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FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
Quarterly Report under Section 13 or 15(d)
of the Securities Exchange Act of 1934
For Quarter Ended September 30, 1998
Commission File Number 1-3376-2
THE POTOMAC EDISON COMPANY
(Exact name of registrant as specified in its charter)
Maryland and Virginia 13-5323955
(State of Incorporation) (I.R.S. Employer Identification No.)
10435 Downsville Pike, Hagerstown, Maryland 21740-1766
Telephone Number - 301-790-3400
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 and (2) has been subject to such
filing requirements for the past 90 days.
At November 16, 1998, 22,385,000 shares of the Common Stock
(no par value) of the registrant were outstanding, all of which
are held by Allegheny Energy, Inc., the Company's parent.
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THE POTOMAC EDISON COMPANY
Form 10-Q for Quarter Ended September 30, 1998
Index
Page
No.
PART I--FINANCIAL INFORMATION:
Statement of income - Three and nine months ended
September 30, 1998 and 1997 3
Balance sheet - September 30, 1998
and December 31, 1997 4
Statement of cash flows - Nine months ended
September 30, 1998 and 1997 5
Notes to financial statements 6-9
Management's discussion and analysis of financial
condition and results of operations 10-19
PART II--OTHER INFORMATION 20
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THE POTOMAC EDISON COMPANY
Statement of Income
(Thousands of Dollars)
Three Months Ended Nine Months Ended
September 30 September 30
1998 1997 1998 1997
ELECTRIC OPERATING REVENUES:
Residential $ 76,633 $ 69,337 $ 232,894 $ 227,156
Commercial 41,743 38,963 118,231 110,826
Industrial 52,883 50,006 153,807 146,777
Wholesale and other, including affiliates 9,299 9,733 30,648 29,207
Bulk power transactions, net 9,975 7,425 24,170 18,593
Total Operating Revenues 190,533 175,464 559,750 532,559
OPERATING EXPENSES:
Operation:
Fuel 37,527 35,737 109,008 104,606
Purchased power and exchanges, net 38,610 32,845 104,053 102,489
Deferred power costs, net (890) 571 4,798 (419)
Other 20,727 21,176 64,426 62,675
Maintenance 12,746 14,523 39,974 45,427
Depreciation 18,660 18,375 56,025 55,126
Taxes other than income taxes 12,368 11,281 37,432 36,211
Federal and state income taxes 14,105 10,568 39,696 32,100
Total Operating Expenses 153,853 145,076 455,412 438,215
Operating Income 36,680 30,388 104,338 94,344
OTHER INCOME AND DEDUCTIONS:
Allowance for other than borrowed funds
used during construction 193 643 408 1,367
Other income, net 2,596 6,423 7,158 12,204
Total Other Income and Deductions 2,789 7,066 7,566 13,571
Income Before Interest Charges 39,469 37,454 111,904 107,915
INTEREST CHARGES:
Interest on long-term debt 11,740 11,919 35,280 35,746
Other interest 666 458 1,617 1,661
Allowance for borrowed funds used during
construction (236) (219) (718) (887)
Total Interest Charges 12,170 12,158 36,179 36,520
NET INCOME $ 27,299 $ 25,296 $ 75,725 $ 71,395
See accompanying notes to financial statements.
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THE POTOMAC EDISON COMPANY
Balance Sheet
(Thousands of Dollars)
September 30, December 31,
1998 1997
ASSETS:
Property, Plant, and Equipment:
At original cost, including $58,589
and $55,702 under construction $ 2,237,028 $ 2,196,262
Accumulated depreciation (912,370) (859,076)
1,324,658 1,337,186
Investments:
Allegheny Generating Company - common stock at equity 45,093 55,847
Other 479 529
45,572 56,376
Current Assets:
Cash 2,577 2,319
Accounts receivable:
Electric service, net of $2,259 and $1,683
uncollectible allowance 77,911 83,431
Affiliated and other 20,892 5,302
Notes receivable from affiliates 33,750 1,450
Notes receivable from subsidiary 66,250 -
Materials and supplies - at average cost:
Operating and construction 22,397 23,715
Fuel 13,873 15,843
Prepaid taxes 15,400 15,052
Other 723 4,716
253,773 151,828
Deferred Charges:
Regulatory assets 75,513 80,651
Unamortized loss on reacquired debt 16,091 17,094
Prepaid pensions 8,525 4,925
Other 14,073 12,587
114,202 115,257
Total Assets $ 1,738,205 $ 1,660,647
CAPITALIZATION AND LIABILITIES:
Capitalization:
Common stock $ 447,700 $ 447,700
Other paid-in capital 2,690 2,690
Retained earnings 286,970 239,391
737,360 689,781
Preferred stock 16,378 16,378
Long-term debt and QUIDS 578,296 627,012
1,332,034 1,333,171
Current Liabilities:
Long-term debt due within one year 50,000 1,800
Accounts payable 23,622 29,125
Accounts payable to affiliates 39,097 19,929
Taxes accrued:
Federal and state income 7,797 2,106
Other 19,163 11,461
Interest accrued 12,985 9,487
Payrolls accrued - 6,353
Other 15,983 10,553
168,647 90,814
Deferred Credits and Other Liabilities:
Unamortized investment credit 20,063 21,470
Deferred income taxes 178,152 178,529
Regulatory liabilities 11,604 12,424
Other 27,705 24,239
237,524 236,662
Total Capitalization and Liabilities $ 1,738,205 $ 1,660,647
See accompanying notes to financial statements.
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THE POTOMAC EDISON COMPANY
Statement of Cash Flows
(Thousands of Dollars)
Nine Months Ended
September 30
1998 1997
CASH FLOWS FROM OPERATIONS:
Net income $ 75,725 $ 71,395
Depreciation 56,025 55,126
Deferred investment credit and income taxes, net 3,603 6,782
Deferred power costs, net 4,798 (419)
Unconsolidated subsidiaries' dividends in excess of earnings 10,788 1,107
Allowance for other than borrowed funds used
during construction (408) (1,367)
Restructuring liability - (13,645)
Changes in certain current assets and
liabilities:
Accounts receivable, net (10,070) 8,064
Materials and supplies 3,288 (3,356)
Accounts payable 13,665 (2,812)
Taxes accrued 13,393 6,106
Interest accrued 3,498 4,350
Other, net (1,920) 5,664
172,385 136,995
CASH FLOWS FROM INVESTING:
Construction expenditures (less allowance for
equity funds used during construction) (44,630) (43,631)
CASH FLOWS FROM FINANCING:
Issuance of long-term debt 33,200 -
Retirement of long-term debt (34,000) (800)
Short-term debt, net - (7,497)
Notes receivable from affiliates (32,300) (39,200)
Notes receivable from subsidiary (66,250) -
Dividends on capital stock:
Preferred stock (613) (613)
Common stock (27,534) (46,561)
(127,497) (94,671)
NET CHANGE IN CASH 258 (1,307)
Cash at January 1 2,319 1,444
Cash at September 30 $ 2,577 $ 137
SUPPLEMENTAL CASH FLOW INFORMATION:
Cash paid during the period for:
Interest (net of amount capitalized) $30,492 $31,657
Income taxes 31,603 23,005
See accompanying notes to financial statements.
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THE POTOMAC EDISON COMPANY
Notes to Financial Statements
1. The Potomac Edison Company (the Company) is a wholly-owned
subsidiary of Allegheny Energy, Inc. The Company's Notes to
Financial Statements in its Annual Report on Form 10-K for
the year ended December 31, 1997 should be read with the
accompanying financial statements and the following notes.
With the exception of the December 31, 1997 balance sheet in
the aforementioned annual report on Form 10-K, the
accompanying financial statements appearing on pages 3
through 5 and these notes to financial statements are
unaudited. In the opinion of the Company, such financial
statements together with these notes contain all adjustments
necessary to present fairly the Company's financial position
as of September 30, 1998, the results of operations for the
three and nine months ended September 30, 1998 and 1997, and
cash flows for the nine months ended September 30, 1998 and
1997.
2. The Statement of Income reflects the results of past
operations and is not intended as any representation as to
future results. The Company's comprehensive income does not
differ from its net income. For purposes of the Balance
Sheet and Statement of Cash Flows, temporary cash investments
with original maturities of three months or less, generally
in the form of commercial paper, certificates of deposit, and
repurchase agreements, are considered to be the equivalent of
cash.
3. The Company owns 28% of the common stock of Allegheny
Generating Company (AGC), and affiliates of the Company own
the remainder. AGC owns an undivided 40% interest, 840
megawatts (MW), in the 2,100 MW pumped-storage hydroelectric
station in Bath County, Virginia, operated by the 60% owner,
Virginia Electric and Power Company, a nonaffiliated utility.
Following is a summary of income statement information for
AGC:
Three Months Ended Nine Months Ended
September 30 September 30
1998 1997 1998 1997
(Thousands of Dollars)
Electric operating revenues $18,303 $19,664 $56,033 $60,288
Operation and maintenance
expense 888 856 3,383 3,612
Depreciation 4,242 4,284 12,710 12,852
Taxes other than income taxes 1,168 1,185 3,505 3,581
Federal income taxes 2,708 3,109 8,480 9,374
Interest charges 3,707 3,888 10,518 11,765
Other income, net (35) (9,054) (86) (9,055)
Net income $ 5,625 $15,396 $17,523 $28,159
The Company's share of the equity in earnings above was $1.6
million and $4.3 million for the three months ended September
30, 1998 and 1997, respectively, and $4.9 million and $7.9
million for the nine months ended September 30, 1998 and
1997, respectively, and was included in other
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income, net, on the Statement of Income. Dividends received
from AGC in 1998 exceeded equity in earnings by $10.8 million
which reflects an effort to reduce AGC equity to about 45% of
capital.
4. On April 7, 1997, the Company's parent, Allegheny Power
System, Inc. (now renamed Allegheny Energy, Inc.) and DQE,
Inc. (DQE), parent company of Duquesne Light Company in
Pittsburgh, Pennsylvania, announced that they had agreed to
merge in a tax-free, stock-for-stock transaction.
On March 25, 1998, the Maryland Public Service Commission
(PSC) approved a settlement agreement between Allegheny
Energy, Inc. (Allegheny Energy) and various parties, in which
the PSC indicated its approval of the merger. This action
was requested in connection with the proposed issuance of
Allegheny Energy stock to exchange for DQE stock to complete
the merger.
On July 8, 1998, the City of Pittsburgh reached a settlement
agreement with Allegheny Energy and agreed to support the
merger.
On July 16, 1998, the Public Utilities Commission of Ohio
(PUCO) found that the proposed merger would be in the public
interest. The PUCO also stated that the Midwest Independent
System Operator (ISO) is the regional transmission entity
that will best serve the interests of the Ohio customers of
Monongahela Power Company, the Company's utility affiliate,
and will best mitigate any market power issues which might
exist.
The Nuclear Regulatory Commission has approved the transfer
of control of the operating licenses for DQE's nuclear
plants. While Duquesne Light Company (Duquesne), principal
subsidiary of DQE, will continue to be the licensee, this
approval was necessary since control of Duquesne will pass
from DQE to Allegheny Energy after the merger.
On July 23, 1998, the Pennsylvania Public Utility Commission
(PUC) approved the Allegheny Energy-DQE merger with
conditions acceptable to Allegheny Energy in response to a
Petition for Reconsideration filed by Allegheny Energy on
June 12, 1998. In its Petition for Reconsideration of a
previous PUC Order, Allegheny Energy reiterated its
commitment to staying in and supporting the Midwest ISO
subject to merger consummation, and also offered to
relinquish some generation in order to mitigate market power
concerns. Allegheny Energy committed to relinquishing
control of the 570 MW Cheswick, Pennsylvania, generating
station through at least June 30, 2000 and, in the event that
the Midwest ISO has not eliminated pancaked transmission
rates by June 30, 2000, Allegheny Energy could be required to
divest up to 2,500 MW of generation, if the PUC were to so
order.
In a letter to Allegheny Energy dated July 28, 1998, DQE
stated that its Board of Directors determined that DQE was
not required to proceed with the merger under present
circumstances, referring to the PUC's Orders of July 23, 1998
(regarding the PUC's approval of the merger described above),
and May 29, 1998 (regarding the restructuring plan of the
Company's Pennsylvania affiliate, West Penn Power Company
(West Penn) described in Note 6 below). DQE took the
position that the findings of both Orders constitute a
material adverse effect under the Agreement and Plan of
Merger and invited Allegheny Energy to agree promptly to
terminate the merger agreement by mutual consent. DQE
asserted that the findings in
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the PUC Orders will result in a failure of the conditions to
DQE's obligation to consummate the merger. DQE indicated
that if Allegheny Energy was not amenable to a consensual
termination, DQE would terminate the agreement unilaterally
not later than October 5, 1998 if circumstances did not
change sufficiently to remedy the adverse effects DQE stated
were associated with the PUC Orders. In a letter dated July
30, 1998, Allegheny Energy informed DQE that DQE's
allegations were incorrect, that the Orders do not constitute
a material adverse effect, that Allegheny Energy remains
committed to the merger, and that if DQE prevents completion
of the merger, Allegheny Energy would pursue all remedies
available to protect the legal and financial interests of
Allegheny Energy and its shareholders. Allegheny Energy has
also notified DQE that its letter and other actions
constitute a material breach of the merger agreement by DQE.
On September 16, 1998, the Federal Energy Regulatory
Commission (FERC) approved Allegheny Energy's merger with DQE
with conditions that were acceptable to Allegheny Energy.
The principal condition is divestiture of the Cheswick
Generating Station which enhances the proposal initially made
by Allegheny Energy and DQE to mitigate market power
concerns.
On October 5, 1998, DQE notified Allegheny Energy that it had
decided to terminate the merger. In response, Allegheny
Energy filed with the United States District Court for the
Western District of Pennsylvania on October 5, 1998, a
complaint for specific performance of the merger agreement
or, alternatively, damages and motions for a temporary
restraining order and preliminary injunction against DQE.
On October 28, 1998, the District Court denied Allegheny
Energy's motions for a temporary restraining order and
preliminary injunction. The District Court did not rule on
the merits of the complaint for specific performance or
damages. On October 30, 1998, Allegheny Energy appealed the
District Court's order to the United States Court of Appeals
for the Third Circuit. Allegheny Energy cannot predict the
outcome of the litigation between it and DQE.
All of the Company's incremental costs of the merger process
($5.0 million through September 30, 1998) are being deferred.
The accumulated merger costs will be written off by the
Company when the merger occurs, or if it is determined that
the merger will not occur.
5. As required by the Maryland PSC, the Company, on July 1,
1998, filed testimony in Maryland's investigation into
stranded costs, price protection, and unbundled rates. The
filing also requested a surcharge to recover the cost of the
Warrior Run cogeneration project which is scheduled to
commence production on October 1, 1999. Hearings are
scheduled to begin in April 1999. A second PSC proceeding is
planned to begin examining market power protective measures
in December 1999. Under the PSC's current timetable, a third
of the state's electricity customers would be able to choose
their electricity suppliers beginning in July 2000, and all
customers would have choice by mid-2002. On October 9, 1998,
the Company and four other electric utilities operating in
Maryland, filed appeals which request judicial review of
decisions by the PSC in which the PSC asserted it has
authority to restructure the electric utility industry
without authorization from the state legislature. The
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appeals allow the restructuring process to continue on
schedule, while preserving the legal rights of utility
companies to have state courts review PSC decisions.
6. In December 1996, Pennsylvania enacted the Electricity
Generation Customer Choice and Competition Act (Customer
Choice Act) to restructure the electric industry in
Pennsylvania to create retail access to a competitive
electric energy generation market. The Company's
Pennsylvania affiliate, West Penn, is subject to this Act.
On August 1, 1997, West Penn filed with the PUC a
comprehensive restructuring plan to implement full customer
choice of electric generation suppliers as required by the
Customer Choice Act.
On November 4, 1998, the PUC tentatively approved an
agreement between West Penn and intervenors to settle West
Penn's restructuring proceeding. Under the settlement
agreement, two-thirds of West Penn's customers may, beginning
in 1999, choose an alternative generation supplier. All of
West Penn's customers can do so beginning in the year 2000.
Additionally, West Penn received authorization to transfer
its generation assets to an unregulated business at book
value, and the unregulated business received authorization,
subject to a code of conduct, to sell generation capacity and
energy in unregulated markets. A majority of West Penn's
generating assets are jointly owned with its affiliates in
Allegheny Energy, including the Company. The Company and its
affiliates, including West Penn, are also parties to a power
supply agreement under which generating capacity, generating
spinning reserves and energy are subject to intercompany
allocations based in large part upon generation reserve
margins of each company which are based on each company's
demand from regulated customers. The anticipated changes in
West Penn's generation demand will require adjustments in the
administration of the power supply agreement. The Company
believes that West Penn's transfer of generation assets to an
unregulated business and the administrative adjustments to
the power supply agreement will not have a significant effect
on the Company's operations or its financial condition.
7. In June 1997, the Financial Accounting Standards Board (FASB)
issued Statement of Financial Accounting Standards (SFAS) No.
131, "Disclosures about Segments of an Enterprise and Related
Information," to establish standards for reporting
information about operating segments in financial statements.
The Company continues to review this standard for further
potential effect on the Company's financial statement
disclosures.
In June 1998, the FASB issued SFAS No. 133, "Accounting for
Derivative Instruments and Hedging Activities," to establish
accounting and reporting standards for derivatives. The new
standard requires recognizing all derivatives as either
assets or liabilities on the balance sheet at their fair
value and specifies the accounting for changes in fair value
depending upon the intended use of the derivative. The new
standard is effective for fiscal years beginning after June
15, 1999. The Company expects to adopt SFAS No. 133 in the
first quarter of 2000. The Company is in the process of
evaluating the impact of SFAS No. 133.
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THE POTOMAC EDISON COMPANY
Management's Discussion and Analysis of Financial Condition
and Results of Operations
COMPARISON OF THIRD QUARTER AND NINE MONTHS ENDED SEPTEMBER 30, 1998
WITH THIRD QUARTER AND NINE MONTHS ENDED SEPTEMBER 30, 1997
The Notes to Financial Statements and Management's
Discussion and Analysis of Financial Condition and Results of
Operations in the Company's Annual Report on Form 10-K for the
year ended December 31, 1997 should be read in conjunction with
the following management's discussion and analysis information.
Factors That May Affect Future Results
This Management's Discussion and Analysis of Financial
Condition and Results of Operations contains forecast information
items that are "forward-looking statements" as defined in the
Private Securities Litigation Reform Act of 1995. These include
statements with respect to deregulation activities and movements
toward competition in states served by the Company and the DQE,
Inc. (DQE) merger as well as results of operations. All such
forward-looking information is necessarily only estimated. There
can be no assurance that actual results will not materially
differ from expectations. Actual results have varied materially
and unpredictably from past expectations.
Factors that could cause actual results to differ
materially include, among other matters, electric utility
restructuring, including the ongoing state and federal
activities; potential Year 2000 operation problems; developments
in the legislative, regulatory, and competitive environments in
which the Company operates, including regulatory proceedings
affecting rates charged by the Company; environmental legislative
and regulatory changes; future economic conditions; developments
relating to the proposed merger with DQE, including expenses that
may be incurred in litigation; and other circumstances that could
affect anticipated revenues and costs such as significant
volatility in the market price of wholesale power, unscheduled
maintenance or repair requirements, weather, and compliance with
laws and regulations.
Significant Events in the First Nine Months of 1998
* Merger with DQE
In a letter to Allegheny Energy dated October 5, 1998,
DQE stated that it had decided to terminate the merger. In
response, Allegheny Energy filed with the United States District
Court for the Western District of Pennsylvania on October 5, 1998
a complaint for specific performance of the merger agreement or,
in the alternative, damages, and also filed a request for a
temporary restraining order and preliminary injunction against
DQE. See Note 4 to the Financial Statements for more information
about the merger. Allegheny Energy believes that DQE's basis for
seeking to terminate the merger is without merit. Accordingly,
Allegheny Energy continues to seek the
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remaining regulatory approvals from the Department of Justice and
the Securities and Exchange Commission. It is not likely either
agency will act on the requests unless Allegheny Energy obtains
judicial relief requiring DQE to move forward. Allegheny Energy
cannot predict the outcome of the litigation between it and DQE.
* Maryland Settlement and Deregulation
After substantial negotiations, the Company reached a
settlement agreement with various parties on the Office of
People's Counsel's (OPC) petition for a reduction in the
Company's Maryland rates. The agreement, which includes
recognition of costs to be incurred from the Warrior Run
cogeneration project, was filed with the Maryland Public Service
Commission (Maryland PSC) on July 30, 1998 and approved by that
Commission on October 27, 1998. Under the terms of the
agreement, the Company will increase its rates about 4% ($13
million) in each of the years 1999, 2000, and 2001 (a $39 million
annual effect in 2001). The increases are designed to recover
additional costs of about $131 million, over the period 1999-
2001, for capacity purchases from AES's Warrior Run generation
project net of alleged overearnings of $52 million for the same
period absent these adjustments. The net effect of these changes
over the 1999-2001 time frame results in a pre-tax income
reduction of $12.0 million in 1999, $18.0 million in 2000, and
$22.0 million in 2001. In addition, the settlement requires that
the Company share, on a 50% customer, 50% shareholder basis,
earnings above a threshold return on equity (ROE) level of 11.4%
for 1999-2001. This sharing will occur through an after-the-fact
true-up conducted after each calendar year is completed. In the
event the merger with DQE is consummated, an additional rate
reduction of $4.4 million annually will occur. "Warrior Run" is
a cogeneration project being built by AES Corporation in western
Maryland. The Company is required to purchase the project's
energy at above-market prices pursuant to the requirements of the
Public Utility Regulatory Policies Act of 1978 (PURPA).
On July 1, 1998, the Company filed testimony in
Maryland's investigation into stranded costs, price protection,
and unbundled rates. See Note 5 to the Financial Statements for
more information regarding the Maryland filing.
* Virginia Rate Settlement
On August 7, 1998, the Virginia State Corporation
Commission (Virginia SCC) approved an agreement reached between
the Company and the Staff of the Virginia SCC which will reduce
base rates for the Company's Virginia customers beginning
September 1, 1998 by about $2.5 million annually. The review of
rates was required by an annual information filing in Virginia.
* Pennsylvania Deregulation
On November 4, 1998, the Pennsylvania Public Utility
Commission (PUC) tentatively approved an agreement between the
Company's Pennsylvania affiliate, West Penn Power Company (West
Penn), and intervenors to settle West Penn's deregulation
proceeding in that state. Under the settlement agreement,
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West Penn's customers will obtain the ability to choose
alternative generation suppliers and West Penn's generation
assets, some of which are jointly owned with the Company, will be
removed from rate regulation. See Note 5 to the Financial
statements for information concerning certain intercompany
transactions between the Company and West Penn which will be
affected by the Pennsylvania deregulation process. The Company
does not believe that the changes to the intercompany
transactions, if any, will have a significant effect on the
Company's operations or its financial condition.
Review of Operations
EARNINGS SUMMARY
The increase in net income in the third quarter and first
nine month periods was due primarily to increased kilowatt-hour
(kWh) sales to retail customers.
SALES AND REVENUES
Percentage changes in revenues and kWh sales by major
customer classes were:
Change from Prior Periods
Three Months Ended Nine Months Ended
September 30 September 30
Revenues kWh Revenues kWh
Residential 10.5% 10.7% 2.5% 2.2%
Commercial 7.1 10.4 6.7 8.3
Industrial 5.8 6.4 4.8 5.7
Total 8.2 8.6 4.2 4.9
Residential kWh sales, which are more weather sensitive
than the other classes, increased 10.7% in the third quarter due
primarily to weather conditions. The third quarter of 1998 was
35% warmer than the corresponding 1997 period as measured in
cooling degree days. Residential kWh sales increased only 2.2%
in the nine month ended period due to mild winter weather in
early 1998. The first quarter winter weather was 11% warmer than
1997 and 22% warmer than normal as measured in heating degree
days. The increase in commercial kWh sales for the three and
nine months ended periods reflects increased usage due to weather
and commercial activity as well as growth in the number of
customers. The increase in industrial kWh sales in both periods
reflects increased sales to paper and printing customers and to
the Eastalco aluminum reduction plant, and generally reflects
continued economic growth in the service territory.
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The changes in revenues from sales to residential,
commercial, and industrial customers resulted from the following:
Change from Prior Periods
Three Months Ended Nine Months Ended
September 30 September 30
(Millions of Dollars)
Fuel clauses $ 2.1 $ 6.4
All other 10.9 13.8
Net change in retail
revenues $13.0 $20.2
Revenues reflect not only the changes in kWh sales, but
also any changes in revenues from fuel and energy cost adjustment
clauses (fuel clauses) which have little effect on net income
because increases and decreases in fuel and purchased power costs
and sales of transmission services and bulk power are passed on
to customers by adjustment of customer bills through fuel
clauses.
All other is the net effect of kWh sales changes due to
changes in customer usage (primarily weather for residential
customers), growth in the number of customers, and changes in
pricing other than changes in general tariff and fuel clause
rates. The increase in the three and nine months ended periods
all other retail revenues was primarily the result of customer
usage and an increase in the number of customers.
Wholesale and other revenues were as follows:
Three Months Ended Nine Months Ended
September 30 September 30
1998 1997 1998 1997
(Millions of Dollars)
Wholesale customers $5.8 $6.8 $18.5 $20.6
Affiliated companies 2.2 2.6 7.5 7.0
Street lighting and other 1.3 .3 4.6 1.6
Total wholesale and other
revenues $9.3 $9.7 $30.6 $29.2
Wholesale customers are cooperatives and municipalities
that own their own distribution systems and buy all or part of
their bulk power needs from the Company under regulation by the
FERC. Competition in the wholesale market for electricity was
initiated by the National Energy Policy Act of 1992 (EPACT),
which permits wholesale generators, utility-owned and otherwise,
and wholesale customers to request from owners of bulk power
transmission facilities a commitment to supply transmission
services. Five-year contracts have been signed (one in 1997 with
an expiration date in 2002 with estimated annual revenues of $3
million, and four in 1998 with expiration dates in 2003 with
estimated annual revenues of $19 million) with the Company's
wholesale customers allowing the Company to continue as their
wholesale supplier. The decrease in wholesale revenues in 1998
was primarily due to the mild 1998 winter as mentioned above.
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Revenues from affiliated companies represent sales of
energy and intercompany allocations of generating capacity,
generation spinning reserves, and transmission services pursuant
to a power supply agreement among the Company and the other
regulated utility subsidiaries of Allegheny Energy. The increase
in such revenues in the nine months ended September 30, 1998
resulted primarily from an increase in the allocation of
transmission services revenues to the Company.
The increases in street lighting and other revenues in
the quarter and year-to-date periods ended September 30, 1998
were primarily due to the recording in 1998 of pole attachment
revenues for 1998 and 1997.
Bulk power transactions consist of sales of power to
power marketers and other utilities. Revenues from bulk power
transactions consist of the following items:
Three Months Ended Nine Months Ended
September 30 September 30
1998 1997 1998 1997
(Millions of Dollars)
Revenues:
Transmission services sales
to nonaffiliated companies $ 6.1 $3.2 $12.4 $10.3
Bulk power 3.9 4.2 11.8 8.3
Total bulk power trans-
actions, net $10.0 $7.4 $24.2 $18.6
Revenues from bulk power sales increased in the first
nine months of 1998 due to increased sales which occurred
primarily in the month of June as a result of warm weather which
increased the demand and price for energy. The increase in
revenues from transmission services was due to an increase in
price.
In June and July 1998, certain events combined to produce
significant volatility in the spot prices for electricity at the
wholesale level. These events included extremely hot weather and
Midwest generation unit outages and transmission constraints.
Wholesale prices for electricity rose from a normal range of from
$25-$40 per megawatt-hour (mWh) to as high as $3,500-$7,000 per
mWh. The costs of purchased power and revenues from sales to
power marketers and other utilities, including transmission
services, are currently recovered from or credited to customers
under fuel and energy cost recovery procedures. The impact to
the fuel and energy cost recovery clauses, either positively or
negatively, depends on whether the Company is a net buyer or
seller of electricity during such periods. The impact of such
price volatility in June and the third quarter of 1998 was
insignificant to the Company because changes are passed through
to customers through operation of fuel clauses.
OPERATING EXPENSES
Fuel expenses for the three and nine months ended
September 30, 1998 increased 5.0% and 4.2%, respectively, due to
a 3.5% and 4.2% increase in kWh's generated. Fuel expenses are
primarily subject to deferred power cost accounting procedures
with the result that changes in fuel expenses have little effect
on net income.
- 15 -
Purchased power and exchanges, net represents power
purchases from and exchanges with other companies, capacity
charges paid to Allegheny Generating Company (AGC), an affiliate
partially owned by the Company, and other transactions with
affiliates made pursuant to a power supply agreement whereby each
company uses the most economical generation available in the
Allegheny Energy System at any given time, and consists of the
following items:
Three Months Ended Nine Months Ended
September 30 September 30
1998 1997 1998 1997
(Millions of Dollars)
Nonaffiliated transactions:
Purchased power $ 6.0 $ 3.3 $ 10.8 $ 8.4
Power exchanges, net (1.1) (.9) (.4) -
Affiliated transactions:
AGC capacity charges 5.8 5.7 18.1 19.0
Other affiliated capacity
charges 10.2 12.4 33.0 38.0
Energy and spinning
reserve charges 17.7 12.4 42.6 37.1
Purchased power and
exchanges, net $38.6 $32.9 $104.1 $102.5
The AES Warrior Run PURPA power station project in the
Company's Maryland jurisdiction is scheduled to commence
generation in 1999. The Company unsuccessfully sought a buyout
or restructuring of the existing contract to reduce the cost of
power purchases ($60 million or more annually) and to prevent the
need for increases in the Company's rates in Maryland because of
the high cost of this energy. On July 30, 1998, a settlement
agreement was filed with the Maryland PSC. The settlement was
approved by the Maryland PSC on October 27, 1998. See page 11
for further information on the agreement.
The increase in other operation expenses for the nine
months ended September 30, 1998 was due primarily to increased
allowances for uncollectible accounts ($1.4 million), expenses
related to competition in Maryland ($1.4 million), and an
increase in salaries and wages.
Maintenance expenses decreased $1.8 million and $5.5
million for the three and nine months ended September 30, 1998,
respectively, because of a management program to postpone such
expenses for the year in response to limited sales growth in the
first quarter due to the warm winter weather. The Company is
postponing these expenses primarily by extending the time between
maintenance outages. Maintenance expenses represent costs
incurred to maintain the power stations, the transmission and
distribution (T&D) system, and general plant, and reflect routine
maintenance of equipment and rights-of-way as well as planned
major repairs and unplanned expenditures, primarily from forced
outages at the power stations and periodic storm damage on the
T&D system. Variations in maintenance expense result primarily
from unplanned events and planned major projects, which vary in
timing and magnitude depending upon the length of time equipment
has been in service without a major overhaul and the amount of
work found necessary when the equipment is dismantled.
- 16 -
The increase in taxes other than income taxes in the
three and nine months ended September 30, 1998 was primarily due
to an increase in gross receipts taxes resulting from greater
revenues from retail customers and increased property taxes
related to an increase in the assessment of property in Maryland.
The increases in federal and state income taxes for the
three and nine months ended September 30, 1998, were primarily
due to increases in income before taxes, exclusive of other
income which is reported net of taxes.
The decreases in allowance for other than borrowed funds
used during construction (AOFDC) of $.5 million and $1.0 million
for the three and nine months ended September 30, 1998,
respectively, resulted primarily from adjustments of prior
periods.
The decreases in other income, net, of $3.8 million and
$5.0 million in the three and nine months ended September 30,
1998, respectively, were primarily due to an interest refund on a
tax-related contract settlement in the three and nine months
ended September 30, 1997, received by the Company's subsidiary,
AGC.
Other interest expense reflects changes in the levels of
short-term debt maintained by the Company throughout the year, as
well as the associated rates.
Financial Condition
The Company's discussion on Financial Condition,
Requirements, and Resources and Significant Continuing Issues in
its Annual Report on Form 10-K for the year ended December 31,
1997 should be read in conjunction with the following
information.
In the normal course of business, the Company is subject
to various contingencies and uncertainties relating to its
operations and construction programs, including legal actions and
regulations and uncertainties related to environmental matters.
See Notes 4, 5, and 6 to the Financial Statements for information
about merger activities, the Maryland activities relating to the
deregulation of electricity generation, and the Pennsylvania
Customer Choice Act's effect on its affiliate, West Penn.
* Year 2000 Readiness Disclosure
As the year 2000 approaches, most organizations,
including the Company, could experience serious problems related
to software and various equipment with embedded chips which may
not properly recognize calendar dates. To minimize such problems,
the Company and its affiliates in the Allegheny Energy System
(the System) are proceeding with a comprehensive effort to
continue operations without significant problems in the Year 2000
(Y2K) and beyond. An Executive Task Force is coordinating the
efforts of 23 separate Y2K Teams, representing all business and
support units in the System.
- 17 -
The System has segmented the Y2K problem into the
following components:
* Computer software
* Embedded chips in various equipment
* Vendors and other organizations on which the System
relies for critical materials and services.
The System's effort for each of these three components
includes assessment of the problem areas, remediation, testing
and contingency plans for critical functions for which
remediation and testing are not possible or which do not provide
reasonable assurance.
The Company has expended significant time and money over
the past several years on upgrading and replacing its large and
complex computer systems and software to achieve greater
efficiency as well as Y2K readiness. As a result, the Company
expects these systems to achieve a state of Y2K readiness on or
about March 31, 1999, subject to continuing review and testing.
Various equipment used by the System includes thousands
of embedded chips. Most are not date sensitive, but identifying
those which are, and which are critical to operations, is a labor
intensive task. Identification, remediation, and testing in many
cases require the assistance of the original equipment
manufacturers. Even they frequently cannot state with certainty
if the chips they used are date sensitive. The System's review
calls for the inventory and assessment of suspect embedded chips
in critical systems to be completed by December 31, 1998, with
remediation initiated as needs are identified, and with 1999 to
complete remediation and testing.
Integrated electric utilities are uniquely reliant on
each other to avoid, in a worst case situation, cascading failure
of the entire electrical system. The System is working with the
Edison Electric Institute (EEI), the Electric Power Research
Institute (EPRI), the North American Electric Reliability Council
(NERC), and the East Central Area Reliability Agreement group
(ECAR) to capitalize on industry-wide experiences and to
participate in industry-wide testing and contingency planning.
The effort with regard to vendors and other organizations is to
obtain reasonable assurance of their readiness to conduct
operations at the Year 2000 and beyond and, where reasonable
assurance is questionable, to develop contingency plans. Of
particular concern are telecommunications systems which are
integral to the System's electricity production and distribution
operations. While the System will develop contingency plans for
critical telecommunication needs, there can be no assurance that
the contingency plans could cope with a significant failure of
major telecommunication systems.
The Company is aware of the importance of electricity to
its service territory and its customers and is using its best
efforts to avoid any serious Y2K problems. Despite the System's
best efforts, including working with internal resources, external
vendors, and industry associations, the Company cannot guarantee
that it will be able to conduct all of its operations without Y2K
interruptions. To the extent that any Y2K problem may be
encountered, the Company is committed to resolution as
expeditiously as possible to minimize the effect.
- 18 -
Expenditures for Y2K readiness are not expected to have a
material effect on the Company's results of operations or
financial position primarily because of the significant time and
money expended over the past several years on upgrading and
replacing its large mainframe computer systems and software.
While the remaining Y2K work is significant, it primarily
represents an internal labor intensive effort of assessment,
remediation, and component testing for non-compliant embedded
chips in equipment, and a substantial labor intensive effort of
multiple systems testing, documentation, and working with other
parties. While outside contractors and equipment vendors will be
employed for some of the work, the Company believes it must rely
on System employees for most of the effort because of their
experience with systems and equipment. The Company currently
estimates that its incremental expenditures for the remaining Y2K
effort will not exceed $4 million.
The descriptions herein of the elements of the Company's
Y2K effort are forward-looking statements as defined in the
Private Securities Litigation Reform Act of 1995. Of necessity,
this effort is based on estimates of assessment, remediation,
testing and contingency planning activities and dates for
perceived problems not yet identified. There can be no assurance
that actual results will not materially differ from expectations.
* Environmental Issues
The Environmental Protection Agency (EPA) issued its
final regional NOx State Implementation Plan (SIP) call rule on
September 24, 1998. EPA's SIP call rule finds that 22 eastern
states (including Maryland, Pennsylvania, and West Virginia) and
the District of Columbia are all contributing significantly to
ozone non-attainment in downwind states. The final rule declares
that this downwind non-attainment will be eliminated (or
sufficiently mitigated) if the upwind states reduce their NOx
emissions by an amount that is precisely set by EPA on a state-by-
state basis. The final SIP call rule requires that all state-
adopted NOx reduction measures must be incorporated into SIPs by
September 24, 1999 and must be implemented by May 1, 2003. The
Company's compliance with these requirements would require the
installation of post-combustion control technologies on most, if
not all, of its power stations at a cost of approximately $105
million. The Company continues to work with other coal-burning
utilities and other affected constituencies in coal-producing
states to challenge this EPA action.
The Company previously reported that the EPA had
identified the Company and its regulated affiliates and
approximately 875 others as potentially responsible parties in a
Superfund site subject to cleanup. A final determination has not
been made for the Company's share of the remediation costs based
on the amount of materials sent to the site. The Company has
also been named as a defendant along with multiple other
affiliated and nonaffiliated defendants in pending asbestos cases
involving one or more plaintiffs. The Company believes that
provisions for liabilities and insurance recoveries are such that
final resolution of these claims will not have a material effect
on its financial position.
- 19 -
* Electric Energy Competition
Allegheny Energy is working actively within its states to
advance customer choice. However, Allegheny Energy believes that
federal legislation is necessary to ensure that electric
restructuring is implemented consistently across state and
regional boundaries so that all electric customers have an equal
opportunity to benefit from competition and customer choice by a
date certain. Federal legislation is also needed to remove
barriers to competition, including the repeal of both the Public
Utility Holding Company Act of 1935 and PURPA. Allegheny Energy
has been working with Congress to advance these goals.
In addition to deregulation activities in Maryland, the
Company serves customers in West Virginia and Virginia which are
exploring the move toward competition and deregulation.
The West Virginia Legislature passed a bill on March 14,
1998 which sets the stage for the restructuring of the electric
utility industry in West Virginia. The bill directed the Public
Service Commission of West Virginia (West Virginia PSC) to
determine if deregulation is in the best interests of the state
and, if so, to develop a transition plan. It also set up a task
force of all interested parties to participate in the plan
development. The West Virginia PSC has been conducting meetings
of the Task Force on Restructuring over the summer to examine if
competition is in the best interest of the state and, if so, to
develop a transition plan. All interested parties have
participated in the process with little apparent progress
concerning a defined plan for restructuring. Due to the workshop
participants' inability to file a consensus position on or before
November 16, 1998, the West Virginia PSC has scheduled additional
meetings in November to discuss how the West Virginia PSC and
workshop participants "should continue to explore electric
industry restructuring." Evidentiary hearings originally
scheduled for September 29, 1998 to address utility unbundling
and stranded cost filings were cancelled.
In early March 1998, the Virginia Senate joined the House
of Delegates in approving a timetable for restructuring the
state's electric utility industry to allow retail competition.
The legislation will give Virginians choice of their electric
power suppliers beginning on January 1, 2004. The details will
be worked out over the coming year by a special Senate-House
subcommittee that has been studying restructuring for two years.
The joint legislative subcommittee studying utility restructuring
has held a series of meetings to examine the issues associated
with restructuring. Two subcommittees have been established to
examine structure and transmission issues and stranded costs.
All interested parties have been invited to participate in the
process. The Virginia State Corporation Commission (Virginia
SCC) ordered two utilities, but not the Company, to develop and
submit their retail pilot programs to the Virginia SCC by
November 1, 1998. The Company has been filing monthly reports on
the status of Independent System Operator (ISO) discussions with
the Virginia SCC.
- 20 -
THE POTOMAC EDISON COMPANY
Part II - Other Information to Form 10-Q
for Quarter Ended September 30, 1998
ITEM 1. LEGAL PROCEEDINGS
On October 5, 1998, Allegheny Energy, Inc. (Allegheny
Energy), filed a lawsuit in the United States District Court for
the Western District of Pennsylvania against DQE, Inc. (DQE) for
specific performance of the Agreement and Plan of Merger among
DQE, Allegheny Power System, Inc., and AYP Sub, Inc., dated as of
April 5, 1997 (the "Merger Agreement"), or for damages.
Allegheny Energy also filed motions for a temporary restraining
order and preliminary injunction against DQE. On October 28,
1998, the court denied Allegheny Energy's motions for a temporary
restraining order and preliminary injunction. On October 30,
1998, Allegheny Energy appealed the order to the Third Circuit
Court of Appeals. Allegheny Energy cannot predict the outcome of
the litigation between it and DQE.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits:
(27) Financial Data Schedule
(b) The Company filed a Form 8-K on October 8, 1998.
Signature
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.
THE POTOMAC EDISON COMPANY
/s/ T. J. KLOC
T. J. Kloc, Controller
(Chief Accounting Officer)
November 16, 1998