Exhibit 99.1
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Risks Relating to Regulation
We are subject to substantial governmental regulation. Compliance with current
and future regulatory requirements and procurement of necessary approvals,
permits and certificates may result in substantial costs to us.
We are subject to substantial regulation from federal, state and
local regulatory agencies. We are required to comply with numerous laws and
regulations and to obtain numerous authorizations, permits, approvals and
certificates from governmental agencies. These agencies regulate various
aspects of our business, including customer rates, service regulations, retail
service territories, sales of securities, asset sales and accounting policies
and practices. We believe the necessary authorizations, permits, approvals and
certificates have been obtained for our existing operations and that our
business is conducted in accordance with applicable laws; however, we are
unable to predict the impact on our operating results from future regulatory
activities of these agencies.
We are also subject to regulation by the SEC under PUHCA, which
imposes a number of restrictions on the operations of registered utility
holding companies and their subsidiaries. These restrictions include a
requirement that, subject to a number of exceptions, the SEC approve in
advance securities issuances, financings, acquisitions and dispositions of
utility assets or of securities of utility companies, and acquisitions of
other businesses. With limited exceptions, PUHCA requires that transactions
between affiliated companies in a registered holding company system be
performed at cost. PUHCA will be repealed effective six months after the
enactment of the Energy Policy Act. Nevertheless, we will continue to be
subject to substantial regulation, including increased authority of FERC. FERC
will exercise certain powers over the electric utility subsidiaries of
formerly registered holding companies like Allegheny that have been preempted
by the SEC's powers under PUHCA. These powers include authority over the
issuance of certain securities and the assumption of certain liabilities.
We are unable to predict the impact of any future revisions or
changes in interpretations of existing regulations or the adoption of new laws
and regulations applicable to us, including the Energy Policy Act. Changes in
regulation or the imposition of additional regulations could influence our
operating environment and may result in substantial costs to us.
Rate regulation may delay or deny full recovery of costs.
The retail rates in the states in which we operate are set by each
state's regulatory body. As a result, in certain states, we may not be able to
recover increased, unexpected or necessary costs and, even if we are able to
do so, there may be a significant delay between the time we incur such costs
and the time we are allowed to recover them. Any denial of, or delay in, cost
recovery could have a material adverse effect on our results of operations and
financial condition.
In Virginia our POLR and T&D rates for all retail customers are
capped through December 31, 2010, subject to certain adjustments. However, our
power supply contract with AE Supply to satisfy our Virginia load expires on
June 30, 2007. We will be required to satisfy our generation requirements
through market purchases after that time. The market rates for purchased power
at that time may be significantly higher than the rates we will be allowed to
recover from retail customers. We are permitted to petition the Virginia SCC
to recover certain increases in the cost of purchased power beginning July 1,
2007. If the Virginia SCC does not allow full recovery of our cost of
purchasing power, it could have a material adverse effect on our financial
condition and results of operations.
Our current power supply contract with AE Supply to satisfy our load
in West Virginia is at below market rates and extends through 2010. Under the
terms of this contract, we have only limited exposure to changes in market
rates. We have agreed to a new contract with AE Supply that would
extend through 2017, subject to various regulatory approvals. However,
Allegheny is currently contemplating an intra-company transfer of assets that
would realign generation ownership and contractual arrangements within the
Allegheny system in order to, among other things, facilitate the construction
and financing of flue gas desulfurization units and related pollution control
equipment at Allegheny's Fort Martin generation facility. As part of this
transaction, our current power sale agreement with AE Supply may be amended
and assigned to Monongahela. Subject to approval from FERC and the West
Virginia PSC, Monongahela would then be responsible for supplying the power to
meet these obligations. The new contract with Monongahela is expected to be at
higher rates than our current contract with AE Supply, and we will be required
to file a rate case with the West Virginia PSC for approval to recover our
resulting increase in costs though increases in the rates that we charge our
customers. The West Virginia PSC may not approve our full request to increase
rates. Even if our request ultimately is approved, the approval process could
result in a significant delay between, on the one hand, the time that our new
contract with Monongahela becomes effective and, on the other hand, the time
at which we are able to charge higher rates. In addition, we cannot assure you
that we will consummate the intra-company asset transfer and related
assignment of our power sales agreement, or, in the alternative, that we will
obtain the approvals necessary to extend our existing agreement with AE Supply
through 2017. In that case, we would be required to purchase power at
prevailing market rates beginning in 2010 to service our load obligations. The
prevailing market rates at that time could be significantly higher than the
rates that the West Virginia PSC permits us to charge, which could have a
material adverse effect on our business, results of operations and financial
condition.
Our rates are also capped for residential customers in Maryland for
specific periods and, therefore, are not subject to rate increases during
those periods. In Maryland, our contract with AE Supply for generation
services contains a limited exposure to changing market rates through the rate
cap period. In addition, as a result of FERC's efforts to implement a
long-term rate design for the Midwest and Mid-Atlantic regions, we may not
fully recover our transmission costs and may have costs shifted to us from
other transmission owners. Due to capped rates and the timing of state rate
cases, we may not be able to pass through these increased transmission costs
to our retail customers for some period of time.
Shifting state and federal regulatory policies impose risks on our operations
and capital structure.
Our operations are subject to evolving regulatory policies, including
initiatives regarding deregulation of the production and sale of electricity
and the restructuring of transmission regulation. State and federal regulators
may also take regulatory action as a result of the power outages that affected
the Northeast and Midwest United States and Canada in August 2003. Any new
requirements arising from these actions could lead to increased operating
expenses and capital expenditures, the amount of which cannot be predicted at
this time. For instance, the Energy Policy Act will make certain electric
reliability rules mandatory on all market participants, including Allegheny
and its subsidiaries, including us. We cannot predict the final terms of these
rules or the potential costs or effects these rules may have on our business,
results of operations and financial condition.
Risks Relating to our Operations
The terms of our power sale agreements with AE Supply could require us to
purchase power at a price that exceeds the price at which we can sell power.
In connection with regulations governing the transition to market
competition, we are required to provide electricity at capped rates to retail
customers who do not choose an alternate electricity generation supplier or
who return to utility service from alternate suppliers. Our capped rates may
be below current wholesale market prices during the transition periods. Our
operations are currently structured so that AE Supply owns the generating
assets that we previously owned. The capped rates reflect the historical costs
of operating and maintaining AE Supply's generating assets. Currently we
purchase a majority of the power required to meet our POLR obligations in
Maryland and Virginia and our West Virginia load obligations from AE Supply
under power sale agreements. Those agreements provide for the supply of a
significant portion of our energy needs at the mandated capped rates with a
specified remaining portion priced on the basis of market prices. The amount
of supply priced at market rates increases over each contract term. These
power supply agreements present risks for us. At times, we may pay for a
portion of our supply at prices that exceed the amount we can charge retail
customers for the power. See "Risks Relating to Regulation" above.
Our operating results are subject to seasonal and weather fluctuations.
Our business is generally seasonal. Demand for electricity in our
service territories peaks during the summer and winter months, and market
prices typically also peak during these times. We historically have sold less
power and, therefore, have produced less revenue when weather conditions are
milder. Unusually mild weather in the future could adversely affect our
business, results of operations and financial condition.
Our revenues, costs and results of operations are subject to risks beyond our
control, including, but not limited to, accidents, storms, natural
catastrophes and terrorism.
Our ability to conduct our operations depends on the integrity of our
assets. The cost of repairing damage to our facilities due to storms, natural
disasters, wars, terrorist acts and other catastrophic events may exceed
reserves or insurance, if any, for such repairs, which may adversely impact
our results of operations and financial condition. Although we have taken, and
will continue to take, reasonable precautions to safeguard our assets, we can
make no assurance that our facilities will not face damage or disruptions or
that we will have sufficient reserves or insurance to cover the cost of
repairs. In addition, in the current geopolitical climate, enhanced concern
regarding the risks of terrorism throughout the economy may impact our
operations in unpredictable ways. Insurance coverage may not cover costs
associated with any of these risks adequately or at all.
Risks Relating to our Internal Controls and Procedures and Operational
Enhancements
Our internal controls and procedures have been substantially deficient, and we
continue to expend significant resources to improve internal controls and
procedures.
In August 2002, Allegheny's independent auditor,
PricewaterhouseCoopers LLP ("PwC"), advised Allegheny that it considered
Allegheny's and its subsidiaries', including Potomac Edison's, internal
controls to have material weaknesses. The term "material weakness" refers to
an organization's internal control deficiency in which the design or operation
of a component of internal control does not reduce to a relatively low level
the risk that a material misstatement may be contained in the organization's
financial statements. In March 2004, PwC advised Allegheny's Audit Committee
that although management had made significant progress in addressing the
specific control weaknesses previously identified, not all of these
deficiencies had been remedied and certain internal control weaknesses
remained. In September 2004, PwC advised Allegheny's Audit Committee that
certain material weaknesses remained and required remediation. As of December
31, 2004, these material weaknesses had been remediated, although some
deficiencies remained. Allegheny intends to expend additional resources to
further improve its internal controls.
We may fail to realize the benefits that we expect from our cost-savings
initiatives.
We have undertaken and expect to continue to undertake cost-savings
initiatives. However, we can make no assurances that we will realize on-going
cost savings or any other benefits from these initiatives. Even if we realize
the benefits of our cost savings initiatives, any cash savings that we achieve
may be offset by other costs, such as environmental compliance costs and
higher fuel, operating and maintenance costs, or could be passed on to
customers through revised rates. Staff reductions may reduce our workforce
below the level needed to effectively manage our business and service our
customers. Our failure to realize the anticipated benefits of our cost-savings
and other initiatives could have a material adverse effect on our business,
results of operations and financial condition.
Other Risks Relating to Potomac Edison
We may be required to make significant contributions to satisfy underfunded
pension liabilities and other postretirement benefits.
All of our workforce is employed by AESC. Through AESC, we are
responsible for our share of pension and retirement benefit costs. Allegheny's
underfunded pension liabilities have increased in recent periods due to
declining interest rates and financial market performance and because of the
implementation of early retirement initiatives to reduce headcount. During the
six months ended June 30, 2005, Allegheny made voluntary contributions to
pension plans of $28.4 million, including $0.2 million to the Supplemental
Executive Retirement Plan (the "SERP"). Minimum required funding contributions
may increase beyond 2005. However, these anticipated mandatory contributions
will change in the future if Allegheny's assumptions regarding prevailing
interest rates change, if actual investments under-perform or out-perform
expectations, or if actuarial assumptions or asset valuation methods change.
Our share of the Allegheny pension funding for the six months ended June 30,
2005 is approximately 14.25%, or $4.0 million.
For the six months ended June 30, 2005, Allegheny also contributed
$11.6 million to its postretirement benefits other than pension plans of which
our share is approximately 14%, or $1.6 million.
We are currently involved in significant litigation that, if not decided
favorably to us, could materially adversely affect our results of operations,
cash flows and financial condition.
We and other subsidiaries of Allegheny have been named as defendants
in pending asbestos litigation involving multiple plaintiffs and multiple
defendants. As of July 9, 2005, 831 asbestos cases were pending against
Allegheny. In addition, asbestos and other regulated substances are, and may
continue to be, present at Allegheny-owned facilities where suitable
alternative materials are not available. Allegheny's management believes that
any remaining asbestos at Allegheny-owned facilities is contained. The
continued presence of asbestos and other regulated substances at
Allegheny-owned facilities, however, could result in additional actions being
brought against Allegheny and its subsidiaries, including us.
We are currently involved in a number of other lawsuits. We intend to
vigorously defend against these claims, but the results of these lawsuits
cannot be predicted. Adverse outcomes for us in these lawsuits could require
us to make significant expenditures and could have a material adverse effect
on our business, results of operations and financial condition.
Energy companies are subject to adverse publicity, which may make us
vulnerable to negative regulatory and litigation outcomes.
The energy sector has been the subject of highly-publicized
allegations of misconduct. Negative publicity of this nature may render
legislatures, regulatory authorities and tribunals less likely to view energy
companies favorably, which could cause them to make decisions or take actions
that are adverse to us. Power outages, such as those that affected the
Northeast and Midwest United States and Canada in August 2003, could
exacerbate negative sentiment regarding the energy industry.
We are dependent on our ability to successfully access capital markets. An
inability to access capital may adversely affect our business.
We rely on access to the capital markets as a source of liquidity and
to satisfy our capital requirements that are not met by the cash flow from our
operations. Capital market disruptions, or a downgrade in our credit ratings,
could increase the cost of borrowing or could adversely affect our ability to
access one or more financial markets. Disruptions to the capital markets could
include, but are not limited to:
o recession or an economic slowdown;
o the bankruptcy of one or more energy companies or highly-
leveraged companies;
o significant increases in the prices for oil or other fuel;
o a terrorist attack or threatened attacks;
o a significant transmission failure; or
o changes in technology.
The past financial and other difficulties of our parent company, Allegheny,
could adversely affect our credit ratings and our ability to access the
capital markets.
Our parent company, Allegheny, experienced significant challenges to
its business beginning in the late 1990s. Allegheny's liquidity was severely
strained and its results of operations were negatively impacted as a result of
deregulation initiatives, the deterioration of the energy trading market, the
identification of material weaknesses in its internal controls and a
downgrading of its credit ratings below investment grade, which resulted in
covenant violations in material energy trading contracts and credit facilities
and restricted access to the capital markets. In response to these challenges,
Allegheny hired new senior management for itself and its subsidiaries,
including us, and took a number of actions to stabilize its liquidity. As the
sole holder of our common stock, Allegheny is currently our only source of
equity capital. In addition, we engage in transactions with Allegheny's other
subsidiaries, including AE Supply, in the ordinary course of business. All
personnel of Allegheny, including those responsible for conducting our
business, are employed by AESC. We paid costs for services provided by AESC
that totaled $100.8 million in 2004. While we believe we currently have
sufficient sources of liquidity to operate our business and fulfill our
current obligations and that Allegheny has made significant progress in
improving its liquidity, any inability of Allegheny to complete its strategy
for liquidity improvement and financial stabilization could have an adverse
effect on our credit ratings or our ability to access the capital markets. The
dividends we pay are a significant contribution to Allegheny's cash resources
and support the ability of Allegheny to service its debt.
Changes in technology may adversely affect our business by decreasing the
demand for our services.
Research and development activities are ongoing to improve
alternative technologies to produce electricity, including fuel cells,
microturbines and photovoltaic (solar) cells. Increased conservation efforts
and advances in technology could reduce demand for electricity supply and
distribution, which could adversely affect our business. Changes in technology
could also alter the channels through which retail electric customers buy
power, which could adversely affect our business.