<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, 1999 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 1-7316 COMMONWEALTH ENERGY SYSTEM (Exact name of registrant as specified in its Declaration of Trust) Massachusetts 04-1662010 (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) Registrant's telephone number, including area code (617) 225-4000 (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, 1999 Common Shares of Beneficial Interest, $2 par value 21,540,550 shares <PAGE 2> PART I. - FINANCIAL INFORMATION Item 1. Financial Statements COMMONWEALTH ENERGY SYSTEM CONSOLIDATED CONDENSED BALANCE SHEETS JUNE 30, 1999 AND DECEMBER 31, 1998 ASSETS (Dollars in thousands) June 30, December 31, 1999 1998 (Unaudited) PROPERTY, PLANT AND EQUIPMENT, at original cost Electric $ 972,360 $ 963,181 Gas 395,754 391,069 Other 116,743 118,717 1,484,857 1,472,967 Less - Accumulated depreciation and amortization 478,696 462,153 1,006,161 1,010,814 Add - Construction work in progress and nuclear fuel in process 13,191 8,510 1,019,352 1,019,324 EQUITY IN CORPORATE JOINT VENTURES Nuclear electric power companies (2.5% to 4.5%) 10,518 10,391 Other investments 3,515 3,640 14,033 14,031 RESTRICTED CASH - LONG-TERM 176,789 172,239 CURRENT ASSETS Cash and cash equivalents 7,252 74,840 Restricted cash 167,468 21,094 Accounts receivable 103,647 122,064 Unbilled revenues 7,886 17,849 Inventories, at average cost 26,050 32,924 Prepaid property taxes - 8,112 Other 8,215 5,466 320,518 282,349 DEFERRED CHARGES Regulatory assets 224,247 210,628 Other 56,151 55,295 280,398 265,923 $1,811,090 $1,753,866 See accompanying notes. <PAGE 3> COMMONWEALTH ENERGY SYSTEM CONSOLIDATED CONDENSED BALANCE SHEETS JUNE 30, 1999 AND DECEMBER 31, 1998 CAPITALIZATION AND LIABILITIES (Dollars in thousands) June 30, December 31, 1999 1998 (Unaudited) CAPITALIZATION Common share investment - Common shares, $2 par value - Authorized - 50,000,000 shares Outstanding - 21,540,550 in 1999 and 1998 $ 43,081 $ 43,081 Amounts paid in excess of par value 112,309 112,170 Retained earnings 304,409 294,341 459,799 449,592 Redeemable preferred shares, less current sinking fund requirements - 11,380 Long-term debt, including premiums, less current sinking fund requirements and maturing debt 384,457 385,602 844,256 846,574 CAPITAL LEASE OBLIGATIONS 10,576 10,982 CURRENT LIABILITIES Interim Financing - Notes payable to banks 90,000 2,000 Maturing long-term debt 28,500 49,000 118,500 51,000 Other Current Liabilities - Current sinking fund requirements 7,196 8,123 Accounts payable 67,140 106,952 Accrued taxes - Income 23,799 8,720 Local property and other 2,847 10,633 Other 98,157 67,985 199,139 202,413 317,639 253,413 DEFERRED CREDITS Accumulated deferred income taxes 111,988 117,026 Regulatory liabilities 372,708 370,829 Purchased power contracts 55,413 59,507 Unamortized investment tax credits and other 98,510 95,535 638,619 642,897 COMMITMENTS AND CONTINGENCIES $1,811,090 $1,753,866 See accompanying notes. <PAGE 4> COMMONWEALTH ENERGY SYSTEM CONSOLIDATED CONDENSED STATEMENTS OF INCOME FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 1999 AND 1998 (Dollars in thousands except per share amounts - unaudited) Three Months Ended Six Months Ended 1999 1998 1999 1998 OPERATING REVENUES Electric $128,385 $139,393 $268,372 $295,197 Gas 53,958 58,235 168,899 173,374 Steam and other 13,222 6,663 27,963 12,324 195,565 204,291 465,234 480,895 OPERATING EXPENSES Fuel and purchased power 68,271 69,398 147,588 156,006 Cost of gas sold 24,511 35,526 79,893 90,903 Other operation and maintenance 66,568 66,244 131,745 124,734 Depreciation 11,176 14,377 24,982 30,556 Taxes - Federal and state income 3,290 912 18,638 17,018 Local property and other 6,680 6,288 15,870 15,078 180,496 192,745 418,716 434,295 OPERATING INCOME 15,069 11,546 46,518 46,600 OTHER INCOME Gain from sale of real estate, net 4,546 - 4,546 - Other (132) 804 477 1,499 4,414 804 5,023 1,499 INCOME BEFORE INTEREST CHARGES 19,483 12,350 51,541 48,099 INTEREST CHARGES Long-term debt 8,430 8,703 17,008 17,220 Other interest charges 4,436 2,678 6,529 4,445 Allowance for borrowed funds used during construction (101) (96) (193) (200) 12,765 11,285 23,344 21,475 NET INCOME 6,718 1,065 28,197 26,624 Dividends on preferred shares - 237 222 474 EARNINGS APPLICABLE TO COMMON SHARES $ 6,718 $ 828 $ 27,975 $ 26,150 AVERAGE NUMBER OF COMMON SHARES OUTSTANDING 21,540,550 21,533,820 21,540,550 21,533,141 BASIC AND DILUTED EARNINGS PER COMMON SHARE $ .31 $ .03 $1.30 $1.21 DIVIDENDS DECLARED PER COMMON SHARE $.415 $.405 $.415 $.405 See accompanying notes. <PAGE 5> COMMONWEALTH ENERGY SYSTEM CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS FOR THE SIX MONTHS ENDED JUNE 30, 1999 AND 1998 (Dollars in thousands - unaudited) 1999 1998 OPERATING ACTIVITIES Net income $ 28,197 $ 26,624 Gain from sale of real estate, net (4,546) - Effects of noncash items - Depreciation and amortization 31,708 36,447 Deferred income taxes and investment tax credits, net 8,439 198 Earnings from corporate joint ventures (469) (852) Dividends from corporate joint ventures 456 277 Change in working capital, exclusive of cash and interim financing 37,343 27,637 Transition costs deferral (15,141) (30,246) Power contract buy-out (2,265) - All other operating items (28,220) 6,952 Net cash provided by operating activities 55,502 67,037 INVESTING ACTIVITIES Purchase of total energy plant and related contracts - (146,270) Proceeds from sale of real estate 9,000 - Additions to property, plant and equipment (inclusive of AFUDC) - Electric (13,396) (15,462) Gas (7,440) (7,428) Other (694) (3,246) Net cash used for investing activities (12,530) (172,406) FINANCING ACTIVITIES Payment of dividends (18,129) (17,939) Reimbursement of transaction costs 4,483 - Proceeds from short-term borrowings 88,000 132,550 Long-term debt issues refunded (20,000) (10,000) Redemption of preferred shares (12,285) - Sinking funds payments (1,705) (1,397) Net cash provided by financing activities 40,364 103,214 Net increase (decrease) in cash, cash equivalents and restricted cash 83,336 (2,155) Cash, cash equivalents and restricted cash at beginning of period 268,173 4,299 Cash, cash equivalents and restricted cash at end of period $351,509 $ 2,144 SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION Cash paid during the period: Interest (net of capitalized amounts) $ 18,382 $ 19,544 Income taxes $ 10,134 $ 22,130 See accompanying notes. <PAGE 6> COMMONWEALTH ENERGY SYSTEM NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (1) General Information Commonwealth Energy System, the parent company, is referred to in this report as the "Parent" and, together with its subsidiaries, is collec- tively referred to as "COM/Energy." The Parent is an exempt public utility holding company under the provisions of the Public Utility Holding Company Act of 1935 with investments in four operating public utility companies located in central, eastern and southeastern Massachusetts. In addition, the Parent has interests in other utility and several non- regulated companies. In December 1998, the Parent signed an Agreement and Plan of Merger with BEC Energy, the parent company of Boston Edison Company, that will create an energy delivery company serving approximately 1.3 million customers located entirely within Massachusetts including more than one million electric customers in 81 communities and 240,000 gas customers in 51 communities. COM/Energy has 1,603 regular employees including 1,019 (64%) repre- sented by various collective bargaining units covered by separate con- tracts with expiration dates ranging from March 2001 through April 2003. In response to the significant changes that have taken place in the utility industry, COM/Energy sold substantially all of its non-nuclear generating assets in 1998 to focus on the transmission and distribution of energy and related services (see Note 2 (c)). (2) Accounting Policies (a) Principles of Accounting COM/Energy's significant accounting policies are described in Note 2 of Notes to Consolidated Financial Statements included in its 1998 Annual Report on Form 10-K filed with the Securities and Exchange Commission. For interim reporting purposes, COM/Energy 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 such expenses 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 of the gas subsidiary, Commonwealth Gas Company (Commonwealth Gas). 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 for each interim period. The unaudited financial statements for the periods ended June 30, 1999 and 1998, reflect, in the opinion of the Parent, all adjustments (consist- ing of only normal recurring accruals) necessary to summarize fairly the results for such periods. In addition, certain prior period amounts are <PAGE 7> COMMONWEALTH ENERGY SYSTEM reclassified from time to time to conform with the presentation 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 seasonal variations in the consump- tion of energy and Commonwealth Gas' seasonal rate structure. (b) Regulatory Assets and Liabilities COM/Energy's operating utility companies are regulated as to rates, accounting and other matters by various authorities, including the Federal Energy Regulatory Commission (FERC) and the Massachusetts Department of Telecommunications and Energy (DTE). Based on the current regulatory framework, COM/Energy 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." Regulated subsidiaries of the Parent have established various regulatory assets in cases where the DTE and/or the FERC have permitted or are expected to permit recovery of specific costs over time. Similarly, the regulatory liabilities estab- lished by COM/Energy are required to be refunded to customers over time. In the event the criteria for applying SFAS No. 71 are no longer met, the accounting impact would be an extraordinary, non-cash charge to operations of an amount that could be material. Criteria that give rise to the discontinuance of SFAS No. 71 include: 1) increasing competition that restricts COM/Energy's ability to establish prices to recover specific costs, and 2) a significant change in the current manner in which rates are set by regulators from cost based regulation to another form of regulation. These criteria are reviewed on a regular basis to ensure the continuing application of SFAS No. 71 is appropriate. Based on the current evaluation of the various factors and conditions that are expected to impact future cost recovery, COM/Energy believes that its regulatory assets, including those related to generation, are probable of future recovery. As a result of electric industry restructuring, COM/Energy's retail electric companies discontinued application of accounting principles applied to their investment in electric generating facilities effective March 1, 1998. COM/Energy will not be required to write off any of its generation-related assets, including regulatory assets. These assets will be retained on the Consolidated Condensed Balance Sheets because the legislation and the DTE's plan for a restructured electric industry specifically provide for their recovery through a non-bypassable transi- tion charge. <PAGE 8> COMMONWEALTH ENERGY SYSTEM The principal regulatory assets included in deferred charges were as follows: June 30, December 31, 1999 1998 (Dollars in thousands) Transition costs $ 66,277 $ 47,771 Maine Yankee unrecovered plant and decommissioning costs 29,382 30,646 Fuel charge stabilization 25,983 26,682 Connecticut Yankee unrecovered plant and decommissioning costs 23,496 25,185 Postretirement benefits costs 23,521 23,958 Deferred income taxes 15,737 15,737 Power contract buy-out 15,277 15,717 FERC Order 636 transition costs 6,206 5,968 Environmental costs 5,469 5,079 Yankee Atomic unrecovered plant and decommissioning costs 2,535 3,676 Seabrook related costs 2,340 3,008 Other 8,024 7,201 $224,247 $210,628 The regulatory liabilities, reflected in the accompanying Consoli- dated Condensed Balance Sheets, were as follows: June 30, December 31, 1999 1998 (Dollars in thousands) Regulatory liability related to sale of generating assets $353,987 $354,226 Deferred income taxes 12,063 12,196 Demand-side management deferral 6,236 3,956 Other 422 451 $372,708 $370,829 The regulatory liability related to the sale of generating assets was established pursuant to COM/Energy's divestiture filing that was approved by the DTE in which COM/Energy agreed to use the net proceeds from the sale of its non-nuclear generating assets to reduce transition costs that are billed to its retail electric customers over the next several years as a result of electric industry restructuring. COM/Energy established Energy Investment Services, Inc. (EIS) as the vehicle to invest the net proceeds from the sale of Canal Electric Company's (Canal Electric) generating assets and a portion of the proceeds from the sale of Cambridge Electric Light Company's (Cambridge Electric) generating assets. These proceeds have been invested in a conservative portfolio of securities that is designed to maintain principal and earn a reasonable return. Both the principal amount and income earned will be used to reduce the transition costs that would otherwise be billed to customers of Cambridge Electric and Commonwealth Electric Company (Commonwealth Electric). The net proceeds have been classified as restricted cash on the accompanying Consolidated Condensed Balance Sheets. <PAGE 9> COMMONWEALTH ENERGY SYSTEM COM/Energy's regulatory assets, including the costs associated with existing power contracts with three Yankee nuclear power plants that have shut down permanently, and all of its regulatory liabilities are reflected in rates charged to customers. Regulatory assets are to be recovered over 11 years pursuant to the legislation discussed below. However, Common- wealth Electric and Cambridge Electric received approximately $56 million and $6.3 million, respectively, from EIS in July 1999 which will reduce the amount of regulatory assets to be recovered in the future. In November 1997, the Commonwealth of Massachusetts enacted a comprehensive electric utility industry restructuring bill. On November 19, 1997, COM/Energy's electric subsidiaries filed a restructuring plan with the DTE. The plan, approved by the DTE on February 27, 1998, provides that COM/Energy's retail electric subsidiaries, beginning March 1, 1998, initiate a ten percent rate reduction for all customer classes and allow customers to choose their energy supplier. As part of the plan, the DTE authorized the recovery of certain strandable costs and provides that certain future costs may be deferred to achieve or maintain the rate reductions that the restructuring bill mandates. The legislation gives the DTE the authority to determine the amount of strandable costs that are eligible for recovery. Costs that qualify as strandable costs and are eligible for recovery include, but are not limited to, certain above market costs associated with generating facilities, costs associated with long-term commitments to purchase power at above market prices from independent power producers and regulatory assets and associated liabili- ties related to the generation portion of the electric business. (c) Divestiture of Generation Assets The cost of transitioning to competition will be mitigated, in part, by the sale of COM/Energy's non-nuclear generating assets. On May 27, 1998, COM/Energy agreed to sell substantially all of its non-nuclear generating assets (984 MW) to affiliates of The Southern Company of Atlanta, Georgia. The sale was conducted through an auction process that was outlined in a restructuring plan filed with the DTE in November 1997 in conjunction with the state's industry restructuring legislation enacted in 1997. The sale was approved by the DTE on October 30, 1998 and by the FERC on November 12, 1998. Proceeds from the sale of these assets, after construction-related adjustments at the closing that occurred on December 30, 1998, amounted to approximately $453.9 million or 6.1 times their book value of approximately $74.2 million. An adjustment of $5.1 million was recorded in the first quarter of 1999 that reduced the book value to $69.1 million. The proceeds from the sale, net of book value, transaction costs and certain other adjustments, now amount to $354 million and will be used to reduce transition costs related to electric industry restructuring that otherwise would have been collected through a non-bypassable transition charge. COM/Energy has determined that this transaction was not a taxable event because it provided no economic benefit to COM/Energy. <PAGE 10> COMMONWEALTH ENERGY SYSTEM (3) Commitments and Contingencies Capital Expenditures (a) Construction Program COM/Energy is engaged in a continuous construction program presently estimated at $327.9 million for the five-year period 1999 through 2003. Of that amount, $63.4 million is estimated for 1999. The program is subject to periodic review and revision. (b) Acquisition On June 1, 1998, Advanced Energy Systems, Inc. (AES), a wholly-owned subsidiary of the Parent, acquired for $146.3 million all of the issued and outstanding shares of capital stock of Harvard University's Medical Area Total Energy Plant, Inc. subsidiary (MATEP) and all rights under customer contracts owned by Harvard University. MATEP's principal asset is a cogeneration plant that provides heating, chilled water service and electricity to several hospitals, medical research centers and teaching institutions in the 200-acre Longwood Medical Area of Boston pursuant to the contracts that were assigned to AES. The purchase price was estab- lished through a sealed-bid auction process and the transaction was initially financed with a short-term bank loan of $150 million that was subsequently reduced with the proceeds from an equity contribution from the Parent to AES of approximately $40 million (financed with a 2-year variable rate term note issued by the Parent). A permanent financing was completed on August 26, 1998 that consisted of $112.5 million in 23-year term notes at a rate of 6.924% with quarterly sinking fund payments scheduled to begin on September 30, 2003 that escalate from $790,000 to $2.7 million at the end of the term. These notes are secured by long-term contracts between MATEP and its customers. The 2-year term note will be repaid in two installments of $20 million each on September 30, 1999 and July 1, 2000. The variable interest rate averaged 5.667% during the first half of 1999. Results for MATEP are included in the accompanying Consolidated Condensed Financial Statements from the date of acquisition. The acquisition was accounted for under the purchase method of accounting. The purchase price was allocated based on the fair value of assets acquired and resulted in the recognition of an intangible asset amounting to approximately $31 million that is being amortized on a straight-line basis over fifteen years. Based on unaudited data, the following pro forma summary presents the consolidated results of operations for the three and six months ended June 30, 1998 as if the acquisition had occurred at the beginning of the year presented: <PAGE 11> COMMONWEALTH ENERGY SYSTEM Three Months Ended Six Months Ended June 30, June 30, 1998 1998 (Dollars in thousands except per share amounts) Revenues $212,581 $502,985 Net Income (Loss) Applicable to Common Shares $ (521) $ 24,335 Basic and Diluted Earnings per Common Share $(.02) $1.13 The pro forma results do not purport to be indicative of the results of operations that actually would have resulted had the acquisition been made at the beginning of the year presented, or of results that may occur in the future. (c) Pilgrim Power Contract Commonwealth Electric had an 11% (73.6 megawatts) contract entitle- ment in the output of the Pilgrim nuclear power plant, located in Plym- outh, MA, which was sold by Boston Edison Company (Boston Edison) on July 13, 1999 to Entergy Nuclear Generating Company (Entergy). On April 29, 1999, the Nuclear Regulatory Commission issued an order approving the transfer of the operating license for the plant from Boston Edison to Entergy. In conjunction with this sale, Commonwealth Electric reached an agreement with Boston Edison to buy out of this life-of-the-unit contract, terminating Commonwealth Electric's rights and obligations under the contract regarding the power output of the plant. Pursuant to the buy-out agreement, Commonwealth Electric paid approximately $105 million in July 1999 to terminate this contract with Boston Edison. The buy-out was paid with funds held by affiliate EIS (see Note 2(b)) that were provided from Commonwealth Electric's share of the net proceeds from Canal Electric's sale of its generating assets. The DTE approved the buy-out transaction as a mitigation measure and approved inclusion of the buy-out payment as a transition cost for purposes of cost recovery by Commonwealth Electric. In a transaction related to the sale of the Pilgrim plant, Commonwealth Electric will buy power generated by the Pilgrim plant from Entergy on a declining basis through 2004. (d) Lowell Cogeneration Company Power Contract On July 22, 1999, Commonwealth Electric filed with the DTE a Petition for Approval of an Amended and Restated Power Sale Agreement between Commonwealth Electric and Lowell Cogeneration Company (Lowell). The Petition requests approval of an amendment to the existing power sales agreement that would terminate Commonwealth Electric's obligation to purchase the output (28 megawatts) from the combined cycle cogeneration facility located in Lowell, MA. <PAGE 12> COMMONWEALTH ENERGY SYSTEM In September 1986, Commonwealth Electric had agreed to purchase all of the electric capacity and energy produced by Lowell through the year 2008. A 1994 restructured agreement eliminated Commonwealth Electric's purchase obligations through the year 2000 while extending the agreement with Lowell through 2010 as a dispatchable unit. Pursuant to the restructured agreement, Commonwealth Electric will retain the right, at its sole option, to purchase the output of the unit under call-back rights to ensure ongoing supply for default and standard offer service. A filing was made with the DTE in July 1999 that seeks approval of the new contract terms and the inclusion of the fixed costs ($1.1 million per month during the 4.5 year term of the restructured agreement), to be paid to Lowell, in the transition costs to be collected from Commonwealth Electric's retail customers. The fixed costs will be paid with funds held by affiliate EIS provided from Commonwealth Elec- tric's share of the net proceeds from Canal Electric's sale of its generating assets. Upon approval of the filing, there will be a reduction in the overall level of transition costs to be recovered from customers of Commonwealth Electric. <PAGE 13> COMMONWEALTH ENERGY SYSTEM Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Merger with BEC Energy The electric utility industry has continued to change in response to legislative and regulatory mandates that are aimed at lowering prices for energy by creating a more competitive marketplace. These pressures have resulted in an increasing trend in the electric industry to seek competi- tive advantages and other benefits through business combinations. On December 5, 1998, COM/Energy and BEC Energy (BEC), headquartered in Boston, Massachusetts, entered into an Agreement and Plan of Merger (the Merger Agreement). Pursuant to the Merger Agreement, COM/Energy and BEC will be merged into a new holding company to be known as NSTAR. Holders of COM/Energy common shares will receive 1.05 shares of NSTAR common stock for each share held while BEC common shareholders will receive one share of NSTAR common stock for each share held. In addition, current COM/Energy and BEC common shareholders have the right to receive cash rather than NSTAR common stock in the amount of $44.10 for each share held, up to an aggregate maximum of $300 million. At the close of the merger, COM/Energy shareholders will own approximately 32% of NSTAR common stock and BEC shareholders will own approximately 68%. The initial quarterly dividend rate of NSTAR is anticipated to be equal to BEC's current rate of 48.5 cents per share ($1.94 per share on an annualized basis). The merger will create an energy delivery company serving approximately 1.3 million customers located entirely within Massachusetts, including more than one million electric customers in 81 communities and 240,000 gas customers in 51 communities. The merger is expected to occur shortly after the satisfaction of certain conditions, including the receipt of the required approvals. On June 24, 1999, common shareholders of COM/Energy and BEC approved the merger. On June 30, 1999, the FERC approved the merger. On July 27, 1999, the DTE approved the rate plan filed by the utility subsidiaries of the two companies that is an integral part of the merger. On August 16, 1999, the Massachusetts Attorney General's Office and a group of four intervenors filed appeals of the DTE's rate plan order with the Massachusetts Supreme Judicial Court. The significant elements of the rate plan include a four-year distribution rate freeze for each of the NSTAR retail utility subsidiaries and recovery of all merger-related costs including an acquisition premium of approxi- mately $516 million. On August 11, 1999, the Nuclear Regulatory Commis- sion approved the transfer of control of Canal Electric's interest in the Seabrook nuclear generating plant from COM/Energy to NSTAR. The remaining merger approval from the Securities and Exchange Commission is expected to be issued in August. The Merger Agreement may be terminated under certain circumstances, including by any party if the merger is not consummated by December 5, 1999, subject to an automatic extension of six months if the requisite regulatory approvals have not yet been obtained by such date. The merger will be accounted for as an acquisition of COM/Energy by BEC using the purchase method of accounting. <PAGE 14> COMMONWEALTH ENERGY SYSTEM Upon effectiveness of the merger, Thomas J. May, BEC's current Chairman, President and Chief Executive Officer (CEO), will become the Chairman and CEO of NSTAR. Russell D. Wright, COM/Energy's current President and CEO, will become the President and Chief Operating Officer of NSTAR and will serve on NSTAR's board of trustees. Also, upon effec- tiveness of the merger, NSTAR's board of trustees will consist of COM/Energy's and BEC's current trustees. Financial Condition Capital resources of the Parent and its subsidiaries are derived principally from retained earnings. Supplemental interim funds are borrowed on a short-term basis and, when necessary, replaced with new equity and/or debt issues through permanent financing secured on an individual company basis. The Parent purchases 100% of all subsidiary common stock issues and provides, to the extent possible, a portion of the subsidiaries' short-term financing needs. These capital resources provide the funds required for the subsidiary companies' construction programs, current operations, debt service and other capital requirements. For the current six-month period, cash flows from operating activi- ties amounted to approximately $55.5 million and reflect net income of $28.2 million and noncash items including depreciation of $25 million and amortization of $6.7 million. The change in working capital since December 31, 1998, exclusive of cash, restricted cash, cash equivalents and interim financing, amounted to $37.3 million and had a positive impact on cash flows from operating activities, reflecting a lower level of accounts receivable ($18.4 million), unbilled revenues ($10 million), prepaid property taxes ($8.1 million) and inventories ($6.9 million) coupled with a higher level of other current liabilities ($29.2 million) and accrued taxes ($7.3 million). These factors were offset, in part, by a decline in accounts payable ($39.8 million) and other current assets ($2.7 million). Construction expenditures for the first half of 1999 were approxi- mately $21.5 million, including an allowance for funds used during construction (AFUDC) and nuclear fuel. Construction expenditures and the preferred and common dividend requirements of the Parent ($18.1 million) were funded with internally-generated funds. On February 12, 1999, the holders of the Parent's Cumulative Pre- ferred Shares (Series A 4.80%, Series B 8.10% and Series C 7.75%) were notified that each series would be redeemed in full effective April 1, 1999. The redemption price of $102 for Series A and $101 for each of Series B and C, plus accrued dividends, was paid by the Parent on April 1, 1999. On July 13, 1999, Commonwealth Electric paid BEC approximately $105 million to buy out of its life-of-the-unit contract entitlement for 11% of the output of the Pilgrim nuclear power plant. The buy-out (see Note 3(c)) was paid with funds held by subsidiary Energy Investment Services, Inc. <PAGE 15> COMMONWEALTH ENERGY SYSTEM Cambridge Electric expects to issue $25 million in long-term debt by the end of the third quarter of this year. The proceeds will be used to repay short-term debt that was required to fund a maturing long-term debt issue ($10 million) as well as construction expenditures. 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 Consolidated 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 Consolidated Condensed Statements of Income for the three and six months ended June 30, 1999 and 1998 and unit sales for these periods are shown below: Three Months Six Months Ended June 30, Ended June 30, 1999 and 1998 1999 and 1998 Increase (Decrease) (Dollars in thousands) Operating Revenues - Electric $(11,008) (7.9)% $(26,825) (9.1)% Gas (4,277) (7.3) (4,475) (2.6) Steam and other 6,559 98.4 15,639 126.9 (8,726) (4.3) (15,661) (3.3) Operating Expenses - Fuel and purchased power (1,127) (1.6) (8,418) (5.4) Cost of gas sold (11,015) (31.0) (11,010) (12.1) Other operation and maintenance 324 0.5 7,011 5.6 Depreciation (3,201) (22.3) (5,574) (18.2) Taxes - Federal and state income 2,378 260.7 1,620 9.5 Local property and other 392 6.2 792 5.3 (12,249) (6.4) (15,579) (3.6) Operating Income 3,523 30.5 (82) (0.2) Other Income 3,610 449.0 3,524 235.1 Income Before Interest Charges 7,133 57.8 3,442 7.2 Interest Charges 1,480 13.1 1,869 8.7 Net Income 5,653 530.8 1,573 5.9 Dividends on preferred shares (237) (100.0) (252) (53.2) Earnings Applicable to Common Shares $ 5,890 711.4 $ 1,825 7.0 <PAGE 16> COMMONWEALTH ENERGY SYSTEM Unit Sales Electric - Megawatthours (MWH) Retail 22,079 2.0 73,151 3.2 Wholesale (424,105) (58.7) (1,108,280) (59.5) (402,026) (22.0) (1,035,129) (25.0) Gas - Billions of British Thermal Units (BBTU) Firm (970) (19.0) 870 4.4 Interruptible and other (513) (37.9) (177) (6.1) Transportation 259 8.5 521 9.6 (1,224) (12.9) 1,214 4.4 The following is a summary of electric unit sales and gas throughput for the periods indicated: Three Months Ended Six Months Ended June 30, June 30, 1999 1998 1999 1998 Electric Sales - MWH Residential 404,901 379,912 907,431 852,131 Commercial 608,373 604,001 1,235,934 1,200,861 Industrial 106,968 114,247 198,380 215,527 Other 4,952 4,955 11,568 11,643 Total retail sales 1,125,194 1,103,115 2,353,313 2,280,162 Wholesale sales 297,943 722,048 754,095 1,862,375 Total 1,423,137 1,825,163 3,107,408 4,142,537 Gas Sales - BBTU Residential 2,619 2,995 13,014 11,763 Commercial 1,154 1,463 5,600 5,515 Industrial 171 352 878 1,167 Other 193 297 943 1,120 Total firm sales 4,137 5,107 20,435 19,565 Interruptible and other 841 1,354 2,740 2,917 Total sales 4,978 6,461 23,175 22,482 Transportation 3,291 3,032 5,920 5,399 Total throughput 8,269 9,493 29,095 27,881 Electric Revenues, Fuel and Purchased Power Costs Operating revenues from regulated operations for the current quarter and six-month period were $13.5 million and $30 million lower, respective- ly, than the corresponding periods in 1998 primarily due to the absence of wholesale revenues derived from the sale of power produced by Canal Electric's generating assets that were sold in December 1998. Also contributing to the decreases were rate reductions resulting from electric industry restructuring legislation and a net decrease in electricity purchased for resale, fuel and transmission charges of $1.1 million (1.6%) and $8.4 million (5.4%), respectively. These decreases were partially offset by higher retail unit sales in both periods. As a result of industry restructuring, COM/Energy has unbundled its rates and provided customers with a ten percent rate reduction as of March 1, 1998 that was <PAGE 17> COMMONWEALTH ENERGY SYSTEM subsequently increased to approximately 12% and 16% for Commonwealth Electric and Cambridge Electric, respectively, effective January 1, 1999 in conjunction with COM/Energy's restructuring plan as approved by the DTE. Operating revenues from a non-regulated subsidiary increased by $2.5 million for the current quarter and $3.2 million for the current six-month period. This legislation also provides customers with the opportunity to purchase generation supply in the competitive market. Unbundled delivery rates are composed of a customer charge (to collect metering and billing costs), a distribution charge (to collect the costs of delivering electric- ity), a transition charge (to collect past costs for investments in generating plants and costs related to power contracts), a transmission charge (to collect the cost of moving the electricity over high voltage lines from a generating plant), an energy conservation charge (to collect costs for demand-side management programs) and a renewable energy charge (to collect the cost to support the development and promotion of renewable energy projects). Electricity supply services provided by COM/Energy include optional standard offer service and default service. Standard offer service is the electricity that is supplied by the local distribution company (such as Commonwealth Electric and Cambridge Electric) until a competitive supplier is chosen by the customer. It is designed as a seven- year transitional service to give the customer time to learn about competi- tive power suppliers. The price of standard offer service will increase over time. Default service is the electricity that is supplied by the local distribution company when a customer is not receiving power from either standard offer service or a competitive power supplier. The market price for default service will fluctuate based on the average market price for power. Amounts collected through these various charges will be reconciled to actual expenditures on an on-going basis. Currently, 85.8% of retail customers receive standard offer service, 14.1% of retail customers receive default service and 0.1% of retail customers receive electricity supply services from competitive power suppliers. For further information on electric industry restructuring, refer to COM/Energy's 1998 Annual Report on Forms 10-K and 10-K/A. Total unit sales decreased in both the current quarter and six month period of 1999 despite 2% and 3.2% increases, respectively, in retail sales as wholesale sales decreased by 58.7% and 59.5%, respectively. These significant decreases reflect the sale of Canal Units 1 and 2 in December 1998. Gas Revenues and Cost of Gas Sold Operating revenues from regulated operations decreased by $2.3 million during the current quarter due primarily to a 23% decrease in total unit sales and a $5.2 million decrease in the cost of gas sold. Partially offsetting these decreases was a $1.7 million increase in transportation revenues. During the current six-month period operating revenues from regulated operations decreased by $656,000 due to a $7.8 million decline in the cost of gas sold offset by a 3.1% increase in total unit sales and a $3 million increase in transportation revenues. Additionally, affecting both periods was a lower average cost of gas. Also during the current quarter and six-month period, operating revenues from an unregulated subsidiary <PAGE 18> COMMONWEALTH ENERGY SYSTEM decreased by $6.5 million and $3.8 million, respectively, compared to the same periods of 1998 due to the sale of that subsidiary's assets in February 1999. The 4.4% increase in unit sales to firm customers during the current six-month period reflects higher sales to all customer segments due to cooler weather conditions experienced during the first quarter of 1999 compared to the same period last year. The 19% decrease in firm unit sales for the current quarter reflects the warmer weather experienced throughout the region during that time. The fluctuation in interruptible and other sales reflects the competitive market that exists today in the natural gas industry. Other Operating Expenses For the current six-month period, other operation and maintenance increased by $7 million (5.6%) and reflects costs associated with the MATEP facility that was acquired in June 1998 ($3.7 million), costs associated with the sale of the assets of an unregulated subsidiary ($1.8 million), the absence in the current period of an adjustment to year-end 1997 payroll (made in January 1998) related to the 1997 personnel reduction program (PRP) ($1.8 million), higher conservation and load management costs ($1.3 million) and an increase in the provision for bad debts ($1.1 million). These increases were partially offset by a decline in insurance and employee benefits costs ($1.5 million). Depreciation decreased $3.2 million and $5.6 million during the current quarter and six-month period of 1999, respectively, and reflects the aforementioned sale of COM/Energy's generating assets in December 1998 partially offset by depreciation related to the MATEP facility. Federal and state income taxes increased during both current periods reflecting a higher level of pre-tax income. The increases in local property and other taxes for both current periods was due primarily to real estate taxes associated with MATEP and higher tax rates and assessments offset, in part, by the absence of real estate taxes related to the generating assets that were sold. Other Income The increase in other income in both current periods is primarily due to the net gain from the sale of real estate by an unregulated subsidiary ($4.6 million) and interest accrued on deferred transition costs associated with electric industry restructuring ($730,000 during the current quarter and $1.3 million during the current six-month period) offset, in part, by expenses incurred related to the pending merger with BEC Energy ($2.5 million during the current quarter and $4.4 million during the current six- month period). Interest Charges The increase in total interest charges for both current periods mainly reflects interest expense on amounts deferred in conjunction with COM/Energy's restructuring plan as approved by the DTE and the issuance of 23-year term notes in August 1998 partially offset by maturing long-term debt and scheduled sinking fund payments. <PAGE 19> COMMONWEALTH ENERGY SYSTEM Environmental Matters Commonwealth Gas 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 contami- nated and whether Commonwealth Gas may be responsible for remedial actions. The DTE has approved recovery of costs associated with MGP sites. Common- wealth Gas is also involved in certain other known or potentially contami- nated sites where the associated costs may not be recoverable in rates. For additional information on other related environmental matters, refer to the 1998 Annual Report on Forms 10-K and 10-K/A. Year 2000 The Year 2000 issue is the result of computer programs being written using two digits rather than four to define the applicable year. Any computer program that has date sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a temporary inability to process transactions or engage in normal business activities. COM/Energy has been involved in Year 2000 compliancy since 1996. COM/Energy, on a coordinated basis and with the assistance of RCG Information Technologies and other consultants, is addressing the Year 2000 issue. COM/Energy has followed a five-phase process in its Year 2000 compliance efforts, as follows: Awareness (through a series of internal announcements to employees and through contacts with vendors); Inventory (all computers, applications and embedded systems that could potentially be affected by the Year 2000 problem); Assessment (all applications or components and the impact on overall business operations and a plan to correct deficiencies and the cost to do so); Remediation (the modification, upgrade or replacement of deficient hardware and software applications and infrastructure modifications); and Testing (a detailed, comprehensive testing program for the modified critical component, system or software that involves the planning, execution and analysis of results). COM/Energy's inventory phase required an assessment of all date sensitive information and transaction processing computer systems and determined that approximately 90% of its software systems needed some modifications or replacement. Plans were developed, implemented, and all of these systems have been modified, upgraded or replaced. COM/Energy is currently at a 98% completion level in its five-phase process for all systems, with completion of the last stages of its extensive testing process for the final six systems expected by September 30, 1999. COM/Energy has also inventoried its non-information technology systems that may be date sensitive (facilities, electric and gas opera- tions, energy supply/production and distribution) that use embedded technology such as micro-controllers and micro-processors. COM/Energy has completed its assessment of these non-information technology systems and determined that 20% of these systems required remediation or replacement. COM/Energy has reported to the North American Electric Reliability Council (NERC) that it met the NERC target date of June 30, 1999 for 100% readiness of all its mission critical components required for the continued safe and <PAGE 20> COMMONWEALTH ENERGY SYSTEM reliable delivery of electricity into the Year 2000. COM/Energy's gas and other operations are also at a 100% completion level for all mission criti- cal issues regarding Year 2000 readiness. Overall, the non-information technology systems are at a 99% completion level, with the final items scheduled for completion by August 31, 1999. Modifying and testing COM/Energy's information and transaction processing systems from 1996 through 2000 is currently expected to cost approximately $10.2 million, including approximately $900,000, $3.1 million and $3.2 million incurred through 1997, 1998 and the first half of 1999, respectively. Approximately $3 million is expected to be spent during the remainder of 1999 and in 2000. Year 2000 costs have been expensed as incurred and will continue to be funded from operations. In addition to its internal efforts, COM/Energy has initiated formal communications with its significant suppliers to determine the extent to which COM/Energy may be vulnerable to its suppliers' failure to correct their own Year 2000 issues. COM/Energy has ranked its vendors in terms of importance, and as of June 30, 1999 has received adequate responses from 100% of its "critical" and "high" rated vendors. Failure of COM/Energy's significant suppliers to address Year 2000 issues could have a material adverse effect on COM/Energy's operations, although it is not possible at this time to quantify the amount of business that might be lost or the costs that could be incurred by COM/Energy. Contact with all other vendors is continuing and inadequate responses are being pursued by COM/Energy. COM/Energy is prepared to replace certain suppliers or to initiate other contingency plans for any vendor not responding to COM/Energy's satisfac- tion. In addition, parts of the global infrastructure, including national banking systems, electrical power grids, gas pipelines, transportation facilities, communications and governmental activities, may not be fully functional after 1999. Infrastructure failures could significantly reduce COM/Energy's ability to acquire energy and its ability to serve its custom- ers as effectively as they are now being served. COM/Energy has identified the elements of the infrastructure that are critical to its operations and has requested and obtained information as to the expected Year 2000 readiness of these elements. COM/Energy has completed the development of its Year 2000 contingency plans for all operational areas that may be effected by Year 2000 issues. COM/Energy's gas and electric operations currently have emergency operating plans, as well as information technology disaster recovery plans, as compo- nents of their standard operating procedures. These plans have been enhanced, identifying potential Year 2000 risks to normal operations and the appropriate response to these potential failures. These plans also include actions to be taken in the event of third party and infrastructure failures with regard to the Year 2000 event, although in certain cases, there may be no practical alternative course of action available to COM/Energy. The implementation of the contingency plans will continue throughout the remainder of 1999. COM/Energy is working with other energy industry entities, both regionally and nationally, with respect to Year 2000 readiness and is <PAGE 21> COMMONWEALTH ENERGY SYSTEM cooperating in the development of local and wide-scale contingency plan- ning. While COM/Energy believes its efforts to address the Year 2000 issue will allow it to be successful in avoiding any material adverse effect on COM/Energy's operations or financial condition, it recognizes that failing to resolve Year 2000 issues on a timely basis would, in a "most reasonably likely worst case scenario," significantly limit its ability to acquire and distribute energy and process its daily business transactions for a period of time, especially if such failure is coupled with third party or infra- structure failures. Similarly, COM/Energy could be significantly effected by the failure of one or more significant suppliers, customers or compo- nents of the infrastructure to conduct their respective operations after 1999. Adverse affects on COM/Energy could include, among other things, business disruption, increased costs, loss of business and other similar risks. The foregoing discussion regarding Year 2000 project timing, effec- tiveness, implementation and costs includes forward-looking statements that are based on management's current evaluation using available information. Factors that might cause material changes include,but are not limited to, the availability of key Year 2000 personnel, the readiness of third parties, and COM/Energy's ability to respond to unforeseen Year 2000 complications. New Accounting Standard In June 1998, the Financial Accounting Standards Board issued 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 fuel supply and power 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, 2000 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 adoption of SFAS No. 133 is not expected to have a material impact on COM/Energy's results of operations or financial condition. <PAGE 22> COMMONWEALTH ENERGY SYSTEM 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 affecting the Parent'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 develop- ments in the legislative, regulatory and competitive environment, certain environmental matters, demands for capital and new business development expenditures and the availability of cash from various sources. <PAGE 23> COMMONWEALTH ENERGY SYSTEM PART II - OTHER INFORMATION Item 1. Legal Proceedings COM/Energy is subject to legal claims and matters arising from its course of business including when Cambridge Electric was an intervenor in an appeal at the Massachusetts Supreme Judicial Court (SJC) filed by the Massachusetts Institute of Technology (MIT) involving a DTE decision approv- ing a customer transition charge (CTC) for the recovery of stranded invest- ment costs. By its terms, the CTC was terminated on March 1, 1998, coinci- dent with the retail access date established by the Massachusetts Legisla- ture in the Electric Industry Restructuring Act. On September 18, 1997, the SJC remanded the CTC matter to the DTE for further consideration. The SJC stated that, although recovery of prudent and verifiable stranded costs by utility companies is in the public interest and consistent with the Public Utility Regulatory Policies Act, the insufficiencies of the DTE's subsidiary findings precluded the SJC from undertaking a meaningful review of the DTE's calculations that formed the basis of the CTC. The DTE is in the process of determining whether to hear additional evidence in the remand or to rely on the record and pleadings already filed. At this time, management is unable to predict the ultimate outcome of this proceeding. Item 2. Changes in Securities and Use of Proceeds None Item 3. Defaults by the Company on its Senior Securities None Item 4. Results of Votes of Security Holders (a) A Special Meeting in Lieu of the Annual Meeting of Shareholders (1999 Annual Meeting) was held on June 24, 1999. (b) The three nominees, Peter H. Cressy, William J. O'Brien and Russell D. Wright, listed in the Parent's Notice of 1999 Annual Meeting and Proxy Statement dated May 14, 1999 were elected to the Board of Trustees of Commonwealth Energy System at the 1999 Annual Meeting. (c) As set forth in COM/Energy's Notice of 1999 Annual Meeting and Proxy Statement dated May 14, 1999, a proposal to consider and vote upon the Agreement and Plan of Merger between COM/Energy and BEC Energy was voted on and approved at the 1999 Annual Meeting. There were 16,550,031 (76.7%) Common Shares voted for this propos- al, 289,633 (1.4%) Common Shares voted against this proposal, 157,938 (0.7%) Common Shares abstained and 4,577,835 (21.2%) Common Shares were not voted. In accordance with the shareholder vote, which required the approval of the holders of two-thirds of COM/Energy's Common Shares, the proposal passed and the Agreement and Plan of Merger was approved. <PAGE 24> COMMONWEALTH ENERGY SYSTEM (d) As set forth in COM/Energy's Notice of 1999 Annual Meeting and Proxy Statement dated May 14, 1999, a shareholder proposal requesting the Board of Trustees to repeal the classified board and institute annual election of trustees was voted upon and failed to pass at the 1999 Annual Meeting. There were 4,518,949 (20.9%) Common Shares voted for this proposal, 11,660,675 (54.1%) Common Shares voted against this proposal, 817,978 (3.8%) Common Shares abstained and 4,577,835 (21.2%) Common Shares were not voted. The affirmative vote of the holders of a majority of the outstanding Common Shares was required for approval of this proposal. 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 six months ended June 30, 1999. Filed herewith as Exhibit 2 is the restated Financial Data Schedule for the year ended December 31, 1998. (b) Reports on Form 8-K No reports on Form 8-K were filed during the three months ended June 30, 1999. <PAGE 25> COMMONWEALTH ENERGY SYSTEM 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 ENERGY SYSTEM (Registrant) Principal Financial and Accounting Officer JAMES D. RAPPOLI James D. Rappoli, Financial Vice President and Treasurer Date: August 16, 1999