibly as early as September 18, 2003) and ending on the date Mirant
is entitled to cease its purchases of energy and capacity from Pepco, all
amounts paid by Mirant to Pepco in respect of the PPA-Related Obligations, less
an amount equal to the price at which Mirant resold the purchased energy and
capacity. Pepco estimates that the amount it could be required to repay to
Mirant in the unlikely event September 18, 2003, is determined to be the
effective date of rejection, is approximately $118.8 million as of November 1,
2004. This repayment would entitle Pepco to file a claim against the bankruptcy
estate in an amount equal to the amount repaid. Mirant has also asked the
Bankruptcy Court to require Pepco to disgorge all amounts paid by Mirant to
Pepco in respect of the PPA-Related Obligations, less an amount equal to the
price at which Mirant resold the purchased energy and capacity, for the period
July 14, 2003 (the date on which Mirant filed its bankruptcy petition) to
September 18, 2003, on the theory that Mirant did not receive value for those
payments. Pepco estimates that the amount it would be required to repay to
Mirant on the disgorgement theory is approximately $22.5 million. Pepco believes
a claim based on this theory should be entitled to administrative expense status
for which complete recovery could be expected in the Bankruptcy Court. If Pepco
were required to repay any such amounts for either period, the payment would be
expensed at the time the payment is made. However, Pepco believes that, to the
extent such amounts were not recovered from the Mirant bankruptcy estate, the
expensed amounts would be recoverable as stranded costs from customers through
distribution rates as described below.
The following are estimates prepared by Pepco of its potential future
exposure if Mirant's motion to reject its PPA-Related Obligations ultimately is
successful. These estimates are based in part on current market prices and
forward price estimates for energy and capacity, and do not include financing
costs, all of which could be subject to significant fluctuation. The estimates
assume no recovery from the Mirant bankruptcy estate and no regulatory recovery,
either of which would mitigate the effect of the estimated loss. Pepco does not
consider it realistic to assume that there will be no such recoveries. Based on
these assumptions, Pepco estimates that its pre-tax exposure as of November 1,
2004, representing the loss of the future benefit of the PPA-Related Obligations
to Pepco, is as follows:
If Pepco were required to purchase capacity and energy from FirstEnergy
commencing as of November 1, 2004, at the rates provided in the PPA (with
an average price per kilowatt hour of approximately 6.0 cents) and resold
the capacity and energy at market rates projected, given the
characteristics of the FirstEnergy PPA, to be approximately 5.0 cents per
kilowatt hour, Pepco estimates that it would cost approximately $9
million for the remainder of 2004, and $33 million in 2005, the last year
of the FirstEnergy PPA.
If Pepco were required to purchase capacity and energy from Panda
commencing as of November 1, 2004, at the rates provided in the PPA (with
an average price per kilowatt hour of approximately 18.4 cents), and
resold the capacity and energy at market rates projected, given the
characteristics of the Panda PPA, to be approximately 8.4 cents per
kilowatt hour, Pepco estimates that it would cost approximately
$8 million for the remainder of 2004, $35 million in 2005, and
$35 million in 2006 and approximately $35 million to $48 million annually
thereafter through the 2021 contract termination date.
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The ability of Pepco to recover from the Mirant bankruptcy estate in respect
to the Mirant Pre-Petition Obligations and damages if the PPA-Related
Obligations are successfully rejected will depend on whether Pepco's claims are
allowed, the amount of assets available for distribution to creditors and
Pepco's priority relative to other creditors. At the current stage of the
bankruptcy proceeding, there is insufficient information to determine the
amount, if any, that Pepco might be able to recover from the Mirant bankruptcy
estate, whether the recovery would be in cash or another form of payment, or the
timing of any recovery.
If Mirant ultimately is successful in rejecting the PPA-Related Obligations
and Pepco's full claim is not recovered from the Mirant bankruptcy estate, Pepco
may seek authority from the Maryland Public Service Commission (MPSC) and the
District of Columbia Public Service Commission (DCPSC) to recover its additional
costs. Pepco is committed to working with its regulatory authorities to achieve
a result that is appropriate for its shareholders and customers. Under the
provisions of the settlement agreements approved by the MPSC and the DCPSC in
the deregulation proceedings in which Pepco agreed to divest its generation
assets under certain conditions, the PPAs were to become assets of Pepco's
distribution business if they could not be sold. Pepco believes that, if Mirant
ultimately is successful in rejecting the PPA-Related Obligations, these
provisions would allow the stranded costs of the PPAs that are not recovered
from the Mirant bankruptcy estate to be recovered from Pepco's customers through
its distribution rates. If Pepco's interpretation of the settlement agreements
is confirmed, Pepco expects to be able to establish the amount of its
anticipated recovery as a regulatory asset. However, there is no assurance that
Pepco's interpretation of the settlement agreements would be confirmed by the
respective public service commissions.
If the PPA-Related Obligations are successfully rejected, and there is no
regulatory recovery, Pepco will incur a loss. However, the accounting treatment
of such a loss depends on a number of legal and regulatory factors, and is not
determinable at this time.
The SMECO Agreement
As a term of the Asset Purchase and Sale Agreement, Pepco assigned to Mirant
a facility and capacity agreement with Southern Maryland Electric Cooperative,
Inc. For a discussion of the status of this agreement in the context of the
Mirant bankruptcy, see Item 2, Management's Discussion and Analysis of Financial
Condition and Results of Operations - Regulatory and Other Matters -
Relationship with Mirant included in Pepco Holdings' Quarterly Report on Form
10-Q for the quarter ended March 31, 2004.
PHI Potential Earnings Charge Relating to Additional Tax Liability
PHI files a consolidated federal income tax return. PHI's federal income tax
liabilities for Pepco legacy companies for all years through 2000, and for
Conectiv legacy companies for all years through 1997, have been determined,
subject to adjustment to the extent of any net operating loss or other loss or
credit carrybacks from subsequent years. The Internal Revenue Service (IRS), as
part of its normal audit of PHI's income tax returns, has questioned whether PHI
was entitled to certain tax deductions as the result of the adoption of a
carry-over tax basis for a non-lease financial asset acquired in 1998 by a
subsidiary of PHI. If the position asserted by the IRS were to prevail and the
deductions were disallowed, PHI may be required to take a charge to earnings for
financial reporting purposes due to the reversal of the tax benefits recognized
in prior periods (including years 1998 through 2000, which remain open due to
net operating loss carrybacks).
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At September 30, 2004, the amount of this potential charge consisted of
approximately $16.3 million reflecting the reversal of the tax benefits and
approximately $3 million of estimated interest on the additional taxes owed. PHI
is in discussions with the IRS regarding a settlement of this matter; however
the ultimate outcome and financial effect are not known at this time.
Rate Proceedings
For a discussion of the history of ACE's proceeding filed with the New Jersey
Board of Public Utilities (NJBPU) to increase its electric distribution rates
and Regulatory Asset Recovery Charge (RARC) in New Jersey, see Item 2,
Management's Discussion and Analysis of Financial Condition and Results of
Operations - Regulatory and Other Matters - Relationship with Mirant included in
Pepco Holdings' Quarterly Reports on Form 10-Q for the quarters ended March 31,
2004 and June 30, 2004. The Ratepayer Advocate and Staff of the NJBPU filed
their briefs in this proceeding in August 2004. The Ratepayer Advocate's brief
supported its earlier proposal of an annual rate decrease of $4.5 million. The
Staff's brief, however, stated for the first time its position calling for an
overall decrease of $10.8 million. Reply briefs were filed on August 23, 2004.
Settlement discussions between ACE, the NJBPU Staff and the Ratepayer Advocate
have been ongoing. ACE cannot predict the outcome of this proceeding.
For a discussion of the history of Phase II to ACE's base rate proceeding,
see Item 2, Management's Discussion and Analysis of Financial Condition and
Results of Operations - Regulatory and Other Matters - Relationship with Mirant
included in Pepco Holdings' Quarterly Reports on Form 10-Q for the quarters
ended March 31, 2004 and June 30, 2004. In August 2004, the Ratepayer Advocate
filed testimony proposing a cost-sharing mechanism related to the operation and
maintenance costs of the B. L. England generating facility and also proposing
the disallowance and/or continued deferral of approximately $30.7 million of
previously deferred costs related to industry restructuring, the divestiture
efforts related to the ACE's fossil generating assets, the arbitration
proceeding with an unaffiliated non-utility generator, and capacity purchases
from an affiliate. ACE cannot predict the outcome of this proceeding.
On August 31, 2004, ACE filed requests with the NJBPU proposing changes to
its Transition Bond Charge (TBC), its Market Transition Charge - Tax rate
(MTC-Tax), and its Basic Generation Service (BGS) Reconciliation charges. The
net impact of these rate changes will be a decrease in ACE's annual revenues of
approximately 1.5%. All of these rate changes were implemented on October 1,
2004.
On October 1, 2004, DPL submitted its annual Gas Cost Rate (GCR) filing to
the DPSC. In its filing, DPL seeks to increase its GCR by approximately 16.8% in
anticipation of increasing natural gas commodity costs. The GCR, which permits
DPL to recover its procurement gas costs through customer rates, becomes
effective November 1, 2004 and is subject to refund pending evidentiary
hearings. A final order is expected in the spring of 2005. DPL cannot predict
the outcome of this proceeding.
Restructuring Deferral
For a discussion of the history of ACE's restructuring deferral proceeding
under the New Jersey Electric Discount and Energy Competition Act, see Item 7,
Management's Discussion and Analysis of Financial Condition and Results of
Operations - Regulatory and Other Matters - Restructuring Deferral included in
Pepco Holdings' Annual Report on Form 10-K/A for the year ended
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December 31, 2003, and Item 2, Management's Discussion and Analysis of Financial
Condition and Results of Operations - Regulatory and Other Matters -
Restructuring Deferral included in Pepco Holdings' Quarterly Report on Form 10-Q
for the quarter ended March 31, 2004. In July 2004, the NJBPU issued its final
order in the restructuring deferral proceeding. The final order did not modify
the amount of the disallowances set forth in the summary order issued in July
2003, but did provide a much more detailed analysis of evidence and other
information relied on by the NJBPU as justification for the disallowances. ACE
believes the record does not justify the level of disallowance imposed by the
NJBPU. In August 2004, ACE filed with the Appellate Division of the Superior
Court of New Jersey, which hears appeals of New Jersey administrative agencies,
including the NJBPU, a Notice of Appeal and a Case Information Statement related
to the July 2004 Final Decision and Order. ACE cannot predict the outcome of
this appeal.
Standard Offer Service
District of Columbia
For a history of the Standard Offer Service (SOS) proceeding pending before
the DCPSC, see Item 7, Management's Discussion and Analysis of Financial
Condition and Results of Operations - Regulatory and Other Matters - Pepco
Regulatory Matters included in Pepco Holdings' Annual Report on Form 10-K/A for
the year ended December 31, 2003 and Item 2, Management's Discussion and
Analysis of Financial Condition and Results of Operations - Regulatory and Other
Matters - SOS and POLR Proceedings included in Pepco Holdings' Quarterly Report
on Form 10-Q for the quarter ended March 31, 2004 and Item 2, Management's
Discussion and Analysis of Financial Condition and Results of Operations -
Regulatory and Other Matters - Standard Offer Service included in Pepco
Holdings' Quarterly Report on Form 10-Q for the quarter ended June 30, 2004. In
August 2004, the DCPSC issued an order adopting administrative charges for
residential, small and large commercial DC SOS customers that are intended to
allow Pepco to recover the administrative costs incurred to provide the SOS
supply. The approved administrative charges include an average margin for Pepco
of approximately $0.00248 per kilowatt hour, calculated based on total sales to
residential, small and large commercial DC SOS customers over the twelve months
ended December 31, 2003. Because margins vary by customer class, the actual
average margin over any given time period will depend on the number of DC SOS
customers from each customer class and the load taken by such customers over the
time period. The administrative charges will go into effect for Pepco's DC SOS
sales beginning February 8, 2005. Pepco completed the first competitive
procurement process for DC SOS at the end of October and filed the proposed new
SOS rates with the DCPSC on November 3, 2004.
The Transition Power Agreement (TPA) with Mirant under which Pepco obtains
the DC SOS supply ends on January 22, 2005, while the new SOS supply contracts
with the winning bidders in the competitive procurement process provide for
supply to begin on February 1, 2005. Pepco will procure power separately on the
spot market to cover the period from January 23 through January 31, 2005, before
the new DC SOS contracts begin. Consequently, Pepco will have to pay the
difference between the procurement cost of power on the spot market and the
current DC SOS rates charged to customers during the period from January 23
through January 31, 2005. In addition, because the new DC SOS rates do not go
into effect until February 8, 2005, Pepco will have to pay the difference
between the procurement cost of power under the new DC SOS contracts and the
current DC SOS rates charged to customers for the period from February 1 to
February 7, 2005. The amount of the difference for these periods will depend on
spot market power prices during the first
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period, weather, and the amount of DC SOS load that Pepco is serving. Pepco
estimates that the total amount of the difference will be in the range from
approximately $7.6 million to approximately $11.4 million. This difference,
however, will be included in the calculation of the Generation Procurement
Credit (GPC) for DC for the period February 8, 2004 through February 7, 2005.
The GPC provides for a sharing between Pepco's customers and shareholders, on an
annual basis, of any margins, but not losses, that Pepco earns providing SOS in
the District of Columbia during the four-year period from February 8, 2001
through February 7, 2005. When the GPC is calculated, Pepco expects that the
cost difference it will pay after the expiration of the Mirant TPA and before
the new DC SOS rates go into effect will reduce to zero the margins earned from
February 8, 2004 through February 7, 2005 that otherwise would have been shared
between Pepco's customers and shareholders. The amount of the difference that
exceeded such margins would be recorded on Pepco's books as a loss. In the event
that Pepco were to ultimately realize a significant recovery from the Mirant
bankruptcy estate associated with the TPA, the GPC would be recalculated,
potentially reducing the amount of any loss recorded on Pepco's books.
Virginia
Under amendments to the Virginia Electric Utility Restructuring Act
implemented in March 2004, DPL is obligated to offer default service to
customers in Virginia for an indefinite period until relieved of that obligation
by the Virginia State Corporation Commission (VSCC). DPL currently obtains all
of the energy and capacity needed to fulfill its default service obligations in
Virginia under a supply agreement with Conectiv Energy. Conectiv Energy has
served notice that the power supply agreement will terminate effective
December 31, 2004. After conducting a competitive bid procedure, DPL has entered
into a new supply agreement with Conectiv Energy, which was the lowest bidder,
to provide wholesale power supply for DPL's Virginia default service customers.
The new supply agreement commences January 1, 2005 and expires in May 2006. On
October 26, 2004, DPL filed an application with the VSCC for approval to
increase the rates that DPL charges its Virginia default service customers to
allow it to recover its costs for power under the new supply agreement plus an
administrative charge and an average margin of approximately $0.00179 per
kilowatt hour, calculated based on total sales to residential and
non-residential Virginia default service customers over the twelve months ended
December 31, 2003. Because margins vary by customer class, the actual average
margin over any given time period will depend on the number of Virginia default
service customers from each customer class and the load taken by such customers
over the time period. DPL cannot predict the outcome of this proceeding.
Contemporaneously, DPL and Conectiv Energy jointly filed an application with the
VSCC under Virginia's Affiliates Act requesting authorization for DPL to enter
into a contract to purchase power from an affiliate. On October 29, 2004,
Conectiv Energy also made a filing with FERC requesting authorization to enter
into a contract to supply power to an affiliate.
Proposed Shut-Down of B.L. England Generating Station
As discussed in Item 2, Management's Discussion and Analysis of Financial
Condition and Results of Operations - Regulatory and Other Matters - Preliminary
Settlement Agreement with NJDEP included in Pepco Holdings' Quarterly Report on
Form 10-Q for the quarter ended March 31, 2004, ACE filed a report in April 2004
with the NJBPU in compliance with the NJBPU order issued in September 2003. This
report recommended that the B.L. England generating plant be shut down in
accordance with the terms of the preliminary
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settlement agreement among PHI, Conectiv and ACE, the New Jersey Department of
Environmental Protection and the Attorney General of New Jersey. In letters
dated May and September 2004 to the PJM Interconnection, LLC (PJM), ACE informed
PJM of its intent, as owner of the B.L. England generating plant, to retire the
entire plant (447 MW) on December 15, 2007. PJM has completed its independent
analysis to determine the upgrades required to eliminate any identified
reliability problems resulting from the retirement of B.L. England and has
recommended that certain transmission upgrades be installed prior to the summer
of 2008. ACE's independent assessment confirmed that the transmission upgrades
identified by PJM are the transmission upgrades necessary to maintain
reliability in the Atlantic zone after the retirement of B.L. England. The
amount of the costs incurred by ACE to construct the recommended transmission
upgrades that ACE would be permitted to recover from load serving entities that
use ACE's transmission system would be subject to approval by FERC. The amount
of construction costs that ACE would be permitted to recover from retail
ratepayers would be determined in accordance with the treatment of
transmission-related revenue requirements in retail rates under the jurisdiction
of the appropriate state regulatory commission. ACE cannot predict how the
recovery of such costs will ultimately be treated by FERC and the state
regulatory commissions and, therefore, cannot predict the financial impact to
ACE of installing the recommended transmission upgrades. However, in the event
that the NJBPU makes satisfactory findings and grants other requested approvals
concerning the retirement of B.L. England and approves the construction of the
transmission upgrades required to maintain reliability in the Atlantic zone
after such retirement, ACE expects to begin construction of the appropriate
transmission upgrades while final decisions by FERC and state regulatory
commissions concerning the methodology for recovery of the costs of such
construction are still pending.
On November 1, 2004, ACE made a filing with the NJBPU requesting approval of
the transmission upgrades required to maintain reliability in the Atlantic zone
after the retirement of B.L. England. Late in November or shortly thereafter,
ACE will file a request that the NJBPU (i) make a finding that the retirement of
the B.L. England generating station is prudent and (ii) approve the categories
of costs that will be stranded costs associated with the retirement, dismantling
and remediation of B.L. England. ACE cannot predict the outcome of these two
proceedings.
Environmental Matters
For a discussion of environmental matters involving Pepco Holdings and its
subsidiaries, see Item 1, Environmental Matters - Hazardous Substance Regulation
included in Pepco Holdings' Annual Report on Form 10-K/A for the year ended
December 31, 2003 and Item 2, Management's Discussion and Analysis of Financial
Condition and Results of Operations - Regulatory and Other Matters - Preliminary
Settlement Agreement with NJDEP included in Pepco Holdings' Quarterly Report on
Form 10-Q for the quarter ended March 31, 2004.
The Comprehensive Environmental Response, Compensation, and Liability Act of
1980 (CERCLA) authorizes the Environmental Protection Agency (EPA) and,
indirectly, the states, to issue orders and bring enforcement actions to compel
responsible parties to investigate and take remedial actions at any site that is
determined to present an actual or potential threat to human health or the
environment because of an actual or threatened release of one or more hazardous
substances. Parties that generated or transported hazardous substances to such
sites, as well as the owners and operators of such sites, may be deemed liable
under CERCLA. Pepco, DPL and ACE each has been named by the EPA or a state
environmental agency as a potentially
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responsible party at certain contaminated sites. In July 2004, DPL entered into
an Administrative Consent Order with the Maryland Department of the Environment
(MDE) to perform a Remedial Investigation/Feasibility Study (RI/FS) to further
identify the extent of soil, sediment and ground and surface water contamination
related to former MGP operations at the Cambridge, Maryland site on DPL-owned
property and to investigate the extent of MGP contamination on adjacent
property. The costs for completing the RI/FS for this site are expected to be
approximately $150,000 between 2004 and 2005; however, the costs of cleanup
resulting from the RI/FS are not determinable until the RI/FS is completed and
an agreement with respect to cleanup is reached with the MDE. DPL expects to
complete the RI/FS in the first quarter of 2005.
CRITICAL ACCOUNTING POLICIES
No material changes to Pepco Holdings' Critical Accounting Policies occurred
during the third quarter of 2004. Accordingly, for a discussion of these
policies, please refer to Item 7, Management's Discussion and Analysis of
Financial Condition and Results of Operations of Pepco Holdings' Annual Report
on Form 10-K/A for the year ended December 31, 2003.
RISK FACTORS
Federal Tax Legislation Affecting Cross-border=0Leases
On October 22, 2004, President Bush signed into law the American Jobs
Creation Act of 2004 (FSC-ETI Bill, H.R. 4520). This legislation provides, in
part, new passive loss limitation rules that will be applied prospectively to
leases (including cross-border=0leases) entered into after March 12, 2004 with
tax indifferent parties (i.e., municipalities and tax exempt or governmental
entities). The assets of PCI include a cross-border=0energy lease portfolio with
a book value of approximately $1.2 billion at September 30, 2004.
Cross-border=0leases are leases by a U.S. taxpayer of property located in a
foreign country. All of PCI's cross-border=0leases are with tax indifferent
parties and were entered into prior to 2004. Therefore, the legislation, as
finally enacted, will not affect PCI's existing leases. Although this
legislation is prospective in nature, it does not prohibit the Internal Revenue
Service from challenging prior leasing transactions.
For information concerning additional risk factors, please refer to Item 7,
Management's Discussion and Analysis of Financial Condition and Results of
Operations in Pepco Holdings' Annual Report on Form 10-K/A for the year ended
December 31, 2003.
FORWARD LOOKING STATEMENTS
Some of the statements contained in this Quarterly Report on Form 10-Q are
forward-looking statements within the meaning of Section 21E of the Securities
Exchange Act of 1934, as amended, and are subject to the safe harbor created by
the Private Securities Litigation Reform Act of 1995. These statements include
declarations regarding Pepco Holdings' intents, beliefs and current
expectations. In some cases, you can identify forward-looking statements by
terminology such as "may," "will," "should," "expects," "plans," "anticipates,"
"believes," "estimates," "predicts," "potential" or "continue" or the negative
of such terms or other comparable terminology. Any forward-looking statements
are not guarantees of future performance, and actual results could differ
materially from those indicated by the forward-looking statements.
Forward-looking statements involve estimates, assumptions, known and unknown
risks, uncertainties and other factors that
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may cause our or our industry's actual results, levels of activity, performance
or achievements to be materially different from any future results, levels of
activity, performance or achievements expressed or implied by such
forward-looking statements.
The forward-looking statements contained herein are qualified in their
entirety by reference to the following important factors, which are difficult to
predict, contain uncertainties, are beyond Pepco Holdings' control and may cause
actual results to differ materially from those contained in forward-looking
statements:
Prevailing governmental policies and regulatory actions affecting the
energy industry, including with respect to allowed rates of return,
industry and rate structure, acquisition and disposal of assets and
facilities, operation and construction of plant facilities, recovery of
purchased power expenses, and present or prospective wholesale and retail
competition;
Changes in and compliance with environmental and safety laws and
policies;
Weather conditions;
Population growth rates and demographic patterns;
Competition for retail and wholesale customers;
General economic conditions, including potential negative impacts
resulting from an economic downturn;
Growth in demand, sales and capacity to fulfill demand;
Changes in tax rates or policies or in rates of inflation;
Changes in project costs;
Unanticipated changes in operating expenses and capital expenditures;
The ability to obtain funding in the capital markets on favorable terms;
Restrictions imposed by PUHCA;
Legal and administrative proceedings (whether civil or criminal) and
settlements that influence our business and profitability;
Pace of entry into new markets;
Volatility in market demand and prices for energy, capacity and fuel;
Interest rate fluctuations and credit market concerns; and
Effects of geopolitical events, including the threat of domestic
terrorism.
Any forward-looking statements speak only as to the date of this Quarterly
Report and Pepco Holdings undertakes no obligation to update any forward-looking
statements to reflect events or circumstances after the date on which such
statements are made or to reflect the occurrence of
104
unanticipated events. New factors emerge from time to time, and it is not
possible for Pepco Holdings to predict all of such factors, nor can Pepco
Holdings assess the impact of any such factor on our business or the extent to
which any factor, or combination of factors, may cause results to differ
materially from those contained in any forward-looking statement.
Pepco Holdings undertakes no obligation to publicly update or revise any
forward-looking statements, whether as a result of new information, future
events or otherwise. The foregoing review of factors should not be construed as
exhaustive.
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MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
POTOMAC ELECTRIC POWER COMPANY
OVERVIEW
Potomac Electric Power Company (Pepco) is engaged in the transmission and
distribution of electricity in Washington, D.C. and major portions of Prince
George's and Montgomery Counties in suburban Maryland. Pepco's service territory
covers approximately 640 square miles and has a population of approximately 2
million. Pepco is a wholly owned subsidiary of Pepco Holdings, Inc. (Pepco
Holdings or PHI).
For additional information, refer to Item 7, Management's Discussion and
Analysis of Financial Condition and Results of Operations of Pepco's Annual
Report on Form 10-K for the year ended December 31, 2003.
RESULTS OF OPERATIONS
The accompanying results of operations discussion is for the three months
ended September 30, 2004 compared to September 30, 2003.
Operating Revenue
2004 2003 Change
(Dollars in Millions)
Regulated T&D Electric Revenue $255.7 $244.2 $11.5
Electricity Supply Service Revenue 310.8 268.2 42.6
Other Electric Revenue 9.0 6.0 3.0
Total Operating Revenue $575.5 $518.4
The table above shows the amount of operating revenue earned that is subject
to price regulation (regulated and ESS) and that which is not subject to price
regulation (other). Regulated T&D (Transmission & Distribution) electric revenue
consists of the revenue Pepco receives for delivery of energy to its customers
for which service Pepco is paid regulated rates. Electricity supply service
(ESS) also known as Standard Offer Service (SOS) consists of revenue Pepco
receives for the procurement of energy for its customers within the service
areas of Pepco. Other revenue includes work and services performed on behalf of
customers including other utilities, which is not subject to price regulation.
Work and services includes mutual assistance to other utilities, highway
relocation, rents, late payments, and collection fees.
Regulated T&D Electric Revenue
Regulated T&D electric revenue increased by $11.5 million primarily due to
the following: (i) an $8.3 million increase in a county surcharge which is a
pass through to the taxing authority (see Other Taxes); (ii) a $4.5 million
increase due to sales growth of 1.0%; partially offset by (iii) a $1.0 million
decrease due to the difference in weather. Delivery sales were 7,410,000 MwH,
compared to 7,334,000 MwH for the comparable period in 2003. Cooling degree days
decreased 3.2% for the three months ended September 30, 2004 compared to the
same period in 2003.
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Electricity Supply Service Revenue
Electricity supply service (ESS) revenue increased by $42.6 million primarily
due to lower customer migration resulting in a 9.0% increase in MwH sales.
At September 30, 2004, 11% of Pepco's Maryland customers and 8% of Pepco's DC
customers had chosen alternate suppliers. The portion of Pepco's Maryland
customers served by an alternate supplier represented 33% of Pepco's total
Maryland load, and Pepco's DC customers served by an alternate supplier
represented 34% of Pepco's total DC load.
At September 30, 2003, 16% of Pepco's Maryland customers and 12% of Pepco's
DC customers had chosen alternate suppliers. The portion of Pepco's Maryland
customers served by an alternate supplier represented 29% of Pepco's total
Maryland load, and Pepco's DC customers served by an alternate supplier
represented 45% of Pepco's total DC load.
Other Electric Revenue
Other electric revenue increased $3.0 million for the three month period
primarily due to increased demands for services from customers and other
utilities. Related expenses are discussed under Other Operation and Maintenance.
Operating Expenses
Fuel and Purchased Energy
Electric fuel and purchased energy increased by $48.4 million to $289.9
million for the three months ended September 30, 2004, from $241.5 million for
the corresponding period in 2003. The increase was primarily due to the
following: (i) $65.9 million higher ESS costs resulting from a 9.0% increase in
ESS sales; and (ii) $13.5 million higher costs as a result of the Transition
Power Agreements (TPA) settlement with Mirant (entered into in November 2003)
that increased the price of energy purchased from Mirant. These increases were
partially offset by: (i) $14.5 million reserve recorded in September 2003 to
reflect a potential exposure related to a pre-petition receivable from Mirant
Corp. for which Pepco filed a creditor's claim in the bankruptcy proceedings;
(ii) $15.9 million reduction in the Generation Procurement Credit (GPC) which
resulted from the lower ESS margin, which in turn provided less customer
sharing; and (iii) $.6 million lower transmission service costs. See the
Regulatory and Other Matters - Relationship with Mirant section herein for
additional information related to Mirant.
Other Operation and Maintenance
Other operation and maintenance expenses increased by $6.9 million to $66.4
million for the three months ended September 30, 2004, from $59.5 million for
the corresponding period in 2003. The increase was primarily due to the
following: (i) $3.7 million higher electric system maintenance costs, (ii) $2.6
million miscellaneous charges billed to customers (see Other Electric Revenue),
(iii) $2.4 million for uncollectibles, (iv) $1.4 million for severance and
incentive costs, (v) $1.0 million SOS Administrative expenses, and (vi) $5.4
million various other items. These increases were partially offset by the
nonrecurrence of storm costs of $9.6 million primarily related to Hurricane
Isabel in September 2003.
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Other Taxes
Other taxes increased by $9.3 million to $72.5 million for the three months
ended September 30, 2004, from $63.2 million for the corresponding period in
2003. The increase was primarily due to a higher county surcharge of $7.9
million, which is a pass through (see Regulated Electric Revenue) and $.9
million for gross receipts tax. The tax rate on the county surcharge based on
kilowatt hours delivered on and after July 1, 2004 increased by approximately
52%.
Income Tax Expense
Pepco's effective tax rate for the three months ended September 30, 2004 was
36.9% as compared to the federal statutory rate of 35%. The major reasons for
this difference were state income taxes (net of federal benefit) and the
flow-through of certain book tax depreciation differences partially offset by
the flow-through of Deferred Investment Tax Credits and changes in estimates
related to tax liabilities of prior tax years subject to audit (which was the
primary reason for the lower effective tax rate as compared to 2003).
Pepco's effective tax rate for the three months ended September 30, 2003 was
40.5% as compared to the federal statutory rate of 35%. The major reasons for
this difference were state income taxes (net of federal benefit) and the
flow-through of certain book tax depreciation differences partially offset by
the flow-through of Deferred Investment Tax Credits and certain removal costs.
The accompanying results of operations discussion is for the nine months
ended September 30, 2004 compared to September 30, 2003.
Operating Revenue
2004 2003 Change
(Dollars in Millions)
Regulated T&D Electric Revenue $658.9 $ 607.1 $51.8
Electricity Supply Service Revenue 719.6 597.7 121.9
Other Electric Revenue 27.8 17.1 10.7
Total Operating Revenue $1,406.3 $1,221.9
Regulated T&D Electric Revenue
Regulated T&D electric revenue increased by $51.8 million primarily due to
the following: (i) a $28.3 million increase in a county surcharge pass through
(see Other Taxes); ii) a $12.7 million increase due to sales growth of 4.3%
(excluding the effects of weather); and (iii) a $9.9 million increase due to net
favorable warmer weather. Delivery sales were 20,771,000 MwH, compared to
19,909,000 MwH for the comparable period in 2003. Cooling degree days increased
by 21.1% and heating degree days decreased by 9.7% for the nine months ended
September 30, 2004 as compared to the same period in 2003.
Electricity Supply Service Revenue
Electricity supply service (ESS) revenue increased by $121.9 million due to
lower customer migration resulting in a 16.6% increase in kilowatt-hour sales.
For a discussion of customer migration at September 30, 2004 refer to the
three months results of Electricity Supply Service Revenue.
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Other Electric Revenue
Other electric revenue increased $10.7 million primarily due to increased
demands for services from customers and other utilities for the nine month
period (See Other Operation and Maintenance).
Operating Expenses
Fuel and Purchased Energy
Electric fuel and purchased energy increased by $156.6 million to $696.9
million for the nine months ended September 30, 2004, from $540.3 million for
the corresponding period in 2003. The increase was primarily due to the
following: (i) $127.1 million higher ESS costs resulting from a 16.6% increase
in ESS sales, (ii) $71.1 million higher costs as a result of the TPA Settlement
with Mirant (entered into in November 2003) that increased the price of energy
purchased from Mirant, and (iii) $3.3 million higher transmission service costs.
These increases were partially offset by (i) $30.4 million reduction in the GPC
which resulted from the lower ESS margin, which in turn provided less customer
sharing; and (ii) $14.5 million reserve recorded in September 2003 to reflect a
potential exposure related to a pre-petition receivable from Mirant Corp. for
which Pepco filed a creditor's claim in the bankruptcy proceedings. See the
Regulatory and Other Matters - Relationship with Mirant section herein for
additional information related to Mirant.
Other Operation and Maintenance
Other operation and maintenance expenses increased by $19.8 million to $196.9
million for the nine months ended September 30, 2004, from $177.1 million for
the corresponding period in 2003. The increase was primarily due to (i) $11.1
million higher electric system maintenance costs, (ii) $7.4 million of costs
related to the increase in miscellaneous charges billed to customers (see Other
Electric Revenue), (iii) $3.7 million for increased professional fees, (iv) $4.6
million for uncollectibles, and (v) $2.4 million for various other items,
partially offset by the nonrecurrence of storm costs of approximately $9.4
million primarily related to Hurricane Isabel in September 2003.
Other Taxes
Other taxes increased by $34.6 million to $187.7 million for the nine months
ended September 30, 2004, from $153.1 million for the corresponding period in
2003. The increase was primarily due to $27.6 million higher county surcharge,
which is a pass through (see Regulated Electric Revenue), $3.9 million higher
gross receipts tax, $1.1 million county Right-of-Way fee adjustment in 2003, and
$.9 million higher use tax. The tax rate on the county surcharge based on
kilowatt hours delivered on and after July 1, 2004 increased by approximately
52%.
Gain on Sale of Asset
Gain on sale of asset of $6.6 million represents the sale of land in the
first quarter of 2004.
Other Income (Expenses)
Other expenses increased by $4.3 million to a net expense of $55.4 million
for the nine months ended September 30, 2004 from a net expense of $51.1 million
for the corresponding period in 2003. This was primarily due
110
to $2.5 million in lower interest income from Edison Capital Reserves which was
dissolved in December 2003, and $.9 million of additional finance costs.
Income Tax Expense
Pepco's effective tax rate for the nine months ended September 30, 2004 was
38.2% as compared to the federal statutory rate of 35%. The major reasons for
this difference were state income taxes (net of federal benefit) and the
flow-through of certain book tax depreciation differences partially offset by
the flow-through of Deferred Investment Tax Credits and certain removal costs
and changes in estimates related to tax liabilities of prior tax years subject
to audit (which was the primary reason for the lower effective tax rate as
compared to 2003).
Pepco's effective tax rate for the nine months ended September 30, 2003 was
40.3% as compared to the federal statutory rate of 35%. The major reasons for
this difference were state income taxes (net of federal benefit) and the
flow-through of certain book tax depreciation differences partially offset by
the flow-through of Deferred Investment Tax Credits and certain removal costs.
CAPITAL RESOURCES AND LIQUIDITY
Financing Activity During the Three Months Ended September 30, 2004
In July 2004, Pepco Holdings, Pepco, DPL and ACE entered into a five-year
credit agreement with an aggregate borrowing limit of $650 million. This
agreement replaces a $550 million 364-day credit agreement that was entered into
on July 29, 2003. The respective companies also are parties to a three-year
credit agreement that was entered into in July 2003 and terminates in July 2006
with an aggregate borrowing limit of $550 million. Pepco Holdings' credit limit
under these agreements is $700 million and the credit limit of each of Pepco,
DPL and ACE is the lower of $300 million and the maximum amount of short-term
debt authorized by the applicable regulatory authority, except that the
aggregate amount of credit utilized by Pepco, DPL and ACE at any given time
under the agreements may not exceed $500 million. The credit agreements
primarily serve as a source of liquidity to support the commercial paper
programs of the respective companies. The companies can also borrow funds for
general corporate purposes and issue letters of credit under the Agreements. The
credit agreements contain customary financial and other covenants that, if not
satisfied, could result in the acceleration of repayment obligations under the
agreements or restrict the ability of the companies to borrow under the
agreements. Among these covenants is the requirement that each borrowing company
maintain a ratio of total indebtedness to total capitalization of 65% or less,
computed in accordance with the terms of the credit agreements. The credit
agreements also contain a number of customary events of default th |