<PAGE 1> UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549-1004 Form 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 1998 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission File Number 2-1647 COMMONWEALTH GAS COMPANY (Exact name of registrant as specified in its charter) Massachusetts 04-1989250 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) One Main Street, Cambridge, Massachusetts 02142-9150 (Address of principal executive offices) (Zip Code) (617) 225-4000 (Registrant's telephone number, including area code) (Former name, address and fiscal year, if changed since last report.) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES [x] NO [ ] Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Outstanding at Class of Common Stock August 1, 1998 Common Stock, $25 par value 2,857,000 shares The Company meets the conditions set forth in General Instruction H(1)(a) and (b) of Form 10-Q as a wholly-owned subsidiary and is therefore filing this Form with the reduced disclosure format. <PAGE 2> PART I - FINANCIAL INFORMATION Item 1. Financial Statements COMMONWEALTH GAS COMPANY CONDENSED BALANCE SHEETS JUNE 30, 1998 AND DECEMBER 31, 1997 ASSETS (Dollars in thousands) June 30, December 31, 1998 1997 (Unaudited) PROPERTY, PLANT AND EQUIPMENT, at original cost $380,747 $375,083 Less - Accumulated depreciation 118,400 110,661 262,347 264,422 Add - Construction work in progress 2,334 570 264,681 264,992 CURRENT ASSETS Cash 9 1,867 Advances to affiliates 400 - Accounts receivable 32,268 49,323 Unbilled revenues 2,658 19,121 Inventories, at average cost 21,691 24,526 Prepaid taxes - Property - 3,176 Income 3,607 5,640 Other 1,687 1,234 62,320 104,887 DEFERRED CHARGES Regulatory assets 21,383 20,873 Other 5,569 5,214 26,952 26,087 $353,953 $395,966 See accompanying notes. <PAGE 3> COMMONWEALTH GAS COMPANY CONDENSED BALANCE SHEETS JUNE 30, 1998 AND DECEMBER 31, 1997 CAPITALIZATION AND LIABILITIES (Dollars in thousands) June 30, December 31, 1998 1997 (Unaudited) CAPITALIZATION Common Equity - Common stock, $25 par value - Authorized and outstanding - 2,857,000 shares, wholly-owned by Commonwealth Energy System (Parent) $ 71,425 $ 71,425 Amounts paid in excess of par value 27,739 27,739 Retained earnings 18,321 16,871 117,485 116,035 Long-term debt, less current sinking fund requirements 105,800 105,800 223,285 221,835 CURRENT LIABILITIES Interim Financing - Notes payable to banks - 39,325 - 39,325 Other Current Liabilities - Current sinking fund requirements 3,650 3,650 Accounts payable - Affiliates 3,820 1,869 Other 15,720 32,450 Accrued taxes - Local property and other 801 3,366 Other 31,971 20,595 55,962 61,930 55,962 101,255 DEFERRED CREDITS Accumulated deferred income taxes 39,197 38,322 Unamortized investment tax credits 5,361 5,461 Other 30,148 29,093 74,706 72,876 $353,953 $395,966 See accompanying notes. <PAGE 4> COMMONWEALTH GAS COMPANY CONDENSED STATEMENTS OF INCOME AND RETAINED EARNINGS FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 1998 AND 1997 (Dollars in thousands - unaudited) Three Months Ended Six Months Ended 1998 1997 1998 1997 GAS OPERATING REVENUES $ 56,301 $ 61,062 $165,089 $193,375 OPERATING EXPENSES Cost of gas sold 32,618 33,385 88,163 108,025 Other operation and maintenance 20,207 26,992 40,057 46,694 Depreciation 1,842 1,768 6,500 6,240 Taxes - Income (1,145) (2,337) 7,311 8,113 Local property 994 1,233 3,721 3,836 Payroll and other 619 643 1,738 1,964 55,135 61,684 147,490 174,872 OPERATING INCOME 1,166 (622) 17,599 18,503 OTHER INCOME 100 11 280 87 INCOME BEFORE INTEREST CHARGES 1,266 (611) 17,879 18,590 INTEREST CHARGES Long-term debt 2,186 1,656 4,372 3,312 Other interest charges 645 926 1,373 1,909 Allowance for borrowed funds used during construction (20) (21) (29) (32) 2,811 2,561 5,716 5,189 NET INCOME (LOSS) (1,545) (3,172) 12,163 13,401 RETAINED EARNINGS - Beginning of period 30,579 27,429 16,871 10,856 Dividends on common stock (10,713) (5,714) (10,713) (5,714) RETAINED EARNINGS - End of period $ 18,321 $ 18,543 $ 18,321 $ 18,543 See accompanying notes. <PAGE 5> COMMONWEALTH GAS COMPANY CONDENSED STATEMENTS OF CASH FLOWS FOR THE SIX MONTHS ENDED JUNE 30, 1998 AND 1997 (Dollars in thousands - unaudited) 1998 1997 OPERATING ACTIVITIES Net income $ 12,163 $ 13,401 Effects of noncash items - Depreciation and amortization 8,069 7,579 Deferred income taxes and investment tax credits, net 650 856 Change in working capital, exclusive of cash, advances to affiliates and interim financing 35,141 37,285 All other operating items 85 (1,454) Net cash provided by operating activities 56,008 57,667 INVESTING ACTIVITIES Additions to property, plant and equipment (inclusive of AFUDC) (7,428) (6,790) Advances to affiliates (400) - Net cash used for investing activities (7,828) (6,790) FINANCING ACTIVITIES Payment of dividends (10,713) (5,714) Payment of short-term borrowings (39,325) (34,875) Payments to affiliates - (9,175) Net cash used for financing activities (50,038) (49,764) Net increase (decrease) in cash (1,858) 1,113 Cash at beginning of period 1,867 421 Cash at end of period $ 9 $ 1,534 SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION Cash paid during the period for: Interest, net of amounts capitalized $ 5,462 $ 4,855 Income taxes $ 4,638 $ 6,106 See accompanying notes. <PAGE 6> COMMONWEALTH GAS COMPANY NOTES TO CONDENSED FINANCIAL STATEMENTS (1) General Information Commonwealth Gas Company (the Company) is a wholly-owned subsidiary of Commonwealth Energy System. The parent company is referred to in this report as the "System" and together with its subsidiaries is collectively referred to as "the system." The System is an exempt public utility holding company under the provisions of the Public Utility Holding Company Act of 1935 and, in addition to its investment in the Company, has interests in other utility and several non-regulated companies. The Company has 596 regular employees including 402 (67%) who are represented by three collective bargaining units. In September 1998, a collective bargaining unit representing approximately 2% of regular employees is scheduled to expire. Two additional contracts (together representing approximately 65% of regular employees) will remain in effect until March and June of 2002. (2) Significant Accounting Policies (a) Principles of Accounting The Company's significant accounting policies are described in Note 2 of Notes to Financial Statements included in its 1997 Annual Report on Form 10-K filed with the Securities and Exchange Commission. For interim reporting purposes, the Company follows these same basic accounting policies but considers each interim period as an integral part of an annual period and makes allocations of certain expenses to interim periods based upon estimates of revenue from firm sales for the year. Generally, certain expenses which relate to more than one interim period are allocated to other periods to more appropriately match revenues and expenses. Principal items of expense which are allocated other than on the basis of passage of time are depreciation and property taxes. These expenses are recorded for interim reporting purposes based upon projected gas revenue. Income tax expense is recorded using the statutory rates in effect applied to book income subject to tax recorded in the interim period. The unaudited financial statements for the periods ended June 30, 1998 and 1997 reflect, in the opinion of the Company, all adjustments (consisting of only normal recurring accruals, except for a one-time charge recorded in June 1997 as described in Management's Discussion and Analysis of Results of Operations) necessary to summarize fairly the results for such periods. In addition, certain prior period amounts are reclassified from time to time to conform with the presenta-tion used in the current period's financial statements. The results for interim periods are not necessarily indicative of results for the entire year because of variations in gas consumption due to the heating season and also because of the Company's seasonal rate structure. <PAGE 7> COMMONWEALTH GAS COMPANY (b) Regulatory Assets and Liabilities The Company is regulated as to rates, accounting and other matters by the Massachusetts Department of Telecommunications and Energy (DTE). Based on the current regulatory framework, the Company accounts for the economic effects of regulation in accordance with the provisions of Statement of Financial Accounting Standards (SFAS) No. 71, "Accounting for the Effects of Certain Types of Regulation." The Company has established various regulatory assets in cases where the DTE has permitted or is expected to permit recovery of specific costs over time. If all or a separable portion of the Company's operations becomes no longer subject to the provisions of SFAS No. 71, a write-off of related regulatory assets and liabilities would be required, unless some form of transition cost recovery continues through rates established and collected for the Company's remaining regulated operations. In addition, the Company would be required to determine any impairment to the carrying costs of deregulated plant and inventory assets. The principal regulatory assets included in deferred charges were as follows: June 30, December 31, 1998 1997 (Dollars in thousands) Postretirement benefits costs $ 9,183 $ 9,607 FERC Order 636 transition costs 6,652 7,336 Environmental costs 5,548 3,930 $21,383 $20,873 The principal regulatory liability, reflected in deferred credits- other and relating to income taxes, was $8.2 million at June 30, 1998 and $8.3 million at December 31, 1997. These regulatory assets are a component that was included in the Company's consensus-based settlement that was filed with the DTE on June 29, 1998. (3) Commitments Construction Program The Company is engaged in a continuous construction program presently estimated at $93 million for the five-year period 1998 through 2002. Of that amount, $17.9 million is estimated for 1998. As of June 30, 1998, the Company's actual construction expenditures amounted to approximately $7.4 million, including an allowance for funds used during construction. The Company expects to finance these expenditures on an interim basis with internally-generated funds and short-term borrowings which are ultimately expected to be repaid with the proceeds from the issuance of long-term debt and/or equity securities. The program is subject to periodic review and revision because of factors such as changes in business conditions, rates of growth, effects of inflation, equipment delivery schedules, licensing delays, availability and cost of capital and environmental regulations. <PAGE 8> COMMONWEALTH GAS COMPANY Item 2. Management's Discussion and Analysis of Results of Operations The following is a discussion of certain significant factors which have affected operating revenues, expenses and net income during the periods included in the accompanying Condensed Statements of Income. This discussion should be read in conjunction with the Notes to Condensed Financial Statements appearing elsewhere in this report. A summary of the period to period changes in the principal items included in the Condensed Statements of Income for the three and six months ended June 30, 1998 and 1997 is shown below: Three Months Six Months Ended June 30, Ended June 30, 1998 and 1997 1998 and 1997 Increase (Decrease) (Dollars in thousands) Gas Operating Revenues $(4,761) (7.8)% $(28,286) (14.6)% Operating Expenses - Cost of gas sold (767) (2.3) (19,862) (18.4) Other operation and maintenance (6,785) (25.1) (6,637) (14.2) Depreciation 74 4.2 260 4.2 Taxes - Federal and state income 1,192 51.0 (802) (9.9) Local property and other (263) (14.0) (341) (5.9) (6,549) (10.6) (27,382) (15.7) Operating Income 1,788 287.5 (904) (4.9) Other Income 89 809.1 193 221.8 Income Before Interest Charges 1,877 307.2 (711) (3.8) Interest Charges 250 9.8 527 10.2 Net Income $ 1,627 51.3 $ (1,238) (9.2) Firm Unit Sales - BBTU (1,697) (24.9) (4,496) (18.7) The following is a summary of unit sales for the periods indicated: Unit Sales - In Billions of British Thermal Units (BBTU) Off- Quasi- Total Firm Interruptible System Firm Three Months Ended June 30, 1998 6,461 5,107 466 888 - June 30, 1997 7,990 6,804 428 735 23 Six Months Ended June 30, 1998 22,482 19,565 992 1,925 - June 30, 1997 26,498 24,061 879 1,532 26 <PAGE 9> COMMONWEALTH GAS COMPANY Operating Revenues and Unit Sales Operating revenues for the current quarter and first six months of 1998 decreased by $4.8 million and $28.3 million, respectively, due primarily to the considerable declines in total unit sales. Also affecting revenues in both periods was a lower average cost of gas. The decline in firm unit sales for both the current quarter and the first six months of 1998 reflects significant decreases in sales to all customer segments that were caused by the milder winter weather experienced in our region. The fluctuation in non-firm sales reflects the competitive environment that currently exists in the natural gas industry. Other Operation and Maintenance The $6.8 million and $6.6 million decreases in other operation and maintenance costs for the current quarter and the first half of 1998, respectively, reflects the absence of costs associated with a Personnel Reduction Program (PRP) that was initiated during the second quarter of last year ($6.7 million) and the resulting labor savings realized during this year ($700,000 in the second quarter and $1.8 million for the six month period). These savings were offset, in part, by higher costs ($1.3 million in the current quarter and $2.8 million year-to-date) relating to the outsourcing of the information technology, telecommunications and network services function that include costs associated with Year 2000 compliance. Depreciation and Taxes Depreciation increased slightly during the current quarter and first six months of 1998 due to a higher level of depreciable plant. The fluctuation in federal and state income taxes for both periods was due to the levels of pretax income. Local property and other taxes decreased in both current periods due primarily to lower payroll costs resulting from the PRP discussed above. Other Income and Interest Charges For both the current quarter and the first half of 1998, the increase in other income was due primarily to higher revenues associated with the Company's merchandising program for water heaters and heating systems. For the current quarter and the first six months of 1998, total interest charges increased $250,000 and $527,000, respectively, due primarily to higher long-term interest charges ($521,000 and $1 million) resulting from the issuance of two new series of long-term debt in late September 1997 and an increase in interest charges related to deferred gas costs ($70,000 and $320,000) offset, in part, by declines in interest on short-term borrowings ($347,000 and $850,000) due primarily to a lower average level of borrowings reflecting the use of proceeds from the new long-term debt issues. <PAGE 10> COMMONWEALTH GAS COMPANY Environmental Matters The Company is participating in the assessment of a number of former manufactured gas plant (MGP) sites and alleged MGP waste disposal locations to determine if and to what extent such sites have been contaminated and whether the Company may be responsible for remedial actions. The DTE has approved recovery of costs associated with MGP sites. The Company is also involved in certain other known or potentially contaminated sites where the associated costs may not be recoverable in rates. For further information on other related environmental matters, refer to the Company's 1997 Annual Report on Form 10-K. Gas Industry Restructuring On July 18, 1997, the DTE directed the ten Massachusetts gas utilities, including the Company, to initiate a collaborative process that will establish guiding principles and specific procedures for unbundling rates and services for all customers. The DTE listed six principles that it considers important to the success of a competitive natural gas market that will provide safe and reliable service at the lowest possible cost to customers. The natural gas market would: (1) provide the broadest possible choice; (2) provide all customers with an opportunity to share in the benefits of increased competition; (3) ensure full and fair competition in the gas supply market; (4) functionally separate supply from local distribution services; (5) support and further the goals of environmental regulation; and lastly (6) rely on incentive regulation where a fully competitive market cannot or presently does not exist. In addition, the DTE outlined several specific issues that it expects the collaborative to address: (1) services that can be offered on a competitive basis; (2) terms and conditions of service; (3) consumer protections and social programs; (4) mitigation of gas related and non-gas related transition costs; (5) third-party supplier qualifications; and (6) curtailment principles. The DTE also suggested that the collaborative reconsider the pricing and provision of interruptible transportation services. On August 18, 1997, the DTE noted that the development of unbundling principles and procedures constitutes only a part of the effort necessary to develop full customer choice for gas service. The DTE recognized that each local distribution company will be filing a comprehensive unbundling proposal at some later date. In the interim, the DTE directed those companies that do not currently have unbundled rates, including the Company, to have such rates in effect no later than November 1, 1998. The Company and eight other gas utilities initiated the Massachusetts Gas Unbundling Collaborative (the Collaborative) on September 15, 1997, to explore and develop generic principles to achieve the goals set forth by the DTE. Collaborative participants represented a broad array of stakeholder interests including the utilities, natural gas marketers, interstate pipelines, producers, energy consultants, labor unions, consumer advocates and representatives for the DTE, the Massachusetts Attorney General's Office, and the Massachusetts Division of Energy Resources. <PAGE 11> COMMONWEALTH GAS COMPANY On November 15, 1997, the Collaborative filed a status report with the DTE that outlined its progress in moving the gas industry to a more competitive structure that provides all customers with meaningful access to competitive markets consistent with public-policy objectives. The status report summarized the substantive issues that had been the subject of Collaborative discussion, including: (1) the disposition of interstate pipeline capacity; (2) the unbundling of rates; (3) customer enrollment, billing, termination, and information exchange procedures; and, (4) consumer protections, low-income discounts, and competitive supplier registration. The status report also established a schedule to implement a final unbundling plan by November 1, 1998. In accordance with that schedule, the Collaborative submitted to the DTE a Rate Unbundling Status Report on January 16, 1998. The report detailed an overall process for developing unbundled rates consistent with the DTE's rate structure goals of efficiency, fairness, simplicity, continuity and earnings stability. In response to the Collaborative's proposal, the DTE ordered the Company to submit, by April 15, 1998, a consensus-based settlement, or partial settlement, of unbundled rate tariffs designed according to the general concepts set forth in the report. Subsequently, the DTE granted the Company an extension to reach a settlement with the Collaborative's participants. On March 18, 1998, the Collaborative filed a second status report that summarized the progress made by the Collaborative since it had last updated the DTE on its activities. The Collaborative reported that it had made substantial progress in the areas of rate unbundling and terms and conditions for unbundled services. The report also described at least two policy issues, capacity disposition and cost responsibility, on which the Collaborative's participants require specific regulatory guidance before completing a comprehensive framework for the transition to a more competitive market structure. In response to the March report, the DTE issued a Notice of Inquiry to address the Collaborative's unresolved issues. On May 1, 1998, the Company filed initial written comments in the proceeding arguing in favor of a mandatory capacity assignment proposal. On June 8, 1998, the DTE, as part of the aforementioned Notice of Inquiry, received final comments regarding the feasibility of implementing comprehensive unbundling for all local distribution companies by November 1, 1998. On June 29, 1998, the Company and three other Massachusetts local distribution companies submitted unbundled rate settlements to the DTE for consideration. The DTE issued a procedural order regarding the Notice of Inquiry on July 2, 1998 which stated that the introduction of comprehensive unbundling for all classes of customers for all local distribution companies is not feasible by November 1, 1998. The DTE stated that unbundled rates for the four local distribution companies that filed settlements on June 29, 1998 (including the Company) shall be in place by November 1, 1998 and that comprehensive unbundling shall be implemented no later than April 1, 1999. Also, as part of the July 2, 1998 procedural order, the DTE ordered that a set of proposed Model Terms and Conditions be submitted by the Collaborative no later than July 15, 1998. These Model Terms and Conditions were submitted on July 10, 1998 and a decision will be issued by the DTE no later than September 30, 1998. The DTE intends to issue an order on capacity assignment and cost responsibility by October 30, 1998. <PAGE 12> COMMONWEALTH GAS COMPANY Year 2000 The Company has been involved in Year 2000 compliancy since 1996. A complete inventory and review of software, information processing, delivery systems and operational components for certain facilities has been completed, and work continues on computer systems wherever necessary. While some computer systems have already been updated, tested and placed in production, the system expects to complete the balance of the modifications by mid-1999. Costs associated with Year 2000 compliancy are being expensed as incurred. The total cost of this project is expected to be funded with internally generated funds. Management believes that, with appropriate modifications, the Company will be fully compliant regarding all Year 2000 issues and will continue to provide its products and services uninterrupted through the millennium change. Failure to become fully compliant could have a significant impact on the Company's operations. New Accounting Standard In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133 (SFAS No. 133), "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 establishes accounting and reporting standards requiring that every derivative instrument (including certain derivative instruments embedded in other contracts possibly including fixed-price gas supply contracts) be recorded on the balance sheet as either an asset or liability measured at its fair value. SFAS No. 133 requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allows a derivative's gains and losses to offset related results on the hedged item in the income statement, and requires that a company must formally document, designate and assess the effectiveness of transactions that receive hedge accounting. SFAS No. 133 is effective for fiscal years beginning after June 15, 1999 and may be implemented as of the beginning of any fiscal quarter after issuance but cannot be applied retroactively. SFAS No. 133 must be applied to derivative instruments and certain derivative instruments embedded in hybrid contracts that were issued, acquired or substantively modified after December 31, 1997 and, at the company's election, before January 1, 1998. The Company has not yet quantified the impacts of adopting SFAS No. 133 on its financial statements and has not determined the timing of its method of adopting SFAS No. 133. Forward-Looking Statements This discussion contains statements which, to the extent it is not a recitation of historical fact, constitute "forward-looking statements" and is intended to be subject to the safe harbor protection provided by the Private Securities Litigation Reform Act of 1995. A number of important factors <PAGE 13> COMMONWEALTH GAS COMPANY affecting the Company's business and financial results could cause actual results to differ materially from those reflected in the forward-looking statements or projected amounts. Those factors include developments in the legislative, regulatory and competitive environment, certain environmental matters, demands for capital and the availability of cash from various sources. <PAGE 14> COMMONWEALTH GAS COMPANY PART II - OTHER INFORMATION Item 1. Legal Proceedings The Company is not a party to any pending material legal proceeding. Item 5. Other Information None. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits Exhibit 27 - Financial Data Schedule Filed herewith as Exhibit 1 is the Financial Data Schedule for the three months ended June 30, 1998. (b) Reports on Form 8-K No reports on Form 8-K were filed for the three months ended June 30, 1998. <PAGE 15> COMMONWEALTH GAS COMPANY SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. COMMONWEALTH GAS COMPANY (Registrant) Principal Financial and Accounting Officer: JAMES D. RAPPOLI James D. Rappoli, Financial Vice President and Treasurer Date: August 14, 1998