In April 2006, ACE Funding made principal payments of $4.8 million on Series 2002-1 Bonds, Class A-1, and $2.0 million on Series 2003-1 Bonds, Class A-1, with a weighted average interest rate of 2.89%. |
In April 2006, PHI, Pepco, DPL and ACE amended their $1.2 billion credit facility due 2010 to extend the maturity by one additional year to May 5, 2011 and to reduce the pricing of the facility by reducing the credit facility fees. |
In April 2006, PCI renegotiated a lease resulting in a $15.1 million reduction in long-term debt. |
In June 2006, DPL made a sinking fund payment of $2.9 million on its 6.95% First Mortgage Bonds due 2008. |
New Accounting Standards |
FSP FTB 85-4-1, "Accounting for Life Settlement Contracts by Third-Party Investors" |
In March 2006, the FASB issued FASB Staff Position (FSP) FTB 85-4-1, "Accounting for Life Settlement Contracts by Third-Party Investors" (FSP FTB 85-4-1). This FSP provides initial and subsequent measurement guidance and financial statement presentation and disclosure guidance for investments by third-party investors in life settlement contracts. FSP FTB 85-4-1 also amends certain provisions of FASBTechnical Bulletin No. 85-4, "Accounting for Purchases of Life Insurance," and FASBStatement No. 133, "Accounting for Derivative Instruments and Hedging Activities." The guidance in FSP FTB 85-4-1 applies prospectively for all new life settlement contracts and is effective for fiscal years beginning after June 15, 2006 (the year ending December 31, 2007 for Pepco Holdings). Pepco Holdings is in the process of evaluating the impact of FSP FTB 85-4-1 and does not anticipate its adoption will have a material impact on its overall financial condition, results of operations, or cash flows. 17 
|
EITF 04-13, "Accounting for Purchases and Sales of Inventory with the Same Counterparty" |
In September 2005, the FASB ratified Emerging Issues Task Force (EITF) Issue No. 04-13, "Accounting for Purchases and Sales of Inventory with the Same Counterparty" (EITF 04-13), which addresses circumstances under which two or more exchange transactions involving inventory with the same counterparty should be viewed as a single exchange transaction for the purposes of evaluating the effect of APB Opinion 29, "Accounting for Nonmonetary Transactions." EITF 04-13 is effective for new arrangements entered into, or modifications or renewals of existing arrangements, beginning in the first interim or annual reporting period beginning after March 15, 2006. |
Pepco Holdings implemented EITF 04-13 on April 1, 2006. The implementation did not have a material impact on Pepco Holdings' overall financial condition, results of operations, or cash flows for the second quarter of 2006. |
SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140" |
In February 2006, the FASB issued Statement No. 155, "Accounting for Certain Hybrid Financial Instruments-an amendment of FASB Statements No. 133 and No. 140" (SFAS No. 155). SFAS No. 155 amends FASB Statements No. 133, "Accounting for Derivative Instruments and Hedging Activities," and No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." SFAS No. 155 resolves issues addressed in Statement 133 Implementation Issue No. D1, "Application of Statement 133 to Beneficial Interests in Securitized Financial Assets." SFAS No. 155 is effective for all financial instruments acquired or issued after the beginning of an entity's first fiscal year that begins after September 15, 2006 (the year ending December 31, 2007 for Pepco Holdings). Pepco Holdings has evaluated the impact of SFAS No. 155 and does not anticipate that its implementation will have a material impact on its overall financial condition, results of operations, or cash flows. |
SFAS No. 156, "Accounting for Servicing of Financial Assets" |
In March 2006, the FASB issued Statement No. 156, "Accounting for Servicing of Financial Assets" (SFAS No. 156), an amendment of SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," with respect to the accounting for separately recognized servicing assets and servicing liabilities. SFAS No. 156 requires an entity to recognize a servicing asset or servicing liability upon undertaking an obligation to service a financial asset via certain servicing contracts, and for all separately recognized servicing assets and servicing liabilities to be initially measured at fair value, if practicable. Subsequent measurement is permitted using either the amortization method or the fair value measurement method for each class of separately recognized servicing assets and servicing liabilities. SFAS No. 156 is effective as of the beginning of an entity's first fiscal year that begins after September 15, 2006 (the year ending Decembe r 31, 2007 for Pepco Holdings). Application is to be applied prospectively to all transactions following adoption of SFAS No. 156. Pepco Holdings has evaluated the impact of SFAS No. 156 and does not anticipate its adoption will have a material impact on its overall financial condition, results of operations, or cash flows. 18
|
FSP FIN 46(R)-6, "Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R)" |
In April 2006, the FASB issued FSP FIN 46(R)-6, "Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R)" (FSP FIN 46(R)-6), which provides guidance on how to determine the variability to be considered in applying FIN 46(R), "Consolidation of Variable Interest Entities." |
The guidance in FSP FIN 46(R)-6 is applicable prospectively beginning the first day of the first reporting period beginning after June 15, 2006 (July 1, 2006 for PHI), although early application is permitted to financial statements not issued. Retrospective application is also permitted if so elected and must be completed no later than the end of the first annual reporting period ending after July 15, 2006 (December 31, 2006 for PHI). |
Pepco Holdings is in the process of evaluating the impact of FIN 46(R)-6. |
EITF Issue No. 06-3, "Disclosure Requirements for Taxes Assessed by a Governmental Authority on Revenue-producing Transactions" |
On June 28, 2006, the FASB ratified EITF Issue No. 06-3, "Disclosure Requirements for Taxes Assessed by a Governmental Authority on Revenue-producing Transactions" (EITF 06-3). EITF 06-3 provides guidance on an entity's disclosure of its accounting policy regarding the gross or net presentation of certain taxes and provides that if taxes included in gross revenues are significant, a company should disclose the amount of such taxes for each period for which an income statement is presented (i.e., both interim and annual periods). Taxes within the scope of EITF 06-3 are those that are imposed on and concurrent with a specific revenue-producing transaction. Taxes assessed on an entity's activities over a period of time are not within the scope of EITF 06-3. |
EITF 06-3 is effective for interim and annual reporting periods beginning after December 15, 2006 (2007 for PHI) although earlier application is permitted. Pepco Holdings is in the process of evaluating the impact of EITF 06-3. |
FSP FAS 13-2, "Accounting for a Change or Projected Change in the Timing of Cash Flows Relating to Income Taxes Generated by a Leverage Lease Transaction" |
On July 13, 2006, the FASB issued FSP FAS 13-2, "Accounting for a Change or Projected Change in the Timing of Cash Flows Relating to Income Taxes Generated by a Leverage Lease Transaction" (FSP FAS 13-2). This FSP, which amends FASB Statement No. 13, "Accounting for Leases," addresses how a change or projected change in the timing of cash flows relating to income taxes generated by a leveraged lease transaction affects the accounting by a lessor for that lease. |
FSP FAS 13-2 will not be effective until the first fiscal year beginning after December 15, 2006 (January 1, 2007 for Pepco Holdings). Pepco Holdings is in the process of evaluating the impact of FSP FAS 13-2. 19
|
FIN 48, "Accounting for Uncertainty in Income Taxes" |
On July 13, 2006, the FASB issued FASB Interpretation No.48, "Accounting for Uncertainty in Income Taxes" (FIN 48). FIN 48 clarifies the criteria for recognition of tax benefits in accordance with SFAS No. 109, "Accounting for Income Taxes," and prescribes a financial statement recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return. Specifically, it clarifies that an entity's tax benefits must be "more likely than not" of being sustained prior to recording the related tax benefit in the financial statements. If the position drops below the "more likely than not" standard, the benefit can no longer be recognized. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. |
FIN 48 is effective the first fiscal year beginning after December 15, 2006 (January 1, 2007 for Pepco Holdings). Pepco Holdings is in the process of evaluating the impact of FIN 48. 20
|
(3) SEGMENT INFORMATION |
Based on the provisions of SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," Pepco Holdings' management has identified its operating segments at June 30, 2006 as Power Delivery, Conectiv Energy, Pepco Energy Services, and Other Non-Regulated. Intercompany (intersegment) revenues and expenses are not eliminated at the segment level for purposes of presenting segment financial results. Elimination of these intercompany amounts is accomplished for PHI's consolidated results through the "Corporate and Other" column. Segment financial information for the three and six months ended June 30, 2006 and 2005, is as follows. |
All pending appeals, adversary actions or other contested matters between Pepco and Mirant will be dismissed with prejudice, and each will release the other from any and all claims relating to the Mirant bankruptcy. |
Separately, Mirant and SMECO have entered into a Settlement Agreement and Release (the SMECO Settlement Agreement). The SMECO Settlement Agreement provides that Mirant will assume, rather than reject, the SMECO Agreement. This assumption ensures that Pepco will not incur liability to SMECO as the guarantor of the SMECO Agreement due to the rejection of the SMECO Agreement, although Pepco will continue to guarantee to SMECO the future performance of Mirant under the SMECO Agreement. |
On May 31, 2006, Mirant submitted the Settlement Agreement and the SMECO Settlement Agreement to the Bankruptcy Court and to the U.S. District Court for the Northern District of Texas (the District Court) for approval. On May 31, 2006, the District Court entered an order referring the Settlement Agreement and the SMECO Settlement Agreement to the Bankruptcy Court for approval. The Settlement Agreement and the SMECO Settlement Agreement will become effective when the Bankruptcy Court or the District Court, as applicable, has entered a final order, not subject to appeal or rehearing, approving both the Settlement Agreement and the SMECO Settlement Agreement. |
On July 5, 2006, the Bankruptcy Court held a full evidentiary hearing on the Settlement Agreement and the SMECO Settlement Agreement. The Bankruptcy Court has not yet issued an order. |
Until the Settlement Agreement and the SMECO Settlement Agreement are approved, Mirant is required to continue to perform all of its contractual obligations to Pepco and SMECO. Pepco intends to place the $450 million portion of the Pepco Distribution related to the rejection of the PPA-Related Obligations in a special purpose account, which will be invested in stable financial instruments to be used to pay for future capacity and energy purchases under the Panda PPA. 26
|
On July 19, 2006, the United States Court of Appeals for the Fifth Circuit issued an opinion affirming the District Court's orders from which Mirant appealed. The District Court's orders had denied Mirant's attempt to reject the PPA-Related Obligations and directed Mirant to resume making payments to Pepco pursuant to the PPA-Related Obligations. Under the circumstances presented in the record on appeal, the court ruled that Mirant may not reject the PPA-Related Obligations and required that Mirant continue to perform. |
Rate Proceedings |
Delaware |
In October 2005, DPL submitted its 2005 Gas Cost Rate (GCR) filing to the Delaware Public Service Commission (DPSC), which permits DPL to recover gas procurement costs through customer rates. The proposed increase of approximately 38% in anticipation of increasing natural gas commodity costs became effective November 1, 2005, subject to refund pending final DPSC approval after evidentiary hearings. DPSC staff, the Delaware Division of the Public Advocate and DPL entered into a written settlement agreement in April 2006, that the GCR should be approved as filed. On July 11, 2006, the DPSC approved the settlement agreement. |
District of Columbia and Maryland |
In February 2006, Pepco filed an update to the District of Columbia Generation Procurement Credit (GPC) for the periods February 8, 2002 through February 7, 2004 and February 8, 2004 through February 7, 2005; and an update to its Maryland GPC for the period July 1, 2003 through June 30, 2004. The GPC provides for sharing of the profit from SOS sales. The updates to the GPC in both the District of Columbia and Maryland take into account the $112.4 million in proceeds received by Pepco from the December 2005 sale of an allowed bankruptcy claim against Mirant arising from a settlement agreement entered into with Mirant relating to Mirant's obligation to supply energy and capacity to fulfill Pepco's SOS obligations in the District of Columbia and Maryland. The filings also incorporate true-ups to previous disbursements in the GPC for both states. In the filings, Pepco requested that $24.3 million be credited to District of Columbia customers and $17.7 million be credited to M aryland customers during the twelve-month period beginning April 2006. The Maryland Public Service Commission (MPSC) approved the updated Maryland GPC in March 2006. |
On June 15, 2006, the District of Columbia Public Service Commission (DCPSC) granted conditional approval of the GPC update as filed, effective July 1, 2006, and directed Pepco to respond to certain questions set forth in the order. Pepco responded to the DCPSC's questions on July 13, 2006. The DCPSC has provided a schedule for comments on Pepco's responses and for replies to those comments, concluding by the end of August. Final approval of the District of Columbia GPC update is pending. |
Federal Energy Regulatory Commission |
On May 15, 2006, Pepco, ACE and DPL updated their FERC-approved formula transmission rates based on the FERC Form 1 data for 2005 for each of the utilities. These rates became effective on June 1, 2006, as follows: for Pepco, $12,009 per megawatt per year; for ACE, $14,155 per megawatt per year; and for DPL, $10,034 per megawatt per year. By operation of the formula rate process, the new rates incorporate true-ups from the 2005 formula rates that were effective June 1, 2005 and the new 2005 customer demand or peak load. Also, beginning 27
in January 2007, the new rates will be applied to 2006 customer demand data, replacing the 2005 demand data that is currently used. This demand component is driven by the prior year peak loads experienced in each respective zone. Further, the rate changes will be positively impacted by changes to distribution rates for Pepco and DPL based on the merger settlements in Maryland and the District of Columbia. The net earnings impact expected from the network transmission rate changes is estimated to be a reduction of approximately $4 million year over year (2005 to 2006). |
Restructuring Deferral |
Pursuant to orders issued by the New Jersey Board of Public Utilities (NJBPU) under the New Jersey Electric Discount and Energy Competition Act (EDECA), beginning August 1, 1999, ACE was obligated to provide BGS to retail electricity customers in its service territory who did not choose a competitive energy supplier. For the period August 1, 1999 through July 31, 2003, ACE's aggregate costs that it was allowed to recover from customers exceeded its aggregate revenues from supplying BGS. These under-recovered costs were partially offset by a $59.3 million deferred energy cost liability existing as of July 31, 1999 (LEAC Liability) that was related to ACE's Levelized Energy Adjustment Clause and ACE's Demand Side Management Programs. ACE established a regulatory asset in an amount equal to the balance of under-recovered costs. |
In August 2002, ACE filed a petition with the NJBPU for the recovery of approximately $176.4 million in actual and projected deferred costs relating to the provision of BGS and other restructuring related costs incurred by ACE over the four-year period August 1, 1999 through July 31, 2003, net of the $59.3 million offset for the LEAC Liability. The petition also requested that ACE's rates be reset as of August 1, 2003 so that there would be no under-recovery of costs embedded in the rates on or after that date. The increase sought represented an overall 8.4% annual increase in electric rates. ACE's recovery of the deferred costs is subject to review and approval by the NJBPU in accordance with EDECA. |
In July 2004, the NJBPU issued a final order in the restructuring deferral proceeding confirming a July 2003 summary order, which (i) permitted ACE to begin collecting a portion of the deferred costs and reset rates to recover on-going costs incurred as a result of EDECA, (ii) approved the recovery of $125 million of the deferred balance over a ten-year amortization period beginning August 1, 2003, (iii) transferred to ACE's then pending base rate case for further consideration approximately $25.4 million of the deferred balance, and (iv) estimated the overall deferral balance as of July 31, 2003 at $195 million, of which $44.6 million was disallowed recovery by ACE. ACE believes the record does not justify the level of disallowance imposed by the NJBPU in the final order. In August 2004, ACE filed with the Appellate Division of the Superior Court of New Jersey (the Superior Court), which hears appeals of the decisions of New Jersey administrative agencies, including the NJ BPU, a Notice of Appeal with respect to the July 2004 final order. Briefs were filed by the parties (ACE, as appellant, and the Division of the New Jersey Ratepayer Advocate and Cogentrix Energy Inc., the co-owner of two cogeneration power plants with contracts to sell ACE approximately 397 megawatts of electricity, as cross-appellants) between August 2005 and January 2006. The Superior Court has not yet set the schedule for oral argument. 28
|
Divestiture Cases |
District of Columbia |
Final briefs on Pepco's District of Columbia divestiture proceeds sharing application were filed with the DCPSC in July 2002 following an evidentiary hearing in June 2002. That application was filed to implement a provision of Pepco's DCPSC-approved divestiture settlement that provided for a sharing of any net proceeds from the sale of Pepco's generation-related assets. One of the principal issues in the case is whether Pepco should be required to share with customers the excess deferred income taxes (EDIT) and accumulated deferred investment tax credits (ADITC) associated with the sold assets and, if so, whether such sharing would violate the normalization provisions of the Internal Revenue Code and its implementing regulations. As of June 30, 2006, the District of Columbia allocated portions of EDIT and ADITC associated with the divested generation assets were approximately $6.5 million and $5.8 million, respectively. |
Pepco believes that a sharing of EDIT and ADITC would violate the Internal Revenue Service (IRS) normalization rules. Under these rules, Pepco could not transfer the EDIT and the ADITC benefit to customers more quickly than on a straight line basis over the book life of the related assets. Since the assets are no longer owned there is no book life over which the EDIT and ADITC can be returned. If Pepco were required to share EDIT and ADITC and, as a result, the normalization rules were violated, Pepco would be unable to use accelerated depreciation on District of Columbia allocated or assigned property. In addition to sharing with customers the generation-related EDIT and ADITC balances, Pepco would have to pay to the IRS an amount equal to Pepco's District of Columbia jurisdictional generation-related ADITC balance ($5.8 million as of June 30, 2006), as well as its District of Columbia jurisdictional transmission and distribution-related ADITC balance ($5.0 million as of J une 30, 2006) in each case as those balances exist as of the later of the date a DCPSC order is issued and all rights to appeal have been exhausted or lapsed, or the date the DCPSC order becomes operative. |
In March 2003, the IRS issued a notice of proposed rulemaking (NOPR), which would allow for the sharing of EDIT and ADITC related to divested assets with utility customers on a prospective basis and at the election of the taxpayer on a retroactive basis. In December 2005 a revised NOPR was issued which, among other things, withdrew the March 2003 NOPR and eliminated the taxpayer's ability to elect to apply the regulation retroactively. Comments on the revised NOPR were filed in March 2006, and a public hearing was held in April 2006. Pepco filed a letter with the DCPSC in January 2006, in which it has reiterated that the DCPSC should continue to defer any decision on the ADITC and EDIT issues until the IRS issues final regulations or states that its regulations project related to this issue will be terminated without the issuance of any regulations. Other issues in the divestiture proceeding deal with the treatment of internal costs and cost allocations as deductions from the gross proceeds of the divestiture. |
Pepco believes that its calculation of the District of Columbia customers' share of divestiture proceeds is correct. However, depending on the ultimate outcome of this proceeding, Pepco could be required to make additional gain-sharing payments to District of Columbia customers, including the payments described above related to EDIT and ADITC. Such additional payments (which, other than the EDIT and ADITC related payments, cannot be estimated) would be charged to expense in the quarter and year in which a final decision is rendered and could have a material adverse effect on Pepco's and PHI's results of operations for those periods. However, 29
neither PHI nor Pepco believes that additional gain-sharing payments, if any, or the ADITC-related payments to the IRS, if required, would have a material adverse impact on its financial position or cash flows. |
Maryland |
Pepco filed its divestiture proceeds plan application with the MPSC in April 2001. The principal issue in the Maryland case is the same EDIT and ADITC sharing issue that has been raised in the District of Columbia case. See the discussion above under "Divestiture Cases - District of Columbia." As of June 30, 2006, the Maryland allocated portions of EDIT and ADITC associated with the divested generation assets were approximately $9.1 million and $10.4 million, respectively. Other issues deal with the treatment of certain costs as deductions from the gross proceeds of the divestiture. In November 2003, the Hearing Examiner in the Maryland proceeding issued a proposed order with respect to the application that concluded that Pepco's Maryland divestiture settlement agreement provided for a sharing between Pepco and customers of the EDIT and ADITC associated with the sold assets. Pepco believes that such a sharing would violate the normalization rules (discussed above) and would r esult in Pepco's inability to use accelerated depreciation on Maryland allocated or assigned property. If the proposed order is affirmed, Pepco would have to share with its Maryland customers, on an approximately 50/50 basis, the Maryland allocated portion of the generation-related EDIT ($9.1 million as of June 30, 2006), and the Maryland-allocated portion of generation-related ADITC. Furthermore, Pepco would have to pay to the IRS an amount equal to Pepco's Maryland jurisdictional generation-related ADITC balance ($10.4 million as of June 30, 2006), as well as its Maryland retail jurisdictional ADITC transmission and distribution-related balance ($8.9 million as of June 30, 2006), in each case as those balances exist as of the later of the date a MPSC order is issued and all rights to appeal have been exhausted or lapsed, or the date the MPSC order becomes operative. The Hearing Examiner decided all other issues in favor of Pepco, except for the determination that only one-half of the severance payments that Pepco included in its calculation of corporate reorganization costs should be deducted from the sales proceeds before sharing of the net gain between Pepco and customers. Pepco filed a letter with the MPSC in January 2006, in which it has reiterated that the MPSC should continue to defer any decision on the ADITC and EDIT issues until the IRS issues final regulations or states that its regulations project related to this issue will be terminated without the issuance of any regulations. |
Pepco has appealed to the MPSC the Hearing Examiner's decision as it relates to the treatment of EDIT and ADITC and corporate reorganization costs. Pepco believes that its calculation of the Maryland customers' share of divestiture proceeds is correct. However, depending on the ultimate outcome of this proceeding, Pepco could be required to share with its customers approximately 50 percent of the EDIT and ADITC balances described above and make additional gain-sharing payments related to the disallowed severance payments. Such additional payments would be charged to expense in the quarter and year in which a final decision is rendered and could have a material adverse effect on results of operations for those periods. However, neither PHI nor Pepco believes that additional gain-sharing payments, if any, or the ADITC-related payments to the IRS, if required, would have a material adverse impact on its financial position or cash flows. 30
|
New Jersey |
In connection with the divestiture by ACE of its nuclear generation assets, the NJBPU in July 2000 preliminarily determined that the amount of stranded costs associated with the divested assets that ACE could recover from ratepayers should be reduced by the amount of the accumulated deferred federal income taxes (ADFIT) associated with the divested nuclear assets. However, due to uncertainty under federal tax law regarding whether the sharing of federal income tax benefits associated with the divested assets, including ADFIT, with ACE's customers would violate the normalization rules, ACE submitted a request to the IRS for a Private Letter Ruling (PLR) to clarify the applicable law. The NJBPU has delayed its final determination of the amount of recoverable stranded costs until after the receipt of the PLR. |
On May 25, 2006, the IRS issued a PLR in which it stated that returning to ratepayers any of the unamortized ADFIT attributable to accelerated depreciation on the divested assets after the sale of the assets by means of a reduction of the amount of recoverable stranded costs would violate the normalization rules. |
On June 9, 2006, ACE submitted a letter to the NJBPU to request that the NJBPU conduct proceedings to finalize the determination of the stranded costs associated with the sale of ACE's nuclear assets in accordance with the PLR. |
Default Electricity Supply Proceedings |
Delaware |
In October 2005, the DPSC approved DPL as the SOS provider to Delaware customers after May 1, 2006, when DPL's fixed-rate POLR obligation ended. DPL obtains the electricity to fulfill its SOS supply obligation under contracts entered into by DPL pursuant to a competitive bid procedure approved by the DPSC. The bids received for the May 1, 2006, through May 31, 2007, period have had the effect of increasing rates significantly for all customer classes, including an average residential customer increase of 59%. |
One of the successful bidders for SOS supply was Conectiv Energy, an affiliate of DPL. Consequently, the affiliate sales from Conectiv Energy to DPL are subject to approval of FERC. FERC issued its order approving the affiliate sales in April 2006. Because DPL is a public utility incorporated in Virginia, with Virginia retail customers, the affiliate sales from Conectiv Energy to DPL are subject to approval of the Virginia State Corporation Commission (VSCC) under the Virginia Affiliates Act. On May 1, 2006, the VSCC approved the affiliate transaction by granting an exemption to DPL for the 2006 agreement and for future power supply agreements between DPL and Conectiv Energy for DPL's non-Virginia SOS load requirements awarded pursuant to a state regulatory commission supervised solicitation process. |
In April 2006, Delaware enacted legislation that provides for a deferral of the financial impact of the increases through a three-step phase-in of the rate increases, with 15% of the increase taking effect on May 1, 2006, 25% of the increase taking effect on January 1, 2007, and any remaining balance taking effect on June 1, 2007. The program is an "opt-out" program, where a customer may make an election not to participate. On April 25, 2006, the DPSC approved several tariff filings implementing the legislation, including DPL's agreement not to charge customers any interest on the deferred balances. As of July 31, 2006, approximately 53% of the eligible Delaware customers have opted not to participate in the deferral of the SOS rates 31
offered by DPL. With approximately 47% of the eligible customers participating in the phase-in program, DPL anticipates a deferral balance of approximately $51.4 million and an estimated interest expense of approximately $3.0 million, net of taxes. The estimated total interest expense is based on a projected interest cost of 5% accrued over the combined 37-month deferral and recovery period. |
The legislation also requires DPL to file an integrated resource plan, in which DPL will evaluate all available supply options (including generation, transmission and demand-side management programs) during the planning period to ensure that DPL acquires sufficient and reliable supply resources to meet its customers' needs at minimal cost. |
Maryland |
Under settlements approved by the MPSC in April 2003 addressing SOS service in Maryland following the expiration of the fixed-rate default supply obligations of Pepco and DPL in mid-2004, each of Pepco and DPL is required to provide default electricity supply to residential and small commercial customers through May 2008 and to medium-sized commercial customers through May 2006 (the obligation to provide default electricity supply to large commercial customers ended in May 2005). In accordance with the respective settlements, each of Pepco and DPL purchases the power supply required to satisfy its default supply obligations from wholesale suppliers under contracts entered into pursuant to a competitive bid procedure approved and supervised by the MPSC. |
In March 2006, Pepco and DPL each announced the results of competitive bids to supply electricity to its Maryland SOS customers for one year beginning June 1, 2006. Due to significant increases in the cost of fuels used to generate electricity, the auction results had the effect of increasing the average monthly electric bill by about 38.5% and 35% for Pepco's and DPL's Maryland residential customers, respectively. One of the successful bidders for SOS supply to both Pepco and DPL was their affiliate, Conectiv Energy. FERC issued its order approving the affiliate sales to both Pepco and DPL on May 18, 2006. Because DPL is a public utility incorporated in Virginia, with Virginia retail customers, the affiliate sales from Conectiv Energy to DPL are also subject to approval of the VSCC under the Virginia Affiliates Act. On May 1, 2006, the VSCC approved the affiliate transaction by granting an exemption to DPL for the 2006 agreement and for future power supply agreements be tween DPL and Conectiv Energy for DPL's non-Virginia SOS load requirements awarded pursuant to a state regulatory commission supervised solicitation process. |
On April 21, 2006, the MPSC approved a settlement agreement among Pepco, DPL, the staff of the MPSC and the Office of Peoples Counsel of Maryland, which provides for a rate mitigation plan for the residential customers of each company. Under the plan, the full increase for each company's residential customers who affirmatively elect to participate will be phased-in in increments of 15% on June 1, 2006, 15.7% on March 1, 2007 and the remainder on June 1, 2007. Customers electing to participate in the rate deferral plan will be required to pay the deferred amounts over an 18-month period beginning June 1, 2007. Both Pepco and DPL will accrue the interest cost to fund the deferral program. The interest cost will be absorbed by Pepco and DPL, during the period that the deferred balance is accumulated and collected from customers, to the extent of and offset against the margins that the companies otherwise would earn for providing SOS to residential customers. To implement th e settlement, Pepco and DPL filed tariff riders with the MPSC on May 2, 2006, which were approved by the MPSC on 32
May 24, 2006, giving customers the opportunity to opt-in to the phase-in of their rates, as described above. As of July 31, 2006, approximately 2% of Pepco's residential customers and approximately 1% of DPL's residential customers have made the decision to participate in the phase-in program. |
On June 23, 2006, Maryland enacted legislation that extended the period for customers to elect to participate in the phase-in of higher rates, revised the obligation to provide SOS to residential and small commercial customers until further action of the General Assembly, and provided for a customer refund reflecting the difference in projected interest expense on the deferred balance at a 25% customer participation level versus such interest expense at the actual participation levels of approximately 2% for Pepco and approximately 1% for DPL. The total amount of the refund is approximately $1.1 million for Pepco customers and approximately $.3 million for DPL customers. At Pepco's 2% level of participation, Pepco estimates that the deferral balance, net of taxes, will be approximately $1.4 million. At DPL's 1% level of participation, DPL estimates that the deferral balance, net of taxes, will be approximately $.2 million. Pepco and DPL each filed a revised tariff rider o n June 30, 2006 to implement the legislation. |
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 VSCC. Until January 1, 2005, DPL obtained all of the energy and capacity needed to fulfill its Default Service obligations in Virginia under a supply agreement with its affiliate, Conectiv Energy. In the fall of 2004, DPL conducted a competitive bidding process to provide energy and capacity for its Virginia default supply customers for the seventeen-month period January 1, 2005 through May 30, 2006. Prior to the expiration of that contract, DPL completed a subsequent competitive bid procedure for Default Service supply for the period June 2006 through May 2007, and entered into a new supply agreement for that period with Conectiv Energy, awarded as a result of the bid process. FERC issued its order approving the affiliate sales from Conectiv Energ y to DPL for its Virginia Default Service load on May 18, 2006. DPL and Conectiv Energy also filed an application with the VSCC for approval of their affiliate transaction under the Virginia Affiliates Act. The VSCC found that its approval was not needed in this case because the affiliate sale was for a period of one year or less. |
On March 10, 2006, DPL filed for a rate increase with the VSCC for its Virginia Default Service customers to take effect on June 1, 2006, which was intended to allow DPL to recover its higher cost for energy established by the competitive bid procedure. The VSCC directed DPL to address whether the proxy rate calculation as required by a memorandum of agreement entered into by DPL and VSCC staff in June 2000 should be applied to the fuel factor in DPL's rate increase filing. The proxy rate calculation is an approximation of what the cost of power would have been if DPL had not divested its generation units. The proxy rate calculation is a component of a memorandum of agreement entered into by DPL, the staff of the VSCC and the Virginia Attorney General's office in the docket approving the asset divestiture, and was a condition of that divestiture. The Virginia Attorney General's office and VSCC staff each filed testimony in April 2006, in which both argued that the 2000 me morandum of agreement requires that the proxy rate fuel factor calculation set forth therein must operate as a cap on recoverable purchased power costs. DPL filed its response in May 2006, rebutting the testimony of the 33
Attorney General and VSCC staff and arguing that retail rates should not be set at a level below what is necessary to recover its prudently incurred costs of procuring the supply necessary for its Default Service obligation. On June 19, 2006, the VSCC issued an order that granted a rate increase for DPL of $11.5 million ($8.5 million less than requested by DPL in its March 2006 filing), to go into effect July 1, 2006. The estimated after-tax earnings and cash flow impacts of the decision are reductions of approximately $3.6 million in 2006 (including the loss of revenue in June 2006 associated with the Default Service rate increase being deferred from June 1 until July 1) and $2.0 million in 2007. The order also mandated that DPL file an application by March 1, 2007, for Default Service rates to become effective June 1, 2007, which should include a calculation of the fuel factor procedure that is consistent with the procedures set forth in the order. |
New Jersey |
On October 12, 2005, the NJBPU, following the evaluation of proposals submitted by ACE and the other three electric distribution companies operating in New Jersey, issued an order reaffirming the current BGS auction process for the annual period from June 1, 2006 through May 2007. The NJBPU order maintained the current size and make up of the Commercial and Industrial Energy Pricing class (CIEP) and approved the electric distribution companies' recommended approach for the CIEP auction product, but deferred a decision on the level of the retail margin funds. |
Proposed Shut Down of B.L. England Generating Facility |
In April 2004, pursuant to a NJBPU order, ACE filed a report with the NJBPU recommending that ACE's B.L. England generating facility, a 447 megawatt plant, be shut down. The report stated that, while operation of the B.L. England generating facility was necessary at the time of the report to satisfy reliability standards, those reliability standards could also be satisfied in other ways. The report concluded that, based on B.L. England's current and projected operating costs resulting from compliance with more restrictive environmental requirements, the most cost-effective way in which to meet reliability standards is to shut down the B.L. England generating facility and construct additional transmission enhancements in southern New Jersey. |
In December 2004, ACE filed a petition with the NJBPU requesting that the NJBPU establish a proceeding that would consist of a Phase I and Phase II and that the procedural process for the Phase I proceeding require intervention and participation by all persons interested in the prudence of the decision to shut down B.L. England generating facility and the categories of stranded costs associated with shutting down and dismantling the facility and remediation of the site. ACE contemplates that Phase II of this proceeding, which would be initiated by an ACE filing in 2008 or 2009, would establish the actual level of prudently incurred stranded costs to be recovered from customers in rates. The NJBPU has not acted on this petition. |
ACE has commenced several construction projects to enhance the transmission system, which will ensure that the reliability of the electric transmission system will be maintained upon the shut down of B.L. England. To date, two projects have been completed and the remaining projects are under construction or are scheduled to be completed prior to December 15, 2007. |
As more fully described below under "Environmental Litigation," ACE, along with PHI and Conectiv, on January 24, 2006, entered into an Administrative Consent Order (ACO) with the 34
New Jersey Department of Environmental Protection (NJDEP) and the Attorney General of New Jersey, which contemplates that ACE will shut down and permanently cease operations at the B.L. England generating facility by December 15, 2007, if ACE does not sell the plant before that time. ACE recorded an asset retirement obligation of $60 million during the first quarter of 2006 (this is reflected as a regulatory liability in PHI's consolidated balance sheet). The shut-down of the B.L. England generating facility will be subject to necessary approvals from the relevant agencies and the outcome of the auction process, discussed under "ACE Auction of Generation Assets," below. |
ACE Auction of Generation Assets |
In May 2005, ACE announced that it would auction its electric generation assets, consisting of its B.L. England generating facility and its ownership interests in the Keystone and Conemaugh generating stations. In November 2005, ACE announced an agreement to sell its interests in the Keystone and Conemaugh generating stations to Duquesne Light Holdings Inc. for $173.1 million. On July 19, 2006, the NJBPU issued the final approval needed to complete the sale. ACE expects the sale to be completed in early September. Approximately $80 million, the net gain from the sale, will be used to offset the remaining unamortized aggregate adjusted deferred balance, which ACE has been recovering in rates, and approximately $54.2 million will be returned to ratepayers over a 33-month period as a credit on their bills. |
ACE received final bids for B.L. England in April 2006 and continues to evaluate those bids, working toward completion of a purchase and sale agreement. Any successful bid for B.L. England must comply with NJBPU approved auction standards. |
Any sale of B.L. England will not affect the stranded costs associated with the plant that already have been securitized. If B.L. England is sold, ACE anticipates that, subject to regulatory approval in Phase II of the proceeding described above, approximately $9 to $10 million of additional assets may be eligible for recovery as stranded costs. |
General Litigation |
Asbestos Litigation |
During 1993, Pepco was served with Amended Complaints filed in the state Circuit Courts of Prince George's County, Baltimore City and Baltimore County, Maryland in separate ongoing, consolidated proceedings known as "In re: Personal Injury Asbestos Case." Pepco and other corporate entities were brought into these cases on a theory of premises liability. Under this theory, the plaintiffs argued that Pepco was negligent in not providing a safe work environment for employees or its contractors, who allegedly were exposed to asbestos while working on Pepco's property. Initially, a total of approximately 448 individual plaintiffs added Pepco to their complaints. While the pleadings are not entirely clear, it appears that each plaintiff sought $2 million in compensatory damages and $4 million in punitive damages from each defendant. |
Since the initial filings in 1993, additional individual suits have been filed against Pepco, and significant numbers of cases have been dismissed. As a result of two motions to dismiss, numerous hearings and meetings and one motion for summary judgment, Pepco has had approximately 400 of these cases successfully dismissed with prejudice, either voluntarily by the plaintiff or by the court. As of June 30, 2006, there were approximately 220 cases still pending against Pepco in the State Courts of Maryland; of those approximately 220 remaining asbestos 35
cases, approximately 85 cases were filed after December 19, 2000, and have been tendered to Mirant for defense and indemnification pursuant to the terms of the Asset Purchase and Sale Agreement. Mirant's Plan of Reorganization, as approved by the Bankruptcy Court in connection with the Mirant bankruptcy, does not alter Mirant's indemnification obligations. |
While the aggregate amount of monetary damages sought in the remaining suits (excluding those tendered to Mirant) exceeds $400 million, PHI and Pepco believe the amounts claimed by current plaintiffs are greatly exaggerated. The amount of total liability, if any, and any related insurance recovery cannot be determined at this time; however, based on information and relevant circumstances known at this time, PHI and Pepco do not believe these suits will have a material adverse effect on its financial position, results of operations or cash flows. However, if an unfavorable decision were rendered against Pepco, it could have a material adverse effect on Pepco's and PHI's financial position, results of operations or cash flows. |
Cash Balance Plan Litigation |
On September 26, 2005, three management employees of PHI Service Company filed suit in the United States District Court for the District of Delaware against the PHI Retirement Plan, PHI and Conectiv, alleging violations of ERISA, on behalf of a class of management employees who did not have enough age and service when the Cash Balance Sub-Plan was implemented in 1999 to assure that their accrued benefits would be calculated pursuant to the terms of the predecessor plans sponsored by ACE and DPL. |
The plaintiffs have challenged the design of the Cash Balance Sub-Plan and are seeking a declaratory judgment that the Cash Balance Sub-Plan is invalid and that the accrued benefits of each member of the class should be calculated pursuant to the terms of the predecessor plans sponsored by ACE and DPL. Specifically, the complaint alleges that the use of a variable rate to compute the plaintiffs' accrued benefit under the Cash Balance Sub-Plan results in reductions in the accrued benefits that violate ERISA. The complaint also alleges that the benefit accrual rates and the minimal accrual requirements of the Cash Balance Sub-Plan violate ERISA as did the notice that was given to plan participants upon implementation of the Cash Balance Sub-Plan. |
PHI, Conectiv and the PHI Retirement Plan filed a motion to dismiss the suit, which was denied by the court on July 11, 2006. The court stayed one count of the complaint regarding alleged age discrimination pending a decision in another case before the U.S. Court of Appeals for the Third Circuit. While PHI believes it has a strong legal position in the case and that it is therefore unlikely that the plaintiffs will prevail, PHI estimates that the SFAS No. 87 ABO and Projected Benefit Obligation (PBO) would each increase by approximately $12 million, assuming no change in benefits for persons who have already retired or whose employment has been terminated and using actuarial valuation data as of the time the suit was filed. (The ABO represents the present value that participants have earned as of the date of calculation. This means that only service already worked and compensation already earned and paid is considered. The PBO is similar to the ABO, except that the PBO i ncludes recognition of the effect that estimated future pay increases would have on the pension plan obligation.) |
Environmental Litigation |
PHI, through its subsidiaries, is subject to regulation by various federal, regional, state, and local authorities with respect to the environmental effects of its operations, including air and 36
water quality control, solid and hazardous waste disposal, and limitations on land use. In addition, federal and state statutes authorize governmental agencies to compel responsible parties to clean up certain abandoned or unremediated hazardous waste sites. PHI's subsidiaries may incur costs to clean up currently or formerly owned facilities or sites found to be contaminated, as well as other facilities or sites that may have been contaminated due to past disposal practices. Although penalties assessed for violations of environmental laws and regulations are not recoverable from customers of the operating utilities, environmental clean-up costs incurred by Pepco, DPL and ACE would be included by each company in its respective cost of service for ratemaking purposes. |
In July 2004, DPL entered into an ACO 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 manufactured gas plant (MGP) operations at the Cambridge, Maryland site on DPL-owned property and to investigate the extent of MGP contamination on adjacent property. The MDE has approved the RI and DPL has completed and submitted the FS to MDE. The costs for completing the RI/FS for this site were approximately $150,000. Although the costs of cleanup resulting from the RI/FS will not be determinable until MDE approves the final remedy, DPL currently anticipates that the costs of removing MGP impacted soils and adjacent creek sediments will be in the range of $1.5 to $2.5 million. |
In the early 1970s, both Pepco and DPL sold scrap transformers, some of which may have contained some level of PCBs, to a metal reclaimer operating at the Metal Bank/Cottman Avenue site in Philadelphia, Pennsylvania, owned by a nonaffiliated company. In December 1987, Pepco and DPL were notified by U.S. Environmental Protection Agency (EPA) that they, along with a number of other utilities and non-utilities, were potentially responsible parties (PRPs) in connection with the PCB contamination at the site. Below is a summary of the proceedings and related matters concerning the Metal Bank/Cottman Avenue site: |
The ACO does not resolve any federal claims for alleged violations at the B.L. England generating station or any federal or state claims regarding alleged violations at Conectiv Energy's Deepwater generating station, about which EPA and NJDEP sought information beginning in February 2000 pursuant to CAA Section 114, or any other facilities. PHI does not believe that any of its subsidiaries has any liability with respect thereto, but cannot predict the consequences of the federal and state inquiries. |
As more fully described above under "Proposed Shut Down of B.L. England Generating Facility," ACE expects that the transmission enhancements necessary to meet reliability standards in lieu of B.L. England will be completed on or before December 15, 2007 and that B.L. England will be shut down by that date, if ACE has not sold the plant before that time. |
Federal Tax Treatment of Cross-Border Leases |
PCI maintains a portfolio of cross-border energy sale-leaseback transactions, which, as of June 30, 2006, had a book value of approximately $1.3 billion, and from which PHI currently derives approximately $55 million per year in tax benefits in the form of interest and depreciation deductions. |
On February 11, 2005, the Treasury Department and IRS issued Notice 2005-13 informing taxpayers that the IRS intends to challenge on various grounds the purported tax benefits claimed by taxpayers entering into certain sale-leaseback transactions with tax-indifferent parties (i.e., municipalities, tax-exempt and governmental entities), including those entered into on or prior to March 12, 2004 (the Notice). All of PCI's cross-border energy leases are with tax indifferent parties and were entered into prior to 2004. In addition, on June 29, 2005 the IRS published a Coordinated Issue Paper concerning the resolution of audit issues related to such transactions. PCI's cross-border energy leases are similar to those sale-leaseback transactions described in the Notice and the Coordinated Issue Paper. |
PCI's leases have been under examination by the IRS as part of the normal PHI tax audit. On June 9, 2006, the IRS issued its final Revenue Agent's Report (RAR) for its audit of PHI's 2001 and 2002 income tax returns. In the RAR, the IRS disallowed the tax benefits claimed by PHI with respect to these leases for those years. The tax benefits claimed by PHI with respect to these leases from 2001 through June 30, 2006 were approximately $259 million. The ultimate outcome of this issue is uncertain; however, if the IRS prevails, PHI would be subject to additional taxes, along with interest and possibly penalties on the additional taxes, which could have a material adverse effect on PHI's financial condition, results of operations, and cash flows. PHI believes that its tax position related to these transactions was proper based on applicable statutes, regulations and case law, and intends to contest any final adjustments proposed by the IRS; however, there is no assurance tha t PHI's position will prevail. |
In November 2005, the U.S. Senate passed The Tax Relief Act of 2005 (S.2020) which would have applied passive loss limitation rules to leases similar to PCI's cross-border energy leases, effective for taxable years beginning after December 31, 2005. This provision, however, 40
was not included in the final tax legislation, the Tax Increase Prevention and Reconciliation Act of 2005, which was signed into law by President Bush on May 17, 2006. |
On July 13, 2006, the FASB issued FSP FAS 13-2, which amends SFAS No. 13 effective for fiscal years beginning after December 15, 2006. This amendment requires a lease to be repriced and the book value adjusted when there is a change or probable change in the timing of tax benefits of the lease regardless of whether the change results in a deferral or permanent loss of tax benefits. Accordingly, a material change in the timing of cash flows under PHI's cross-border leases as the result of a settlement with the IRS would require an adjustment to the book value of the leases and a charge to earnings equal to the repricing impact of the disallowed deductions which could result in a material adverse effect on PHI's financial condition, results of operations, and cash flows. |
IRS Mixed Service Cost Issue |
During 2001, Pepco, DPL, and ACE changed their methods of accounting with respect to capitalizable construction costs for income tax purposes. The change allowed the companies to accelerate the deduction of certain expenses that were previously capitalized and depreciated. Through December 31, 2005, these accelerated deductions have generated incremental tax cash flow benefits of approximately $205 million (consisting of $94 million for Pepco, $62 million for DPL, and $49 million for ACE) for the companies, primarily attributable to their 2001 tax returns. |
On August 2, 2005, the Treasury Department released regulations that, if adopted in their current form, would require Pepco, DPL, and ACE to change their method of accounting with respect to capitalizable construction costs for income tax purposes for future tax periods beginning in 2005. Under these regulations, Pepco, DPL, and ACE will have to capitalize and depreciate a portion of the construction costs that they have previously deducted and include the impact of this adjustment in taxable income over a two-year period beginning with tax year 2005. PHI is in the process of finalizing an alternative method of accounting for capitalizable construction costs that management believes will be acceptable to the IRS to replace the method disallowed by the proposed regulations. |
On the same day that the new regulations were released, the IRS issued Revenue Ruling 2005-53 (the Revenue Ruling) which is intended to limit the ability of certain taxpayers to utilize the method of accounting for income tax purposes they utilized on their tax returns for 2004 and prior years. In line with this Revenue Ruling, the IRS issued its RAR, which disallows substantially all of the incremental tax benefits that Pepco, DPL and ACE had claimed on their 2001 and 2002 tax returns by requiring the companies to capitalize and depreciate certain expenses rather than treat such expenses as current deductions. |
In February 2006, PHI paid approximately $121 million of taxes to cover the amount of taxes management estimates will be payable once a new final method of tax accounting is adopted on its 2005 tax return, due to the proposed regulations. PHI intends to contest the adjustments that the IRS has proposed to the 2001 and 2002 tax returns, under the Revenue Ruling referenced above. However, if the IRS is successful in requiring Pepco, DPL and ACE to capitalize and depreciate construction costs that result in a tax and interest assessment greater than management's estimate of $121 million, PHI will be required to pay additional taxes and interest only to the extent these adjustments exceed the $121 million payment made in February 2006. 41
|
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 June 30, 2006, 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: |
55
|
New Accounting Standards |
FSP FTB 85-4-1, "Accounting for Life Settlement Contracts by Third-Party Investors" |
In March 2006, the FASB issued FASB Staff Position (FSP) FTB 85-4-1, "Accounting for Life Settlement Contracts by Third-Party Investors" (FSP FTB 85-4-1). This FSP provides initial and subsequent measurement guidance and financial statement presentation and disclosure guidance for investments by third-party investors in life settlement contracts. FSP FTB 85-4-1 also amends certain provisions of FASB Technical Bulletin No. 85-4, "Accounting for Purchases of Life Insurance," and FASB Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities." The guidance in FSP FTB 85-4-1 applies prospectively for all new life settlement contracts and is effective for fiscal years beginning after June 15, 2006 (the year ending December 31, 2007 for Pepco). Pepco is in the process of evaluating the impact of FSP FTB 85-4-1 and does not anticipate its adoption will have a material impact on its overall financial condition, results of operations, or cash flows. |
EITF 04-13, "Accounting for Purchases and Sales of Inventory with the Same Counterparty" |
In September 2005, the FASB ratified Emerging Issues Task Force (EITF) Issue No. 04-13, "Accounting for Purchases and Sales of Inventory with the Same Counterparty" (EITF 04-13), which addresses circumstances under which two or more exchange transactions involving inventory with the same counterparty should be viewed as a single exchange transaction for the purposes of evaluating the effect of APB Opinion 29, "Accounting for Nonmonetary Transactions." EITF 04-13 is effective for new arrangements entered into, or modifications or renewals of existing arrangements, beginning in the first interim or annual reporting period beginning after March 15, 2006. |
Pepco implemented EITF 04-13 on April 1, 2006. The implementation did not impact Pepco's overall financial condition, results of operations, or cash flows for the second quarter of 2006. |
FSP FIN 46(R)-6, "Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R)" |
In April 2006, the FASB issued FSP FIN 46(R)-6, "Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R)" (FSP FIN 46(R)-6), which provides guidance on how to determine the variability to be considered in applying FIN 46(R), "Consolidation of Variable Interest Entities." |
The guidance in FSP FIN 46(R)-6 is applicable prospectively beginning the first day of the first reporting period beginning after June 15, 2006 (July 1, 2006 for Pepco), although early application is permitted to financial statements not issued. Retrospective application is also permitted if so elected and must be completed no later than the end of the first annual reporting period ending after July 15, 2006 (December 31, 2006 for Pepco). |
Pepco is in the process of evaluating the impact of FIN 46(R)-6. 56
|
EITF Issue No. 06-3, "Disclosure Requirements for Taxes Assessed by a Governmental Authority on Revenue-producing Transactions" |
On June 28, 2006, the FASB ratified EITF Issue No. 06-3, "Disclosure Requirements for Taxes Assessed by a Governmental Authority on Revenue-producing Transactions" (EITF 06-3). EITF 06-3 provides guidance on an entity's disclosure of its accounting policy regarding the gross or net presentation of certain taxes and provides that if taxes included in gross revenues are significant, a company should disclose the amount of such taxes for each period for which an income statement is presented (i.e., both interim and annual periods). Taxes within the scope of EITF 06-3 are those that are imposed on and concurrent with a specific revenue-producing transaction. Taxes assessed on an entity's activities over a period of time are not within the scope of EITF 06-3. |
EITF 06-3 is effective for interim and annual reporting periods beginning after December 15, 2006 (2007 for Pepco) although earlier application is permitted. Pepco is in the process of evaluating the impact of EITF 06-3. |
FIN 48, "Accounting for Uncertainty in Income Taxes" |
On July 13, 2006, the FASB issued FASB Interpretation No.48, "Accounting for Uncertainty in Income Taxes" (FIN 48). FIN 48 clarifies the criteria for recognition of tax benefits in accordance with SFAS No. 109, "Accounting for Income Taxes," and prescribes a financial statement recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return. Specifically, it clarifies that an entity's tax benefits must be "more likely than not" of being sustained prior to recording the related tax benefit in the financial statements. If the position drops below the "more likely than not" standard, the benefit can no longer be recognized. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. |
FIN 48 is effective the first fiscal year beginning after December 15, 2006 (January 1, 2007 for Pepco). Pepco is in the process of evaluating the impact of FIN 48. |
(3) SEGMENT INFORMATION |
In accordance with Statement of Financial Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information," Pepco has one segment, its regulated utility business. |
(4) COMMITMENTS AND CONTINGENCIES |
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. In July 2003, Mirant 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). On December 9, 2005, the Bankruptcy Court approved Mirant's Plan of Reorganization (the Reorganization Plan), and the Mirant business emerged from bankruptcy on January 3, 2006, as a new corporation of the same name (together with its predecessors, Mirant). |
As part of the bankruptcy proceeding, Mirant had been seeking to reject the ongoing contractual arrangements under the Asset Purchase and Sale Agreement entered into by Pepco 57
and Mirant for the sale of the generation assets that are described below. The Reorganization Plan did not resolve the issues relating to Mirant's efforts to reject these obligations nor did it resolve certain Pepco damage claims against the Mirant bankruptcy estate. |
Power Purchase Agreement |
Under a power purchase agreement with Panda-Brandywine, L.P. (Panda) Pepco is obligated to purchase from Panda 230 megawatts of energy and capacity annually through 2021 (the Panda PPA). At the time of the sale of Pepco's generation assets to Mirant, the purchase price of the energy and capacity under the Panda PPA was, and since that time has continued to be, substantially in excess of the market price. 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 through 2021 to purchase from Pepco the capacity and energy that Pepco is obligated to purchase under the Panda PPA at a price equal to Pepco's purchase price from Panda (the PPA-Related Obligations). |
The SMECO Agreement |
Under the Asset Purchase and Sale Agreement, Pepco assigned to Mirant a Facility and Capacity Agreement entered into by Pepco with Southern Maryland Electric Cooperative, Inc. (SMECO), under which Pepco was obligated to purchase from SMECO the capacity of an 84-megawatt combustion turbine installed and owned by SMECO at a former Pepco generating facility at a cost of approximately $500,000 per month until 2015 (the SMECO Agreement). Pepco is responsible to SMECO for the performance of the SMECO Agreement if Mirant fails to perform its obligations thereunder. |
Settlement Agreements with Mirant |
On May 30, 2006, Pepco, PHI, and certain affiliated companies entered into a Settlement Agreement and Release (the Settlement Agreement) with Mirant, which, subject to court approval, settles all outstanding issues between the parties arising from or related to the Mirant bankruptcy. Under the terms of the Settlement Agreement: |
All pending appeals, adversary actions or other contested matters between Pepco and Mirant will be dismissed with prejudice, and each will release the other from any and all claims relating to the Mirant bankruptcy. |
Separately, Mirant and SMECO have entered into a Settlement Agreement and Release (the SMECO Settlement Agreement). The SMECO Settlement Agreement provides that Mirant will assume, rather than reject, the SMECO Agreement. This assumption ensures that Pepco will not incur liability to SMECO as the guarantor of the SMECO Agreement due to the rejection of the SMECO Agreement, although Pepco will continue to guarantee to SMECO the future performance of Mirant under the SMECO Agreement. |
On May 31, 2006, Mirant submitted the Settlement Agreement and the SMECO Settlement Agreement to the Bankruptcy Court and to the U.S. District Court for the Northern District of Texas (the District Court) for approval. On May 31, 2006, the District Court entered an order referring the Settlement Agreement and the SMECO Settlement Agreement to the Bankruptcy Court for approval. The Settlement Agreement and the SMECO Settlement Agreement will become effective when the Bankruptcy Court or the District Court, as applicable, has entered a final order, not subject to appeal or rehearing, approving both the Settlement Agreement and the SMECO Settlement Agreement. |
On July 5, 2006, the Bankruptcy Court held a full evidentiary hearing on the Settlement Agreement and the SMECO Settlement Agreement. The Bankruptcy Court has not yet issued an order. |
Until the Settlement Agreement and the SMECO Settlement Agreement are approved, Mirant is required to continue to perform all of its contractual obligations to Pepco and SMECO. Pepco intends to place the $450 million portion of the Pepco Distribution related to the rejection of the PPA-Related Obligations in a special purpose account, which will be invested in stable financial instruments to be used to pay for future capacity and energy purchases under the Panda PPA. |
On July 19, 2006, the United States Court of Appeals for the Fifth Circuit issued an opinion affirming the District Court's orders from which Mirant appealed. The District Court's orders 59
had denied Mirant's attempt to reject the PPA-Related Obligations and directed Mirant to resume making payments to Pepco pursuant to the PPA-Related Obligations. Under the circumstances presented in the record on appeal, the court ruled that Mirant may not reject the PPA-Related Obligations and required that Mirant continue to perform. |
Rate Proceedings |
District of Columbia and Maryland |
In February 2006, Pepco filed an update to the District of Columbia Generation Procurement Credit (GPC) for the periods February 8, 2002 through February 7, 2004 and February 8, 2004 through February 7, 2005; and an update to its Maryland GPC for the period July 1, 2003 through June 30, 2004. The GPC provides for sharing of the profit from SOS sales. The updates to the GPC in both the District of Columbia and Maryland take into account the $112.4 million in proceeds received by Pepco from the December 2005 sale of an allowed bankruptcy claim against Mirant arising from a settlement agreement entered into with Mirant relating to Mirant's obligation to supply energy and capacity to fulfill Pepco's SOS obligations in the District of Columbia and Maryland. The filings also incorporate true-ups to previous disbursements in the GPC for both states. In the filings, Pepco requested that $24.3 million be credited to District of Columbia customers and $17.7 million be credited to M aryland customers during the twelve-month period beginning April 2006. The Maryland Public Service Commission (MPSC) approved the updated Maryland GPC in March 2006. |
On June 15, 2006, the District of Columbia Public Service Commission (DCPSC) granted conditional approval of the GPC update as filed, effective July 1, 2006, and directed Pepco to respond to certain questions set forth in the order. Pepco responded to the DCPSC's questions on July 13, 2006. The DCPSC has provided a schedule for comments on Pepco's responses and for replies to those comments, concluding by the end of August. Final approval of the District of Columbia GPC update is pending. |
Federal Energy Regulatory Commission |
On May 15, 2006, Pepco updated its FERC-approved formula transmission rates based on its FERC Form 1 data for 2005. This new rate of $12,009 per megawatt per year became effective on June 1, 2006 at. By operation of the formula rate process, the new rate incorporates true-ups from the 2005 formula rate that was effective June 1, 2005 and the new 2005 customer demand or peak load. Also, beginning in January 2007, the new rates will be applied to 2006 customer demand data, replacing the 2005 demand data that is currently used. This demand component is driven by Pepco's prior year peak load. Further, the rate change will be positively impacted by changes to distribution rates based on the merger settlements in Maryland and the District of Columbia. The net earnings impact expected from the network transmission rate changes is estimated to be a reduction of approximately $1 million year over year (2005 to 2006). |
Divestiture Cases |
District of Columbia |
Final briefs on Pepco's District of Columbia divestiture proceeds sharing application were filed with the DCPSC in July 2002 following an evidentiary hearing in June 2002. That application was filed to implement a provision of Pepco's DCPSC-approved divestiture settlement that provided for a sharing of any net proceeds from the sale of Pepco's generation- 60
related assets. One of the principal issues in the case is whether Pepco should be required to share with customers the excess deferred income taxes (EDIT) and accumulated deferred investment tax credits (ADITC) associated with the sold assets and, if so, whether such sharing would violate the normalization provisions of the Internal Revenue Code and its implementing regulations. As of June 30, 2006, the District of Columbia allocated portions of EDIT and ADITC associated with the divested generation assets were approximately $6.5 million and $5.8 million, respectively. |
Pepco believes that a sharing of EDIT and ADITC would violate the Internal Revenue Service (IRS) normalization rules. Under these rules, Pepco could not transfer the EDIT and the ADITC benefit to customers more quickly than on a straight line basis over the book life of the related assets. Since the assets are no longer owned there is no book life over which the EDIT and ADITC can be returned. If Pepco were required to share EDIT and ADITC and, as a result, the normalization rules were violated, Pepco would be unable to use accelerated depreciation on District of Columbia allocated or assigned property. In addition to sharing with customers the generation-related EDIT and ADITC balances, Pepco would have to pay to the IRS an amount equal to Pepco's District of Columbia jurisdictional generation-related ADITC balance ($5.8 million as of June 30, 2006), as well as its District of Columbia jurisdictional transmission and distribution-related ADITC balance ($5.0 million as of J une 30, 2006) in each case as those balances exist as of the later of the date a DCPSC order is issued and all rights to appeal have been exhausted or lapsed, or the date the DCPSC order becomes operative. |
In March 2003, the IRS issued a notice of proposed rulemaking (NOPR), which would allow for the sharing of EDIT and ADITC related to divested assets with utility customers on a prospective basis and at the election of the taxpayer on a retroactive basis. In December 2005 a revised NOPR was issued which, among other things, withdrew the March 2003 NOPR and eliminated the taxpayer's ability to elect to apply the regulation retroactively. Comments on the revised NOPR were filed in March 2006, and a public hearing was held in April 2006. Pepco filed a letter with the DCPSC in January 2006, in which it has reiterated that the DCPSC should continue to defer any decision on the ADITC and EDIT issues until the IRS issues final regulations or states that its regulations project related to this issue will be terminated without the issuance of any regulations. Other issues in the divestiture proceeding deal with the treatment of internal costs and cost allocations as deductions from the gross proceeds of the divestiture. |
Pepco believes that its calculation of the District of Columbia customers' share of divestiture proceeds is correct. However, depending on the ultimate outcome of this proceeding, Pepco could be required to make additional gain-sharing payments to District of Columbia customers, including the payments described above related to EDIT and ADITC. Such additional payments (which, other than the EDIT and ADITC related payments, cannot be estimated) would be charged to expense in the quarter and year in which a final decision is rendered and could have a material adverse effect on Pepco's results of operations for those periods. However, Pepco does not believe that additional gain-sharing payments, if any, or the ADITC-related payments to the IRS, if required, would have a material adverse impact on its financial position or cash flows. |
Maryland |
Pepco filed its divestiture proceeds plan application with the MPSC in April 2001. The principal issue in the Maryland case is the same EDIT and ADITC sharing issue that has been raised in the District of Columbia case. See the discussion above under "Divestiture Cases - 61
District of Columbia." As of June 30, 2006, the Maryland allocated portions of EDIT and ADITC associated with the divested generation assets were approximately $9.1 million and $10.4 million, respectively. Other issues deal with the treatment of certain costs as deductions from the gross proceeds of the divestiture. In November 2003, the Hearing Examiner in the Maryland proceeding issued a proposed order with respect to the application that concluded that Pepco's Maryland divestiture settlement agreement provided for a sharing between Pepco and customers of the EDIT and ADITC associated with the sold assets. Pepco believes that such a sharing would violate the normalization rules (discussed above) and would result in Pepco's inability to use accelerated depreciation on Maryland allocated or assigned property. If the proposed order is affirmed, Pepco would have to share with its Maryland customers, on an approximately 50/50 basis, the Maryland allocated portion of the generation-related EDIT ($9.1 million as of June 30, 2006), and the Maryland-allocated portion of generation-related ADITC. Furthermore, Pepco would have to pay to the IRS an amount equal to Pepco's Maryland jurisdictional generation-related ADITC balance ($10.4 million as of June 30, 2006), as well as its Maryland retail jurisdictional ADITC transmission and distribution-related balance ($8.9 million as of June 30, 2006), in each case as those balances exist as of the later of the date a MPSC order is issued and all rights to appeal have been exhausted or lapsed, or the date the MPSC order becomes operative. The Hearing Examiner decided all other issues in favor of Pepco, except for the determination that only one-half of the severance payments that Pepco included in its calculation of corporate reorganization costs should be deducted from the sales proceeds before sharing of the net gain between Pepco and customers. Pepco filed a letter with the MPSC in January 2006, in which it has reiterated that the MPSC should continue to defer any decision on the ADITC and EDIT issues until the IRS issues final regulations or states that its regulations project related to this issue will be terminated without the issuance of any regulations. |
Pepco has appealed to the MPSC the Hearing Examiner's decision as it relates to the treatment of EDIT and ADITC and corporate reorganization costs. Pepco believes that its calculation of the Maryland customers' share of divestiture proceeds is correct. However, depending on the ultimate outcome of this proceeding, Pepco could be required to share with its customers approximately 50 percent of the EDIT and ADITC balances described above and make additional gain-sharing payments related to the disallowed severance payments. Such additional payments would be charged to expense in the quarter and year in which a final decision is rendered and could have a material adverse effect on results of operations for those periods. However, Pepco does not believe that additional gain-sharing payments, if any, or the ADITC-related payments to the IRS, if required, would have a material adverse impact on its financial position or cash flows. |
Default Electricity Supply Proceedings |
Under a settlement approved by the MPSC in April 2003 addressing SOS service in Maryland following the expiration of Pepco's fixed-rate default supply obligations in mid-2004, Pepco is required to provide default electricity supply to residential and small commercial customers through May 2008 and to medium-sized commercial customers through May 2006 (the obligation to provide default electricity supply to large commercial customers ended in May 2005). In accordance the settlement, Pepco purchases the power supply required to satisfy its default supply obligations from wholesale suppliers under contracts entered into pursuant to a competitive bid procedure approved and supervised by the MPSC. 62
|
In March 2006, Pepco announced the results of competitive bids to supply electricity to its Maryland SOS customers for one year beginning June 1, 2006. Due to significant increases in the cost of fuels used to generate electricity, the auction results had the effect of increasing the average monthly electric bill by about 38.5% for Pepco's Maryland residential customers. One of the successful bidders for SOS supply to Pepco was its affiliate, a subsidiary of Conectiv Energy Holding Company (Conectiv Energy). FERC issued its order approving the affiliate sales to Pepco on May 18, 2006. |
On April 21, 2006, the MPSC approved a settlement agreement among Pepco, DPL, the staff of the MPSC and the Office of Peoples Counsel of Maryland, which provides for a rate mitigation plan for Pepco's residential customers. Under the plan, the full increase for Pepco's residential customers who affirmatively elect to participate will be phased-in in increments of 15% on June 1, 2006, 15.7% on March 1, 2007 and the remainder on June 1, 2007. Customers electing to participate in the rate deferral plan will be required to pay the deferred amounts over an 18-month period beginning June 1, 2007. Pepco will accrue the interest cost to fund the deferral program. The interest cost will be absorbed by Pepco, during the period that the deferred balance is accumulated and collected from customers, to the extent of and offset against the margins that Pepco otherwise would earn for providing SOS to residential customers. To implement the settlement, Pepco filed tariff riders with the MPSC on May 2, 2006, which were approved by the MPSC on May 24, 2006, giving customers the opportunity to opt-in to the phase-in of their rates, as described above. As of July 31, 2006, approximately 2% of Pepco's residential customers have made the decision to participate in the phase-in program. |
On June 23, 2006, Maryland enacted legislation that extended the period for customers to elect to participate in the phase-in of higher rates, revised the obligation to provide SOS to residential and small commercial customers until further action of the General Assembly, and provided for a customer refund reflecting the difference in projected interest expense on the deferred balance at a 25% customer participation level versus such interest expense at the actual participation levels of approximately 2% for Pepco. The total amount of the refund is approximately $1.1 million for Pepco customers. At Pepco's 2% level of participation, Pepco estimates that the deferral balance, net of taxes, will be approximately $1.4 million. Pepco filed a revised tariff rider on June 30, 2006 to implement the legislation. |
General Litigation |
During 1993, Pepco was served with Amended Complaints filed in the state Circuit Courts of Prince George's County, Baltimore City and Baltimore County, Maryland in separate ongoing, consolidated proceedings known as "In re: Personal Injury Asbestos Case." Pepco and other corporate entities were brought into these cases on a theory of premises liability. Under this theory, the plaintiffs argued that Pepco was negligent in not providing a safe work environment for employees or its contractors, who allegedly were exposed to asbestos while working on Pepco's property. Initially, a total of approximately 448 individual plaintiffs added Pepco to their complaints. While the pleadings are not entirely clear, it appears that each plaintiff sought $2 million in compensatory damages and $4 million in punitive damages from each defendant. |
Since the initial filings in 1993, additional individual suits have been filed against Pepco, and significant numbers of cases have been dismissed. As a result of two motions to dismiss, numerous hearings and meetings and one motion for summary judgment, Pepco has had approximately 400 of these cases successfully dismissed with prejudice, either voluntarily by the 63
plaintiff or by the court. As of June 30, 2006, there were approximately 220 cases still pending against Pepco in the State Courts of Maryland; of those approximately 220 remaining asbestos cases, approximately 85 cases were filed after December 19, 2000, and have been tendered to Mirant for defense and indemnification pursuant to the terms of the Asset Purchase and Sale Agreement. Mirant's Plan of Reorganization, as approved by the Bankruptcy Court in connection with the Mirant bankruptcy, does not alter Mirant's indemnification obligations. |
While the aggregate amount of monetary damages sought in the remaining suits (excluding those tendered to Mirant) exceeds $400 million, Pepco believes the amounts claimed by current plaintiffs are greatly exaggerated. The amount of total liability, if any, and any related insurance recovery cannot be determined at this time; however, based on information and relevant circumstances known at this time, Pepco does not believe these suits will have a material adverse effect on its financial position, results of operations or cash flows. However, if an unfavorable decision were rendered against Pepco, it could have a material adverse effect on Pepco's financial position, results of operations or cash flows. |
Environmental Litigation |
Pepco is subject to regulation by various federal, regional, state, and local authorities with respect to the environmental effects of its operations, including air and water quality control, solid and hazardous waste disposal, and limitations on land use. In addition, federal and state statutes authorize governmental agencies to compel responsible parties to clean up certain abandoned or unremediated hazardous waste sites. Pepco may incur costs to clean up currently or formerly owned facilities or sites found to be contaminated, as well as other facilities or sites that may have been contaminated due to past disposal practices. Although penalties assessed for violations of environmental laws and regulations are not recoverable from Pepco's customers, environmental clean-up costs incurred by Pepco would be included in its cost of service for ratemaking purposes. |
In the early 1970s, Pepco sold scrap transformers, some of which may have contained some level of PCBs, to a metal reclaimer operating at the Metal Bank/Cottman Avenue site in Philadelphia, Pennsylvania, owned by a nonaffiliated company. In December 1987, Pepco was notified by U.S. Environmental Protection Agency (EPA) that it, along with a number of other utilities and non-utilities, was a potentially responsible party (PRP) in connection with the PCB contamination at the site. Below is a summary of the proceedings and related matters concerning the Metal Bank/Cottman Avenue site: |
75
|
New Accounting Standards |
FSP FTB 85-4-1, "Accounting for Life Settlement Contracts by Third-Party Investors" |
In March 2006, the FASB issued FASB Staff Position (FSP) FTB 85-4-1, "Accounting for Life Settlement Contracts by Third-Party Investors" (FSP FTB 85-4-1). This FSP provides initial and subsequent measurement guidance and financial statement presentation and disclosure guidance for investments by third-party investors in life settlement contracts. FSP FTB 85-4-1 also amends certain provisions of FASB Technical Bulletin No. 85-4, "Accounting for Purchases of Life Insurance," and FASB Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities." The guidance in FSP FTB 85-4-1 applies prospectively for all new life settlement contracts and is effective for fiscal years beginning after June 15, 2006 (the year ending December 31, 2007 for DPL). DPL is in the process of evaluating the impact of FSP FTB 85-4-1 and does not anticipate its adoption will have a material impact on its overall financial condition, results of operations, or cash flows. |
EITF 04-13, "Accounting for Purchases and Sales of Inventory with the Same Counterparty" |
In September 2005, the FASB ratified Emerging Issues Task Force (EITF) Issue No. 04-13, "Accounting for Purchases and Sales of Inventory with the Same Counterparty" (EITF 04-13), which addresses circumstances under which two or more exchange transactions involving inventory with the same counterparty should be viewed as a single exchange transaction for the purposes of evaluating the effect of APB Opinion 29, "Accounting for Nonmonetary Transactions." EITF 04-13 is effective for new arrangements entered into, or modifications or renewals of existing arrangements, beginning in the first interim or annual reporting period beginning after March 15, 2006. |
DPL implemented EITF 04-13 on April 1, 2006. The implementation did not impact DPL's overall financial condition, results of operations, or cash flows for the second quarter of 2006. |
FSP FIN 46(R)-6, "Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R)" |
In April 2006, the FASB issued FSP FIN 46(R)-6, "Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R)" (FSP FIN 46(R)-6), which provides guidance on how to determine the variability to be considered in applying FIN 46(R), "Consolidation of Variable Interest Entities." |
The guidance in FSP FIN 46(R)-6 is applicable prospectively beginning the first day of the first reporting period beginning after June 15, 2006 (July 1, 2006 for DPL), although early application is permitted to financial statements not issued. Retrospective application is also permitted if so elected and must be completed no later than the end of the first annual reporting period ending after July 15, 2006 (December 31, 2006 for DPL). |
DPL is in the process of evaluating the impact of FIN 46(R)-6. 76
|
EITF Issue No. 06-3, "Disclosure Requirements for Taxes Assessed by a Governmental Authority on Revenue-producing Transactions" |
On June 28, 2006, the FASB ratified EITF Issue No. 06-3, "Disclosure Requirements for Taxes Assessed by a Governmental Authority on Revenue-producing Transactions" (EITF 06-3). EITF 06-3 provides guidance on an entity's disclosure of its accounting policy regarding the gross or net presentation of certain taxes and provides that if taxes included in gross revenues are significant, a company should disclose the amount of such taxes for each period for which an income statement is presented (i.e., both interim and annual periods). Taxes within the scope of EITF 06-3 are those that are imposed on and concurrent with a specific revenue-producing transaction. Taxes assessed on an entity's activities over a period of time are not within the scope of EITF 06-3. |
EITF 06-3 is effective for interim and annual reporting periods beginning after December 15, 2006 (2007 for DPL) although earlier application is permitted. DPL is in the process of evaluating the impact of EITF 06-3. |
FIN 48, "Accounting for Uncertainty in Income Taxes" |
On July 13, 2006, the FASB issued FASB Interpretation No.48, "Accounting for Uncertainty in Income Taxes" (FIN 48). FIN 48 clarifies the criteria for recognition of tax benefits in accordance with SFAS No. 109, "Accounting for Income Taxes," and prescribes a financial statement recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return. Specifically, it clarifies that an entity's tax benefits must be "more likely than not" of being sustained prior to recording the related tax benefit in the financial statements. If the position drops below the "more likely than not" standard, the benefit can no longer be recognized. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. |
FIN 48 is effective the first fiscal year beginning after December 15, 2006 (January 1, 2007 for DPL). DPL is in the process of evaluating the impact of FIN 48. |
(3) SEGMENT INFORMATION |
In accordance with Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information," DPL has one segment, its regulated utility business. |
(4) COMMITMENTS AND CONTINGENCIES |
REGULATORY AND OTHER MATTERS |
Rate Proceedings |
Delaware |
In October 2005, DPL submitted its 2005 Gas Cost Rate (GCR) filing to the Delaware Public Service Commission (DPSC), which permits DPL to recover gas procurement costs through customer rates. The proposed increase of approximately 38% in anticipation of increasing natural gas commodity costs became effective November 1, 2005, subject to refund pending final DPSC approval after evidentiary hearings. DPSC staff, the Delaware Division of the 77
Public Advocate and DPL entered into a written settlement agreement in April 2006, that the GCR should be approved as filed. On July 11, 2006, the DPSC approved the settlement agreement. |
Federal Energy Regulatory Commission |
On May 15, 2006, DPL updated its FERC-approved formula transmission rates based on its FERC Form 1 data for 2005. This new rate of $10,034 per megawatt per year became effective on June 1, 2006. By operation of the formula rate process, the new rate incorporates true-ups from the 2005 formula rate that was effective June 1, 2005 and the new 2005 customer demand or peak load. Also, beginning in January 2007, the new rate will be applied to 2006 customer demand data, replacing the 2005 demand data that is currently used. This demand component is driven by DPL's prior year peak load. Further, the rate changes will be positively impacted by changes to distribution rates based on the merger settlements in Maryland. The net earnings impact expected from the network transmission rate changes is estimated to be a reduction of approximately $3 million year over year (2005 to 2006). |
Default Electricity Supply Proceedings |
Delaware |
In October 2005, the DPSC approved DPL as the SOS provider to Delaware customers after May 1, 2006, when DPL's fixed-rate POLR obligation ended. DPL obtains the electricity to fulfill its SOS supply obligation under contracts entered into by DPL pursuant to a competitive bid procedure approved by the DPSC. The bids received for the May 1, 2006, through May 31, 2007, period have had the effect of increasing rates significantly for all customer classes, including an average residential customer increase of 59%. |
One of the successful bidders for SOS supply was a subsidiary of Conectiv Energy Holding Company (Conectiv Energy), an affiliate of DPL. Consequently, the affiliate sales from Conectiv Energy to DPL are subject to approval of FERC. FERC issued its order approving the affiliate sales in April 2006. Because DPL is a public utility incorporated in Virginia, with Virginia retail customers, the affiliate sales from Conectiv Energy to DPL are subject to approval of the Virginia State Corporation Commission (VSCC) under the Virginia Affiliates Act. On May 1, 2006, the VSCC approved the affiliate transaction by granting an exemption to DPL for the 2006 agreement and for future power supply agreements between DPL and Conectiv Energy for DPL's non-Virginia SOS load requirements awarded pursuant to a state regulatory commission supervised solicitation process. |
In April 2006, Delaware enacted legislation that provides for a deferral of the financial impact of the increases through a three-step phase-in of the rate increases, with 15% of the increase taking effect on May 1, 2006, 25% of the increase taking effect on January 1, 2007, and any remaining balance taking effect on June 1, 2007. The program is an "opt-out" program, where a customer may make an election not to participate. On April 25, 2006, the DPSC approved several tariff filings implementing the legislation, including DPL's agreement not to charge customers any interest on the deferred balances. As of July 31, 2006, approximately 53% of the eligible Delaware customers have opted not to participate in the deferral of the SOS rates offered by DPL. With approximately 47% of the eligible customers participating in the phase-in program, DPL anticipates a deferral balance of approximately $51.4 million and an estimated interest expense of approximately $3.0 million, net of taxes. The estimated total interest expense 78
is based on a projected interest cost of 5% accrued over the combined 37-month deferral and recovery period. |
The legislation also requires DPL to file an integrated resource plan, in which DPL will evaluate all available supply options (including generation, transmission and demand-side management programs) during the planning period to ensure that DPL acquires sufficient and reliable supply resources to meet its customers' needs at minimal cost. |
Maryland |
Under a settlement approved by the MPSC in April 2003 addressing SOS service in Maryland following the expiration of DPL's fixed-rate default supply obligations in mid-2004, DPL is required to provide default electricity supply to residential and small commercial customers through May 2008 and to medium-sized commercial customers through May 2006 (the obligation to provide default electricity supply to large commercial customers ended in May 2005). In accordance with the settlement, DPL purchases the power supply required to satisfy its default supply obligations from wholesale suppliers under contracts entered into pursuant to a competitive bid procedure approved and supervised by the MPSC. |
In March 2006, DPL announced the results of competitive bids to supply electricity to its Maryland SOS customers for one year beginning June 1, 2006. Due to significant increases in the cost of fuels used to generate electricity, the auction results had the effect of increasing the average monthly electric bill by about 35% for DPL's Maryland residential customers. One of the successful bidders for SOS supply to DPL was its affiliate, Conectiv Energy. FERC issued its order approving the affiliate sales to DPL on May 18, 2006. Because DPL is a public utility incorporated in Virginia, with Virginia retail customers, the affiliate sales from Conectiv Energy to DPL are also subject to approval of the VSCC under the Virginia Affiliates Act. On May 1, 2006, the VSCC approved the affiliate transaction by granting an exemption to DPL for the 2006 agreement and for future power supply agreements between DPL and Conectiv Energy for DPL's non-Virginia SOS load requirements awarded pursuant to a state regulatory commission supervised solicitation process. |
On April 21, 2006, the MPSC approved a settlement agreement among Pepco, DPL, the staff of the MPSC and the Office of Peoples Counsel of Maryland, which provides for a rate mitigation plan for DPL's residential customers. Under the plan, the full increase for DPL's residential customers who affirmatively elect to participate will be phased-in in increments of 15% on June 1, 2006, 15.7% on March 1, 2007 and the remainder on June 1, 2007. Customers electing to participate in the rate deferral plan will be required to pay the deferred amounts over an 18-month period beginning June 1, 2007. DPL will accrue the interest cost to fund the deferral program. The interest cost will be absorbed by DPL, during the period that the deferred balance is accumulated and collected from customers, to the extent of and offset against the margins that the companies otherwise would earn for providing SOS to residential customers. To implement the settlement, DPL filed tariff riders with the M PSC on May 2, 2006, which were approved by the MPSC on May 24, 2006, giving customers the opportunity to opt-in to the phase-in of their rates, as described above. As of July 31, 2006, approximately 1% of DPL's residential customers have made the decision to participate in the phase-in program. |
On June 23, 2006, Maryland enacted legislation that extended the period for customers to elect to participate in the phase-in of higher rates, revised the obligation to provide SOS to 79
residential and small commercial customers until further action of the General Assembly, and provided for a customer refund reflecting the difference in projected interest expense on the deferred balance at a 25% customer participation level versus such interest expense at the actual participation levels of approximately 1% for DPL. The total amount of the refund is approximately $.3 million for DPL customers. At DPL's 1% level of participation, DPL estimates that the deferral balance, net of taxes, will be approximately $.2 million. DPL filed a revised tariff rider on June 30, 2006 to implement the legislation. |
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 VSCC. Until January 1, 2005, DPL obtained all of the energy and capacity needed to fulfill its Default Service obligations in Virginia under a supply agreement with its affiliate, Conectiv Energy. In the fall of 2004, DPL conducted a competitive bidding process to provide energy and capacity for its Virginia default supply customers for the seventeen-month period January 1, 2005 through May 30, 2006. Prior to the expiration of that contract, DPL completed a subsequent competitive bid procedure for Default Service supply for the period June 2006 through May 2007, and entered into a new supply agreement for that period with Conectiv Energy, awarded as a result of the bid process. FERC issued its order approving the affiliate sales from Conectiv Energ y to DPL for its Virginia Default Service load on May 18, 2006. DPL and Conectiv Energy also filed an application with the VSCC for approval of their affiliate transaction under the Virginia Affiliates Act. The VSCC found that its approval was not needed in this case because the affiliate sale was for a period of one year or less. |
On March 10, 2006, DPL filed for a rate increase with the VSCC for its Virginia Default Service customers to take effect on June 1, 2006, which was intended to allow DPL to recover its higher cost for energy established by the competitive bid procedure. The VSCC directed DPL to address whether the proxy rate calculation as required by a memorandum of agreement entered into by DPL and VSCC staff in June 2000 should be applied to the fuel factor in DPL's rate increase filing. The proxy rate calculation is an approximation of what the cost of power would have been if DPL had not divested its generation units. The proxy rate calculation is a component of a memorandum of agreement entered into by DPL, the staff of the VSCC and the Virginia Attorney General's office in the docket approving the asset divestiture, and was a condition of that divestiture. The Virginia Attorney General's office and VSCC staff each filed testimony in April 2006, in which both argued that the 2000 me morandum of agreement requires that the proxy rate fuel factor calculation set forth therein must operate as a cap on recoverable purchased power costs. DPL filed its response in May 2006, rebutting the testimony of the Attorney General and VSCC staff and arguing that retail rates should not be set at a level below what is necessary to recover its prudently incurred costs of procuring the supply necessary for its Default Service obligation. On June 19, 2006, the VSCC issued an order that granted a rate increase for DPL of $11.5 million ($8.5 million less than requested by DPL in its March 2006 filing), to go into effect July 1, 2006. The estimated after-tax earnings and cash flow impacts of the decision are reductions of approximately $3.6 million in 2006 (including the loss of revenue in June 2006 associated with the Default Service rate increase being deferred from June 1 until July 1) and $2.0 million in 2007. The order also mandated that DPL file an application by March 1, 2007, for Default Serv ice rates to become effective June 1, 2007, which should include 80
a calculation of the fuel factor procedure that is consistent with the procedures set forth in the order. |
Environmental Litigation |
DPL is subject to regulation by various federal, regional, state, and local authorities with respect to the environmental effects of its operations, including air and water quality control, solid and hazardous waste disposal, and limitations on land use. In addition, federal and state statutes authorize governmental agencies to compel responsible parties to clean up certain abandoned or unremediated hazardous waste sites. DPL may incur costs to clean up currently or formerly owned facilities or sites found to be contaminated, as well as other facilities or sites that may have been contaminated due to past disposal practices. Although penalties assessed for violations of environmental laws and regulations are not recoverable from DPL's customers, environmental clean-up costs incurred by DPL would be included in its cost of service for ratemaking purposes. |
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 manufactured gas plant (MGP) operations at the Cambridge, Maryland site on DPL-owned property and to investigate the extent of MGP contamination on adjacent property. The MDE has approved the RI and DPL has completed and submitted the FS to MDE. The costs for completing the RI/FS for this site were approximately $150,000. Although the costs of cleanup resulting from the RI/FS will not be determinable until MDE approves the final remedy, DPL currently anticipates that the costs of removing MGP impacted soils and adjacent creek sediments will be in the range of $1.5 to $2.5 million. |
In the early 1970s, DPL sold scrap transformers, some of which may have contained some level of PCBs, to a metal reclaimer operating at the Metal Bank/Cottman Avenue site in Philadelphia, Pennsylvania, owned by a nonaffiliated company. In December 1987, DPL was notified by U.S. Environmental Protection Agency (EPA) that it, along with a number of other utilities and non-utilities, was a potentially responsible party (PRP) in connection with the PCB contamination at the site. In 1999, DPL entered into a de minimis settlement with EPA and paid approximately $107,000 to resolve its liability for cleanup costs at the Metal Bank/Cottman Avenue site. The de minimis settlement did not resolve DPL's responsibility for natural resource damages, if any, at the site. DPL believes that any liability for natural resource damages at this site will not have a material adverse effect on its financial position, results of operations or cash flows. |
IRS Mixed Service Cost Issue |
During 2001, DPL changed its method of accounting with respect to capitalizable construction costs for income tax purposes. The change allowed DPL to accelerate the deduction of certain expenses that were previously capitalized and depreciated. Through December 31, 2005, these accelerated deductions have generated incremental tax cash flow benefits of approximately $62 million for DPL, primarily attributable to its 2001 tax return. |
On August 2, 2005, the Treasury Department released regulations that, if adopted in their current form, would require DPL to change its method of accounting with respect to capitalizable construction costs for income tax purposes for future tax periods beginning in 81
2005. Under these regulations, DPL will have to capitalize and depreciate a portion of the construction costs that they have previously deducted and include the impact of this adjustment in taxable income over a two-year period beginning with tax year 2005. DPL is in the process of finalizing an alternative method of accounting for capitalizable construction costs that management believes will be acceptable to the IRS to replace the method disallowed by the proposed regulations. |
On the same day that the new regulations were released, the IRS issued Revenue Ruling 2005-53 (the Revenue Ruling) which is intended to limit the ability of certain taxpayers to utilize the method of accounting for income tax purposes they utilized on their tax returns for 2004 and prior years. In line with this Revenue Ruling, the IRS issued its RAR, which disallows substantially all of the incremental tax benefits that DPL claimed on their 2001 and 2002 tax returns by requiring the companies to capitalize and depreciate certain expenses rather than treat such expenses as current deductions. |
In February 2006, DPL's parent, PHI paid approximately $121 million of taxes (a portion of which is attributable to DPL) to cover the amount of taxes management estimates will be payable once a new final method of tax accounting is adopted on its 2005 tax return, due to the proposed regulations. PHI intends to contest the adjustments that the IRS has proposed to the 2001 and 2002 tax returns, under the Revenue Ruling referenced above. However, if the IRS is successful in requiring DPL to capitalize and depreciate construction costs that result in a tax and interest assessment greater than management's estimate of $121 million, PHI will be required to pay additional taxes and interest only to the extent these adjustments exceed the $121 million payment made in February 2006. 82
|
(5) RESTATEMENT |
As reported in DPL's Annual Report on Form 10-K for the year ended December 31, 2005, our parent company, Pepco Holdings, restated its previously reported financial statements for the three and six months ended June 30, 2005, to correct the accounting for certain deferred compensation arrangements. The restatement includes the correction of other errors for the same period, primarily relating to unbilled revenue, taxes, and various accrual accounts, which were considered by management to be immaterial. These other errors would not themselves have required a restatement absent the restatement to correct the accounting for deferred compensation arrangements. The restatement of Pepco Holdings consolidated financial statements was required solely because the cumulative impact of the correction for deferred compensation, if recorded in the fourth quarter of 2005, would have been material to that period's reported net income. The restatement to correct the accounting for t he deferred compensation arrangements had no impact on DPL; however, DPL restated its previously reported financial statements for the three and six months ended June 30, 2005, to reflect the correction of other errors. The correction of these other errors, primarily relating to unbilled revenue, taxes, and various accrual accounts, was considered by management to be immaterial. The following table sets forth for DPL's results of operations for the three and six months ended June 30, 2005, its financial position at June 30, 2005, and its cash flows for the six months ended June 30, 2005, the impact of the restatement to correct the errors noted above (millions of dollars): |
New Accounting Standards |
FSP FTB 85-4-1, "Accounting for Life Settlement Contracts by Third-Party Investors" |
In March 2006, the FASB issued FASB Staff Position (FSP) FTB 85-4-1, "Accounting for Life Settlement Contracts by Third-Party Investors" (FSP FTB 85-4-1). This FSP provides initial and subsequent measurement guidance and financial statement presentation and disclosure guidance for investments by third-party investors in life settlement contracts. FSP FTB 85-4-1 also amends certain provisions of FASB Technical Bulletin No. 85-4, "Accounting for Purchases of Life Insurance," and FASB Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities." The guidance in FSP FTB 85-4-1 applies prospectively for all new life settlement contracts and is effective for fiscal years beginning after June 15, 2006 (the year ending December 31, 2007 for ACE). ACE is in the process of evaluating the impact of FSP FTB 85-4-1 and does not anticipate its adoption will have a material impact on its overall financial condition, results of operations, or cash flows. 93
|
EITF 04-13, "Accounting for Purchases and Sales of Inventory with the Same Counterparty" |
In September 2005, the FASB ratified Emerging Issues Task Force (EITF) Issue No. 04-13, "Accounting for Purchases and Sales of Inventory with the Same Counterparty" (EITF 04-13), which addresses circumstances under which two or more exchange transactions involving inventory with the same counterparty should be viewed as a single exchange transaction for the purposes of evaluating the effect of APB Opinion 29, "Accounting for Nonmonetary Transactions." EITF 04-13 is effective for new arrangements entered into, or modifications or renewals of existing arrangements, beginning in the first interim or annual reporting period beginning after March 15, 2006. |
ACE implemented EITF 04-13 on April 1, 2006. The implementation did not impact ACE's overall financial condition, results of operations, or cash flows for the second quarter of 2006. |
FSP FIN 46(R)-6, "Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R)" |
In April 2006, the FASB issued FSP FIN 46(R)-6, "Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R)" (FSP FIN 46(R)-6), which provides guidance on how to determine the variability to be considered in applying FIN 46(R), "Consolidation of Variable Interest Entities." |
The guidance in FSP FIN 46(R)-6 is applicable prospectively beginning the first day of the first reporting period beginning after June 15, 2006 (July 1, 2006 for ACE), although early application is permitted to financial statements not issued. Retrospective application is also permitted if so elected and must be completed no later than the end of the first annual reporting period ending after July 15, 2006 (December 31, 2006 for ACE). |
ACE is in the process of evaluating the impact of FIN 46(R)-6. |
EITF Issue No. 06-3, "Disclosure Requirements for Taxes Assessed by a Governmental Authority on Revenue-producing Transactions" |
On June 28, 2006, the FASB ratified EITF Issue No. 06-3, "Disclosure Requirements for Taxes Assessed by a Governmental Authority on Revenue-producing Transactions" (EITF 06-3). EITF 06-3 provides guidance on an entity's disclosure of its accounting policy regarding the gross or net presentation of certain taxes and provides that if taxes included in gross revenues are significant, a company should disclose the amount of such taxes for each period for which an income statement is presented (i.e., both interim and annual periods). Taxes within the scope of EITF 06-3 are those that are imposed on and concurrent with a specific revenue-producing transaction. Taxes assessed on an entity's activities over a period of time are not within the scope of EITF 06-3. |
EITF 06-3 is effective for interim and annual reporting periods beginning after December 15, 2006 (2007 for ACE) although earlier application is permitted. ACE is in the process of evaluating the impact of EITF 06-3. 94
|
FIN 48, "Accounting for Uncertainty in Income Taxes" |
On July 13, 2006, the FASB issued FASB Interpretation No.48, "Accounting for Uncertainty in Income Taxes" (FIN 48). FIN 48 clarifies the criteria for recognition of tax benefits in accordance with SFAS No. 109, "Accounting for Income Taxes," and prescribes a financial statement recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return. Specifically, it clarifies that an entity's tax benefits must be "more likely than not" of being sustained prior to recording the related tax benefit in the financial statements. If the position drops below the "more likely than not" standard, the benefit can no longer be recognized. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. |
FIN 48 is effective the first fiscal year beginning after December 15, 2006 (January 1, 2007 for ACE). ACE is in the process of evaluating the impact of FIN 48. |
(3) SEGMENT INFORMATION |
In accordance with Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information," ACE has one segment, its regulated utility business. |
(4) COMMITMENTS AND CONTINGENCIES |
REGULATORY AND OTHER MATTERS |
Rate Proceedings |
On May 15, 2006, ACE updated its FERC-approved formula transmission rates based on its FERC Form 1 data for 2005. This new rate of $14,155 per megawatt per year became effective on June 1, 2006. By operation of the formula rate process, the new rate incorporates true-ups from the 2005 formula rate that was effective June 1, 2005 and the new 2005 customer demand or peak load. Also, beginning in January 2007, the new rates will be applied to 2006 customer demand data, replacing the 2005 demand data that is currently used. This demand component is driven by ACE's prior year peak load. The net earnings impact from the network transmission rate changes year over year (2005 to 2006) is not expected to be material to ACE's overall financial condition, results of operations, or cash flows. |
Restructuring Deferral |
Pursuant to orders issued by the New Jersey Board of Public Utilities (NJBPU) under the New Jersey Electric Discount and Energy Competition Act (EDECA), beginning August 1, 1999, ACE was obligated to provide BGS to retail electricity customers in its service territory who did not choose a competitive energy supplier. For the period August 1, 1999 through July 31, 2003, ACE's aggregate costs that it was allowed to recover from customers exceeded its aggregate revenues from supplying BGS. These under-recovered costs were partially offset by a $59.3 million deferred energy cost liability existing as of July 31, 1999 (LEAC Liability) that was related to ACE's Levelized Energy Adjustment Clause and ACE's Demand Side Management Programs. ACE established a regulatory asset in an amount equal to the balance of under-recovered costs. 95
|
In August 2002, ACE filed a petition with the NJBPU for the recovery of approximately $176.4 million in actual and projected deferred costs relating to the provision of BGS and other restructuring related costs incurred by ACE over the four-year period August 1, 1999 through July 31, 2003, net of the $59.3 million offset for the LEAC Liability. The petition also requested that ACE's rates be reset as of August 1, 2003 so that there would be no under-recovery of costs embedded in the rates on or after that date. The increase sought represented an overall 8.4% annual increase in electric rates. ACE's recovery of the deferred costs is subject to review and approval by the NJBPU in accordance with EDECA. |
In July 2004, the NJBPU issued a final order in the restructuring deferral proceeding confirming a July 2003 summary order, which (i) permitted ACE to begin collecting a portion of the deferred costs and reset rates to recover on-going costs incurred as a result of EDECA, (ii) approved the recovery of $125 million of the deferred balance over a ten-year amortization period beginning August 1, 2003, (iii) transferred to ACE's then pending base rate case for further consideration approximately $25.4 million of the deferred balance, and (iv) estimated the overall deferral balance as of July 31, 2003 at $195 million, of which $44.6 million was disallowed recovery by ACE. ACE believes the record does not justify the level of disallowance imposed by the NJBPU in the final order. In August 2004, ACE filed with the Appellate Division of the Superior Court of New Jersey (the Superior Court), which hears appeals of the decisions of New Jersey administrative agencies, including the NJ BPU, a Notice of Appeal with respect to the July 2004 final order. Briefs were filed by the parties (ACE, as appellant, and the Division of the New Jersey Ratepayer Advocate and Cogentrix Energy Inc., the co-owner of two cogeneration power plants with contracts to sell ACE approximately 397 megawatts of electricity, as cross-appellants) between August 2005 and January 2006. The Superior Court has not yet set the schedule for oral argument. |
Divestiture Case |
In connection with the divestiture by ACE of its nuclear generation assets, the NJBPU in July 2000 preliminarily determined that the amount of stranded costs associated with the divested assets that ACE could recover from ratepayers should be reduced by the amount of the accumulated deferred federal income taxes (ADFIT) associated with the divested nuclear assets. However, due to uncertainty under federal tax law regarding whether the sharing of federal income tax benefits associated with the divested assets, including ADFIT, with ACE's customers would violate the normalization rules, ACE submitted a request to the Internal Revenue Service (IRS) for a Private Letter Ruling (PLR) to clarify the applicable law. The NJBPU has delayed its final determination of the amount of recoverable stranded costs until after the receipt of the PLR. |
On May 25, 2006, the IRS issued a PLR in which it stated that returning to ratepayers any of the unamortized ADFIT attributable to accelerated depreciation on the divested assets after the sale of the assets by means of a reduction of the amount of recoverable stranded costs would violate the normalization rules. |
On June 9, 2006, ACE submitted a letter to the NJBPU to request that the NJBPU conduct proceedings to finalize the determination of the stranded costs associated with the sale of ACE's nuclear assets in accordance with the PLR. 96
|
Default Electricity Supply Proceedings |
On October 12, 2005, the NJBPU, following the evaluation of proposals submitted by ACE and the other three electric distribution companies operating in New Jersey, issued an order reaffirming the current BGS auction process for the annual period from June 1, 2006 through May 2007. The NJBPU order maintained the current size and make up of the Commercial and Industrial Energy Pricing class (CIEP) and approved the electric distribution companies' recommended approach for the CIEP auction product, but deferred a decision on the level of the retail margin funds. |
Proposed Shut Down of B.L. England Generating Facility |
In April 2004, pursuant to a NJBPU order, ACE filed a report with the NJBPU recommending that ACE's B.L. England generating facility, a 447 megawatt plant, be shut down. The report stated that, while operation of the B.L. England generating facility was necessary at the time of the report to satisfy reliability standards, those reliability standards could also be satisfied in other ways. The report concluded that, based on B.L. England's current and projected operating costs resulting from compliance with more restrictive environmental requirements, the most cost-effective way in which to meet reliability standards is to shut down the B.L. England generating facility and construct additional transmission enhancements in southern New Jersey. |
In December 2004, ACE filed a petition with the NJBPU requesting that the NJBPU establish a proceeding that would consist of a Phase I and Phase II and that the procedural process for the Phase I proceeding require intervention and participation by all persons interested in the prudence of the decision to shut down B.L. England generating facility and the categories of stranded costs associated with shutting down and dismantling the facility and remediation of the site. ACE contemplates that Phase II of this proceeding, which would be initiated by an ACE filing in 2008 or 2009, would establish the actual level of prudently incurred stranded costs to be recovered from customers in rates. The NJBPU has not acted on this petition. |
ACE has commenced several construction projects to enhance the transmission system, which will ensure that the reliability of the electric transmission system will be maintained upon the shut down of B.L. England. To date, two projects have been completed and the remaining projects are under construction or are scheduled to be completed prior to December 15, 2007. |
As more fully described below under "Environmental Litigation," ACE, along with PHI and Conectiv, on January 24, 2006, entered into an Administrative Consent Order (ACO) with the New Jersey Department of Environmental Protection (NJDEP) and the Attorney General of New Jersey, which contemplates that ACE will shut down and permanently cease operations at the B.L. England generating facility by December 15, 2007, if ACE does not sell the plant before that time. ACE recorded an asset retirement obligation of $60 million during the first quarter of 2006 (this is reflected as a regulatory liability in PHI's consolidated balance sheet). The shut-down of the B.L. England generating facility will be subject to necessary approvals from the relevant agencies and the outcome of the auction process, discussed under "ACE Auction of Generation Assets," below. |
ACE Auction of Generation Assets |
In May 2005, ACE announced that it would auction its electric generation assets, consisting of its B.L. England generating facility and its ownership interests in the Keystone and 97
Conemaugh generating stations. In November 2005, ACE announced an agreement to sell its interests in the Keystone and Conemaugh generating stations to Duquesne Light Holdings Inc. for $173.1 million. On July 19, 2006, the NJBPU issued the final approval needed to complete the sale. ACE expects the sale to be completed in early September. Approximately $80 million, the net gain from the sale, will be used to offset the remaining unamortized aggregate adjusted deferred balance, which ACE has been recovering in rates, and approximately $54.2 million will be returned to ratepayers over a 33-month period as a credit on their bills. |
ACE received final bids for B.L. England in April 2006 and continues to evaluate those bids, working toward completion of a purchase and sale agreement. Any successful bid for B.L. England must comply with NJBPU approved auction standards. |
Any sale of B.L. England will not affect the stranded costs associated with the plant that already have been securitized. If B.L. England is sold, ACE anticipates that, subject to regulatory approval in Phase II of the proceeding described above, approximately $9 to $10 million of additional assets may be eligible for recovery as stranded costs. |
Environmental Litigation |
ACE is subject to regulation by various federal, regional, state, and local authorities with respect to the environmental effects of its operations, including air and water quality control, solid and hazardous waste disposal, and limitations on land use. In addition, federal and state statutes authorize governmental agencies to compel responsible parties to clean up certain abandoned or unremediated hazardous waste sites. ACE may incur costs to clean up currently or formerly owned facilities or sites found to be contaminated, as well as other facilities or sites that may have been contaminated due to past disposal practices. Although penalties assessed for violations of environmental laws and regulations are not recoverable from customers of the operating utilities, environmental clean-up costs incurred by ACE would be included in its cost of service for ratemaking purposes. |
In June 1992, the U.S. Environmental Protection Agency (EPA) identified ACE as a potentially responsible party (PRP) at the Bridgeport Rental and Oil Services Superfund site in Logan Township, New Jersey. In September 1996, ACE along with other PRPs signed a consent decree with EPA and NJDEP to address remediation of the site. ACE's liability is limited to .232 percent of the aggregate remediation liability and thus far ACE has made contributions of approximately $105,000. Based on information currently available, ACE anticipates that it may be required to contribute approximately an additional $52,000. ACE believes that its liability at this site will not have a material adverse effect on its financial position, results of operations or cash flows. |
In November 1991, NJDEP identified ACE as a PRP at the Delilah Road Landfill site in Egg Harbor Township, New Jersey. In 1993, ACE, along with other PRPs, signed an ACO with NJDEP to remediate the site. The soil cap remedy for the site has been completed and the NJDEP conditionally approved the report submitted by the parties on the implementation of the remedy in January 2003. In March 2004, NJDEP approved a Ground Water Sampling and Analysis Plan. Positive results of groundwater monitoring events have resulted in a reduced level of groundwater monitoring. In March 2003, EPA demanded from the PRP group reimbursement for EPA's past costs at the site, totaling $168,789. The PRP group objected to the demand for certain costs, but agreed to reimburse EPA approximately $19,000. Based on 98
information currently available, ACE anticipates that its share of additional cost associated with this site will be approximately $555,000 to $600,000. ACE believes that its liability for post-remedy operation and maintenance costs will not have a material adverse effect on its financial position, results of operations or cash flows. |
On January 24, 2006, PHI, Conectiv and ACE entered into an ACO with NJDEP and the Attorney General of New Jersey resolving New Jersey's claim for alleged violations of the Federal Clean Air Act (CAA) and the NJDEP's concerns regarding ACE's compliance with New Source Review (NSR) requirements and the New Jersey Air Pollution Control Act (APCA) with respect to the B.L. England generating facility and various other environmental issues relating to ACE and Conectiv Energy facilities in New Jersey. Among other things, the ACO provides that: |
All pending appeals, adversary actions or other contested matters between Pepco and Mirant will be dismissed with prejudice, and each will release the other from any and all claims relating to the Mirant bankruptcy. |
Separately, Mirant and SMECO have entered into a Settlement Agreement and Release (the SMECO Settlement Agreement). The SMECO Settlement Agreement provides that Mirant will assume, rather than reject, the SMECO Agreement. This assumption ensures that Pepco will not incur liability to SMECO as the guarantor of the SMECO Agreement due to the rejection of the SMECO Agreement, although Pepco will continue to guarantee to SMECO the future performance of Mirant under the SMECO Agreement. |
On May 31, 2006, Mirant submitted the Settlement Agreement and the SMECO Settlement Agreement to the Bankruptcy Court and to the U.S. District Court for the Northern District of Texas (the District Court) for approval. On May 31, 2006, the District Court entered an order referring the Settlement Agreement and the SMECO Settlement Agreement to the Bankruptcy Court for approval. The Settlement Agreement and the SMECO Settlement Agreement will become effective when the Bankruptcy Court or the District Court, as applicable, has entered a final order, not subject to appeal or rehearing, approving both the Settlement Agreement and the SMECO Settlement Agreement. |
On July 5, 2006, the Bankruptcy Court held a full evidentiary hearing on the Settlement Agreement and the SMECO Settlement Agreement. The Bankruptcy Court has not yet issued an order. |
Until the Settlement Agreement and the SMECO Settlement Agreement are approved, Mirant is required to continue to perform all of its contractual obligations to Pepco and SMECO. Pepco intends to place the $450 million portion of the Pepco Distribution related to the rejection of the PPA-Related Obligations in a special purpose account, which will be invested in stable financial instruments to be used to pay for future capacity and energy purchases under the Panda PPA. |
On July 19, 2006, the United States Court of Appeals for the Fifth Circuit issued an opinion affirming the District Court's orders from which Mirant appealed. The District Court's orders had denied Mirant's attempt to reject the PPA-Related Obligations and directed Mirant to resume making payments to Pepco pursuant to the PPA-Related Obligations. Under the circumstances 140
presented in the record on appeal, the court ruled that Mirant may not reject the PPA-Related Obligations and required that Mirant continue to perform. |
Rate Proceedings |
Delaware |
For a discussion of the history DPL's 2005 annual Gas Cost Rate (GCR) filing in Delaware, please refer to Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations -- Regulatory and Other Matters -- Rate Proceedings -- Delaware of PHI's Annual Report on Form 10-K for the year ended December 31, 2005 (the PHI 2005 10-K) and Item 2, Management's Discussion and Analysis of Financial Condition and Results of Operations -- Regulatory and Other Matters -- Rate Proceedings -- Delaware of PHI's Quarterly Report on Form 10-Q for the quarter ended March 31, 2006 (the 1st Quarter 10-Q). On July 11, 2006, the Delaware Public Service Commission (DPSC) approved the settlement agreement between the DPSC staff, the Delaware Division of the Public Advocate and DPL, approving the GCR rates as filed. |
Maryland |
For a discussion of the history Pepco's application for an update to its Generation Procurement Credit (GPC) in the District of Columbia, please refer to Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations -- Regulatory and Other Matters -- Rate Proceedings -- District of Columbia and Maryland of the PHI 2005 10-K and Item 2, Management's Discussion and Analysis of Financial Condition and Results of Operations -- Regulatory and Other Matters -- Rate Proceedings -- District of Columbia and Maryland of the 1st Quarter 10-Q. On June 15, 2006, the District of Columbia Public Service Commission (DCPSC) granted conditional approval of the GPC update as filed, effective July 1, 2006, and directed Pepco to respond to certain questions set forth in the order. Pepco responded to the DCPSC's questions on July 13, 2006. The DCPSC has provided a schedule for comments on Pepco's responses and for replies to those comments, concluding by the end of August. Final approval of the District of Columbia GPC update is pending. |
Federal Energy Regulatory Commission |
On May 15, 2006, Pepco, ACE and DPL updated their FERC-approved formula transmission rates based on the FERC Form 1 data for 2005 for each of the utilities. These rates became effective on June 1, 2006, as follows: for Pepco, $12,009 per megawatt per year; for ACE, $14,155 per megawatt per year; and for DPL, $10,034 per megawatt per year. By operation of the formula rate process, the new rates incorporate true-ups from the 2005 formula rates that were effective June 1, 2005 and the new 2005 customer demand or peak load. Also, beginning in January 2007, the new rates will be applied to 2006 customer demand data, replacing the 2005 demand data that is currently used. This demand component is driven by the prior year peak loads experienced in each respective zone. Further, the rate changes will be positively impacted by changes to distribution rates for Pepco and DPL based on the merger settlements in Maryland and the District of Columbia. The net earnings impact expected from the network transmission rate changes is estimated to be a reduction of approximately $4 million year over year (2005 to 2006). 141
|
Divestiture Cases |
New Jersey |
In connection with the divestiture by ACE of its nuclear generation assets, the NJBPU in July 2000 preliminarily determined that the amount of stranded costs associated with the divested assets that ACE could recover from ratepayers should be reduced by the amount of the accumulated deferred federal income taxes (ADFIT) associated with the divested nuclear assets. However, due to uncertainty under federal tax law regarding whether the sharing of federal income tax benefits associated with the divested assets, including ADFIT, with ACE's customers would violate the normalization rules, ACE submitted a request to the IRS for a Private Letter Ruling (PLR) to clarify the applicable law. The NJBPU has delayed its final determination of the amount of recoverable stranded costs until after the receipt of the PLR. |
On May 25, 2006, the IRS issued a PLR in which it stated that returning to ratepayers any of the unamortized ADFIT attributable to accelerated depreciation on the divested assets after the sale of the assets by means of a reduction of the amount of recoverable stranded costs would violate the normalization rules. |
On June 9, 2006, ACE submitted a letter to the NJBPU to request that the NJBPU conduct proceedings to finalize the determination of the stranded costs associated with the sale of ACE's nuclear assets in accordance with the PLR. |
Default Electricity Supply Proceedings |
Delaware |
For a discussion of the history of the SOS proceedings in Delaware, please refer to Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations -- Regulatory and Other Matters -- Default Electricity Supply Proceedings -- Delaware of the PHI 2005 10-K and Item 2, Management's Discussion and Analysis of Financial Condition and Results of Operations -- Regulatory and Other Matters -- Default Electricity Supply Proceedings -- Delaware of the 1st Quarter 10-Q. As of July 31, 2006, approximately 53% of the eligible Delaware customers have opted not to participate in the deferral of the SOS rates offered by DPL. With approximately 47% of the eligible customers participating in the phase-in program, DPL anticipates a deferral balance of approximately $51.4 million and an estimated interest expense of approximately $3.0 million, net of taxes. The estimated total interest expense is based on a projected interest cost of 5% accrued over th e combined 37-month deferral and recovery period. |
Maryland |
For a discussion of the history of the SOS proceedings in Maryland, please refer to Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations -- Regulatory and Other Matters -- Default Electricity Supply Proceedings -- Maryland of the PHI 2005 10-K and Item 2, Management's Discussion and Analysis of Financial Condition and Results of Operations -- Regulatory and Other Matters -- Default Electricity Supply Proceedings -- Maryland of the 1st Quarter 10-Q. One of the successful bidders for SOS supply to both Pepco and DPL was their affiliate, Conectiv Energy. FERC issued its order approving the affiliate sales from Conectiv Energy to both Pepco and DPL on May 18, 2006. As previously 142
discussed, because DPL is a public utility incorporated in Virginia, with Virginia retail customers, the affiliate sales from Conectiv Energy to DPL are also subject to approval of the Virginia State Corporation Commission (VSCC) under the Virginia Affiliates Act. On May 1, 2006, the VSCC approved the affiliate transaction by granting an exemption to DPL for the 2006 agreement and for future power supply agreements between DPL and Conectiv Energy for DPL's non-Virginia SOS load requirements awarded pursuant to a state regulatory commission supervised solicitation process. |
To implement the settlement agreement among Pepco, DPL, the staff of the MPSC and the Office of Peoples Counsel of Maryland, which provides for a rate mitigation plan for the residential customers of each company, Pepco and DPL filed tariff riders with the MPSC on May 2, 2006. The tariff riders were approved by the MPSC on May 24, 2006, giving customers opportunity to opt-in to the phase-in of their rates. As of July 31, 2006, approximately 2% of Pepco's residential customers and approximately 1% of DPL's residential customers have made the decision to participate in the phase-in program. |
On June 23, 2006, Maryland enacted legislation that extended the period for customers to elect to participate in the phase-in of higher rates, revised the obligation to provide SOS to residential and small commercial customers until further action of the General Assembly, and provided for a customer refund reflecting the difference in projected interest expense on the deferred balance at a 25% customer participation level versus such interest expense at the actual participation levels of approximately 2% for Pepco and approximately 1% for DPL. The total amount of the refund is approximately $1.1 million for Pepco customers and approximately $.3 million for DPL customers. At Pepco's 2% level of participation, Pepco estimates that the deferral balance, net of taxes, will be approximately $1.4 million. At DPL's 1% level of participation, DPL estimates that the deferral balance, net of taxes, will be approximately $.2 million. Pepco and DPL each filed a revised tariff rider o n June 30, 2006 to implement the legislation. |
Virginia |
For a discussion of the history of the Default Service proceedings in Virginia, please refer to Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations -- Regulatory and Other Matters -- Default Electricity Supply Proceedings -- Virginia of the PHI 2005 10-K and Item 2, Management's Discussion and Analysis of Financial Condition and Results of Operations -- Regulatory and Other Matters -- Default Electricity Supply Proceedings -- Virginia of the 1st Quarter 10-Q. FERC issued its order approving the affiliate sales from Conectiv Energy to DPL for its Virginia Default Service load on May 18, 2006. DPL and Conectiv Energy also filed an application with the VSCC for approval of their affiliate transaction under the Virginia Affiliates Act. The VSCC found that its approval was not needed in this case because the affiliate sale was for a period of one year or less. |
For a discussion of the history of DPL's rate increase filing for Default Service in Virginia, please refer to Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations -- Regulatory and Other Matters -- Default Electricity Supply Proceedings -- Virginia of the PHI 2005 10-K and Item 2, Management's Discussion and Analysis of Financial Condition and Results of Operations -- Regulatory and Other Matters -- Default Electricity Supply Proceedings -- Virginia of the 1st Quarter 10-Q. On June 19, 2006, the VSCC issued an order that granted a rate increase for DPL of $11.5 million ($8.5 million less than 143
requested by DPL in its March 2006 filing), to go into effect July 1, 2006. The estimated after-tax earnings and cash flow impacts of the decision are reductions of approximately $3.6 million in 2006 (including the loss of revenue in June 2006 associated with the Default Service rate increase being deferred from June 1 until July 1) and $2.0 million in 2007. The order also mandated that DPL file an application by March 1, 2007, for Default Service rates to become effective June 1, 2007, which should include a calculation of the fuel factor procedure that is consistent with the proxy rate calculation procedures set forth in the order. The proxy rate calculation is an approximation of what the cost of power would have been if DPL had not divested its generation units. The proxy rate calculation is a component of a memorandum of agreement entered into by DPL, the staff of the VSCC and the Virginia Attorney General's office in the docket approving the asset divestiture, and was a condition of that di vestiture. |
Proposed Shut Down of B.L. England Generating Facility |
For a discussion of the proposed shut down of the B.L. England generating facility, please refer to Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations -- Regulatory and Other Matters -- Proposed Shut Down of B.L. England Generating Facility of the PHI 2005 10-K In and Item 2, Management's Discussion and Analysis of Financial Condition and Results of Operations -- Regulatory and Other Matters -- Proposed Shut Down of B.L. England Generating Facility of the 1st Quarter 10-Q. ACE has commenced several construction projects to enhance the transmission system, which will ensure that the reliability of the electric transmission system will be maintained upon the shut down of B.L. England. To date, two projects have been completed and the remaining projects are under construction or are scheduled to be completed prior to December 15, 2007. |
ACE Auction of Generation Assets |
For a discussion of ACE's auction of generation assets, please refer to Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations -- Regulatory and Other Matters -- ACE Auction of Generation Assets of the PHI 2005 10-K and Item 2, Management's Discussion and Analysis of Financial Condition and Results of Operations -- Regulatory and Other Matters -- ACE Auction of Generation Assets of the 1st Quarter 10-Q. As previously discussed, in November 2005, ACE announced an agreement to sell its interests in the Keystone and Conemaugh generating stations to Duquesne Light Holdings Inc. for $173.1 million. On July 19, 2006, the NJBPU issued the final approval needed to complete the sale. ACE expects the sale to be completed in early September. Approximately $80 million, the net gain from the sale, will be used to offset the remaining unamortized aggregate adjusted deferred balance, which ACE has been recovering in rates, and approximat ely $54.2 million will be returned to ratepayers over a 33-month period as a credit on their bills. |
ACE received final bids for B.L. England in April 2006 and continues to evaluate those bids, working toward completion of a purchase and sale agreement. Any successful bid for B.L. England must comply with NJBPU approved auction standards. |
General Litigation |
On September 26, 2005, three management employees of PHI Service Company filed suit in the United States District Court for the District of Delaware against the PHI Retirement Plan, PHI and Conectiv, alleging violations of the Employment Retirement Income Security Act of 144
1974 (ERISA), on behalf of a class of management employees who did not have enough age and service when the Cash Balance Sub-Plan was implemented in 1999 to assure that their accrued benefits would be calculated pursuant to the terms of the predecessor plans sponsored by ACE and DPL. |
The plaintiffs have challenged the design of the Cash Balance Sub-Plan and are seeking a declaratory judgment that the Cash Balance Sub-Plan is invalid and that the accrued benefits of each member of the class should be calculated pursuant to the terms of the predecessor plans sponsored by ACE and DPL. Specifically, the complaint alleges that the use of a variable rate to compute the plaintiffs' accrued benefit under the Cash Balance Sub-Plan results in reductions in the accrued benefits that violate ERISA. The complaint also alleges that the benefit accrual rates and the minimal accrual requirements of the Cash Balance Sub-Plan violate ERISA as did the notice that was given to plan participants upon implementation of the Cash Balance Sub-Plan. |
PHI, Conectiv and the PHI Retirement Plan filed a motion to dismiss the suit, which was denied by the court on July 11, 2006. The court stayed one count of the complaint regarding alleged age discrimination pending a decision in another case before the U.S. Court of Appeals for the Third Circuit. While PHI believes it has a strong legal position in the case and that it is therefore unlikely that the plaintiffs will prevail, PHI estimates that the SFAS No. 87 ABO and Projected Benefit Obligation (PBO) would each increase by approximately $12 million, assuming no change in benefits for persons who have already retired or whose employment has been terminated and using actuarial valuation data as of the time the suit was filed. (The ABO represents the present value that participants have earned as of the date of calculation. This means that only service already worked and compensation already earned and paid is considered. The PBO is similar to the ABO, except that the PBO i ncludes recognition of the effect that estimated future pay increases would have on the pension plan obligation.) |
Federal Tax Treatment of Cross-Border Leases |
For a discussion of the history of the IRS's tax treatment of PCI's cross-border leases, please refer to Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations -- Regulatory and Other Matters -- Federal Tax Treatment of Cross-Border Leases of the PHI 2005 10-K and Item 2, Management's Discussion and Analysis of Financial Condition and Results of Operations -- Regulatory and Other Matters -- Federal Tax Treatment of Cross-Border Leases of the 1st Quarter 10-Q. On June 9, 2006, the IRS issued its final Revenue Agent's Report (RAR) for its audit of PHI's 2001 and 2002 income tax returns. In the RAR, the IRS disallowed the tax benefits claimed by PHI with respect to these leases for those years. The tax benefits claimed by PHI with respect to these leases from 2001 through June 30, 2006 were approximately $259 million. |
As previously discussed, in November 2005, the U.S. Senate passed The Tax Relief Act of 2005 (S.2020) which would have applied passive loss limitation rules to leases similar to PCI's cross-border energy leases, effective for taxable years beginning after December 31, 2005. This provision, however, was not included in the final tax legislation, the Tax Increase Prevention and Reconciliation Act of 2005, which was signed into law by President Bush on May 17, 2006. |
On July 13, 2006, the FASB issued FSP FAS 13-2, which amends SFAS No. 13 effective for fiscal years beginning after December 15, 2006. This amendment requires a lease to be repriced and the book value adjusted when there is a change or probable change in the timing of tax 145
benefits of the lease regardless of whether the change results in a deferral or permanent loss of tax benefits. Accordingly, a material change in the timing of cash flows under PHI's cross-border leases as the result of a settlement with the IRS would require an adjustment to the book value of the leases and a charge to earnings equal to the repricing impact of the disallowed deductions which could result in a material adverse effect on PHI's financial condition, results of operations, and cash flows. |
CRITICAL ACCOUNTING POLICIES |
For a discussion of Pepco Holdings' critical accounting policies, 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 for the year ended December 31, 2005. No material changes to Pepco Holdings' critical accounting policies occurred during the second quarter of 2006. |
NEW ACCOUNTING STANDARDS |
FSP FTB 85-4-1, "Accounting for Life Settlement Contracts by Third-Party Investors" |
In March 2006, the Financial Accounting Standards Board (FASB) issued FASB Staff Position (FSP) FTB 85-4-1, "Accounting for Life Settlement Contracts by Third-Party Investors" (FSP FTB 85-4-1). This FSP provides initial and subsequent measurement guidance and financial statement presentation and disclosure guidance for investments by third-party investors in life settlement contracts. FSP FTB 85-4-1 also amends certain provisions of FASB Technical Bulletin No. 85-4, "Accounting for Purchases of Life Insurance," and FASB Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities." The guidance in FSP FTB 85-4-1 applies prospectively for all new life settlement contracts and is effective for fiscal years beginning after June 15, 2006 (the year ending December 31, 2007 for Pepco Holdings). Pepco Holdings is in the process of evaluating the impact of FSP FTB 85-4-1 and does not anticipate its adoption will have a material impact on its overall finan cial condition, results of operations, or cash flows. |
EITF 04-13, "Accounting for Purchases and Sales of Inventory with the Same Counterparty" |
In September 2005, the FASB ratified Emerging Issues Task Force (EITF) Issue No. 04-13, "Accounting for Purchases and Sales of Inventory with the Same Counterparty" (EITF 04-13), which addresses circumstances under which two or more exchange transactions involving inventory with the same counterparty should be viewed as a single exchange transaction for the purposes of evaluating the effect of APB Opinion 29, "Accounting for Nonmonetary Transactions." EITF 04-13 is effective for new arrangements entered into, or modifications or renewals of existing arrangements, beginning in the first interim or annual reporting period beginning after March 15, 2006. |
Pepco Holdings implemented EITF 04-13 on April 1, 2006. The implementation did not have a material impact on Pepco Holdings' overall financial condition, results of operations, or cash flows for the second quarter of 2006. 146
|
SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140" |
In February 2006, the FASB issued Statement No. 155, "Accounting for Certain Hybrid Financial Instruments-an amendment of FASB Statements No. 133 and No. 140" (SFAS No. 155). SFAS No. 155 amends FASB Statements No. 133, "Accounting for Derivative Instruments and Hedging Activities," and No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." SFAS No. 155 resolves issues addressed in Statement 133 Implementation Issue No. D1, "Application of Statement 133 to Beneficial Interests in Securitized Financial Assets." SFAS No. 155 is effective for all financial instruments acquired or issued after the beginning of an entity's first fiscal year that begins after September 15, 2006 (the year ending December 31, 2007 for Pepco Holdings). Pepco Holdings has evaluated the impact of SFAS No. 155 and does not anticipate that its implementation will have a material impact on its overall financial condition, results of operations, or cash flows. |
SFAS No. 156, "Accounting for Servicing of Financial Assets" |
In March 2006, the FASB issued Statement No. 156, "Accounting for Servicing of Financial Assets" (SFAS No. 156), an amendment of SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," with respect to the accounting for separately recognized servicing assets and servicing liabilities. SFAS No. 156 requires an entity to recognize a servicing asset or servicing liability upon undertaking an obligation to service a financial asset via certain servicing contracts, and for all separately recognized servicing assets and servicing liabilities to be initially measured at fair value, if practicable. Subsequent measurement is permitted using either the amortization method or the fair value measurement method for each class of separately recognized servicing assets and servicing liabilities. SFAS No. 156 is effective as of the beginning of an entity's first fiscal year that begins after September 15, 2006 (the year ending Decembe r 31, 2007 for Pepco Holdings). Application is to be applied prospectively to all transactions following adoption of SFAS No. 156. Pepco Holdings has evaluated the impact of SFAS No. 156 and does not anticipate its adoption will have a material impact on its overall financial condition, results of operations, or cash flows. |
FSP FIN 46(R)-6, "Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R)" |
In April 2006, the FASB issued FSP FIN 46(R)-6, "Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R)" (FSP FIN 46(R)-6), which provides guidance on how to determine the variability to be considered in applying FIN 46(R), "Consolidation of Variable Interest Entities." |
The guidance in FSP FIN 46(R)-6 is applicable prospectively beginning the first day of the first reporting period beginning after June 15, 2006 (July 1, 2006 for PHI), although early application is permitted to financial statements not issued. Retrospective application is also permitted if so elected and must be completed no later than the end of the first annual reporting period ending after July 15, 2006 (December 31, 2006 for PHI). |
Pepco Holdings is in the process of evaluating the impact of FIN 46(R)-6. 147
|
EITF Issue No. 06-3, "Disclosure Requirements for Taxes Assessed by a Governmental Authority on Revenue-producing Transactions" |
On June 28, 2006, the FASB ratified EITF Issue No. 06-3, "Disclosure Requirements for Taxes Assessed by a Governmental Authority on Revenue-producing Transactions" (EITF 06-3). EITF 06-3 provides guidance on an entity's disclosure of its accounting policy regarding the gross or net presentation of certain taxes and provides that if taxes included in gross revenues are significant, a company should disclose the amount of such taxes for each period for which an income statement is presented (i.e., both interim and annual periods). Taxes within the scope of EITF 06-3 are those that are imposed on and concurrent with a specific revenue-producing transaction. Taxes assessed on an entity's activities over a period of time are not within the scope of EITF 06-3. |
EITF 06-3 is effective for interim and annual reporting periods beginning after December 15, 2006 (2007 for PHI) although earlier application is permitted. Pepco Holdings is in the process of evaluating the impact of EITF 06-3. |
FSP FAS 13-2, "Accounting for a Change or Projected Change in the Timing of Cash Flows Relating to Income Taxes Generated by a Leverage Lease Transaction" |
On July 13, 2006, the FASB issued FSP FAS 13-2, "Accounting for a Change or Projected Change in the Timing of Cash Flows Relating to Income Taxes Generated by a Leverage Lease Transaction" (FSP FAS 13-2). This FSP, which amends FASB Statement No. 13, "Accounting for Leases," addresses how a change or projected change in the timing of cash flows relating to income taxes generated by a leveraged lease transaction affects the accounting by a lessor for that lease. |
FSP FAS 13-2 will not be effective until the first fiscal year beginning after December 15, 2006 (January 1, 2007 for Pepco Holdings). Pepco Holdings is in the process of evaluating the impact of FSP FAS 13-2. |
FIN 48, "Accounting for Uncertainty in Income Taxes" |
On July 13, 2006, the FASB issued FASB Interpretation No.48, "Accounting for Uncertainty in Income Taxes" (FIN 48). FIN 48 clarifies the criteria for recognition of tax benefits in accordance with SFAS No. 109, "Accounting for Income Taxes," and prescribes a financial statement recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return. Specifically, it clarifies that an entity's tax benefits must be "more likely than not" of being sustained prior to recording the related tax benefit in the financial statements. If the position drops below the "more likely than not" standard, the benefit can no longer be recognized. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. |
FIN 48 is effective the first fiscal year beginning after December 15, 2006 (January 1, 2007 for Pepco Holdings). Pepco Holdings is in the process of evaluating the impact of FIN 48. 148
|
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 may cause PHI'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: |
169
|
Default Supply Revenue increased by $55.3 million primarily due to the following: (i) $41.7 million in higher retail energy rates, primarily resulting from new market based BGS increases in New Jersey (partially offset in Fuel and Purchased Energy expense), (ii) $7.9 million increase due to an adjustment for estimated unbilled revenue in the second quarter 2005 primarily reflecting higher estimated power line losses, (iii) $7.1 million increase due to higher load in 2006, (iv) $3.7 million increase in sales due to customer growth, the result of a 1.5% increase in 2006, (v) $2.4 million increase in other sales and rate variances, offset by (vi) $8.4 million decrease due to weather-related sales, the result of a 19% decrease in Heating Degree Days and a 4% decrease in Cooling Degree Days in 2006. |
For the six months ended June 30, 2006, ACE's customers served energy by ACE represented 78% of ACE's total sales. For the six months ended June 30, 2005, ACE's customers served energy by ACE represented 75% of ACE's total sales. |
Operating Expenses |
Fuel and Purchased Energy |
Fuel and Purchased Energy increased by $44.0 million to $431.1 million in 2006, from $387.1 million in 2005. The increase is primarily due to the following: (i) $36.0 million increase in average energy costs, the result of higher cost supply contracts in June 2006 and 2005, (ii) $5.5 million increase due to higher BGS load in 2006, and (iii) $2.4 million increase in other sales and rate variances (partially offset in Default Supply Revenue). |
Other Operation and Maintenance |
Other Operation and Maintenance increased by $5.5 million to $95.9 million in 2006 from $90.4 million in 2005. The increase is primarily due to (i) $5.0 million in Default Electricity Supply (primarily deferred and recoverable), (ii) $1.6 million increase in system maintenance, (iii) $1.6 million increase in emergency restoration costs, offset by (iv) $1.3 million decrease in pole rental expense and (v) $1.1 million decrease in T&D insurance. |
Depreciation and Amortization |
Depreciation and Amortization expenses increased by $2.9 million to $59.8 million in 2006, from $56.9 million in 2005. The increase is primarily due to (i) $10.6 million higher amortization of regulatory assets, offset by (ii) $7.7 million in lower depreciation due to a change in depreciation technique and rates resulting from a 2005 final rate order from the New Jersey Board of Public Utilities (NJBPU). |
Deferred Electric Service Costs |
Deferred Electric Service Costs decreased by $11.0 million to a credit of $10.2 million in 2006 from a debit $.8 million in 2005. The decrease represents (i) $5.4 million net under-recovery associated with New Jersey BGS, NUGS, market transition charges and other restructuring items, and (ii) $5.6 million in regulatory disallowances (net of amounts previously reserved) associated with the April 2005 NJBPU settlement agreement. At June 30, 2006, ACE's balance sheet included as a regulatory liability an over-recovery of $47.2 million with respect to these items, which amount is net of a $48.0 million reserve for items disallowed by the NJBPU in a ruling that is under appeal. 170
|
Other Income (Expenses) |
Other Expenses (which are net of other income) increased by $6.3 million to a net expense of $31.1 million in 2006 from a net expense of $24.8 million in 2005. The increase is primarily due to (i) $3.0 million increase due to a Contribution in Aid of Construction tax gross-up and (ii) $3.3 million increase in interest expense related to ACE's deferred electric service costs regulatory liability. |
Income Tax Expense |
ACE's effective tax rate for the six months ended June 30, 2006 was 28% 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 changes in estimates related to tax liabilities of prior tax years subject to audit, and the flow-through of deferred investment tax credits. |
ACE's effective tax rate for the six months ended June 30, 2005 was 41% 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, changes in estimates related to tax liabilities of prior tax years subject to audit, partially offset by the flow-through of deferred investment tax credits. |
Extraordinary Item |
As a result of the April 2005 settlement of ACE's electric distribution rate case, ACE reversed $15.2 million in accruals related to certain deferred costs that are now deemed recoverable. The after-tax credit to income of $9.0 million is classified as an extraordinary gain in the 2005 financial statements since the original accrual was part of an extraordinary charge in conjunction with the accounting for competitive restructuring in 1999. |
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 ACE's 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 may cause ACE or ACE's 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 ACE's control and may cause actual results to differ materially from those contained in forward-looking statements: 171
|
For additional information concerning market risk, please refer to Item 7A, Quantitative and Qualitative Disclosure About Market Risk in Pepco Holdings' Annual Report on Form 10-K for the year ended December 31, 2005. |
INFORMATION FOR THIS ITEM IS NOT REQUIRED FOR PEPCO, DPL, AND ACE AS THEY MEET THE CONDITIONS SET FORTH IN GENERAL INSTRUCTION H(1)(a) AND (b) OF FORM 10-Q AND THEREFORE ARE FILING THIS FORM WITH A REDUCED FILING FORMAT. 176
|
Item 4. CONTROLS AND PROCEDURES |
Pepco Holdings, Inc. |
Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures |
Under the supervision, and with the participation of management, including the chief executive officer and the chief financial officer, Pepco Holdings, Inc. (PHI or Pepco Holdings) has evaluated the effectiveness of the design and operation of its disclosure controls and procedures as of June 30, 2006, and, based upon this evaluation, the chief executive officer and the chief financial officer of Pepco Holdings have concluded that these controls and procedures are effective to provide reasonable assurance that material information relating to Pepco Holdings and its subsidiaries that is required to be disclosed in reports filed with, or submitted to, the Securities and Exchange Commission (SEC) under the Securities Exchange Act of 1934 (i) is recorded, processed, summarized and reported within the time periods specified by the SEC rules and forms and (ii) is accumulated and communicated to management, including its chief executive officer and chief financial officer, as approp riate, to allow timely decisions regarding required disclosure. |
Management's Consideration of the Restatement |
As discussed in Note 15 of the Notes to Consolidated Financial Statements in Part II, Item 8 of Pepco Holdings' 2005 Form 10-K filed on March 13, 2006, Pepco Holdings restated its previously reported consolidated financial statements as of December 31, 2004 and for the years ended December 31, 2004 and 2003, the quarterly financial information for the first three quarters in 2005, and all quarterly periods in 2004, to correct the accounting for certain deferred compensation arrangements and to correct errors with respect to unbilled revenue, taxes and various accrual accounts. In coming to the conclusion that Pepco Holdings' disclosure controls and procedures and Pepco Holdings' internal control over financial reporting were effective as of December 31, 2005, management concluded that the restatement items described in Note 15 of the Notes to Consolidated Financial Statements in Part II, Item 8 of the Form 10-K filed on March 13, 2006, individually or in the aggregate, did n ot constitute a material weakness. In coming to this conclusion, management reviewed and analyzed the SEC's Staff Accounting Bulletin (SAB) No. 99, "Materiality," paragraph 29 of Accounting Principles Board Opinion No. 28, "Interim Financial Reporting," and SAB Topic 5F, "Accounting Changes Not Retroactively Applied Due to Immateriality," and took into consideration (i) that the restatement adjustments did not have a material impact on the financial statements of prior interim or annual periods taken as a whole; (ii) that the cumulative impact of the restatement adjustments on shareholders' equity was not material to the financial statements of prior interim or annual periods; and (iii) that Pepco Holdings decided to restate its previously issued financial statements solely because the cumulative impact of the adjustments would have been material to the fourth quarter of 2005 reported net income. |
Changes in Internal Control Over Financial Reporting |
During the three months ended June 30, 2006, there was no change in Pepco Holdings' internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, Pepco Holdings' internal control over financial reporting. 177
|
On August 1, 2006, Conectiv Energy Holding Company (Conectiv Energy), a subsidiary of Pepco Holdings, completed development of new energy transaction software that provides additional functionality, such as enhanced PJM Interconnection, LLC (PJM) invoice reconciliation capability, hedge accounting, greater risk analysis capability and enhanced regulatory reporting capability. Extensive pre-implementation testing was performed to ensure internal controls over financial reporting continue to be effective. Operating effectiveness of internal controls over financial reporting will continue to be evaluated post implementation. |
Potomac Electric Power Company |
Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures |
Under the supervision, and with the participation of management, including the chief executive officer and the chief financial officer, Potomac Electric Power Company (Pepco) has evaluated the effectiveness of the design and operation of its disclosure controls and procedures as of June 30, 2006, and, based upon this evaluation, the chief executive officer and the chief financial officer of Pepco have concluded that these controls and procedures are effective to provide reasonable assurance that material information relating to Pepco and its subsidiaries that is required to be disclosed in reports filed with, or submitted to, the SEC under the Securities Exchange Act of 1934 (i) is recorded, processed, summarized and reported within the time periods specified by the SEC rules and forms and (ii) is accumulated and communicated to management, including its chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosur e. |
Management's Consideration of the Restatement |
As discussed in Note 13 of the Notes to Financial Statements in Part II, Item 8 of Pepco's 2005 Form 10-K filed on March 13, 2006, Pepco restated its previously reported financial statements as of December 31, 2004 and for the years ended December 31, 2004 and 2003, the quarterly financial information for the first three quarters in 2005, and all quarterly periods in 2004, to correct the accounting for certain deferred compensation arrangements and to correct errors with respect to unbilled revenue, taxes and various accrual accounts. In coming to the conclusion that Pepco's disclosure controls and procedures were effective as of December 31, 2005, management concluded that the restatement items described in Note 13 of the Notes to Financial Statements in Part II, Item 8 of the Form 10-K filed on March 13, 2006, individually or in the aggregate, did not constitute a material weakness. In coming to this conclusion, management reviewed and analyzed the SEC's SAB No. 99, "Mate riality," paragraph 29 of Accounting Principles Board Opinion No. 28, "Interim Financial Reporting," and SAB Topic 5F, "Accounting Changes Not Retroactively Applied Due to Immateriality," and took into consideration (i) that the restatement adjustments did not have a material impact on the financial statements of prior interim or annual periods taken as a whole; (ii) that the cumulative impact of the restatement adjustments on shareholders' equity was not material to the financial statements of prior interim or annual periods; and (iii) that Pepco decided to restate its previously issued financial statements solely because the cumulative impact of the adjustments would have been material to the fourth quarter of 2005 reported net income. 178
|
Changes in Internal Control Over Financial Reporting |
During the three months ended June 30, 2006, there was no change in Pepco's internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, Pepco's internal control over financial reporting. |
Delmarva Power & Light Company |
Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures |
Under the supervision, and with the participation of management, including the chief executive officer and the chief financial officer, Delmarva Power & Light Company (DPL) has evaluated the effectiveness of the design and operation of its disclosure controls and procedures as of June 30, 2006, and, based upon this evaluation, the chief executive officer and the chief financial officer of DPL have concluded that these controls and procedures are effective to provide reasonable assurance that material information relating to DPL that is required to be disclosed in reports filed with, or submitted to, the SEC under the Securities Exchange Act of 1934 (i) is recorded, processed, summarized and reported within the time periods specified by the SEC rules and forms and (ii) is accumulated and communicated to management, including its chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure. |
Management's Consideration of the Restatement |
As discussed in Note 13 of the Notes to Financial Statements in Part II, Item 8 of DPL's 2005 Form 10-K filed on March 13, 2006, DPL restated its previously reported financial statements as of December 31, 2004 and for the years ended December 31, 2004 and 2003, the quarterly financial information for the first three quarters in 2005, and all quarterly periods in 2004, to correct errors with respect to unbilled revenue, taxes and various accrual accounts. In coming to the conclusion that DPL's disclosure controls and procedures were effective as of December 31, 2005, management concluded that the restatement items described in Note 13 of the Notes to Financial Statements in Part II, Item 8 of the Form 10-K filed on March 13, 2006, individually or in the aggregate, did not constitute a material weakness. In coming to this conclusion, management reviewed and analyzed the SEC's SAB No. 99, "Materiality," paragraph 29 of Accounting Principles Board Opinion No. 28, "Interim Fina ncial Reporting," and SAB Topic 5F, "Accounting Changes Not Retroactively Applied Due to Immateriality," and took into consideration (i) that the restatement adjustments did not have a material impact on the financial statements of prior interim or annual periods taken as a whole; (ii) that the cumulative impact of the restatement adjustments on shareholders' equity was not material to the financial statements of prior interim or annual periods; and (iii) that DPL decided to restate its previously issued financial statements solely because of corrections recorded in Pepco Holdings consolidated financial statements. |
Changes in Internal Control Over Financial Reporting |
During the three months ended June 30, 2006, there was no change in DPL's internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, DPL's internal control over financial reporting. 179
|
Atlantic City Electric Company |
Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures |
Under the supervision, and with the participation of management, including the chief executive officer and the chief financial officer, Atlantic City Electric Company (ACE) has evaluated the effectiveness of the design and operation of its disclosure controls and procedures as of June 30, 2006, and, based upon this evaluation, the chief executive officer and the chief financial officer of ACE have concluded that these controls and procedures are effective to provide reasonable assurance that material information relating to ACE and its subsidiaries that is required to be disclosed in reports filed with, or submitted to, the SEC under the Securities Exchange Act of 1934 (i) is recorded, processed, summarized and reported within the time periods specified by the SEC rules and forms and (ii) is accumulated and communicated to management, including its chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosu re. |
Management's Consideration of the Restatement |
As discussed in Note 14 of the Notes to Consolidated Financial Statements in Part II, Item 8 of ACE's 2005 Form 10-K filed on March 13, 2006, ACE restated its previously reported consolidated financial statements as of December 31, 2004 and for the years ended December 31, 2004 and 2003, the quarterly financial information for the first three quarters in 2005, and all quarterly periods in 2004, to correct errors with respect to taxes and various accrual accounts. In coming to the conclusion that ACE's disclosure controls and procedures were effective as of December 31, 2005, management concluded that the restatement items described in Note 14 of the Notes to Consolidated Financial Statements in Part II, Item 8 of the Form 10-K filed on March 13, 2006, individually or in the aggregate, did not constitute a material weakness. In coming to this conclusion, management reviewed and analyzed the SEC's SAB No. 99, "Materiality," paragraph 29 of Accounting Principles Board Opi nion No. 28, "Interim Financial Reporting," and SAB Topic 5F, "Accounting Changes Not Retroactively Applied Due to Immateriality," and took into consideration (i) that the restatement adjustments did not have a material impact on the financial statements of prior interim or annual periods taken as a whole; (ii) that the cumulative impact of the restatement adjustments on shareholders' equity was not material to the financial statements of prior interim or annual periods; and (iii) that ACE restated is previously issued consolidated financial statements solely because of corrections recorded in Pepco Holdings consolidated financial statements. |
Changes in Internal Control Over Financial Reporting |
During the three months ended June 30, 2006, there was no change in ACE's internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, ACE's internal control over financial reporting. 180
|
Part II OTHER INFORMATION |
Item 1. LEGAL PROCEEDINGS |
Pepco Holdings |
In 2000, Pepco sold substantially all of its electricity generation assets to Mirant Corporation, formerly Southern Energy, Inc. In July 2003, Mirant 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. On December 9, 2005, the Bankruptcy Court approved Mirant's Plan of Reorganization, and the Mirant business emerged from bankruptcy on January 3, 2006. On May 30, 2006, Pepco, PHI and certain affiliated companies entered into a Settlement Agreement and Release with Mirant, which, subject to court approval, settles all outstanding issues among the parties arising from or related to the Mirant bankruptcy. |
For further information concerning the litigation with Mirant and other litigation matters, please refer to Item 3, "Legal Proceedings," included in Pepco Holdings' Annual Report on Form 10-K for the year ended December 31, 2005 and Note (4), Commitments and Contingencies, to the financial statements of PHI included herein. |
Pepco |
In 2000, Pepco sold substantially all of its electricity generation assets to Mirant Corporation, formerly Southern Energy, Inc. In July 2003, Mirant 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. On December 9, 2005, the Bankruptcy Court approved Mirant's Plan of Reorganization, and the Mirant business emerged from bankruptcy on January 3, 2006. On May 30, 2006, Pepco, PHI and certain affiliated companies entered into a Settlement Agreement and Release with Mirant, which, subject to court approval, settles all outstanding issues among the parties arising from or related to the Mirant bankruptcy. |
For further information concerning the litigation with Mirant and other litigation matters, please refer to Note (4), Commitments and Contingencies, to the financial statements of Pepco included herein. |
DPL |
For information concerning litigation matters, please refer to Note (4), Commitments and Contingencies, to the financial statements of DPL included herein. |
ACE |
For information concerning litigation matters, please refer to Note (4), Commitments and Contingencies, to the financial statements of ACE included herein. 181
|
Item 1A. RISK FACTORS |
Pepco Holdings |
For a discussion of Pepco Holdings' risk factors, please refer to Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Risk Factors" in Pepco Holdings' Annual Report on Form 10-K for the year ended December 31, 2005. Except for the risk factors listed below, no material changes to Pepco Holdings' risk factors occurred during the second quarter of 2006. The risk factors as to which there has been a material change are updated as follows: |
Update Regarding Mirant Bankruptcy |
On May 30, 2006, Pepco, PHI and certain affiliated companies entered into a Settlement Agreement and Release with Mirant, which, subject to court approval, settles all outstanding issues among the parties arising from or related to the Mirant bankruptcy. On July 19, 2006, the United States Court of Appeals for the Fifth Circuit issued an opinion affirming the District Court's orders from which Mirant appealed. Under the circumstances presented in the record in appeal, the court ruled that Mirant may not reject the PPA-Related Obligations and required that Mirant continue to perform. See Note (4) Commitments and Contingencies -- Regulatory and Other Matters, herein, for additional information. |
The IRS challenge to cross-border energy sale and lease-back transaction entered into by a PHI subsidiary could result in loss of prior and future tax benefits |
PCI maintains a portfolio of cross-border energy sale-leaseback transactions, which as of June 30, 2006, had a book value of approximately $1.3 billion and from which PHI derives approximately $55 million per year in tax benefits in the form of interest and depreciation deductions During the quarter ended June 30, 2006, the IRS issued its final proposed adjustments on PCI's cross-border sale-leaseback transactions in which the IRS disallowed the tax benefits claimed by PHI with respect to these leases for the years 2001 and 2002. See Note (4) Commitments and Contingencies -- Regulatory and Other Matters, herein, for additional information. |
Pending tax legislation could result in a loss of future tax benefits from cross-border energy sale and lease-back transactions entered into by a PHI subsidiary |
In November 2005, the U.S. Senate passed The Tax Relief Act of 2005 (S.2020) which would have applied passive loss limitation rules to leases similar to PCI's cross-border energy leases, effective for taxable years beginning after December 31, 2005. This provision, however, was not included in the final tax legislation, the Tax Increase Prevention and Reconciliation Act of 2005, which became law on May 17, 2006. |
IRS Revenue Ruling 2005-53 on Mixed Service Costs could require PHI to incur additional tax and interest payments in connection with the IRS audit for this issue for the tax years 2001 through 2004 (IRS Revenue Ruling 2005-53) |
During 2001, Pepco, DPL, and ACE changed their methods of accounting with respect to capitalizable construction costs for accounting purposes, which allow the companies to accelerate the deduction of certain expenses that were previously capitalized and depreciated. Through 182
December 31, 2005, there accelerated deductions have generated incremental tax cash flow benefits of approximately $205 million (consisting of $94 million for Pepco, $62 million for DPL, and $49 million for ACE) for the companies primarily attributed to their 2001 tax return. In February 2006, PHI paid approximately $121 million to cover the amount of taxes management estimates will be payable once a new final method of accounting is adopted on its 2005 tax return due to the proposed regulations. |
During the quarter ended June 30, 2006, the IRS issued its final proposed adjustments (based on Revenue Ruling 2005-53) which disallow substantially all of the incremental tax benefits that Pepco, DPL and ACE had claimed on their 2001 and 2002 tax returns by requiring the companies to capitalize and depreciate certain expenses rather than treat such expenses as current deductions. |
PHI intends to contest the adjustments that the IRS has proposed to the 2001 and 2002 tax returns. However, if the IRS is successful in requiring Pepco, DPL and ACE to capitalize and depreciate construction costs that results in a tax and interest assessment greater than management's estimate of $121 million, PHI will be required to pay additional taxes and interest to the extent these adjustments exceed the $121 million additional tax payment made in February 2006. See Note (4) Commitments and Contingencies -- Regulatory and Other Matters, herein, for additional information. |
Pepco |
For a discussion of Pepco's risk factors, please refer to Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Risk Factors" in Pepco's Annual Report on Form 10-K for the year ended December 31, 2005. Except for the risk factors listed below, no material changes to Pepco's risk factors occurred during the second quarter of 2006. The risk factor as to which there has been a material change is updated as follows: |
Update Regarding Mirant Bankruptcy |
On May 30, 2006, Pepco, PHI and certain affiliated companies entered into a Settlement Agreement and Release with Mirant, which, subject to court approval, settles all outstanding issues among the parties arising from or related to the Mirant bankruptcy. On July 19, 2006, the United States Court of Appeals for the Fifth Circuit issued an opinion affirming the District Court's orders from which Mirant appealed. Under the circumstances presented in the record in appeal, the court ruled that Mirant may not reject the PPA-Related Obligations and required that Mirant continue to perform. See Note (4) Commitments and Contingencies -- Regulatory and Other Matters, herein, for additional information. |
DPL |
For a discussion of DPL's risk factors, please refer to Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Risk Factors" in DPL's Annual Report on Form 10-K for the year ended December 31, 2005. No material changes to DPL's risk factors occurred during the second quarter of 2006. |
ACE |
For a discussion of ACE's risk factors, please refer to Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Risk Factors" in ACE's Annual 183
Report on Form 10-K for the year ended December 31, 2005. No material changes to ACE's risk factors occurred during the second quarter of 2006. |
Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS |
Pepco Holdings |
None. |
INFORMATION FOR THIS ITEM IS NOT REQUIRED FOR PEPCO, DPL, AND ACE AS THEY MEET THE CONDITIONS SET FORTH IN GENERAL INSTRUCTION H(1)(a) AND (b) OF FORM 10-Q AND THEREFORE ARE FILING THIS FORM WITH A REDUCED FILING FORMAT. |
Item 3. DEFAULTS UPON SENIOR SECURITIES |
Pepco Holdings |
None. |
INFORMATION FOR THIS ITEM IS NOT REQUIRED FOR PEPCO, DPL, AND ACE AS THEY MEET THE CONDITIONS SET FORTH IN GENERAL INSTRUCTION H(1)(a) AND (b) OF FORM 10-Q AND THEREFORE ARE FILING THIS FORM WITH A REDUCED FILING FORMAT. |
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS |
Pepco Holdings |
(a) The Annual Meeting of Shareholders was held on May 19, 2006. |
(b) Directors who were elected at the annual meeting: |
