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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

March 31, 2012 For the quarter ended March 31, 2012

 

 

 

Commission File Number

  

Exact Name of Registrant as specified in its Charter, State or Other Jurisdiction of Incorporation,

Address of Principal Executive Offices, Zip Code

and Telephone Number (Including Area Code)

  

I.R.S. Employer
Identification
Number

001-31403   

PEPCO HOLDINGS, INC.

(Pepco Holdings or PHI), a Delaware corporation

701 Ninth Street, N.W.

Washington, D.C. 20068

Telephone: (202)872-2000

   52-2297449
001-01072   

POTOMAC ELECTRIC POWER COMPANY

(Pepco), a District of Columbia and Virginia corporation

701 Ninth Street, N.W.

Washington, D.C. 20068

Telephone: (202)872-2000

   53-0127880
001-01405   

DELMARVA POWER & LIGHT COMPANY

(DPL), a Delaware and Virginia corporation

500 North Wakefield Drive

Newark, DE 19702

Telephone: (202)872-2000

   51-0084283
001-03559   

ATLANTIC CITY ELECTRIC COMPANY

(ACE), a New Jersey corporation

500 North Wakefield Drive

Newark, DE 19702

Telephone: (202)872-2000

   21-0398280

 

 

Indicate by check mark whether each 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.

 

Pepco Holdings

   Yes  x   No  ¨   Pepco    Yes  x   No  ¨

DPL

   Yes  x   No  ¨   ACE    Yes  x   No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).


Table of Contents

Pepco Holdings

   Yes  x   No  ¨   Pepco    Yes  x   No  ¨

DPL

   Yes  x   No  ¨   ACE    Yes  x   No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

     Large
Accelerated

Filer
   Accelerated
Filer
   Non-
Accelerated
Filer
   Smaller
Reporting
Company

Pepco Holdings

   x    ¨    ¨    ¨

Pepco

   ¨    ¨    x    ¨

DPL

   ¨    ¨    x    ¨

ACE

   ¨    ¨    x    ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

 

Pepco Holdings

   Yes  ¨   No  x   Pepco    Yes  ¨   No  x

DPL

   Yes  ¨   No  x   ACE    Yes  ¨   No  x

Pepco, DPL, and ACE meet the conditions set forth in General Instruction H(1)(a) and (b) of Form 10-Q and are therefore filing this Form 10-Q with reduced disclosure format specified in General Instruction H(2) of Form 10-Q.

 

Registrant   

Number of Shares of Common Stock of
the Registrant Outstanding at April  25, 2012

Pepco Holdings

   228,280,444 ($.01 par value)

Pepco

   100 ($.01 par value) (a)

DPL

   1,000 ($2.25 par value) (b)

ACE

   8,546,017 ($3.00 par value) (b)

 

(a) All voting and non-voting common equity is owned by Pepco Holdings.
(b) All voting and non-voting common equity is owned by Conectiv, LLC, a wholly owned subsidiary of Pepco Holdings.

 

 

THIS COMBINED FORM 10-Q IS SEPARATELY FILED BY PEPCO HOLDINGS, PEPCO, DPL, AND ACE. INFORMATION CONTAINED HEREIN RELATING TO ANY INDIVIDUAL REGISTRANT IS FILED BY SUCH REGISTRANT ON ITS OWN BEHALF. EACH REGISTRANT MAKES NO REPRESENTATION AS TO INFORMATION RELATING TO THE OTHER REGISTRANTS.

 

 

 


Table of Contents

TABLE OF CONTENTS

 

          Page  
   Glossary of Terms      i  
   Forward-Looking Statements      1  
PART I    FINANCIAL INFORMATION      3  
    Item 1.        - Financial Statements      3  
    Item 2.        - Management’s Discussion and Analysis of Financial Condition and Results of Operations      104  
    Item 3.        - Quantitative and Qualitative Disclosures About Market Risk      149  
    Item 4.        - Controls and Procedures      151  
PART II    OTHER INFORMATION      151  
    Item 1.        - Legal Proceedings      151  
    Item 1A        - Risk Factors      152  
    Item 2.        - Unregistered Sales of Equity Securities and Use of Proceeds      153  
    Item 3.        - Defaults Upon Senior Securities      153  
    Item 4.        - Mine Safety Disclosures      153  
    Item 5.        - Other Information      153  
    Item 6.        - Exhibits      154  
    Signatures      157  


Table of Contents

GLOSSARY OF TERMS

 

Term

  

Definition

2011 Form 10-K    The Annual Report on Form 10-K for the year ended December 31, 2011, as amended, for each Reporting Company, as applicable
ACE    Atlantic City Electric Company
ACE Funding    Atlantic City Electric Transition Funding LLC
AMI    Advanced metering infrastructure
AOCL    Accumulated Other Comprehensive Loss
ASC    Accounting Standards Codification
BGS    Basic Generation Service (the supply of electricity by ACE to retail customers in New Jersey who have not elected to purchase electricity from a competitive supplier)
Bondable Transition Property    The principal and interest payments on the Transition Bonds and related taxes, expenses and fees
BSA    Bill Stabilization Adjustment
Calpine    Calpine Corporation
CERCLA    Comprehensive Environmental Response, Compensation, and Liability Act of 1980
Conectiv    Conectiv, LLC, a wholly owned subsidiary of PHI and the parent of DPL and ACE
CSA    Credit Support Annex
DCPSC    District of Columbia Public Service Commission
DDOE    District of Columbia Department of the Environment
DEDA    Delaware Economic Development Authority
Default Electricity Supply    The supply of electricity by PHI’s electric utility subsidiaries at regulated rates to retail customers who do not elect to purchase electricity from a competitive supplier, and which, depending on the jurisdiction, is also known as Standard Offer Service or BGS
Default Electricity Supply Revenue    Revenue primarily from Default Electricity Supply
DOE    U.S. Department of Energy
DPL    Delmarva Power & Light Company
DPSC    Delaware Public Service Commission
EDCs    Electric distribution companies
EmPower Maryland    A Maryland demand-side management program for Pepco and DPL
Energy Services   

Energy savings performance contracting services provided principally to federal, state

and local government customers, and designing, constructing and operating combined

heat and power, and central energy plants by Pepco Energy Services

EPA    U.S Environmental Protection Agency
EPS    Earnings per share
Exchange Act    Securities Exchange Act of 1934, as amended
FASB    Financial Accounting Standards Board
FERC    Federal Energy Regulatory Commission
GAAP    Accounting principles generally accepted in the United States of America
GCR    Gas Cost Rate
GWh    Gigawatt hour
IIP    ACE’s Infrastructure Investment Program
IRS    Internal Revenue Service
ISDA    International Swaps and Derivatives Association
ISRA    New Jersey’s Industrial Site Recovery Act
MAPP    Mid-Atlantic Power Pathway
Market Transition Charge Tax    Revenue ACE receives and pays to ACE Funding to recover income taxes associated with Transition Bond Charge revenue
MDC    MDC Industries, Inc.
MFVRD    Modified fixed variable rate design
Mirant    Mirant Corporation
MMBtu    One Million British Thermal Units
MPSC    Maryland Public Service Commission

 

i


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Term

  

Definition

MWh    Megawatt hour
NJBPU    New Jersey Board of Public Utilities
NPL    National Priorities List, which, among other things, serves as a guide to EPA in determining which sites warrant further investigation to assess the nature and extent of the human health and environmental risks associated with a site
NUGs    Non-utility generators
NYMEX    New York Mercantile Exchange
PCI    Potomac Capital Investment Corporation and its subsidiaries
Pepco    Potomac Electric Power Company
Pepco Energy Services    Pepco Energy Services, Inc. and its subsidiaries
Pepco Holdings or PHI    Pepco Holdings, Inc.
PHI Retirement Plan    PHI’s noncontributory retirement plan
PJM    PJM Interconnection, LLC
PJM RTO    PJM regional transmission organization
Power Delivery    PHI’s Power Delivery Business
PPA    Power purchase agreement
PRP    Potentially responsible party
PUHCA 2005    Public Utility Holding Company Act of 2005
RECs    Renewable energy credits
Regulated T&D Electric Revenue    Revenue from the transmission and the distribution of electricity to PHI’s customers within its service territories at regulated rates
Reporting Company    PHI, Pepco, DPL or ACE
RI/FS    Remedial investigation and feasibility study
RIM    Reliability investment recovery mechanism
ROE    Return on equity
RPS    Renewable Energy Portfolio Standards
SEC    Securities and Exchange Commission
SOCAs    Standard Offer Capacity Agreements required to be entered into by ACE pursuant to a New Jersey law enacted to promote the construction of qualified electric generation facilities in New Jersey
SOS   

Standard Offer Service, how Default Electricity Supply is referred to in Delaware,

the District of Columbia and Maryland

SRECs    Solar renewable energy credits
SPCC    Spill Prevention, Control, and Countermeasure plans, required pursuant to federal regulations requiring plans for facilities using oil-containing equipment in proximity to surface waters
Transition Bond Charge    Revenue ACE receives, and pays to ACE Funding, to fund the principal and interest payments on Transition Bonds and related taxes, expenses and fees
Transition Bonds    Transition Bonds issued by ACE Funding
VADEQ    Virginia Department of Environmental Quality
VaR    Value at Risk

 

ii


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FORWARD-LOOKING STATEMENTS

Some of the statements contained in this Quarterly Report on Form 10-Q with respect to Pepco Holdings, Inc. (PHI or Pepco Holdings), Potomac Electric Power Company (Pepco), Delmarva Power & Light Company (DPL) and Atlantic City Electric Company (ACE), including each of their respective subsidiaries, are forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended (the Exchange Act), and Section 27A of the Securities Act of 1933, as amended, and are subject to the safe harbor created thereby and by the Private Securities Litigation Reform Act of 1995. These statements include declarations regarding the intents, beliefs, estimates and current expectations of one or more of PHI, Pepco, DPL of ACE (each a Reporting Company) or their subsidiaries. In some cases, you can identify forward-looking statements by terminology such as “may,” “might,” “will,” “should,” “could,” “expects,” “intends,” “assumes,” “seeks to,” “plans,” “anticipates,” “believes,” “projects,” “estimates,” “predicts,” “potential,” “future,” “goal,” “objective,” or “continue” or the negative of such terms or other variations thereof or comparable terminology, or by discussions of strategy that involve risks and uncertainties. Forward-looking statements involve estimates, assumptions, known and unknown risks, uncertainties and other factors that may cause one or more Reporting Company’s or their subsidiaries’ actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forward-looking statements. Therefore, forward-looking statements are not guarantees or assurances of future performance, and actual results could differ materially from those indicated by the forward-looking statements.

The forward-looking statements contained herein are qualified in their entirety by reference to the following important factors, which are difficult to predict, contain uncertainties, are beyond each Reporting Company’s or their subsidiaries’ control and may cause actual results to differ materially from those contained in forward-looking statements:

 

   

Changes in governmental policies and regulatory actions affecting the energy industry, including allowed rates of return, industry and rate structure, acquisition and disposal of assets and facilities, operation and construction of transmission and distribution facilities and the recovery of purchased power expenses;

 

   

The outcome of pending and future rate cases, including the possible disallowance of costs and expenses;

 

   

The expenditures necessary to comply with regulatory requirements, including regulatory orders, and to implement reliability enhancement, emergency response and customer service improvement programs;

 

   

Possible fines, penalties or other sanctions assessed by regulatory authorities against PHI’s regulated utilities;

 

   

Weather conditions affecting usage and emergency restoration costs;

 

   

Population growth rates and changes in demographic patterns;

 

   

Changes in customer energy demand due to conservation measures and the use of more energy-efficient products;

 

   

General economic conditions, including the impact of an economic downturn or recession on energy usage;

 

   

Changes in and compliance with environmental and safety laws and policies;

 

   

Changes in tax rates or policies;

 

   

Changes in rates of inflation;

 

   

Changes in accounting standards or practices;

 

   

Unanticipated changes in operating expenses and capital expenditures;

 

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Rules and regulations imposed by, and decisions of, federal and/or state regulatory commissions, PJM Interconnection, LLC (PJM), the North American Electric Reliability Corporation (NERC) and other applicable electric reliability organizations;

 

   

Legal and administrative proceedings (whether civil or criminal) and settlements that affect a Reporting Company’s or their subsidiaries’ business and profitability;

 

   

Pace of entry into new markets;

 

   

Interest rate fluctuations and the impact of credit and capital market conditions on the ability to obtain funding on favorable terms; and

 

   

Effects of geopolitical events, including the threat of domestic terrorism or cyber attacks.

These forward-looking statements are also qualified by, and should be read together with, the risk factors included in “Part I, Item 1A. Risk Factors” and other statements in each Reporting Company’s annual report on Form 10-K for the year ended December 31, 2011, as amended to include the executive compensation and other information required by Part III of Form 10-K (which information originally had been omitted as permitted by that form), (2011 Form 10-K), as filed with the Securities and Exchange Commission (SEC), and in this Form 10-Q, and investors should refer to such risk factors and other statements in evaluating the forward-looking statements contained in this Form 10-Q.

Any forward-looking statements speak only as to the date of this Quarterly Report on Form 10-Q for each Reporting Company and none of the Reporting Companies undertakes an obligation to update any forward-looking statements to reflect events or circumstances after the date on which such statements are made or to reflect the occurrence of unanticipated events. New factors emerge from time to time, and it is not possible for a Reporting Company to predict all such factors, nor can the impact of any such factor be assessed on such Reporting Company’s or its subsidiaries’ business (viewed independently or together with the business or businesses of some or all of the other Reporting Companies or their subsidiaries) or the extent to which any factor, or combination of factors, may cause results to differ materially from those contained in any forward-looking statement. The foregoing factors should not be construed as exhaustive.

 

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PART I FINANCIAL INFORMATION

 

Item 1. FINANCIAL STATEMENTS

Listed below is a table that sets forth, for each registrant, the page number where the information is contained herein.

 

     Registrants  

Item

   Pepco
Holdings
     Pepco*      DPL*      ACE  

Consolidated Statements of Income

     4        49        67        88  

Consolidated Statements of Comprehensive Income

     5        N/A        N/A        N/A  

Consolidated Balance Sheets

     6        50        68        89  

Consolidated Statements of Cash Flows

     8        52        70        91  

Consolidated Statement of Equity

     9        53        71        92  

Notes to Consolidated Financial Statements

     10        54        72        93  

 

* Pepco and DPL have no operating subsidiaries and, therefore, their financial statements are not consolidated.

 

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PEPCO HOLDINGS

PEPCO HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

 

     Three Months Ended
March 31,
 
         2012             2011      
     (millions of dollars, except per share data)  

Operating Revenue

    

Power Delivery

   $ 1,055     $ 1,249  

Pepco Energy Services

     228       373  

Other

     9       12  
  

 

 

   

 

 

 

Total Operating Revenue

     1,292       1,634  
  

 

 

   

 

 

 

Operating Expenses

    

Fuel and purchased energy

     684       995  

Other services cost of sales

     45       43  

Other operation and maintenance

     225       234  

Depreciation and amortization

     110       105  

Other taxes

     104       111  

Deferred electric service costs

     (15 )     (3 )
  

 

 

   

 

 

 

Total Operating Expenses

     1,153       1,485  
  

 

 

   

 

 

 

Operating Income

     139       149  
  

 

 

   

 

 

 

Other Income (Expenses)

    

Interest expense

     (65 )     (62 )

Loss from equity investments

     —          (1 )

Other income

     8       10  
  

 

 

   

 

 

 

Total Other Expenses

     (57 )     (53 )
  

 

 

   

 

 

 

Income from Continuing Operations Before Income Tax Expense

     82       96  

Income Tax Expense Related to Continuing Operations

     14       34  
  

 

 

   

 

 

 

Net Income from Continuing Operations

     68       62  

Income from Discontinued Operations, net of Income Taxes

     —          2  
  

 

 

   

 

 

 

Net Income

   $ 68     $ 64  
  

 

 

   

 

 

 

Basic and Diluted Earnings per Share Information

    

Weighted average shares outstanding (millions)

     228       225  
  

 

 

   

 

 

 

Earnings per share of common stock from Continuing Operations

   $ 0.30     $ 0.27  

Earnings per share of common stock from Discontinued Operations

     —          0.01  
  

 

 

   

 

 

 

Basic and diluted earnings per share

   $ 0.30     $ 0.28  
  

 

 

   

 

 

 

 

The accompanying Notes are an integral part of these Consolidated Financial Statements.

 

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PEPCO HOLDINGS

 

PEPCO HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

 

     Three Months Ended
March 31,
 
     2012      2011  
     (millions of dollars)  

Net Income

   $ 68      $ 64  
  

 

 

    

 

 

 

Other Comprehensive Income

     

Gains (losses) on commodity derivatives designated as cash flow hedges:

     

Losses arising during period

     —           (1 )

Amount of losses reclassified into income

     13        27  
  

 

 

    

 

 

 

Net gains on commodity derivatives

     13        26  

Amortization of gains for prior service costs

     1        1  
  

 

 

    

 

 

 

Other comprehensive income, before income taxes

     14        27  

Income tax expense related to other comprehensive income

     6        11  
  

 

 

    

 

 

 

Other comprehensive income, net of income taxes

     8        16  
  

 

 

    

 

 

 

Comprehensive Income

   $ 76      $ 80  
  

 

 

    

 

 

 

The accompanying Notes are an integral part of these Consolidated Financial Statements.

 

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PEPCO HOLDINGS

 

PEPCO HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Unaudited)

 

     March 31,
2012
    December 31,
2011
 
     (millions of dollars)  

ASSETS

    

CURRENT ASSETS

    

Cash and cash equivalents

   $ 64      $ 109   

Restricted cash equivalents

     10       11  

Accounts receivable, less allowance for uncollectible accounts of $43 million and $49 million, respectively

     843       929  

Inventories

     129       132  

Derivative assets

     6       5  

Prepayments of income taxes

     131       74  

Deferred income tax assets, net

     43       59  

Prepaid expenses and other

     122       120  
  

 

 

   

 

 

 

Total Current Assets

     1,348       1,439  
  

 

 

   

 

 

 

INVESTMENTS AND OTHER ASSETS

    

Goodwill

     1,407       1,407  

Regulatory assets

     2,215       2,196  

Investment in finance leases held in trust

     1,362       1,349  

Income taxes receivable

     217       84  

Restricted cash equivalents

     15       15  

Assets and accrued interest related to uncertain tax positions

     60       37  

Other

     165       163  
  

 

 

   

 

 

 

Total Investments and Other Assets

     5,441       5,251  
  

 

 

   

 

 

 

PROPERTY, PLANT AND EQUIPMENT

    

Property, plant and equipment

     13,080       12,855  

Accumulated depreciation

     (4,681 )     (4,635 )
  

 

 

   

 

 

 

Net Property, Plant and Equipment

     8,399       8,220  
  

 

 

   

 

 

 

TOTAL ASSETS

   $ 15,188     $ 14,910  
  

 

 

   

 

 

 

 

The accompanying Notes are an integral part of these Consolidated Financial Statements.

 

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PEPCO HOLDINGS

 

PEPCO HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Unaudited)

 

     March 31,
2012
    December 31,
2011
 
     (millions of dollars, except shares)  

LIABILITIES AND EQUITY

    

CURRENT LIABILITIES

    

Short-term debt

   $ 986     $ 732  

Current portion of long-term debt and project funding

     114       112  

Accounts payable and accrued liabilities

     522       549  

Capital lease obligations due within one year

     8       8  

Taxes accrued

     99       110  

Interest accrued

     79       47  

Liabilities and accrued interest related to uncertain tax positions

     3       3  

Derivative liabilities

     25       26  

Other

     259       274  
  

 

 

   

 

 

 

Total Current Liabilities

     2,095       1,861  
  

 

 

   

 

 

 

DEFERRED CREDITS

    

Regulatory liabilities

     526       526  

Deferred income taxes, net

     3,119       2,863  

Investment tax credits

     22       22  

Pension benefit obligation

     232       424  

Other postretirement benefit obligations

     467       469  

Liabilities and accrued interest related to uncertain tax positions

     10       32  

Derivative liabilities

     2       6  

Other

     179       191  
  

 

 

   

 

 

 

Total Deferred Credits

     4,557       4,533  
  

 

 

   

 

 

 

LONG-TERM LIABILITIES

    

Long-term debt

     3,794       3,794  

Transition bonds issued by ACE Funding

     285       295  

Long-term project funding

     13       13  

Capital lease obligations

     78       78  
  

 

 

   

 

 

 

Total Long-Term Liabilities

     4,170       4,180  
  

 

 

   

 

 

 

COMMITMENTS AND CONTINGENCIES (NOTE 15)

    

EQUITY

    

Common stock, $.01 par value, 400,000,000 shares authorized, 228,244,115 and 227,500,190 shares outstanding, respectively

     2       2  

Premium on stock and other capital contributions

     3,340       3,325  

Accumulated other comprehensive loss

     (55 )     (63 )

Retained earnings

     1,079       1,072  
  

 

 

   

 

 

 

Total Equity

     4,366       4,336  
  

 

 

   

 

 

 

TOTAL LIABILITIES AND EQUITY

   $ 15,188      $ 14,910   
  

 

 

   

 

 

 

The accompanying Notes are an integral part of these Consolidated Financial Statements.

 

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PEPCO HOLDINGS

 

PEPCO HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

     Three Months Ended
March  31,
 
     2012     2011  
     (millions of dollars)  

OPERATING ACTIVITIES

    

Net income

   $ 68     $ 64  

Income from discontinued operations

     —          (2 )

Adjustments to reconcile net income to net cash from operating activities:

    

Depreciation and amortization

     110       105  

Non-cash rents from cross-border energy lease investments

     (13 )     (14 )

Deferred income taxes

     259       90  

Other

     (4 )     (4 )

Changes in:

    

Accounts receivable

     78       87  

Inventories

     3       10  

Prepaid expenses

     —          10  

Regulatory assets and liabilities, net

     (37 )     11  

Accounts payable and accrued liabilities

     (60 )     (126 )

Pension contributions

     (200 )     (110 )

Pension benefit obligation, excluding contributions

     15       16  

Cash collateral related to derivative activities

     20       31  

Taxes accrued

     (247 )     (49 )

Interest accrued

     33       31  

Other assets and liabilities

     (2 )     16  

Conectiv Energy net assets held for sale

     —          31  
  

 

 

   

 

 

 

Net Cash From Operating Activities

     23       197  
  

 

 

   

 

 

 

INVESTING ACTIVITIES

    

Investment in property, plant and equipment

     (291 )     (171 )

Department of Energy capital reimbursement awards received

     7       9  

Changes in restricted cash equivalents

     1       (2 )

Net other investing activities

     2       —     
  

 

 

   

 

 

 

Net Cash Used By Investing Activities

     (281 )     (164 )
  

 

 

   

 

 

 

FINANCING ACTIVITIES

    

Dividends paid on common stock

     (61 )     (61 )

Common stock issued for the Dividend Reinvestment Plan and employee-related compensation

     17       14  

Redemption of preferred stock of subsidiaries

     —          (6 )

Reacquisitions of long-term debt

     (9 )     (9 )

Issuances of short-term debt, net

     253       33  

Cost of issuances

     (3 )     —     

Net other financing activities

     16       (7 )
  

 

 

   

 

 

 

Net Cash From (Used By) Financing Activities

     213       (36 )
  

 

 

   

 

 

 

Net Decrease in Cash and Cash Equivalents

     (45 )     (3 )

Cash and Cash Equivalents at Beginning of Period

     109       21  
  

 

 

   

 

 

 

CASH AND CASH EQUIVALENTS AT END OF PERIOD

   $ 64     $ 18  
  

 

 

   

 

 

 

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION

    

Cash paid for income taxes, net

   $ —        $ 2  

The accompanying Notes are an integral part of these Consolidated Financial Statements.

 

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PEPCO HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF EQUITY

(Unaudited)

 

      Common Stock      Premium
on Stock
    Accumulated
Other
Comprehensive
(Loss) Income
    Retained
Earnings
    Total  
(millions of dollars, except shares)    Shares      Par Value           

BALANCE, DECEMBER 31, 2011

     227,500,190      $ 2      $ 3,325     $ (63 )   $ 1,072     $ 4,336  

Net income

     —           —           —          —          68       68  

Other comprehensive income

     —           —           —          8       —          8  

Dividends on common stock ($0.27 per share)

     —           —           —          —          (61 )     (61 )

Issuance of common stock:

              

Original issue shares, net

     319,037        —           9       —          —          9  

Shareholder DRP original shares

     424,888        —           8       —          —          8  

Net activity related to stock-based awards

     —           —           (2 )     —          —          (2 )
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

BALANCE, MARCH 31, 2012

     228,244,115      $ 2       $ 3,340     $ (55 )   $ 1,079     $ 4,366  
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

The accompanying Notes are an integral part of these Consolidated Financial Statements.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

PEPCO HOLDINGS, INC.

(1) ORGANIZATION

Pepco Holdings, Inc. (PHI or Pepco Holdings), a Delaware corporation incorporated in 2001, is a holding company that, through the following regulated public utility subsidiaries, is engaged primarily in the transmission, distribution and default supply of electricity and, to the lesser extent, the distribution and supply of natural gas (Power Delivery):

 

   

Potomac Electric Power Company (Pepco), which was incorporated in Washington, D.C. in 1896 and became a domestic Virginia corporation in 1949,

 

   

Delmarva Power & Light Company (DPL), which was incorporated in Delaware in 1909 and became a domestic Virginia corporation in 1979, and

 

   

Atlantic City Electric Company (ACE), which was incorporated in New Jersey in 1924.

Each of PHI, Pepco, DPL and ACE is also a Reporting Company under the Securities Exchange Act of 1934, as amended. Together, Pepco, DPL and ACE constitute the Power Delivery segment, for financial reporting purposes.

Through Pepco Energy Services, Inc. and its subsidiaries (collectively, Pepco Energy Services), PHI provides energy savings performance contracting services, primarily to commercial, industrial and government customers. Pepco Energy Services is in the process of winding down its competitive electricity and natural gas retail supply business. Pepco Energy Services constitutes a separate segment for financial reporting purposes.

PHI Service Company, a subsidiary service company of PHI, provides a variety of support services, including legal, accounting, treasury, tax, purchasing and information technology services to PHI and its operating subsidiaries. These services are provided pursuant to a service agreement among PHI, PHI Service Company and the participating operating subsidiaries. The expenses of PHI Service Company are charged to PHI and the participating operating subsidiaries in accordance with cost allocation methodologies set forth in the service agreement.

Power Delivery

Each of Pepco, DPL and ACE is a regulated public utility in the jurisdictions that comprise its service territory. Each utility owns and operates a network of wires, substations and other equipment that is classified as transmission facilities, distribution facilities or common facilities (which are used for both transmission and distribution). Transmission facilities are high-voltage systems that carry wholesale electricity into, or across, the utility’s service territory. Distribution facilities are low-voltage systems that carry electricity to end-use customers in the utility’s service territory.

Each utility is responsible for the distribution of electricity, and in the case of DPL, natural gas, in its service territory for which it is paid tariff rates established by the applicable local public service commissions. Each utility also supplies electricity at regulated rates to retail customers in its service territory who do not elect to purchase electricity from a competitive energy supplier. The regulatory term for this supply service is Standard Offer Service in Delaware, the District of Columbia and Maryland, and Basic Generation Service in New Jersey. In these Notes to the consolidated financial statements, these supply service obligations are referred to generally as Default Electricity Supply.

 

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Pepco Energy Services

Pepco Energy Services is engaged in the following businesses:

 

   

providing energy efficiency services principally to federal, state and local government customers, and designing, constructing and operating combined heat and power and central energy plants,

 

   

providing high voltage electric construction and maintenance services to customers throughout the United States and low voltage electric construction and maintenance services and streetlight construction and asset management services to utilities, municipalities and other customers in the Washington, D.C. metropolitan area, and

 

   

providing retail customers electricity and natural gas under its remaining contractual obligations.

Pepco Energy Services also owns and operates two oil-fired generation facilities that are scheduled for deactivation in May 2012.

In December 2009, PHI announced the wind-down of the retail energy supply component of the Pepco Energy Services business. Pepco Energy Services is implementing this wind-down by not entering into any new supply contracts while continuing to perform under its existing supply contracts through their respective expiration dates, the last of which is June 1, 2014. The retail energy supply business has historically generated a substantial portion of the operating revenues and net income of the Pepco Energy Services segment. Operating revenues related to the retail energy supply business for the three months ended March 31, 2012 and 2011 were $160 million and $305 million, respectively, while operating income for the same periods was $15 million and $12 million, respectively.

In connection with the operation of the retail energy supply business, Pepco Energy Services provided letters of credit of $1 million and posted cash collateral of $92 million as of March 31, 2012. These collateral requirements, which are based on existing wholesale energy purchase and sale contracts and current market prices, will decrease as the contracts expire, with the collateral expected to be fully released by June 1, 2014. The energy services business will not be affected by the wind-down of the retail energy supply business.

Other Business Operations

Through its subsidiary Potomac Capital Investment Corporation (PCI), PHI maintains a portfolio of cross-border energy lease investments. This activity constitutes a third operating segment for financial reporting purposes, which is designated as “Other Non-Regulated.” For a discussion of PHI’s cross-border energy lease investments, see Note (8), “Leasing Activities,” and Note (15), “Commitments and Contingencies – PHI’s Cross-Border Energy Lease Investments.”

Discontinued Operations

In April 2010, the Board of Directors approved a plan for the disposition of PHI’s competitive wholesale power generation, marketing and supply business, which had been conducted through subsidiaries of Conectiv Energy Holding Company (collectively Conectiv Energy). On July 1, 2010, PHI completed the sale of Conectiv Energy’s wholesale power generation business to Calpine Corporation (Calpine) for $1.64 billion. The disposition of all of Conectiv Energy’s remaining assets and businesses, consisting of its load service supply contracts, energy hedging portfolio, certain tolling agreements and other assets not included in the Calpine sale, is complete. The former operations of Conectiv Energy have been accounted for as a discontinued operation and no longer constitute a separate segment for financial reporting purposes.

 

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(2) SIGNIFICANT ACCOUNTING POLICIES

Financial Statement Presentation

Pepco Holdings’ unaudited consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States of America (GAAP). Pursuant to the rules and regulations of the Securities and Exchange Commission, certain information and footnote disclosures normally included in annual consolidated financial statements prepared in accordance with GAAP have been omitted. Therefore, these consolidated financial statements should be read along with the annual consolidated financial statements included in PHI’s annual report on Form 10-K for the year ended December 31, 2011, as amended to include the executive compensation and other information required by Part III of Form 10-K (which information originally had been omitted as permitted by that form). In the opinion of PHI’s management, the consolidated financial statements contain all adjustments (which all are of a normal recurring nature) necessary to state fairly Pepco Holdings’ financial condition as of March 31, 2012, in accordance with GAAP. The year-end December 31, 2011 consolidated balance sheet was derived from audited consolidated financial statements, but does not include all disclosures required by GAAP. Interim results for the three months ended March 31, 2012 may not be indicative of PHI’s results that will be realized for the full year ending December 31, 2012.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make certain estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities in the consolidated financial statements and accompanying notes. Although Pepco Holdings believes that its estimates and assumptions are reasonable, they are based upon information available to management at the time the estimates are made. Actual results may differ significantly from these estimates.

Significant matters that involve the use of estimates include the assessment of goodwill and long-lived assets for impairment, fair value calculations for derivative instruments, the costs of providing pension and other postretirement benefits, evaluation of the probability of recovery of regulatory assets, accrual of storm restoration costs, accrual of self-insurance reserves for general and auto liability claims, accrual of interest related to income taxes, accrual of unbilled revenue, recognition of changes in network service transmission rates for prior service year costs, and the recognition of income tax benefits for investments in finance leases held in trust associated with PHI’s portfolio of cross-border energy lease investments. Additionally, PHI is subject to legal, regulatory and other proceedings and claims that arise in the ordinary course of its business. PHI records an estimated liability for these proceedings and claims, when it is probable that a loss has been incurred and the loss is reasonably estimable.

Consolidation of Variable Interest Entities

PHI assesses its contractual arrangements with variable interest entities to determine whether it is the primary beneficiary and thereby has to consolidate the entities in accordance with Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 810. The guidance addresses conditions under which an entity should be consolidated based upon variable interests rather than voting interests. Subsidiaries of PHI have the following contractual arrangements to which the guidance applies.

ACE Power Purchase Agreements

PHI, through its ACE subsidiary, is a party to three power purchase agreements (PPAs) with unaffiliated, non-utility generators (NUGs) totaling 459 megawatts. One of the agreements ends in 2016 and the other two end in 2024. PHI was unable to obtain sufficient information to determine whether these three entities were variable interest entities or if ACE was the primary beneficiary. As a result, PHI applied the scope exemption from the consolidation guidance for enterprises that have not been able to obtain such information.

 

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Net purchase activities with the NUGs for the three months ended March 31, 2012 and 2011 were approximately $51 million and $57 million, respectively, of which approximately $50 million and $53 million, respectively, consisted of power purchases under the PPAs. The power purchase costs are recoverable from ACE’s customers through regulated rates.

DPL Renewable Energy Transactions

DPL is subject to Renewable Energy Portfolio Standards (RPS) in the state of Delaware that require it to obtain renewable energy credits (RECs) for energy delivered to its customers. DPL’s costs associated with obtaining RECs to fulfill its RPS obligations are recoverable from its customers by law. PHI, through its DPL subsidiary, has entered into three land-based wind PPAs in the aggregate amount of 128 megawatts and one solar PPA with a 10 megawatt facility as of March 31, 2012. All of the facilities associated with these PPAs are operational, and DPL is obligated to purchase energy and RECs in amounts generated and delivered by the wind facilities and solar renewable energy credits (SRECs) from the solar facility at rates that are primarily fixed under these agreements. PHI has concluded that consolidation is not required for any of these agreements under the FASB guidance on the consolidation of variable interest entities.

DPL is obligated to purchase energy and RECs from one of the wind facilities through 2024 in amounts not to exceed 50 megawatts, the second of the wind facilities through 2031 in amounts not to exceed 40 megawatts, and the third facility through 2031 in amounts not to exceed 38 megawatts. DPL’s purchases under the three wind PPAs totaled $9 million and $5 million for the three months ended March 31, 2012 and 2011, respectively. The term of the agreement with the solar facility is 20 years and DPL is obligated to purchase SRECs in an amount up to 70 percent of the energy output at a fixed price. DPL’s purchases under the solar agreement were zero for the three months ended March 31, 2012.

On October 18, 2011, the Delaware Public Service Commission (DPSC) approved a tariff submitted by DPL in accordance with the requirements of the RPS specific to fuel cell facilities totaling 30 megawatts to be constructed by a qualified fuel cell provider. The tariff and the RPS establish that DPL would be an agent to collect payments in advance from its distribution customers and remit them to the qualified fuel cell provider for each megawatt hour of energy produced by the fuel cell facilities over 21 years. DPL would have no liability to the qualified fuel cell provider other than to remit payments collected from its distribution customers pursuant to the tariff. The RPS provides for a reduction in DPL’s REC requirements based upon the actual energy output of the facilities. In June 2012, a 3 megawatt generation facility is expected to be placed into service under the tariff. A 27 megawatt generation facility is expected to be placed into service in 5 megawatt increments beginning in January 2013. PHI has concluded that DPL would account for this arrangement as an agency transaction.

Atlantic City Electric Transition Funding LLC

Atlantic City Electric Transition Funding LLC (ACE Funding) was established in 2001 by ACE solely for the purpose of securitizing authorized portions of ACE’s recoverable stranded costs through the issuance and sale of bonds (Transition Bonds). The proceeds of the sale of each series of Transition Bonds have been transferred to ACE in exchange for the transfer by ACE to ACE Funding of the right to collect non-bypassable transition bond charges (the Transition Bond Charges) from ACE customers pursuant to bondable stranded costs rate orders issued by the New Jersey Board of Public Utilities (NJBPU) in an amount sufficient to fund the principal and interest payments on the Transition Bonds and related taxes, expenses and fees (Bondable Transition Property). ACE collects the Transition Bond Charges from its customers on behalf of ACE Funding and the holders of the Transition Bonds. The assets of ACE Funding, including the Bondable Transition Property, and the Transition Bond Charges collected from ACE’s customers, are not available to creditors of ACE. The holders of the Transition Bonds have recourse only to the assets of ACE Funding. ACE owns 100 percent of the equity of ACE Funding and PHI consolidates ACE Funding in its financial statements as ACE is the primary beneficiary of ACE Funding under the variable interest entity consolidation guidance.

 

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ACE Standard Offer Capacity Agreements

In April 2011, ACE entered into three Standard Offer Capacity Agreements (SOCAs) by order of the NJBPU, each with a different generation company. The SOCAs were established under a New Jersey law enacted to promote the construction of qualified electric generation facilities in New Jersey. The SOCAs are 15-year, financially settled transactions approved by the NJBPU that allow generators to receive payments from, or make payments to, ACE based on the difference between the fixed price in the SOCAs and the price for capacity that clears PJM Interconnection, LLC (PJM). Each of the other electricity distribution companies (EDCs) in New Jersey has entered into SOCAs having the same terms with the same generation companies. The annual share of payments or receipts for ACE and the other EDCs is based upon each company’s annual proportion of the total New Jersey load attributable to all EDCs. The NJBPU has approved full recovery from distribution customers of payments made by ACE and the other EDCs, and distribution customers would be entitled to any payments received by ACE and the other EDCs.

Currently, PHI believes that FASB guidance on derivative accounting and the accounting for regulated operations would apply to ACE’s obligations under the SOCA once the related capacity has cleared a PJM auction. Once cleared, the gain (loss) associated with the fair value of a derivative would be offset by the recognition of a regulatory liability (asset). The next PJM capacity auction is scheduled for May 2012. PHI has concluded that consolidation is not required for the SOCAs under the FASB guidance on the consolidation of variable interest entities.

Goodwill

Goodwill represents the excess of the purchase price of an acquisition over the fair value of the net assets acquired at the acquisition date. Substantially all of Pepco Holdings’ goodwill was generated by Pepco’s acquisition of Conectiv (now Conectiv, LLC (Conectiv)) in 2002 and is allocated entirely to Power Delivery for purposes of impairment testing based on the aggregation of its components because its utilities have similar characteristics. Pepco Holdings tests its goodwill for impairment annually as of November 1 and whenever an event occurs or circumstances change in the interim that would more likely than not reduce the fair value of a reporting unit below the carrying amount of its net assets. Factors that may result in an interim impairment test include, but are not limited to: a change in the identified reporting units; an adverse change in business conditions; a protracted decline in PHI’s stock price causing market capitalization to fall below book value; an adverse regulatory action; or an impairment of long-lived assets in the reporting unit. PHI concluded that an interim impairment test was not required during the three months ended March 31, 2012.

Taxes Assessed by a Governmental Authority on Revenue-Producing Transactions

Taxes included in Pepco Holdings’ gross revenues were $92 million and $96 million for the three months ended March 31, 2012 and 2011, respectively.

Reclassifications and Adjustments

Certain prior period amounts have been reclassified in order to conform to the current period presentation. The following adjustments have been recorded and are not considered material either individually or in the aggregate:

Pepco Energy Services Derivative Accounting Adjustments

During the first quarter of 2011, PHI recorded an adjustment associated with an increase in the value of certain derivatives from October 1, 2010 to December 31, 2010, which had been erroneously recorded in other comprehensive income at December 31, 2010. This adjustment resulted in an increase in revenue and pre-tax earnings of $2 million for the three months ended March 31, 2011.

 

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Income Tax Adjustments

During the first quarter of 2011, Pepco recorded an adjustment to correct certain income tax errors related to prior periods associated with interest on uncertain tax positions. The adjustment resulted in an increase in income tax expense of $1 million for the three months ended March 31, 2011.

(3) NEWLY ADOPTED ACCOUNTING STANDARDS

Fair Value Measurements and Disclosures (ASC 820)

The FASB issued new guidance on fair value measurement and disclosures that was effective beginning with PHI’s March 31, 2012 consolidated financial statements. The new measurement guidance did not have a material impact on PHI’s consolidated financial statements and the new disclosure requirements are in Note (14), “Fair Value Disclosures,” of PHI’s consolidated financial statements.

Comprehensive Income (ASC 220)

The FASB issued new disclosure requirements for reporting comprehensive income that were effective beginning with PHI’s March 31, 2012 consolidated financial statements. PHI did not have to change the presentation of its comprehensive income because it had already reported comprehensive income in two separate but consecutive statements of income and comprehensive income. PHI also has provided the new required disclosures of the income tax effects of items in other comprehensive income or amounts reclassified from other comprehensive income to income on a quarterly basis in Note (16), “Accumulated Other Comprehensive Loss.”

Goodwill (ASC 350)

The FASB issued new guidance that changes the annual and interim assessments of goodwill for impairment. The new guidance modifies the required annual impairment test by giving entities the option to perform a qualitative assessment of whether it is more likely than not that goodwill is impaired before performing a quantitative assessment. The new guidance also amends the events and circumstances that entities should assess to determine whether an interim quantitative impairment test is necessary. As of January 1, 2012, PHI has adopted the new guidance and concluded it did not have a material impact on its consolidated financial statements.

(4) RECENTLY ISSUED ACCOUNTING STANDARDS, NOT YET ADOPTED

Balance Sheet (ASC 210)

In December 2011, the FASB issued new disclosure requirements for financial assets and liabilities, such as derivatives, that are subject to contractual netting arrangements. The new disclosures will include information about the gross exposures of the instruments and the net exposure of the instruments under contractual netting arrangements, how the exposures are presented in the financial statements, and the terms and conditions of the contractual netting arrangements. The new disclosures are effective beginning with PHI’s March 31, 2013 consolidated financial statements. PHI is evaluating the impact of this new guidance on its consolidated financial statements.

 

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(5) SEGMENT INFORMATION

Pepco Holdings’ management has identified its operating segments at March 31, 2012 as Power Delivery, Pepco Energy Services and Other Non-Regulated. In the tables below, the Corporate and Other column is included to reconcile the segment data with consolidated data and includes unallocated Pepco Holdings’ (parent company) capital costs, such as financing costs. Segment financial information for continuing operations for the three months ended March 31, 2012 and 2011 is as follows:

 

     Three Months Ended March 31, 2012  
     (millions of dollars)  
     Power
Delivery
     Pepco
Energy
Services
     Other
Non-
Regulated
     Corporate
and
Other (a)
    PHI
Consolidated
 

Operating Revenue

   $ 1,055      $ 228      $ 13      $ (4 )   $ 1,292  

Operating Expenses (b)

     954        211        1        (13 )     1,153  

Operating Income

     101        17        12        9       139  

Interest Income

     —           —           1        (1 )     —     

Interest Expense

     53        1        3        8       65  

Other Income (Expenses)

     8        —           1        (1 )     8  

Preferred Stock Dividends

     —           —           1        (1 )     —     

Income Tax Expense (Benefit)

     9        6        —           (1 )     14  

Net Income from Continuing Operations

     47        10        10        1       68  

Total Assets

     11,473        544        1,487        1,684       15,188  

Construction Expenditures

   $ 280      $ 5      $ —         $ 6     $ 291   

 

(a) Total Assets in this column includes Pepco Holdings’ goodwill balance of $1.4 billion, all of which is allocated to Power Delivery for purposes of assessing impairment. Total assets also include capital expenditures related to certain hardware and software expenditures which primarily benefit Power Delivery. These expenditures are recorded as incurred in the Corporate and Other segment and are allocated to Power Delivery once the assets are placed in service. Corporate and Other includes intercompany amounts of $(4) million for Operating Revenue, $(6) million for Operating Expenses, $(5) million for Interest Income, $(5) million for Interest Expense and $(1) million for Preferred Stock Dividends.
(b) Includes depreciation and amortization expense of $110 million, consisting of $99 million for Power Delivery, $6 million for Pepco Energy Services, $1 million for Other Non-Regulated and $4 million for Corporate and Other.

 

     Three Months Ended March 31, 2011  
     (millions of dollars)  
     Power
Delivery
     Pepco
Energy
Services
     Other
Non-
Regulated
    Corporate
and
Other (a)
    PHI
Consolidated
 

Operating Revenue

   $ 1,249       $ 373       $ 14      $ (2   $ 1,634   

Operating Expenses (b)

     1,131        357        2       (5 )     1,485  

Operating Income

     118        16        12       3       149  

Interest Income

     —           —           1       (1 )     —     

Interest Expense

     50        1        3       8       62  

Other Income (Expenses)

     8        1        (1 )     1       9  

Preferred Stock Dividends

     —           —           1       (1 )     —     

Income Tax Expense (Benefit)

     29        6        2       (3 )     34  

Net Income (Loss) from Continuing Operations

     47        10        6       (1 )     62  

Total Assets (excluding Assets Held For Sale)

     10,667        613        1,645       1,295       14,220  

Construction Expenditures

   $ 160      $ 1      $ —        $ 10     $ 171  

 

(a) Total Assets in this column includes Pepco Holdings’ goodwill balance of $1.4 billion, all of which is allocated to Power Delivery for purposes of assessing impairment. Total assets also include capital expenditures related to certain hardware and software expenditures which primarily benefit Power Delivery. These expenditures are recorded as incurred in the Corporate and Other segment and are allocated to Power Delivery once the assets are placed in service. Corporate and Other includes intercompany amounts of $(2) million for Operating Revenue, $(2) million for Operating Expenses, $(5) million for Interest Income, $(4) million for Interest Expense and $(1) million for Preferred Stock Dividends.
(b) Includes depreciation and amortization expense of $105 million, consisting of $97 million for Power Delivery, $4 million for Pepco Energy Services and $4 million for Corporate and Other.

 

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(6) GOODWILL

PHI’s goodwill balance of $1.4 billion was unchanged during the three months ended March 31, 2012. Substantially all of PHI’s goodwill balance was generated by Pepco’s acquisition of Conectiv in 2002 and is allocated entirely to the Power Delivery reporting unit based on the aggregation of its regulated public utility company components for purposes of assessing impairment under FASB guidance on goodwill and other intangibles (ASC 350).

PHI’s annual impairment test as of November 1, 2011 indicated that goodwill was not impaired. For the three months ended March 31, 2012, PHI concluded that there were no events requiring it to perform an interim goodwill impairment test. PHI will perform its next annual impairment test as of November 1, 2012.

(7) REGULATORY MATTERS

Rate Proceedings

Over the last several years, PHI’s utility subsidiaries have proposed in each of their respective jurisdictions the adoption of a mechanism to decouple retail distribution revenue from the amount of power delivered to retail customers. To date:

 

   

A bill stabilization adjustment (BSA) has been approved and implemented for Pepco and DPL electric service in Maryland and for Pepco electric service in the District of Columbia. The Maryland Public Service Commission (MPSC) has issued an order requiring modification of the BSA in Maryland so that revenues lost as a result of major storm outages are not collected through the BSA if electric service is not restored to the pre-major storm levels within 24 hours of the start of a major storm (as discussed below).

 

   

A modified fixed variable rate design (MFVRD) has been approved in concept for DPL electric service in Delaware, but the implementation has been deferred by the DPSC pending the development of an implementation plan and a customer education plan. DPL anticipates that the MFVRD will be in place for electric service by early 2013.

 

   

A MFVRD has been approved in concept for DPL natural gas service in Delaware, but implementation likewise has been deferred until development of an implementation plan and a customer education plan. DPL anticipates that the MFVRD will be in place for natural gas service by early 2013.

 

   

In New Jersey, a BSA proposed by ACE as part of a Phase 2 to the base rate proceeding filed in August 2009 was not included in the final settlement approved by the NJBPU on May 16, 2011. Accordingly, there is no BSA proposal currently pending in New Jersey.

Under the BSA, customer distribution rates are subject to adjustment (through a credit or surcharge mechanism), depending on whether actual distribution revenue per customer exceeds or falls short of the revenue-per-customer amount approved by the applicable public service commission. The MFVRD approved in concept in Delaware provides for a fixed customer charge (i.e., not tied to the customer’s volumetric consumption) to recover the utility’s fixed costs, plus a reasonable rate of return. Although different from the BSA, PHI views the MFVRD as an appropriate distribution revenue decoupling mechanism.

In an effort to reduce the shortfall in revenues due to the delay in time or lag between when costs are incurred and when they are reflected in rates (regulatory lag), Pepco and DPL have proposed, in each of their respective jurisdictions, a reliability investment recovery mechanism (RIM) to recover reliability-related capital expenditures incurred between base rate cases. Through the RIM, Pepco or DPL, as applicable, in each year would collect through a surcharge the amount of its reliability-related capital expenditures based on its budget for that year. The budgeted amount would be reconciled with actual capital expenditures on an annual basis and any over-recovery or under-recovery would be reflected in the next year’s surcharge. The work

 

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undertaken pursuant to the RIM would be subject to a prudency review by the applicable state regulatory commission in the next base rate case or at more frequent intervals as determined by such commission. Pepco’s or DPL’s respective operation and maintenance costs and other capital expenditures would remain subject to recovery through the traditional ratemaking process.

Pepco and DPL also have each requested, in each of their respective jurisdictions, public service commission approval of the use of fully forecasted test years in future rate cases. Traditionally, past test years with actual historical costs are used for ratemaking purposes; however, fully forecasted test years would be comprised of forward-looking costs. If approved, such fully forecasted test years would be more reflective of current costs and would mitigate the effects of regulatory lag.

Delaware

Gas Cost Rates

DPL makes an annual Gas Cost Rate (GCR) filing with the DPSC for the purpose of allowing DPL to recover natural gas procurement costs through customer rates. In August 2011, DPL made its 2011 GCR filing. The filing includes the second year of the effect of a two-year amortization of under-recovered gas costs that had been proposed, and approved by the DPSC, in DPL’s 2010 GCR filing (the settlement approved by the DPSC in the 2010 GCR case included the first year of such two-year amortization). The rates proposed in the 2011 GCR, which include the second year of the two-year amortization approved in the 2010 GCR case, would result in a GCR decrease for the typical retail natural gas customer of 5.6% in the level of GCR. On September 20, 2011, the DPSC issued an order allowing DPL to place the new rates into effect on November 1, 2011, subject to refund and pending final DPSC approval. The parties to the 2011 GCR proceeding have executed a settlement agreement that recommends approval of the 2011 GCR as filed. A DPSC decision on the settlement agreement is expected during the third quarter of 2012.

On February 21, 2012, DPL submitted its application for a waiver under its GCR tariff, which requires DPL to request an interim GCR rate increase when the under-recovery exceeds 6.0%. The DPSC granted the waiver on March 6, 2012.

Electric Distribution Base Rates

On December 2, 2011, DPL submitted an application with the DPSC to increase its electric distribution base rates. The filing seeks approval of an annual rate increase of approximately $31.8 million, based on a requested return on equity (ROE) of 10.75%, and requests approval of implementation of the MFVRD. DPL requested that the rates become effective on January 31, 2012. The filing includes a request for DPSC approval of a RIM and the use of fully forecasted test years in future DPL rate cases. On January 10, 2012, the DPSC entered an order suspending the full increase and allowing a temporary rate increase of $2.5 million to go into effect on January 31, 2012, subject to refund and pending final DPSC approval. As permitted by Delaware law, DPL intends to place the remainder of approximately $29.3 million of the requested increase into effect on July 2, 2012, subject to refund and pending final DPSC approval. A decision by the DPSC is expected by the end of 2012.

District of Columbia

On July 8, 2011, Pepco filed an application with the District of Columbia Public Service Commission (DCPSC) to increase its electric distribution base rates by approximately $42 million annually, based on a requested ROE of 10.75%. The filing includes a request for DCPSC approval of a RIM and the use of fully forecasted test years in future Pepco rate cases. A decision by the DCPSC is expected in the third quarter of 2012.

 

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Maryland

DPL Electric Distribution Base Rates

On December 9, 2011, DPL submitted an application with the MPSC to increase its electric distribution base rates. The filing seeks approval of an annual rate increase of approximately $25.2 million, based on a requested ROE of 10.75%. The filing includes a request for MPSC approval of a RIM and the use of fully forecasted test years in future DPL rate cases. A decision by the MPSC is expected in July 2012.

Pepco Electric Distribution Base Rates

On December 16, 2011, Pepco submitted an application with the MPSC to increase its electric distribution base rates. The filing seeks approval of an annual rate increase of approximately $68.4 million, based on a requested ROE of 10.75%. The filing includes a request for MPSC approval of a RIM and the use of fully forecasted test years in future Pepco rate cases. A decision by the MPSC is expected in July 2012.

Major Storm Damage Recovery Proceedings

In February 2011, the MPSC initiated proceedings involving Pepco and DPL, as well as unaffiliated utilities in Maryland, for the purpose of reviewing how the BSA operates to recover revenues lost as a result of major storm outages. On January 25, 2012, the MPSC issued an order modifying the BSA to prevent the Maryland utilities, including Pepco and DPL, from collecting lost utility revenue through the BSA if electric service is not restored to the pre-major storm levels within 24 hours of the start of a major storm (defined by the MPSC as a weather-related event during which more than the lesser of 10% or 100,000 of an electric utility’s customers have a sustained outage for more than 24 hours). The period for which the lost utility revenue may not be collected through the BSA commences 24 hours after the start of the major storm and continues until all major storm-related outages are restored. The MPSC stated that waivers permitting collection of BSA revenues would be granted in rare and extraordinary circumstances where a utility can show that an outage was not due to inadequate emphasis on reliability and restoration efforts were reasonable under the circumstances. A similar provision excluding revenues lost as a result of major storm outages from the calculation of future BSA adjustments is already included in the BSA for Pepco in the District of Columbia as approved by the DCPSC. The financial impact of service interruptions due to a major storm as a result of this MPSC order would generally depend on the scope and duration of the outages.

New Jersey

Electric Distribution Base Rates

On August 5, 2011, ACE filed a petition with the NJBPU to increase its electric distribution rates by the net amount of approximately $58.9 million (increased to approximately $80.2 million on February 24, 2012, to reflect the 2011 test year), based on a requested ROE of 10.75% (the ACE 2011 Base Rate Case). The modified net increase consists of a rate increase proposal of approximately $90.3 million, less a deduction from base rates of approximately $17 million attributable to excess depreciation expenses, plus approximately a $6.3 million increase in sales-and-use taxes and an upward adjustment of approximately $0.6 million in the Regulatory Asset Recovery Charge. A decision in the electric distribution rate case is expected by the end of 2012.

Infrastructure Investment Program

In July 2009, the NJBPU approved certain rate recovery mechanisms in connection with ACE’s Infrastructure Investment Program (the IIP). In exchange for the increase in infrastructure investment, the NJBPU, through

 

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the IIP, allowed recovery of ACE’s infrastructure investment capital expenditures through a special rate outside the normal rate recovery mechanism of a base rate filing. The IIP was designed to stimulate the New Jersey economy and provide incremental employment in ACE’s service territory by increasing the infrastructure expenditures to a level above otherwise normal budgeted levels. In an October 18, 2011 petition (subsequently amended December 16, 2011) with the NJBPU, ACE requested an extension and expansion to the IIP under which ACE proposes to spend approximately $63 million, $94 million and $81 million in calendar years 2012, 2013 and 2014, respectively, on non-revenue reliability-related capital expenditures. As proposed, capital expenditures related to the proposed special rate would be subject to annual reconciliation and approval by the NJBPU. A decision by the NJBPU on ACE’s IIP filing is expected by the end of the third quarter of 2012.

Storm Damage Restoration Costs Recovery

In August 2011, ACE filed a petition with the NJBPU seeking authorization for deferred accounting treatment of uninsured incremental storm damage restoration costs not otherwise recovered through base rates. In that petition, ACE sought deferred accounting treatment for recovery of storm costs of approximately $8 million incurred during Hurricane Irene, which impacted ACE’s service territory in the third quarter of 2011. In an order dated December 15, 2011, the NJBPU directed that this petition be transmitted to the Office of Administrative Law with a request that the matter be consolidated with the ACE 2011 Base Rate Case, discussed above.

Update and Reconciliation of Certain Under-Recovered Balances

In February 2012, ACE filed a petition with the NJBPU seeking to reconcile and update several pass-through charges related to (i) the recovery of above-market costs associated with ACE’s long-term power purchase contracts with the NUGs, (ii) costs related to surcharges that fund several statewide social programs and ACE’s uncollected accounts, and (iii) operating costs associated with ACE’s residential appliance cycling program. The filing proposes to recover the projected deferred under-recovered balance related to the NUGs of $113.8 million as of May 31, 2012 through a four-year amortization schedule. The net impact of adjusting the charges as proposed (including both the annual impact of the proposed four-year amortization of the historical under-recovered balances related to the NUGs and the going-forward cost recovery of all the other components for the period June 1, 2012 through May 31, 2013, and including associated changes in sales-and-use taxes), is an overall annual rate increase of approximately $54.5 million. A decision by the NJBPU on this filing is expected by the end of the second quarter of 2012.

Maryland Public Service Commission New Generation Contract Requirement

On September 29, 2009, the MPSC initiated an investigation into whether the EDCs in Maryland should be required to enter into long-term contracts with entities that construct, acquire or lease, and operate, new electric generation facilities in Maryland.

The MPSC issued an order on April 12, 2012, in which it determined that there is a need for one new power plant in the range of 650 to 700 MW beginning in 2015. The order requires Pepco, DPL and Baltimore Gas and Electric Company to negotiate and enter into a contract with the winning bidder in amounts proportionate to their relative SOS loads. Under the contract, the winning bidder will construct a 661 MW natural gas-fired combined cycle generation plant in Waldorf, Maryland, with a commercial operation date of June 1, 2015. The order acknowledges the EDCs’ concerns about the requirements of the contract and directs them to negotiate with the winning bidder and submit any proposed changes in the contract to the MPSC for approval. The order further specifies that the EDCs entering into the contract will recover the associated costs from their respective SOS customers through surcharges. PHI is evaluating the impact of the order on each of Pepco and DPL, and, at this time, cannot predict (i) the extent of the negative effect that the order and, once finalized, the contract for new generation, may have on PHI’s, Pepco’s and DPL’s balance sheets, as well as their respective credit metrics, as

 

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calculated by independent rating agencies that evaluate and rate PHI, Pepco and DPL and each of their debt issuances, (ii) the effect on Pepco’s and DPL’s ability to recover their associated costs of the contract for new generation if a significant number of SOS customers elect to buy their energy from alternative energy suppliers, and (iii) the effect of the order on the financial condition, results of operations and cash flows of each of PHI, Pepco and DPL. On April 27, 2012, a group of generators operating in the PJM region filed a complaint in the United States District Court for the Northern District of Maryland challenging the MPSC’s order on the grounds that that such order violated the commerce clause and the supremacy clause of the U.S. Constitution. PHI continues to evaluate whether to seek judicial review of the MPSC’s order.

ACE Standard Offer Capacity Agreements

In April 2011, ACE entered into three SOCAs by order of the NJBPU, each with a different generation company, as more fully described in Note (2), “Significant Accounting Policies – Consolidation of Variable Interest Entities – ACE Standard Offer Capacity Agreements.” ACE and the other New Jersey EDCs entered the SOCAs under protest based on concerns about the potential cost to distribution customers. In May 2011, the NJBPU denied a joint motion for reconsideration of its order requiring each of the EDCs to enter into the SOCAs. In June 2011, ACE and the other EDCs filed appeals related to the NJBPU orders with the Appellate Division of the New Jersey Superior Court. On March 5, 2012, the court remanded the case to the NJBPU with instructions to refer the case to an Administrative Law Judge for further consideration.

In February 2011, ACE joined other plaintiffs in an action filed in the United States District Court for the District of New Jersey challenging the constitutionality of the New Jersey law under which the SOCAs were established. ACE and the other plaintiffs filed a motion for summary judgment with the United States District Court for the District of New Jersey in December 2011. Cross motions for summary judgment were filed in January 2012. The motions remain pending.

In October 2011 and January 2012, respectively, two of the three generation companies sent notices of dispute under the SOCA to ACE. The notices of dispute allege that certain actions taken by PJM will have an adverse effect on the generation company’s ability to clear the PJM auction, which is required for payment under the SOCA. As of February 2012, the two generation companies had filed petitions with the NJBPU seeking to amend their respective SOCAs. One of the generation companies seeks to postpone the effective date (currently expected to be in 2015) of the SOCA until the litigation is complete. The other generation company proposes to adjust the payment terms of the SOCA to reflect the total expected revenues under the original bid, which the generation company alleges may be in jeopardy if it were unable to clear in the PJM auction commencing in 2015. ACE does not believe that a dispute exists under the SOCAs and is disputing the amendment of the SOCAs jointly with the other EDCs. ACE does not believe the impact of either of such SOCA amendments would be material, although the result of such amendments, if approved, may be to prolong the term of one or both SOCAs. In April 2012, the NJBPU issued an order consolidating the two matters. A decision is expected in the second quarter of 2012.

(8) LEASING ACTIVITIES

Investment in Finance Leases Held in Trust

PHI has a portfolio of cross-border energy lease investments (the lease portfolio) consisting of hydroelectric generation facilities, coal-fired electric generation facilities and natural gas distribution networks located outside of the United States. Each lease investment is comprised of a number of leases. As of March 31, 2012 and December 31, 2011, the lease portfolio consisted of seven investments with an aggregate book value of $1.4 billion and $1.3 billion, respectively.

 

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The components of the cross-border energy lease investments as of March 31, 2012 and as of December 31, 2011 are summarized below:

 

     March 31,
2012
    December 31,
2011
 
     (millions of dollars)  

Scheduled lease payments to PHI, net of non-recourse debt

   $ 2,120     $ 2,120  

Less: Unearned and deferred income

     (758 )     (771 )
  

 

 

   

 

 

 

Investment in finance leases held in trust

     1,362       1,349  

Less: Deferred income tax liabilities

     (797 )     (793 )
  

 

 

   

 

 

 

Net investment in finance leases held in trust

   $ 565     $ 556  
  

 

 

   

 

 

 

Income recognized from cross-border energy lease investments was comprised of the following for the three months ended March 31, 2012 and 2011:

 

     Three Months Ended
March  31,
 
     2012      2011  
     (millions of dollars)  

Pre-tax income from PHI’s cross-border energy lease investments (included in Other Revenue)

   $ 13       $ 14   

Income tax expense

     1         4   
  

 

 

    

 

 

 

Net income from PHI’s cross-border energy lease investments

   $ 12       $ 10   
  

 

 

    

 

 

 

To ensure credit quality, PHI regularly monitors the financial performance and condition of the lessees under its cross-border energy lease investments. Changes in credit quality are also assessed to determine if they should be reflected in the carrying value of the leases. PHI reviews each lessee’s performance versus annual compliance requirements set by the terms and conditions of the leases. This includes a comparison of published credit ratings to minimum credit rating requirements in the leases for lessees with public credit ratings. In addition, PHI routinely meets with senior executives of the lessees to discuss their company and asset performance. If the annual compliance requirements or minimum credit ratings are not met, remedies are available under the leases. At March 31, 2012, all lessees were in compliance with the terms and conditions of their lease agreements.

The table below shows PHI’s net investment in these leases by the published credit ratings of the lessees as of March 31, 2012 and December 31, 2011:

 

Lessee Rating (a)

   March 31,
2012
     December 31,
2011
 
     (millions of dollars)  

Rated Entities

     

AA/Aa and above

   $ 746       $ 737   

A

     616         612   
  

 

 

    

 

 

 

Total

   $ 1,362       $ 1,349   
  

 

 

    

 

 

 

 

(a) Excludes the credit ratings associated with collateral posted by the lessees in these transactions.

 

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(9) PENSION AND OTHER POSTRETIREMENT BENEFITS

The following Pepco Holdings information is for the three months ended March 31, 2012 and 2011:

 

     Pension Benefits     Other  Postretirement
Benefits
 
     2012     2011     2012     2011  
     (millions of dollars)  

Service cost

   $ 11     $ 10     $ 1     $ 2  

Interest cost

     26       26       9       9  

Expected return on plan assets

     (34 )     (31 )     (5 )     (5 )

Amortization of prior service cost

     —          —          (1 )     (1 )

Amortization of net actuarial loss

     14       13       5       4  
  

 

 

   

 

 

   

 

 

   

 

 

 

Net periodic benefit cost

   $ 17     $ 18     $ 9     $ 9  
  

 

 

   

 

 

   

 

 

   

 

 

 

Pension and Other Postretirement Benefits

Net periodic benefit cost related to continuing operations is included in other operation and maintenance expense, net of the portion of the net periodic benefit cost that is capitalized as part of the cost of labor for internal construction projects. After intercompany allocations, the three utility subsidiaries are responsible for substantially all of the total PHI net periodic pension and other postretirement benefit costs related to continuing operations.

Pension Contributions

PHI’s funding policy with regard to PHI’s non-contributory retirement plan (the PHI Retirement Plan) is to maintain a funding level that is at least equal to the target liability as defined under the Pension Protection Act of 2006. In the first quarter of 2012, Pepco, DPL and ACE made discretionary tax-deductible contributions to the PHI Retirement Plan in the amounts of $85 million, $85 million and $30 million, respectively, which is expected to bring the PHI Retirement Plan assets to at least the funding target level for 2012 under the Pension Protection Act. In the first quarter of 2011, Pepco, DPL and ACE made discretionary tax-deductible contributions to the PHI Retirement Plan in the amounts of $40 million, $40 million and $30 million, which brought plan assets to the funding target level for 2011 under the Pension Protection Act.

(10) DEBT

Credit Facility

PHI, Pepco, DPL and ACE maintain an unsecured syndicated credit facility to provide for their respective liquidity needs, including obtaining letters of credit, borrowing for general corporate purposes and supporting their commercial paper programs. On August 1, 2011, PHI, Pepco, DPL and ACE entered into an amended and restated credit agreement with respect to the facility, which among other changes extended the expiration date of the facility to August 1, 2016.

The aggregate borrowing limit under the amended and restated credit facility is $1.5 billion, all or any portion of which may be used to obtain loans and up to $500 million of which may be used to obtain letters of credit. The facility also includes a swingline loan sub-facility, pursuant to which each company may make same day borrowings in an aggregate amount not to exceed 10% of the total amount of the facility. Any swingline loan must be repaid by the borrower within fourteen days of receipt. The initial credit sublimit for PHI is $750 million and $250 million for each of Pepco, DPL and ACE. The sublimits may be increased or

 

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decreased by the individual borrower during the term of the facility, except that (i) the sum of all of the borrower sublimits following any such increase or decrease must equal the total amount of the facility and (ii) the aggregate amount of credit used at any given time by (a) PHI may not exceed $1.25 billion and (b) each of Pepco, DPL or ACE may not exceed the lesser of $500 million and the maximum amount of short-term debt the company is permitted to have outstanding by its regulatory authorities. The total number of the sublimit reallocations may not exceed eight per year during the term of the facility.

The interest rate payable by each company on utilized funds is, at the borrowing company’s election, (i) the greater of the prevailing prime rate, the federal funds effective rate plus 0.5% and one month LIBOR plus 1.0%, or (ii) the prevailing Eurodollar rate, plus a margin that varies according to the credit rating of the borrower.

In order for a borrower to use the facility, certain representations and warranties must be true and correct, and the borrower must be in compliance with specified financial covenants, including (i) the requirement that each borrowing company maintain a ratio of total indebtedness to total capitalization of 65% or less, computed in accordance with the terms of the credit agreement, which calculation excludes from the definition of total indebtedness certain trust preferred securities and deferrable interest subordinated debt (not to exceed 15% of total capitalization), (ii) with certain exceptions, a restriction on sales or other dispositions of assets, and (iii) a restriction on the incurrence of liens on the assets of a borrower or any of its significant subsidiaries other than permitted liens. The credit agreement contains certain covenants and other customary agreements and requirements that, if not complied with, could result in an event of default and the acceleration of repayment obligations of one or more of the borrowers thereunder. Each of the borrowers was in compliance with all covenants under this facility as of March 31, 2012.

The absence of a material adverse change in PHI’s business, property, results of operations or financial condition is not a condition to the availability of credit under the credit agreement. The credit agreement does not include any rating triggers.

At March 31, 2012 and December 31, 2011, the amount of cash plus unused borrowing capacity under the credit facility available to meet the future liquidity needs of PHI and its utility subsidiaries on a consolidated basis totaled $679 million and $1 billion, respectively. PHI’s utility subsidiaries had combined cash and unused borrowing capacity under the credit facility of $452 million and $711 million at March 31, 2012 and December 31, 2011, respectively.

Commercial Paper

PHI, Pepco, DPL and ACE maintain on-going commercial paper programs to address short-term liquidity needs. As of March 31, 2012, the maximum capacity available under these programs was $875 million, $500 million, $500 million and $250 million, respectively, subject to available borrowing capacity under the credit facility. In January 2012, the Board of Directors approved an increase in PHI’s maximum to $1.25 billion, which has not been put into effect as of March 31, 2012.

PHI, Pepco and DPL had $521 million, $204 million and $133 million, respectively, of commercial paper outstanding at March 31, 2012. ACE did not issue commercial paper during the first quarter of 2012 and had no commercial paper outstanding at March 31, 2012. The weighted average interest rate for commercial paper issued by PHI, Pepco and DPL during the three months ended March 31, 2012 was 0.75%, 0.40% and 0.39%, respectively. The weighted average maturity of all commercial paper issued by PHI, Pepco and DPL during the three months ended March 31, 2012 was twelve, five and four days, respectively.

Other Financing Activities

In January 2012, ACE Funding made principal payments of $7 million on its Series 2002-1 Bonds, Class A-3, and $2 million on its Series 2003-1 Bonds, Class A-2.

 

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Financing Activities Subsequent to March 31, 2012

Bond Payments

In April 2012, ACE Funding made principal payments of $6 million on its Series 2002-1 Bonds, Class A-3, and $2 million on its Series 2003-1 Bonds, Class A-2.

Bond Issuance

In April 2012, Pepco issued $200 million of 3.05% first mortgage bonds due April 1, 2022. Proceeds from the issuance of the long-term debt were primarily used to repay Pepco’s outstanding commercial paper that was issued to temporarily fund capital expenditures and working capital, to redeem, prior to maturity, all of the $38.3 million outstanding of the 5.375% pollution control revenue refunding bonds due February 15, 2024 issued by the Industrial Development Authority of the City of Alexandria, Virginia, on Pepco’s behalf and for general corporate purposes.

Bond Redemption

On April 30, 2012, all of the $38.3 million of the outstanding 5.375% pollution control revenue refunding bonds were redeemed as noted in the preceding paragraph. In connection with such redemption, Pepco redeemed all of the $38.3 million outstanding of its 5.375% first mortgage bonds due February 15, 2024 that secured the obligations under such pollution control bonds.

Term Loan Agreement

On April 24, 2012, PHI entered into a $200 million term loan agreement, pursuant to which PHI has borrowed (and may not reborrow) $200 million at a rate of interest equal to the prevailing Eurodollar rate, which is determined by reference to LIBOR with respect to the relevant interest period, all as defined in the loan agreement, plus a margin of 0.875%. PHI’s Eurodollar borrowings under the loan agreement may be converted into floating rate loans under certain circumstances, and, in that event, for so long as any loan remains a floating rate loan, interest would accrue on that loan at a rate per year equal to (i) the highest of (a) the prevailing prime rate, (b) the federal funds effective rate plus 0.5%, or (c) the one-month Eurodollar rate plus 1%, plus (ii) a margin of 0.875%. As of April 24, 2012, outstanding borrowings under the loan agreement bore an annual interest rate of 1.115%, which is subject to adjustment from time to time. All borrowings under the loan agreement are unsecured, and the aggregate principal amount of all loans, together with any accrued but unpaid interest due under the loan agreement, must be repaid in full on or before April 23, 2013.

PHI intends to use the net proceeds of the borrowings under the loan agreement to repay outstanding commercial paper obligations and for general corporate purposes. Under the terms of the loan agreement, PHI must be in compliance with specified covenants, including (i) the requirement that PHI maintain a ratio of total indebtedness to total capitalization of 65% or less, computed in accordance with the terms of the loan agreement, which calculation excludes from the definition of total indebtedness certain trust preferred securities and deferrable interest subordinated debt (not to exceed 15% of total capitalization), (ii) a restriction on sales or other dispositions of assets, other than certain permitted sales and dispositions, and (iii) a restriction on the incurrence of liens (other than liens permitted by the loan agreement) on the assets of PHI or any of its significant subsidiaries. The loan agreement does not include any rating triggers.

Collateral Requirements of Pepco Energy Services

In the ordinary course of its energy supply business, which is in the process of being wound down, Pepco Energy Services enters into various contracts to buy and sell electricity, fuels and related products, including derivative instruments, designed to reduce its financial exposure to changes in the value of its assets and obligations due to energy price fluctuations. These contracts typically have collateral requirements. Depending on the contract terms, the collateral required to be posted by Pepco Energy Services can be of varying forms, including cash and letters of credit.

 

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As of March 31, 2012, Pepco Energy Services had posted net cash collateral of $92 million and letters of credit of $1 million. At December 31, 2011, Pepco Energy Services had posted net cash collateral of $112 million and letters of credit of $1 million.

At March 31, 2012 and December 31, 2011, the amount of cash, plus borrowing capacity under PHI’s credit facility available to meet the future liquidity needs of Pepco Energy Services totaled $227 million and $283 million, respectively.

(11) INCOME TAXES

A reconciliation of PHI’s consolidated effective income tax rate from continuing operations is as follows:

 

     Three Months Ended March 31,  
     2012     2011  
     (millions of dollars)  

Income tax at Federal statutory rate

   $ 29       35.0   $ 33       35.0

Increases (decreases) resulting from:

        

State income taxes, net of Federal effect

     4       4.9        5       5.0   

Asset removal costs

     (3 )     (3.7     (1 )     (0.7

Cross-border energy lease investments

     (1 )     (1.2     (1 )     (1.2

Change in estimates and interest related to uncertain and effectively settled tax positions

     (13 )     (15.9     1       1.2   

Investment tax credits

     (1 )     (1.2     (1 )     (1.2

Permanent differences related to deferred compensation

     (1 )     (1.2     (2 )     (2.2

Other, net

     —         0.4        —         (0.5
  

 

 

   

 

 

   

 

 

   

 

 

 

Consolidated income tax expense related to continuing operations

   $ 14       17.1   $ 34       35.4
  

 

 

   

 

 

   

 

 

   

 

 

 

PHI’s consolidated effective tax rates for the three months ended March 31, 2012 and 2011 were 17.1% and 35.4%, respectively. The decrease in the effective tax rate primarily resulted from changes in estimates and interest related to uncertain and effectively settled tax positions in the first quarter of 2012, primarily due to the effective settlement with the Internal Revenue Service (IRS) with respect to the methodology used historically to calculate deductible mixed service costs and the expiration of the statute of limitations associated with an uncertain tax position in Pepco. The effective rate was further decreased as a result of the increase in asset removal costs in Pepco in 2012 primarily related to a higher level of asset retirements.

 

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(12) EQUITY AND EARNINGS PER SHARE

Basic and Diluted Earnings Per Share

PHI’s basic and diluted earnings per share (EPS) calculations are shown below:

 

     Three Months
Ended March 31,
 
     2012      2011  
     (millions of dollars, except
per share data)
 

Income (Numerator):

     

Net income from continuing operations

   $ 68      $ 62  

Net income from discontinued operations

     —           2  
  

 

 

    

 

 

 

Net income

   $ 68      $ 64  
  

 

 

    

 

 

 

Shares (Denominator) (in millions):

     

Weighted average shares outstanding for basic computation:

     

Average shares outstanding

     228        225  

Adjustment to shares outstanding

     —           —     
  

 

 

    

 

 

 

Weighted Average Shares Outstanding for Computation of Basic Earnings Per Share of Common Stock

     228        225  

Net effect of potentially dilutive shares (a)

     —           —     
  

 

 

    

 

 

 

Weighted Average Shares Outstanding for Computation of Diluted Earnings Per Share of Common Stock

     228        225  
  

 

 

    

 

 

 

Basic and Diluted Earnings per Share

     

Earnings per share of common stock from continuing operations

   $ 0.30      $ 0.27  

Earnings per share of common stock from discontinued operations

     —           0.01  
  

 

 

    

 

 

 

Basic and diluted earnings per share

   $ 0.30       $ 0.28  
  

 

 

    

 

 

 

 

(a) The number of options to purchase shares of common stock that were excluded from the calculation of diluted EPS because they were anti-dilutive was 3,000 and 133,066 for the three months ended March 31, 2012 and 2011, respectively.

Equity Forward Transaction

On March 5, 2012, PHI entered into an equity forward transaction in connection with a public offering of 17,922,077 shares of PHI common stock. The use of an equity forward transaction substantially eliminates future equity market price risk by fixing a common equity offering sales price under the then existing market conditions, while mitigating immediate share dilution resulting from the offering by postponing the actual issuance of common stock until funds are needed in accordance with PHI’s capital investment and regulatory plans.

Pursuant to the terms of this transaction, a forward counterparty borrowed 17,922,077 shares of PHI’s common stock from third parties and sold them to a group of underwriters for $19.25 per share, less an underwriting discount equal to $0.67375 per share. Under the terms of the equity forward transaction, to the extent that the transaction is physically settled, PHI would be required to issue and deliver shares of PHI common stock to the forward counterparty at the then applicable forward sale price. The forward sale price was initially determined to be $18.57625 per share at the time the equity forward transaction was entered into, and the amount of cash to be received by PHI upon physical settlement of the equity forward is subject to certain adjustments in accordance with the terms of the equity forward transaction. The equity forward transaction must be settled fully within 12 months of the transaction date. Except in specified circumstances or events that would require physical settlement, PHI is able to elect to settle the equity forward transaction by means of physical, cash or net share settlement, and in whole or in part, at any time on or prior to March 5, 2013.

 

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The equity forward transaction has no initial fair value since it was entered into at the then market price of the common stock. PHI will not receive any proceeds from the sale of common stock until the equity forward transaction is settled, and at that time PHI will record the proceeds, if any, in equity. PHI concluded that the equity forward transaction was an equity instrument based on the accounting guidance in ASC 480 and ASC 815 and that it qualified for an exception from derivative accounting under ASC 815 because the forward sale transaction was indexed to its own stock. Currently, PHI anticipates settling the equity forward transaction through physical settlement.

At March 31, 2012, the equity forward transaction could have been settled with physical delivery of the shares to the forward counterparty in exchange for cash of $328 million. At March 31, 2012, the equity forward transaction could also have been cash settled, with delivery of cash of approximately $14 million to the forward counterparty, or net share settled with delivery of approximately 740,000 shares of common stock to the forward counterparty.

Prior to its settlement, the equity forward transaction will be reflected in PHI’s diluted earnings per share calculations using the treasury stock method. Under this method, the number of shares of PHI’s common stock used in calculating diluted earnings per share for a reporting period is deemed to be increased by the excess, if any, of the number of shares that would be issued upon physical settlement of the equity forward transaction less the number of shares that could be purchased by PHI in the market (based on the average market price during that reporting period) using the proceeds receivable upon settlement (based on the adjusted forward sale price at the end of that reporting period). The excess number of shares is weighted for the portion of the reporting period in which the equity forward transaction is outstanding.

Accordingly, before physical or net share settlement of the equity forward transaction, and subject to the occurrence of certain events, PHI anticipates that the forward sale agreement will have a dilutive effect on PHI’s earnings per share only during periods when the applicable average market price per share of PHI’s common stock is above the per share adjusted forward sale price, as described above. However, if PHI decides to physically or net share settle the forward sale agreement, any delivery by PHI of shares upon settlement could result in dilution to PHI’s earnings per share.

For the three months ended March 31, 2012, the equity forward transaction did not have a material dilutive effect on PHI’s earnings per share.

(13) DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

Derivatives are used by Pepco Energy Services and Power Delivery to hedge commodity price risk, as well as by PHI, from time to time, to hedge interest rate risk.

The retail energy supply business of Pepco Energy Services, which is in the process of being wound down, enters into energy commodity contracts in the form of electricity and natural gas futures, swaps, options and forward contracts to hedge commodity price risk in connection with the purchase of physical natural gas and electricity for distribution to customers. The primary risk management objective is to manage the spread between retail sales commitments and the cost of supply used to service those commitments to ensure stable cash flows and lock in favorable prices and margins when they become available.

Pepco Energy Services’ commodity contracts that are not designated for hedge accounting, do not qualify for hedge accounting, or do not meet the requirements for normal purchase and normal sale accounting, are marked to market through current earnings. Forward contracts that meet the requirements for normal purchase and normal sale accounting are recorded on an accrual basis.

In Power Delivery, DPL uses derivative instruments in the form of swaps and over-the-counter options primarily to reduce natural gas commodity price volatility and to limit its customers’ exposure to increases in the market price of natural gas under a hedging program approved by the DPSC. DPL uses these derivatives to manage the commodity price risk associated with its physical natural gas purchase contracts. The natural

 

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gas purchase contracts qualify as normal purchases, which are not required to be recorded in the financial statements until settled. DPL’s capacity contracts are not classified as derivatives. All premiums paid and other transaction costs incurred as part of DPL’s natural gas hedging activity, in addition to all gains and losses related to hedging activities, are deferred under FASB guidance on regulated operations (ASC 980) until recovered from its customers through a fuel adjustment clause approved by the DPSC.

PHI also uses derivative instruments from time to time to mitigate the effects of fluctuating interest rates on debt issued in connection with the operation of their businesses. In June 2002, PHI entered into several treasury rate lock transactions in anticipation of the issuance of several series of fixed-rate debt commencing in August 2002. Upon issuance of the fixed rate-debt in August 2002, the treasury rate locks were terminated at a loss. The loss has been deferred in Accumulated Other Comprehensive Loss (AOCL) and is being recognized in income over the life of the debt issued as interest payments are made.

The tables below identify the balance sheet location and fair values of derivative instruments as of March 31, 2012 and December 31, 2011:

 

     As of March 31, 2012  

Balance Sheet Caption

   Derivatives
Designated as
Hedging
Instruments (a)
    Other
Derivative
Instruments (b)
    Gross
Derivative
Instruments
    Effects of
Cash
Collateral
and
Netting
    Net
Derivative
Instruments
 
     (millions of dollars)  

Derivative assets (current assets)

   $ 9     $ 8     $ 17     $ (11 )   $ 6  

Derivative assets (non-current assets)

     —          1       1       —          1  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total Derivative assets

     9       9       18       (11 )     7  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Derivative liabilities (current liabilities)

     (38 )     (50 )     (88 )     63       (25 )

Derivative liabilities (non-current liabilities)

     (8 )     (6 )     (14 )     12       (2 )
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total Derivative liabilities

     (46 )     (56 )     (102 )     75       (27 )
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net Derivative (liability) asset

   $ (37 )   $ (47 )   $ (84 )   $ 64     $ (20 )
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(a) Amounts included in Derivatives Designated as Hedging Instruments primarily consist of derivatives that were designated as cash flow hedges prior to Pepco Energy Services’ election to discontinue cash flow hedge accounting for these derivatives.
(b) Amounts included in Other Derivative Instruments include gains or losses on gas derivatives that are not accounted for as cash flow hedges subsequent to Pepco Energy Services’ election to discontinue cash flow hedge accounting.

 

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     As of December 31, 2011  

Balance Sheet Caption

   Derivatives
Designated as
Hedging
Instruments (a)
    Other
Derivative
Instruments (b)
    Gross
Derivative
Instruments
    Effects of
Cash
Collateral
and
Netting
    Net
Derivative
Instruments
 
     (millions of dollars)  

Derivative assets (current assets)

   $ 17     $ 6     $ 23     $ (18 )   $ 5  

Derivative assets (non-current assets)

     —          1       1       (1 )     —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total Derivative assets

     17       7       24       (19 )     5  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Derivative liabilities (current liabilities)

     (55 )     (48 )     (103 )     77       (26 )

Derivative liabilities (non-current liabilities)

     (11 )     (10 )     (21 )     15       (6 )
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total Derivative liabilities

     (66 )     (58 )     (124 )     92       (32 )
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net Derivative (liability) asset

   $ (49 )   $ (51 )   $ (100 )   $ 73     $ (27 )
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(a) Amounts included in Derivatives Designated as Hedging Instruments primarily consist of derivatives that were designated as cash flow hedges prior to Pepco Energy Services’ election to discontinue cash flow hedge accounting for these derivatives.
(b) Amounts included in Other Derivative Instruments include gains or losses on gas derivatives that are not accounted for as cash flow hedges subsequent to Pepco Energy Services’ election to discontinue cash flow hedge accounting.

Under FASB guidance on the offsetting of balance sheet accounts (ASC 210-20), PHI offsets the fair value amounts recognized for derivative instruments and the fair value amounts recognized for related collateral positions executed with the same counterparty under master netting agreements. The amount of cash collateral that was offset against these derivative positions is as follows:

 

     March 31,
2012
     December 31,
2011
 
     (millions of dollars)  

Cash collateral pledged to counterparties with the right to reclaim (a)

   $ 64       $ 73  

 

(a) Includes cash deposits on commodity brokerage accounts

As of March 31, 2012 and December 31, 2011, all PHI cash collateral pledged related to derivative instruments accounted for at fair value was entitled to offset under master netting agreements.

Derivatives Designated as Hedging Instruments

Cash Flow Hedges

Pepco Energy Services

For energy commodity contracts that are designated and qualify as cash flow hedges, the effective portion of the gain or loss on the derivative is reported as a component of AOCL and is reclassified into income in the same period or periods during which the hedged transactions affect income. Gains and losses on the derivative that are related to hedge ineffectiveness or the forecasted hedged transaction being probable not to occur, are recognized in income. Pepco Energy Services has elected to no longer apply cash flow hedge accounting to certain of its electricity derivatives and all of its natural gas derivatives. Amounts included in AOCL for these cash flow hedges as of March 31, 2012 represent net losses on derivatives prior to the election to discontinue cash flow hedge accounting less amounts reclassified into income as the hedged transactions occur or because the hedged transactions were deemed probable not to occur. Gains or losses on these derivatives after the election to discontinue cash flow hedge accounting are recognized directly in income.

 

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The cash flow hedge activity during the three months ended March 31, 2012 and 2011 is provided in the tables below:

 

     Three Months Ended
March  31,
 
     2012      2011  
     (millions of dollars)  

Amount of net pre-tax loss arising during the period included in accumulated other comprehensive loss

   $ —         $ (1 )
  

 

 

    

 

 

 

Amount of net pre-tax loss reclassified into income:

     

Effective portion:

     

Fuel and purchased energy

     13        27  

Ineffective portion: (a)

     

Revenue

     —           —     
  

 

 

    

 

 

 

Total net pre-tax loss reclassified into income

     13        27  
  

 

 

    

 

 

 

Net pre-tax gain on commodity derivatives included in accumulated other comprehensive loss

   $ 13      $ 26  
  

 

 

    

 

 

 

 

(a) For the three months ended March 31, 2012 and 2011, no amounts were reclassified from AOCL to income because it was deemed probable that the forecasted hedged transactions would not occur.

As of March 31, 2012 and December 31, 2011, Pepco Energy Services had the following types and quantities of outstanding energy commodity contracts employed as cash flow hedges of forecasted purchases and forecasted sales.

 

     Quantities  

Commodity

   March 31,
2012
     December 31,
2011
 

Forecasted Purchases Hedges

     

Natural gas (One Million British Thermal Units (MMBtu))

     —           —     

Electricity (Megawatt hours (MWh))

     246,680        614,560  

Electricity capacity (MW-Days)

     —           —     

Forecasted Sales Hedges

     

Electricity (MWh)

     246,680        614,560  

Power Delivery

All premiums paid and other transaction costs incurred as part of DPL’s natural gas hedging activity, in addition to all of DPL’s gains and losses related to hedging activities, are deferred under FASB guidance on regulated operations until recovered from customers based on the fuel adjustment clause approved by the DPSC. The following table indicates the amount of the net unrealized derivative losses arising during the period included in Regulatory assets and the realized losses recognized in the consolidated statements of income for the three months ended March 31, 2012 and 2011 associated with cash flow hedges:

 

     Three Months Ended
March  31,
 
     2012      2011  
     (millions of dollars)  

Net unrealized (loss) gain arising during the period included in Regulatory assets

   $ —         $ —     

Net realized loss recognized in Fuel and purchased energy expense

     —           (2 )

 

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Cash Flow Hedges Included in Accumulated Other Comprehensive Loss

The tables below provide details regarding effective cash flow hedges included in PHI’s consolidated balance sheets as of March 31, 2012 and 2011. Cash flow hedges are marked to market on the consolidated balance sheets with corresponding adjustments to AOCL for effective cash flow hedges. As of March 31, 2012, $33 million of the losses in AOCL were associated with derivatives that Pepco Energy Services previously designated as cash flow hedges. Although Pepco Energy Services no longer designates these derivatives as cash flow hedges, gains or losses previously deferred in AOCL prior to the decision to discontinue cash flow hedge accounting will remain in AOCL until the hedged forecasted transaction occurs unless it is deemed probable that the hedged forecasted transaction will not occur. The data in the following tables indicate the cumulative net loss after-tax related to effective cash flow hedges by contract type included in AOCL, the portion of AOCL expected to be reclassified to income during the next 12 months, and the maximum hedge or deferral term:

 

     As of March 31, 2012         

Contracts

   Accumulated
Other
Comprehensive Loss
After-tax
     Portion Expected
to be Reclassified
to Income during
the Next 12 Months
     Maximum
Term
 
     (millions of dollars)         

Energy commodity (a)

   $ 21       $ 17         26 months   

Interest rate

     10         1         245 months  
  

 

 

    

 

 

    

Total

   $ 31       $ 18      
  

 

 

    

 

 

    

 

(a) The unrealized derivative losses recorded in AOCL relate to forecasted physical natural gas and electricity purchases which are used to supply retail natural gas and electricity contracts that are in gain positions and subject to accrual accounting. Under accrual accounting, no asset is recorded on PHI’s consolidated balance sheet and the purchase cost is not recognized until the period of distribution.

 

     As of March 31, 2011         

Contracts

   Accumulated
Other
Comprehensive Loss
After-tax
     Portion Expected
to be Reclassified
to Income during
the Next 12 Months
     Maximum
Term
 
     (millions of dollars)         

Energy commodity (a)

   $ 62      $ 38        38 months   

Interest rate

     11        1        257 months   
  

 

 

    

 

 

    

Total

   $ 73      $ 39     
  

 

 

    

 

 

    

 

(a) The unrealized derivative losses recorded in AOCL relate to forecasted physical natural gas and electricity purchases which are used to supply retail natural gas and electricity contracts that are in gain positions and subject to accrual accounting. Under accrual accounting, no asset is recorded on PHI’s consolidated balance sheet and the purchase cost is not recognized until the period of distribution.

Other Derivative Activity

Pepco Energy Services

Pepco Energy Services holds certain derivatives that are not in hedge accounting relationships and are not designated as normal purchases or normal sales. These derivatives are recorded at fair value on the balance sheet with changes in fair value recorded through income.

 

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For the three months ended March 31, 2012 and 2011, the amount of the derivative gain (loss) for Pepco Energy Services recognized in income is provided in the table below:

 

     Three Months Ended March 31,  
     2012     2011  
     (millions of dollars)  

Reclassification to realized on settlement of contracts

   $ 10     $ (4

Unrealized mark-to-market loss

     (10     —     
  

 

 

   

 

 

 

Total net loss

   $ —        $ (4
  

 

 

   

 

 

 

As of March 31, 2012 and December 31, 2011, Pepco Energy Services had the following net outstanding commodity forward contract quantities and net position on derivatives that did not qualify for hedge accounting:

 

     March 31, 2012      December 31, 2011  

Commodity

   Quantity      Net Position      Quantity      Net Position  

Financial transmission rights (MWh)

     79,607        Long         267,480        Long  

Electric capacity (MW–Days)

     5,185        Long        12,920        Long  

Electric (MWh)

     657,240        Long        788,280         Long  

Natural gas (MMBtu)

     15,037,300        Long        24,550,257        Long  

Power Delivery

DPL holds certain derivatives that are not in hedge accounting relationships and are not designated as normal purchases or normal sales. These derivatives are recorded at fair value on the consolidated balance sheets with the gain or loss for the change in fair value recorded in income. In accordance with FASB guidance on regulated operations, offsetting regulatory liabilities or regulatory assets are recorded on the consolidated balance sheets and the recognition of the derivative gain or loss is deferred because of the DPSC-approved fuel adjustment clause. For the three months ended March 31, 2012 and 2011, the net unrealized derivative losses arising during the period included in Regulatory assets and the net realized losses recognized in the consolidated statements of income are provided in the table below:

 

     Three Months Ended
March  31,
 
     2012     2011  

Net unrealized gain (loss) arising during the period included in Regulatory assets

   $ (4   $ (1 )

Net realized loss recognized in Fuel and purchased energy expense

     (7     (7

As of March 31, 2012 and December 31, 2011, DPL had the following net outstanding natural gas commodity forward contracts that did not qualify for hedge accounting:

 

     March 31, 2012      December 31, 2011  

Commodity

   Quantity      Net Position      Quantity      Net Position  

Natural gas (MMBtu)

     4,109,100        Long        6,161,200         Long   

 

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Contingent Credit Risk Features

The primary contracts used by Pepco Energy Services and Power Delivery for derivative transactions are entered into under the International Swaps and Derivatives Association Master Agreement (ISDA) or similar agreements that closely mirror the principal credit provisions of the ISDA. The ISDAs include a Credit Support Annex (CSA) that governs the mutual posting and administration of collateral security. The failure of a party to comply with an obligation under the CSA, including an obligation to transfer collateral security when due or the failure to maintain any required credit support, constitutes an event of default under the ISDA for which the other party may declare an early termination and liquidation of all transactions entered into under the ISDA, including foreclosure against any collateral security. In addition, some of the ISDAs have cross default provisions under which a default by a party under another commodity or derivative contract, or the breach by a party of another borrowing obligation in excess of a specified threshold, is a breach under the ISDA.

Under the ISDA or similar agreements, the parties establish a dollar threshold of unsecured credit for each party in excess of which the party would be required to post collateral to secure its obligations to the other party. The amount of the unsecured credit threshold varies according to the senior, unsecured debt rating of the respective parties or that of a guarantor of the party’s obligations. The fair values of all transactions between the parties are netted under the master netting provisions. Transactions may include derivatives accounted for on-balance sheet as well as those designated as normal purchases and normal sales that are accounted for off-balance sheet. If the aggregate fair value of the transactions in a net loss position exceeds the unsecured credit threshold, then collateral is required to be posted in an amount equal to the amount by which the unsecured credit threshold is exceeded. The obligations of Pepco Energy Services are usually guaranteed by PHI. The obligations of DPL are stand-alone obligations without the guaranty of PHI. If PHI’s or DPL’s debt rating were to fall below “investment grade,” the unsecured credit threshold would typically be set at zero and collateral would be required for the entire net loss position. Exchange-traded contracts are required to be fully collateralized without regard to the debt rating of the holder.

The gross fair values of PHI’s derivative liabilities with credit risk-related contingent features as of March 31, 2012 and December 31, 2011, were $40 million and $54 million, respectively, before giving effect to offsetting transactions or collateral under master netting agreements. As of March 31, 2012, PHI had posted no cash collateral against its gross derivative liability, resulting in a net liability of $40 million. As of December 31, 2011, PHI had posted cash collateral of $1 million against its gross derivative liability, resulting in a net liability of $53 million. If PHI’s and DPL’s debt ratings had been downgraded below investment grade as of March 31, 2012 and December 31, 2011, PHI’s net settlement amounts, including both the fair value of its derivative liabilities and its normal purchase and normal sale contracts in loss positions, would have been approximately $111 million and $124 million, respectively, and PHI would have been required to post additional collateral with the counterparties of approximately $111 million and $123 million, respectively. The net settlement and additional collateral amounts reflect the effect of offsetting transactions under master netting agreements.

PHI’s primary sources for posting cash collateral or letters of credit are its credit facility. At March 31, 2012 and December 31, 2011, the aggregate amount of cash plus borrowing capacity under the credit facility available to meet the future liquidity needs of PHI and its subsidiaries totaled $679 million and $1 billion, respectively, of which $227 million and $283 million, respectively, was available to Pepco Energy Services.

 

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(14) FAIR VALUE DISCLOSURES

Financial Instruments Measured at Fair Value on a Recurring Basis

PHI applies FASB guidance on fair value measurement and disclosures (ASC 820) that established a framework for measuring fair value and expanded disclosures about fair value measurements. As defined in the guidance, fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). PHI utilizes market data or assumptions that market participants would use in pricing the asset or liability, including assumptions about risk and the risks inherent in the inputs to the valuation technique. These inputs can be readily observable, market corroborated or generally unobservable. Accordingly, PHI utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. The guidance establishes a fair value hierarchy that prioritizes the inputs used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (level 1) and the lowest priority to unobservable inputs (level 3).

The following tables set forth, by level within the fair value hierarchy, PHI’s financial assets and liabilities (excluding Conectiv Energy assets and liabilities held for sale) that were accounted for at fair value on a recurring basis as of March 31, 2012 and December 31, 2011. As required by the guidance, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. PHI’s assessment of the significance of a particular input to the fair value measurement requires the exercise of judgment, and may affect the valuation of fair value assets and liabilities and their placement within the fair value hierarchy levels.

 

     Fair Value Measurements at March 31, 2012  

Description

   Total      Quoted Prices in
Active Markets
for Identical
Instruments
(Level 1) (a)
     Significant
Other
Observable
Inputs
(Level 2) (a)
     Significant
Unobservable
Inputs
(Level 3)
 
     (millions of dollars)  

ASSETS

           

Derivative instruments (b)

           

Electricity (c)

   $ 3       $ —         $ 3      $ —     

Cash equivalents

           

Treasury fund

     70        70        —           —     

Executive deferred compensation plan assets

           

Money market funds

     16        16        —           —     

Life insurance contracts

     61        —           43        18  
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ 150       $ 86       $ 46       $ 18   
  

 

 

    

 

 

    

 

 

    

 

 

 

LIABILITIES

           

Derivative instruments (b)

           

Electricity (c)

   $ 31      $ —         $ 31      $ —     

Natural gas (d)

     56        42        —           14  

Executive deferred compensation plan liabilities

           

Life insurance contracts

     28        —           28        —     
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ 115       $ 42       $ 59       $ 14   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(a) There were no transfers of instruments between level 1 and level 2 valuation categories.
(b) The fair value of derivative assets and liabilities reflect netting by counterparty before the impact of collateral.
(c) Represents wholesale electricity futures and swaps that are used mainly as part of Pepco Energy Services’ retail energy supply business.
(d) Level 1 instruments represent wholesale gas futures and swaps that are used mainly as part of Pepco Energy Services’ retail energy supply business and level 3 instruments represent natural gas options purchased by DPL as part of a natural gas hedging program approved by the DPSC, as well as Pepco Energy Services physical basis contracts.

 

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     Fair Value Measurements at December 31, 2011  

Description

   Total      Quoted Prices in
Active Markets
for Identical
Instruments
(Level 1) (a)
     Significant
Other
Observable
Inputs
(Level 2) (a)
     Significant
Unobservable
Inputs
(Level 3)
 
     (millions of dollars)  

ASSETS

           

Cash equivalents

           

Treasury fund

   $ 114      $ 114      $ —         $ —     

Executive deferred compensation plan assets

           

Money market funds

     18        18        —           —     

Life insurance contracts

     60        —           43        17  
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ 192       $ 132       $ 43      $ 17   
  

 

 

    

 

 

    

 

 

    

 

 

 

LIABILITIES

           

Derivative instruments (b)

           

Electricity (c)

   $ 32       $ —         $ 32       $ —     

Natural gas (d)

     67        50        —           17  

Capacity

     1        —           1         —     

Executive deferred compensation plan liabilities

           

Life insurance contracts

     28        —           28        —     
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ 128       $ 50       $ 61       $ 17   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(a) There were no transfers of instruments between level 1 and level 2 valuation categories.
(b) The fair value of derivative liabilities reflect netting by counterparty before the impact of collateral.
(c) Represents wholesale electricity futures and swaps that are used mainly as part of Pepco Energy Service’s retail energy supply business.
(d) Level 1 instruments represent wholesale gas futures and swaps that are used mainly as part of Pepco Energy Services’ retail energy supply business and level 3 instruments represent natural gas options purchased by DPL as part of a natural gas hedging program approved by the DPSC.

PHI classifies its fair value balances in the fair value hierarchy based on the observability of the inputs used in the fair value calculation as follows:

Level 1 – Quoted prices are available in active markets for identical assets or liabilities as of the reporting date. Active markets are those in which transactions for the asset or liability occur in sufficient frequency and volume to provide pricing information on an ongoing basis, such as the New York Mercantile Exchange (NYMEX).

Level 2 – Pricing inputs are other than quoted prices in active markets included in level 1, which are either directly or indirectly observable as of the reporting date. Level 2 includes those financial instruments that are valued using broker quotes in liquid markets and other observable data. Level 2 also includes those financial instruments that are valued using methodologies that have been corroborated by observable market data through correlation or by other means. Significant assumptions are observable in the marketplace throughout the full term of the instrument and can be derived from observable data or are supported by observable levels at which transactions are executed in the marketplace.

PHI’s level 2 derivative instruments primarily consist of electricity derivatives at March 31, 2012. Level 2 power swaps are provided by a pricing service that uses liquid trading hub prices or liquid hub prices plus a congestion adder to estimate the fair value at zonal locations within trading hubs.

Executive deferred compensation plan assets consist of life insurance policies that are categorized as level 2 assets because they are priced based on the assets underlying the policies, which consist of short-term cash equivalents and fixed income securities that are priced using observable market data and can be liquidated for the value of the underlying assets as of March 31, 2012. The level 2 liability associated with the life insurance policies represents a deferred compensation obligation, the value of which is tracked via underlying insurance sub-accounts. The sub-accounts are designed to mirror existing mutual funds and money market funds that are observable and actively traded.

 

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Level 3 – Pricing inputs include significant inputs that are generally less observable than those from objective sources. Level 3 includes those financial instruments that are valued using models or other valuation methodologies.

Derivative instruments categorized as level 3 include natural gas options used by DPL as part of a natural gas hedging program approved by the DPSC and natural gas physical basis contracts held by Pepco Energy Services. DPL applies a Black-Scholes model to value its options, which contains inputs, such as the forward price curves, contract prices, contract volumes, the risk-free rate and the implied volatility factors, which are based on a range of historical NYMEX option prices. The implied volatility is a factor based on a range between 0.60 and 2.03. DPL maintains valuation policies and procedures and reviews the validity and relevance of the inputs used to estimate the fair value of its options. The natural gas physical basis contracts held by Pepco Energy Services are valued using liquid hub prices plus a congestion adder. The congestion adder is between the range of two cents to forty-three cents, which is an internally derived adder based on historical data and experience. Pepco Energy Services obtains the liquid hub prices from a third party and reviews the valuation methodologies, inputs, and reasonableness of the congestion adder on a quarterly basis.

The table below summarizes the primary unobservable inputs used to determine the fair value of PHI’s level 3 instruments and the range of values that could be used for those inputs as of March 31, 2012:

 

Type of Instrument

   Fair Value at
March 31, 2012
     Valuation Technique    Unobservable Input    Range  
     (millions of dollars)                   

Natural Gas Options

   $ 12       Option model    Volatility Factor      0.60 – 2.03   

Natural Gas Physical Basis Contracts

   $ 2       Market comparable    Congestion adder    $ 0.02 – $0.43   

PHI used values within these ranges as part of its fair value estimates, and a significant change in any of the unobservable inputs within these ranges would have an insignificant impact on the reported fair value as of March 31, 2012.

Executive deferred compensation plan assets and liabilities include certain life insurance policies that are valued using the cash surrender value of the policies, net of loans against those policies. The cash surrender values do not represent a quoted price in an active market; therefore, are unobservable and are categorized as level 3. Cash surrender values are provided by third parties and reviewed by PHI for reasonableness.

 

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Reconciliations of the beginning and ending balances of PHI’s fair value measurements using significant unobservable inputs (level 3) for the three months ended March 31, 2012 and 2011 are shown below:

 

     Three Months Ended
March 31, 2012
 
     Natural
Gas
    Life
Insurance
Contracts
 
     (millions of dollars)  

Beginning balance as of January 1

   $ (17 )   $ 17  

Total gains (losses) (realized and unrealized)

    

Included in income

     —          1  

Included in accumulated other comprehensive loss

     —          —     

Included in regulatory assets

     (3 )     —     

Purchases

     —          —     

Issuances

     —          —     

Settlements

     6        —     

Transfers in (out) of level 3

     —          —     
  

 

 

   

 

 

 

Ending balance as of March 31

   $ (14 )   $ 18  
  

 

 

   

 

 

 

 

     Three Months Ended
March 31, 2011
 
     Natural
Gas
    Life
Insurance
Contracts
 
     (millions of dollars)  

Beginning balance as of January 1

   $ (23   $ 19   

Total gains (losses) (realized and unrealized)

    

Included in income

     —          3  

Included in accumulated other comprehensive loss

     —          —     

Included in regulatory assets

     (1 )     —     

Purchases

     —          —     

Issuances

     —          (1 )

Settlements

     5       (4 )

Transfers in (out) of level 3

     —          —     
  

 

 

   

 

 

 

Ending balance as of March 31

   $ (19   $ 17  
  

 

 

   

 

 

 

The breakdown of realized and unrealized gains on level 3 instruments included in income as a component of Other income or Other operation and maintenance expense for the periods below were as follows:

 

     Three Months Ended March 31,  
     2012      2011  
     (millions of dollars)  

Total net gains included in income for the period

   $ 1      $ 3  
  

 

 

    

 

 

 

Change in unrealized gains relating to assets still held at reporting date

   $ 1      $ 1  
  

 

 

    

 

 

 

 

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Other Financial Instruments

The estimated fair values of PHI’s debt instruments that are measured at amortized cost in PHI’s consolidated financial statements and the associated level of the estimates within the fair value hierarchy as of March 31, 2012 are shown in the table below. As required by the fair value measurement guidance, debt instruments are classified in their entirety within the fair value hierarchy based on the lowest level of input that is significant to the fair value measurement. PHI’s assessment of the significance of a particular input to the fair value measurement requires the exercise of judgment, which may affect the valuation of fair value debt instruments and their placement within the fair value hierarchy levels.

 

     Fair Value Measurements at March 31, 2012  

Description

   Total      Quoted Prices in
Active Markets
for Identical
Instruments
(Level 1)
     Significant
Other
Observable
Inputs
(Level 2)
     Significant
Unobservable
Inputs
(Level 3)
 
     (millions of dollars)  

LIABILITIES

           

Debt instruments

           

Long-term debt (a)

   $ 4,569      $ 408      $ 3,681       $ 480  

Transition Bonds issued by ACE Funding (b)

     370        —           370        —     

Long-term project funding

     15        —           —           15  
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ 4,954      $ 408      $ 4,051       $ 495  
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(a) The carrying amount for Long-term debt is $3,868 million as of March 31, 2012.
(b) The carrying amount for Transition Bonds issued by ACE Funding, including amounts due within one year, is $323 million as of March 31, 2012.

The fair value of Long-term debt categorized as level 1 is based on actual quoted trade prices for the debt in active markets on the measurement date.

The fair value of Long-term debt and Transition Bonds issued by ACE Funding categorized as level 2 is based on a blend of quoted prices for the debt and quoted prices for similar debt in active markets, but not on the measurement date. The blend places more weight on current pricing information when determining the final fair value measurement. The fair value information is provided by brokers and PHI reviews the methodologies and results.

The fair value of Long-term debt categorized as level 3 is based on a discounted cash flow methodology using observable inputs, such as the U.S. Treasury yield, and unobservable inputs, such as credit spreads, because quoted prices for the debt or similar debt in active markets were insufficient. The Long-Term project funding represents debt instruments issued by Pepco Energy Services related to its energy savings contracts. Long-Term project funding is categorized as level 3 because PHI concluded that the amortized cost carrying amounts for these instruments approximates fair value, which does not represent a quoted price in an active market.

 

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The estimated fair values of PHI’s debt instruments at December 31, 2011 are shown below:

 

     December 31, 2011  
     Carrying
Amount
     Fair
Value
 
     (millions of dollars)  

Long-term debt

   $ 3,867      $ 4,577  

Transition Bonds issued by ACE Funding

     332        380  

Long-term project funding

     15        15  

The carrying amounts of all other financial instruments in the accompanying consolidated financial statements approximate fair value.

(15) COMMITMENTS AND CONTINGENCIES

General Litigation

In 1993, Pepco was served with Amended Complaints filed in the state Circuit Courts of Prince George’s County, Baltimore City and Baltimore County, Maryland in separate ongoing, consolidated proceedings known as “In re: Personal Injury Asbestos Case.” Pepco and other corporate entities were brought into these cases on a theory of premises liability. Under this theory, the plaintiffs argued that Pepco was negligent in not providing a safe work environment for employees or its contractors, who allegedly were exposed to asbestos while working on Pepco’s property. Initially, a total of approximately 448 individual plaintiffs added Pepco to their complaints. While the pleadings were not entirely clear, it appeared that each plaintiff sought $2 million in compensatory damages and $4 million in punitive damages from each defendant. In the intervening years, most of the cases were voluntarily dismissed by the plaintiffs prior to their respective trial dates. At the beginning of the first quarter of 2012, there were approximately 90 cases pending against Pepco in the Maryland State Courts (excluding those tendered to Mirant Corporation (Mirant) for defense and indemnification in connection with the sale by Pepco of its generation assets to Mirant in 2000), with an aggregate amount of monetary damages sought of approximately $360 million. On March 1, 2012, the parties to these consolidated proceedings (each represented by the same law firm) filed a stipulation of dismissal, by which the plaintiffs voluntarily dismissed Pepco as a defendant, eliminating any reasonably possible liability Pepco may have had with respect to these proceedings.

In September 2011, an asbestos complaint was filed in the New Jersey Superior Court, Law Division, against ACE (among other defendants) asserting claims under New Jersey’s Wrongful Death and Survival statutes. The complaint, filed by the estate of a decedent who was the wife of a former employee of ACE, alleges that the decedent’s mesothelioma was caused by exposure to asbestos brought home by her husband on his work clothes. Unlike the other jurisdictions to which PHI subsidiaries are subject, New Jersey courts have recognized a cause of action against a premise owner in a so-called “take home” case if it can be shown that the harm was foreseeable. In this case, the complaint seeks recovery of an unspecified amount of damages for, among other things, the decedent’s past medical expenses, loss of earnings, and pain and suffering between the time of injury and death, and asserts a punitive damage claim. At this time, ACE has concluded that a loss is reasonably possible with respect to this matter, but ACE was unable to estimate an amount or range of reasonably possible loss because (i) the damages sought are indeterminate, (ii) the proceedings are in the early stages, and (iii) the matter involves facts that ACE believes are distinguishable from the facts of the “take home” cause of action recognized by the New Jersey courts.

 

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Environmental Matters

PHI, through its subsidiaries, is subject to regulation by various federal, regional, state and local authorities with respect to the environmental effects of its operations, including air and water quality control, solid and hazardous waste disposal and limitations on land use. Although penalties assessed for violations of environmental laws and regulations are not recoverable from customers of PHI’s utility subsidiaries, environmental clean-up costs incurred by Pepco, DPL and ACE generally are included by each company in its respective cost of service for ratemaking purposes. The total accrued liabilities for the environmental contingencies of PHI and its subsidiaries described below at March 31, 2012 are summarized as follows:

 

            Legacy Generation                
     Transmission and
Distribution
     Regulated      Non-Regulated      Other      Total  
     (millions of dollars)  

Beginning balance as of January 1

   $ 15       $ 8       $ 10       $ 2       $ 35   

Accruals

     —          —           —           —           —     

Payments

     —           1         —           —           1   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Ending balance as of March 31

     15         7         10        2         34   

Less amounts in Other current liabilities

     2         2         —           2         6   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Amounts in Other deferred credits

   $ 13       $ 5       $ 10      $ —         $ 28   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Conectiv Energy Wholesale Power Generation Sites

On July 1, 2010, PHI sold the Conectiv Energy wholesale power generation business to Calpine. Under New Jersey’s Industrial Site Recovery Act (ISRA), the transfer of ownership triggered an obligation on the part of Conectiv Energy to remediate any environmental contamination at each of the nine Conectiv Energy generating facility sites located in New Jersey. Under the terms of the sale, Calpine has assumed responsibility for performing the ISRA-required remediation and for the payment of all related ISRA compliance costs up to $10 million. PHI is obligated to indemnify Calpine for any ISRA compliance remediation costs in excess of $10 million. According to preliminary estimates, the costs of ISRA-required remediation activities at the nine generating facility sites located in New Jersey are in the range of approximately $7 million to $18 million. The amount accrued by PHI for the ISRA-required remediation activities at the nine generating facility sites is included in the table above under the column entitled Legacy Generation – Non-Regulated.

On September 14, 2011, PHI received a request for data from the U.S. Environmental Protection Agency (EPA) regarding operations at the Deepwater generating facility in New Jersey (which was included in the sale to Calpine) between January 1, 2001 and July 1, 2010, to demonstrate compliance with the Clean Air Act’s new source review permitting program. The data request covers the period from February 2004 to July 1, 2010. Under the terms of the Calpine sale, PHI is obligated to indemnify Calpine for any failure of PHI, on or prior to the closing date of the sale, to comply with environmental laws attributable to the construction of new, or modification of existing, sources of air emissions. At this time, PHI does not expect this inquiry to have a material effect on its financial position or results of operations.

The sale of the Conectiv Energy wholesale power generation business to Calpine did not include a coal ash landfill site located at the Edge Moor generating facility, which PHI intends to close. The preliminary estimate of the costs to PHI to close the coal ash landfill ranges from approximately $2 million to $3 million, plus annual post-closure operations, maintenance and monitoring costs, estimated to range between $120,000 and $193,000 per year for 30 years. The amounts accrued by PHI for this matter are included in the table above under the column entitled Legacy Generation - Non-Regulated.

 

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Franklin Slag Pile Site

In November 2008, ACE received a general notice letter from EPA concerning the Franklin Slag Pile site in Philadelphia, Pennsylvania, asserting that ACE is a potentially responsible party (PRP) that may have liability for clean-up costs with respect to the site and for the costs of implementing an EPA-mandated remedy. EPA’s claims are based on ACE’s sale of boiler slag from the B.L. England generating facility, then owned by ACE, to MDC Industries, Inc. (MDC) during the period June 1978 to May 1983. EPA claims that the boiler slag ACE sold to MDC contained copper and lead, which are hazardous substances under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CERCLA), and that the sales transactions may have constituted an arrangement for the disposal or treatment of hazardous substances at the site, which could be a basis for liability under CERCLA. The EPA letter also states that, as of the date of the letter, EPA’s expenditures for response measures at the site have exceeded $6 million. EPA estimates the additional cost for future response measures will be approximately $6 million. ACE believes that EPA sent similar general notice letters to three other companies and various individuals.

ACE believes that the B.L. England boiler slag sold to MDC was a valuable material with various industrial applications and, therefore, the sale was not an arrangement for the disposal or treatment of any hazardous substances as would be necessary to constitute a basis for liability under CERCLA. ACE intends to contest any claims to the contrary made by EPA. In a May 2009 decision arising under CERCLA, which did not involve ACE, the U.S. Supreme Court rejected an EPA argument that the sale of a useful product constituted an arrangement for disposal or treatment of hazardous substances. While this decision supports ACE’s position, at this time ACE cannot predict how EPA will proceed with respect to the Franklin Slag Pile site, or what portion, if any, of the Franklin Slag Pile site response costs EPA would seek to recover from ACE. Costs to resolve this matter are not expected to be material and are expensed as incurred.

Peck Iron and Metal Site

EPA informed Pepco in a May 2009 letter that Pepco may be a PRP under CERCLA with respect to the cleanup of the Peck Iron and Metal site in Portsmouth, Virginia, and for costs EPA has incurred in cleaning up the site. The EPA letter states that Peck Iron and Metal purchased, processed, stored and shipped metal scrap from military bases, governmental agencies and businesses and that Peck’s metal scrap operations resulted in the improper storage and disposal of hazardous substances. EPA bases its allegation that Pepco arranged for disposal or treatment of hazardous substances sent to the site on information provided by former Peck Iron and Metal personnel, who informed EPA that Pepco was a customer at the site. Pepco has advised EPA by letter that its records show no evidence of any sale of scrap metal by Pepco to the site. Even if EPA has such records and such sales did occur, Pepco believes that any such scrap metal sales may be entitled to the recyclable material exemption from CERCLA liability. In a Federal Register notice published on November 4, 2009, EPA placed the Peck Iron and Metal site on the National Priorities List (NPL). The NPL, among other things, serves as a guide to EPA in determining which sites warrant further investigation to assess the nature and extent of the human health and environmental risks associated with a site. In September 2011, EPA initiated a remedial investigation/feasibility study (RI/FS) using federal funds. Pepco cannot at this time estimate an amount or range of reasonably possible loss associated with the RI/FS, any remediation activities to be performed at the site or any other costs that EPA might seek to impose on Pepco.

Ward Transformer Site

In April 2009, a group of PRPs with respect to the Ward Transformer site in Raleigh, North Carolina, filed a complaint in the U.S. District Court for the Eastern District of North Carolina, alleging cost recovery and/or contribution claims against a number of entities, including ACE, DPL and Pepco with respect to past and

 

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future response costs incurred by the PRP group in performing a removal action at the site. In a March 2010 order, the court denied the defendants’ motion to dismiss. The next step in the litigation will be the filing of summary judgment motions regarding liability for certain “test case” defendants, not including ACE, DPL and Pepco. The case has been stayed as to the remaining defendants pending rulings upon the test cases. Although PHI cannot at this time estimate an amount or range of reasonably possible losses to which it may be exposed, PHI does not believe that any of its three utility subsidiaries had extensive business transactions, if any, with the Ward Transformer site and therefore, costs incurred to resolve this matter are not expected to be material.

Benning Road Site

In September 2010, PHI received a letter from EPA stating that EPA and the District of Columbia Department of the Environment (DDOE) have identified the Benning Road location, consisting of a transmission and distribution facility operated by Pepco and a generation facility operated by Pepco Energy Services, as one of six land-based sites potentially contributing to contamination of the lower Anacostia River. The letter stated that the principal contaminants of concern are polychlorinated biphenyls and polycyclic aromatic hydrocarbons. In January 2011, Pepco and Pepco Energy Services entered into a proposed consent decree with DDOE that requires Pepco and Pepco Energy Services to conduct a RI/FS for the Benning Road site and an approximately 10-15 acre portion of the adjacent Anacostia River. The RI/FS will form the basis for DDOE’s selection of a remedial action for the Benning Road site and for the Anacostia River sediment associated with the site. In February 2011, the District of Columbia filed a complaint against Pepco and Pepco Energy Services in the United States District Court for the District of Columbia for the purpose of obtaining judicial approval of the consent decree. On December 1, 2011, the District Court issued an order granting the motion to enter a revised consent decree. The District Court’s order entering the consent decree requires DDOE to solicit and consider public comment on the key RI/FS documents prior to final approval, requires DDOE to make final versions of all approved RI/FS documents available to the public, and requires the parties to submit a written status report to the District Court on May 24, 2013 regarding the implementation of the requirements of the consent decree and any related plans for remediation. In addition, if the RI/FS has not been completed by May 24, 2013, the status report must provide an explanation and a showing of good cause for why the work has not been completed.

Pepco and Pepco Energy Services anticipate that a RI/FS work plan will be approved by the DDOE by the end of the third quarter of 2012, at which time the RI/FS field work activities will commence.

The remediation costs accrued for this matter are included in the table above under the columns entitled Transmission and Distribution, Legacy Generation – Regulated and Legacy Generation – Non-Regulated.

Indian River Oil Release

In 2001, DPL entered into a consent agreement with the Delaware Department of Natural Resources and Environmental Control for remediation, site restoration, natural resource damage compensatory projects and other costs associated with environmental contamination resulting from an oil release at the Indian River generating facility, which was sold in June 2001. The amount of remediation costs accrued for this matter is included in the table above under the column entitled Legacy Generation - Regulated.

Potomac River Mineral Oil Release

In January 2011, a coupling failure on a transformer cooler pipe resulted in a release of non-toxic mineral oil at Pepco’s Potomac River substation in Alexandria, Virginia. An overflow of an underground secondary containment reservoir resulted in approximately 4,500 gallons of mineral oil flowing into the Potomac River.

 

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The release falls within the regulatory jurisdiction of multiple federal and state agencies. Beginning in March 2011, DDOE issued a series of compliance directives that require Pepco to prepare an incident report, provide certain records, and prepare and implement plans for sampling surface water and river sediments and assessing ecological risks and natural resources damages. Pepco has submitted an incident report and is providing the requested records. In December 2011, Pepco completed field sampling and anticipates submitting a report to DDOE during the second quarter of 2012.

On March 16, 2011, the Virginia Department of Environmental Quality (VADEQ) requested documentation regarding the release and the preparation of an emergency response report, which Pepco submitted to the agency on April 20, 2011. On March 25, 2011, Pepco received a notice of violation from VADEQ and in December 2011, VADEQ executed a consent agreement that had been executed by Pepco in August, pursuant to which Pepco paid a civil penalty of approximately $40,000. The U.S. Coast Guard assessed a $5,000 penalty against Pepco for the release of oil into the waters of the United States, which Pepco has paid.

During March 2011, EPA conducted an inspection of the Potomac River substation to review compliance with federal regulations regarding Spill Prevention, Control, and Countermeasure (SPCC) plans for facilities using oil-containing equipment in proximity to surface waters. As a result, EPA identified several potential violations of the SPCC regulations relating to SPCC plan content, recordkeeping, and secondary containment, which EPA advised may lead to an EPA demand for noncompliance penalties. As a result of the oil release, Pepco submitted a revised SPCC plan to EPA in August 2011 and implemented certain interim operational changes to the secondary containment systems at the facility which involve pumping accumulated storm water to an aboveground holding tank for off-site disposal. In December 2011, Pepco completed the installation of a treatment system designed to allow automatic discharge of accumulated storm water from the secondary containment system. Pepco is currently seeking DDOE’s and EPA’s approval to commence operation of the new system and, after receiving such approval, will submit a further revised SPCC plan to EPA. In the meantime, Pepco will continue to use the above ground holding tank to manage storm water from the secondary containment system.

In addition to the cost to remediate impacts to the river and shoreline, Pepco also may be liable for non-compliance penalties and/or natural resource damages in addition to those it has already paid. It is not possible to accurately estimate an amount or range of reasonably possible loss to which it may be exposed associated with this liability at this time; however, based on current information, PHI and Pepco do not believe this matter will have a material adverse effect on their respective financial conditions, results of operations or cash flows.

The amounts accrued for these matters are included in the table above under the column entitled Transmission and Distribution.

Fauquier County Landfill Site

In October 2011, Pepco Energy Services received a notice of violation from the VADEQ, which advised Pepco Energy Services of information on which VADEQ may rely to institute an administrative or judicial enforcement action in connection with alleged violation of Virginia air pollution control law and regulations at the facility of Pepco Energy Services’ subsidiary Fauquier County Landfill Gas, L.L.C. in Warrenton, Virginia. The notice of violation is based on an on-site VADEQ inspection during which VADEQ observed certain alleged deficiencies relating to the facility’s permit to construct and operate. On February 21, 2012, Pepco Energy Services signed a proposed consent order sent by VADEQ, pursuant to which Pepco Energy Services agreed to perform certain remedial actions and agreed to pay a civil charge of approximately $10,000.

 

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PHI’s Cross-Border Energy Lease Investments

PCI has entered seven cross-border energy lease investments involving public utility assets (primarily consisting of hydroelectric generation and coal-fired electric generation facilities and natural gas distribution networks) located outside of the United States. Each of these investments is comprised of multiple leases and each investment is structured as a sale and leaseback transaction commonly referred to by the IRS as a sale-in, lease-out, or SILO transaction. PHI current annual tax benefits from these lease investments are approximately $48 million. As of March 31, 2012, the book value of PHI’s investment in its cross-border energy lease investments was approximately $1.4 billion. After taking into consideration the $74 million paid with the 2001-2002 audit (as discussed below), the net federal and state tax benefits received for the remaining leases from January 1, 2001, the earliest year that remains open to audit, to March 31, 2012, has been approximately $522 million.

Since 2005, PHI’s cross-border energy lease investments have been under examination by the IRS as part of the PHI federal income tax audits. In connection with the audit of PHI’s 2001-2002 and 2003-2005 income tax returns, respectively, the IRS disallowed the depreciation and interest deductions in excess of rental income claimed by PHI with respect to each of its cross-border energy lease investments. In addition, the IRS has sought to recharacterize each of the leases as a loan transaction as to which PHI would be subject to original issue discount income. PHI disagreed with the IRS’ proposed adjustments and filed protests of these findings with the Office of Appeals of the IRS. In November 2010, PHI entered into a settlement agreement with the IRS for the 2001 and 2002 tax years and subsequently filed refund claims in July 2011 for the disallowed tax deductions relating to the leases for these years. In January 2011, as part of this settlement, PHI paid $74 million of additional tax for 2001 and 2002, penalties of $1 million, and $28 million in interest associated with the disallowed deductions. Since the July 2011 claim for refund was not approved by the IRS within the statutory six-month period, in January 2012 PHI filed complaints in the U.S. Court of Federal Claims seeking recovery of the tax payment, interest and penalties. Absent a settlement, this litigation against the IRS may take several years to resolve. The 2003-2005 income tax return review continues to be in process with the IRS Office of Appeals and at present, will not be a part of the U.S. Court of Federal Claims litigation discussed above.

In the event that the IRS were to be successful in disallowing 100% of the tax benefits associated with these lease investments and recharacterizing these lease investments as loans, PHI estimates that, as of March 31, 2012, it would be obligated to pay approximately $658 million in additional federal and state taxes and $127 million of interest on the remaining leases. The $785 million in additional federal and state taxes and interest is net of the $74 million tax payment made in January 2011. In addition, the IRS could require PHI to pay a penalty of up to 20% on the amount of additional taxes due.

PHI anticipates that any additional taxes that it would be required to pay as a result of the disallowance of prior deductions or a re-characterization of the leases as loans would be recoverable in the form of lower taxes over the remaining terms of the affected leases. Moreover, the entire amount of any additional federal and state tax would not be due immediately, but rather, the federal and state taxes would be payable when the open audit years are closed and PHI amends subsequent tax returns not then under audit. To mitigate the taxes due in the event of a total disallowance of tax benefits, PHI could elect to liquidate all or a portion of its remaining cross-border energy lease investments, which PHI estimates could be accomplished over a period of six months to one year. Based on current market values, PHI estimates that liquidation of the remaining portfolio would generate sufficient cash proceeds to cover the estimated $785 million in federal and state taxes and interest due as of March 31, 2012, in the event of a total disallowance of tax benefits and a recharacterization of the leases as loans. If payments of additional taxes and interest preceded the receipt of liquidation proceeds, the payments would be funded by currently available sources of liquidity.

To the extent that PHI does not prevail in this matter and suffers a disallowance of the tax benefits and incurs imputed original issue discount income, PHI would be required under FASB guidance on leases (ASC 840) to recalculate the timing of the tax benefits generated by the cross-border energy lease investments and adjust the equity value of the investments, which would result in a non-cash charge to earnings.

 

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District of Columbia Tax Legislation

On January 20, 2012, the District of Columbia Office of Tax and Revenue issued proposed regulations to implement the mandatory unitary combined reporting method for tax years beginning in 2011. PHI will continue to analyze these regulations and will record the impact, if any, of such regulations on PHI’s results of operations in the period in which the proposed regulations are adopted as final regulations.

Third Party Guarantees, Indemnifications, and Off-Balance Sheet Arrangements

PHI and certain of its subsidiaries have various financial and performance guarantees and indemnification obligations that they have entered into in the normal course of business to facilitate commercial transactions with third parties as discussed below.

As of March 31, 2012, PHI and its subsidiaries were parties to a variety of agreements pursuant to which they were guarantors for standby letters of credit, energy procurement obligations, and other commitments and obligations. The commitments and obligations, in millions of dollars, were as follows:

 

     Guarantor         
     PHI      Pepco      DPL      ACE      Total  

Energy procurement obligations of Pepco Energy Services (a)

   $ 160      $ —         $ —         $ —         $ 160  

Guarantees associated with disposal of Conectiv Energy assets (b)

     18        —           —           —           18  

Guaranteed lease residual values (c)

     2        4        5        3        14  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 180      $ 4      $ 5      $ 3      $ 192  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(a) PHI has contractual commitments for performance and related payments of Pepco Energy Services to counterparties under routine energy sales and procurement obligations.
(b) Represents guarantees by PHI of Conectiv Energy’s tolling agreements and derivatives portfolio transferred in connection with the disposition of Conectiv Energy’s wholesale business. The tolling agreement guarantees cover the payment by the entity to which the tolling agreement was assigned. The guaranteed amounts on the transferred tolling agreements totaled $5 million at March 31, 2012 and decline until the termination of the guarantees in June 2012. The derivative portfolio guarantee is currently $13 million and covers Conectiv Energy’s performance prior to the assignment. This guarantee will remain in effect until the end of 2015.
(c) Subsidiaries of PHI have guaranteed any residual values in excess of fair value of certain leased equipment and fleet vehicles. As of March 31, 2012, obligations under the guarantees were approximately $14 million. Assets leased under agreements subject to residual value guarantees are typically for periods ranging from 2 years to 10 years. Historically, payments under the guarantees have not been made by the guarantor as, under normal conditions, the contract runs to full term at which time the residual value is immaterial. As such, PHI believes the likelihood of payments being required under the guarantees is remote.

PHI and certain of its subsidiaries have entered into various indemnification agreements related to purchase and sale agreements and other types of contractual agreements with vendors and other third parties. These indemnification agreements typically cover environmental, tax, litigation and other matters, as well as breaches of representations, warranties and covenants set forth in these agreements. Typically, claims may be made by third parties under these indemnification agreements over various periods of time depending on the nature of the claim. The maximum potential exposure under these indemnification agreements can range from a specified dollar amount to an unlimited amount depending on the nature of the claim and the particular transaction. The total maximum potential amount of future payments under these indemnification agreements is not estimable due to several factors, including uncertainty as to whether or when claims may be made under these indemnities.

Energy Services Performance and Construction Contracts

Pepco Energy Services has a diverse portfolio of energy services performance contracts that are associated with the installation of energy savings equipment or combined heat and power for federal, state and local government customers. As part of the energy savings contracts, Pepco Energy Services typically guarantees that the equipment or systems installed by Pepco Energy Services will generate a specified amount of energy savings on an annual basis over a multi-year period. As of March 31, 2012, Pepco Energy Services’ energy savings guarantees on both completed projects and projects under construction totaled $441 million over the

 

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life of the performance contracts with the longest remaining term being 15 years. On an annual basis, Pepco Energy Services undertakes a measurement and verification process to determine the amount of energy savings for the year and whether there is any shortfall in the annual energy savings compared to the guaranteed amount. As of March 31, 2012, Pepco Energy Services had performance guarantee contracts associated with the production at its combined heat and power facilities on both completed projects and projects under construction totaling $15 million over the life of the contracts, with the longest remaining term being 20 years. Pepco Energy Services recognizes a liability for the value of the estimated energy savings or production shortfalls when it is probable that the guaranteed amounts will not be achieved and the amount is reasonably estimable. As of March 31, 2012, Pepco Energy Services did not have an accrued liability for energy savings or combined heat and power performance contracts. There was no significant change in the type of contracts issued for the three months ended March 31, 2012. Based on its historical experience, Pepco Energy Services believes the probability of incurring a material loss under its energy savings or combined heat and power performance contracts is remote.

From time to time, PHI is also required to guarantee the obligations of Pepco Energy Services under certain of its construction contracts. At March 31, 2012, PHI’s guarantees of Pepco Energy Services’ construction projects totaled $143 million.

Dividends

On April 26, 2012, Pepco Holdings’ Board of Directors declared a dividend on common stock of 27 cents per share payable June 29, 2012, to stockholders of record on June 11, 2012.

(16) ACCUMULATED OTHER COMPREHENSIVE LOSS

The components of Pepco Holdings’ AOCL relating to continuing operations are as follows. For additional information, see the consolidated statements of comprehensive income.

 

     Commodity
Derivatives
    Treasury
Lock
    Prior Service
Costs
    Total  
     (millions of dollars)  

Balance, December 31, 2011

   $ (29 )   $ (10   $ (24 )   $ (63

Current year change

     8       —          —          8  
  

 

 

   

 

 

   

 

 

   

 

 

 

Balance, March 31, 2012

   $ (21 )   $ (10 )   $ (24 )   $ (55
  

 

 

   

 

 

   

 

 

   

 

 

 

The income tax expense for each component of Pepco Holdings’ other comprehensive income is as follows:

 

     Commodity
Derivatives  (a)
     Treasury
Lock (b)
     Prior Service
Costs (b)
     Total  
     (millions of dollars)  

For the three months ended March 31, 2012

   $ 5       $ —         $ 1      $ 6   

For the three months ended March 31, 2011

   $ 11       $ —         $ —         $ 11   

 

(a) Includes tax expense for losses reclassified to income during the three months ended March 31, 2012 and 2011, of $5 million and $11 million, respectively.
(b) No material income tax effect of losses reclassified to income in the current period.

 

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(17) DISCONTINUED OPERATIONS

In April 2010, the Board of Directors approved a plan for the disposition of PHI’s competitive wholesale power generation, marketing and supply business, which had been conducted through Conectiv Energy. On July 1, 2010, PHI completed the sale of Conectiv Energy’s wholesale power generation business to Calpine. The disposition of all of Conectiv Energy’s remaining assets and businesses, consisting of its load service supply contracts, energy hedging portfolio, certain tolling agreements and other assets not included in the Calpine sale, is complete.

Income from discontinued operations, net of income taxes for the three months ended March 31, 2012 and 2011, was zero and $2 million, respectively.

 

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POTOMAC ELECTRIC POWER COMPANY

STATEMENTS OF INCOME

(Unaudited)

 

     Three Months Ended
March 31,
 
     2012     2011  
     (millions of dollars)  

Operating Revenue

   $ 465     $ 534  
  

 

 

   

 

 

 

Operating Expenses

    

Purchased energy

     185       255  

Other operation and maintenance

     103       102  

Depreciation and amortization

     47       42  

Other taxes

     90       92  
  

 

 

   

 

 

 

Total Operating Expenses

     425       491  
  

 

 

   

 

 

 

Operating Income

     40       43  
  

 

 

   

 

 

 

Other Income (Expenses)

    

Interest expense

     (25 )     (24 )

Other income

     4       6  
  

 

 

   

 

 

 

Total Other Expenses

     (21 )     (18 )
  

 

 

   

 

 

 

Income Before Income Tax Expense

     19       25  

Income Tax (Benefit) Expense

     (5 )     7  
  

 

 

   

 

 

 

Net Income

   $ 24     $ 18  
  

 

 

   

 

 

 

The accompanying Notes are an integral part of these Financial Statements.

 

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POTOMAC ELECTRIC POWER COMPANY

BALANCE SHEETS

(Unaudited)

 

     March 31,
2012
    December 31,
2011
 
     (millions of dollars)  

ASSETS

    

CURRENT ASSETS

    

Cash and cash equivalents

   $ 7     $ 12  

Accounts receivable, less allowance for uncollectible accounts of $16 million and $18 million, respectively

     305       339  

Inventories

     54       50  

Prepayments of income taxes

     18       7  

Income taxes receivable

     31       31  

Prepaid expenses and other

     29       32  
  

 

 

   

 

 

 

Total Current Assets

     444       471  
  

 

 

   

 

 

 

INVESTMENTS AND OTHER ASSETS

    

Regulatory assets

     332       299  

Prepaid pension expense

     368       289  

Investment in trust

     30       31  

Income taxes receivable

     103       24  

Other

     63       55  
  

 

 

   

 

 

 

Total Investments and Other Assets

     896       698  
  

 

 

   

 

 

 

PROPERTY, PLANT AND EQUIPMENT

    

Property, plant and equipment

     6,691       6,578  

Accumulated depreciation

     (2,722 )     (2,704 )
  

 

 

   

 

 

 

Net Property, Plant and Equipment

     3,969       3,874  
  

 

 

   

 

 

 

TOTAL ASSETS

   $ 5,309     $ 5,043  
  

 

 

   

 

 

 

 

The accompanying Notes are an integral part of these Financial Statements.

 

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POTOMAC ELECTRIC POWER COMPANY

BALANCE SHEETS

(Unaudited)

 

     March 31,
2012
     December 31,
2011
 
     (millions of dollars, except shares)  

LIABILITIES AND EQUITY

     

CURRENT LIABILITIES

     

Short-term debt

   $ 204      $ 74  

Accounts payable and accrued liabilities

     200        209  

Accounts payable due to associated companies

     64        57  

Capital lease obligations due within one year

     8        8  

Taxes accrued

     51        63  

Interest accrued

     36        17  

Other

     111        110  
  

 

 

    

 

 

 

Total Current Liabilities

     674        538  
  

 

 

    

 

 

 

DEFERRED CREDITS

     

Regulatory liabilities

     173        169  

Deferred income taxes, net

     1,173        1,039  

Investment tax credits

     5        5  

Other postretirement benefit obligations

     67        66  

Liabilities and accrued interest related to uncertain tax positions

     5        38  

Other

     68        68  
  

 

 

    

 

 

 

Total Deferred Credits

     1,491        1,385  
  

 

 

    

 

 

 

LONG-TERM LIABILITIES

     

Long-term debt

     1,540        1,540  

Capital lease obligations

     78        78  
  

 

 

    

 

 

 

Total Long-Term Liabilities

     1,618        1,618  
  

 

 

    

 

 

 

COMMITMENTS AND CONTINGENCIES (NOTE 11)

     

EQUITY

     

Common stock, $.01 par value, 200,000,000 shares authorized, 100 shares outstanding

     —           —     

Premium on stock and other capital contributions

     705        705  

Retained earnings

     821        797  
  

 

 

    

 

 

 

Total Equity

     1,526        1,502  
  

 

 

    

 

 

 

TOTAL LIABILITIES AND EQUITY

   $ 5,309      $ 5,043  
  

 

 

    

 

 

 

The accompanying Notes are an integral part of these Financial Statements.

 

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POTOMAC ELECTRIC POWER COMPANY

STATEMENTS OF CASH FLOWS

(Unaudited)

 

     Three Months Ended
March  31,
 
     2012     2011  
     (millions of dollars)  

OPERATING ACTIVITIES

    

Net income

   $ 24     $ 18  

Adjustments to reconcile net income to net cash from operating activities:

    

Depreciation and amortization

     47       42  

Deferred income taxes

     127       26  

Changes in:

    

Accounts receivable

     35       28  

Inventories

     (4 )     (4 )

Regulatory assets and liabilities, net

     (14 )     (4 )

Accounts payable and accrued liabilities

     (7 )     (33 )

Pension contributions

     (85 )     (40 )

Taxes accrued

     (139 )     50  

Interest accrued

     19       19  

Other assets and liabilities

     4       16  
  

 

 

   

 

 

 

Net Cash From Operating Activities

     7       118  
  

 

 

   

 

 

 

INVESTING ACTIVITIES

    

Investment in property, plant and equipment

     (158 )     (97 )

Department of Energy capital reimbursement awards received

     6       8  

Net other investing activities

     2       (1 )
  

 

 

   

 

 

 

Net Cash Used By Investing Activities

     (150 )     (90 )
  

 

 

   

 

 

 

FINANCING ACTIVITIES

    

Issuances of short-term debt, net

     130       —     

Net other financing activities

     8       —     
  

 

 

   

 

 

 

Net Cash From Financing Activities

     138       —     
  

 

 

   

 

 

 

Net (Decrease) Increase in Cash and Cash Equivalents

     (5 )     28  

Cash and Cash Equivalents at Beginning of Period

     12       88  
  

 

 

   

 

 

 

CASH AND CASH EQUIVALENTS AT END OF PERIOD

   $ 7     $ 116  
  

 

 

   

 

 

 

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION

    

Cash paid (received) for income taxes (includes payments to (from) PHI for federal income taxes)

   $ 1     $ (70 )

The accompanying Notes are an integral part of these Financial Statements.

 

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POTOMAC ELECTRIC POWER COMPANY

STATEMENT OF EQUITY

(Unaudited)

 

      Common Stock      Premium
on Stock
     Retained
Earnings
     Total  
(millions of dollars, except shares)    Shares      Par Value           

BALANCE, DECEMBER 31, 2011

     100      $ —         $ 705      $ 797      $ 1,502  

Net Income

     —           —           —           24        24  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

BALANCE, MARCH 31, 2012

     100      $ —         $ 705      $ 821      $ 1,526  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

The accompanying Notes are an integral part of these Financial Statements.

 

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NOTES TO FINANCIAL STATEMENTS

POTOMAC ELECTRIC POWER COMPANY

(1) ORGANIZATION

Potomac Electric Power Company (Pepco) is engaged in the transmission and distribution of electricity in the District of Columbia and major portions of Prince George’s County and Montgomery County in suburban Maryland. Pepco also provides Default Electricity Supply, which is the supply of electricity at regulated rates to retail customers in its service territories who do not elect to purchase electricity from a competitive supplier. Default Electricity Supply is known as Standard Offer Service in both the District of Columbia and Maryland. Pepco is a wholly owned subsidiary of Pepco Holdings, Inc. (Pepco Holdings or PHI).

(2) SIGNIFICANT ACCOUNTING POLICIES

Financial Statement Presentation

Pepco’s unaudited financial statements are prepared in conformity with accounting principles generally accepted in the United States of America (GAAP). Pursuant to the rules and regulations of the Securities and Exchange Commission, certain information and footnote disclosures normally included in annual financial statements prepared in accordance with GAAP have been omitted. Therefore, these financial statements should be read along with the annual financial statements included in Pepco’s annual report on Form 10-K for the year ended December 31, 2011, as amended to include the executive compensation and other information required by Part III of Form 10-K (which information originally had been omitted as permitted by that form). In the opinion of Pepco’s management, the financial statements contain all adjustments (which all are of a normal recurring nature) necessary to state fairly Pepco’s financial condition as of March 31, 2012, in accordance with GAAP. The year-end December 31, 2011 balance sheet was derived from audited financial statements, but does not include all disclosures required by GAAP. Interim results for the three months ended March 31, 2012 may not be indicative of results that will be realized for the full year ending December 31, 2012.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make certain estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities in the financial statements and accompanying notes. Although Pepco believes that its estimates and assumptions are reasonable, they are based upon information available to management at the time the estimates are made. Actual results may differ significantly from these estimates.

Significant matters that involve the use of estimates include the assessment of contingencies, the calculation of future cash flows and fair value amounts for use in asset impairment evaluations, pension and other postretirement benefits assumptions, the assessment of the probability of recovery of regulatory assets, accrual of storm restoration costs, accrual of unbilled revenue, recognition of changes in network service transmission rates for prior service year costs, accrual of self-insurance reserves for general and auto liability claims, and income tax provisions and reserves. Additionally, Pepco is subject to legal, regulatory and other proceedings and claims that arise in the ordinary course of its business. Pepco records an estimated liability for these proceedings and claims when it is probable that a loss has been incurred and the loss is reasonably estimable.

Taxes Assessed by a Governmental Authority on Revenue-Producing Transactions

Taxes included in Pepco’s gross revenues were $84 million and $85 million for the three months ended March 31, 2012 and 2011, respectively.

 

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Reclassifications and Adjustments

Certain prior period amounts have been reclassified in order to conform to the current period presentation. The following adjustment has been recorded and is not considered material:

Income Tax Adjustments

During the first quarter of 2011, Pepco recorded an adjustment to correct certain income tax errors related to prior periods associated with interest on uncertain tax positions. The adjustment resulted in an increase in income tax expense of $1 million for the three months ended March 31, 2011.

(3) NEWLY ADOPTED ACCOUNTING STANDARDS

Fair Value Measurements and Disclosures (Accounting Standards Codification (ASC) 820)

The Financial Accounting Standards Board (FASB) issued new guidance on fair value measurement and disclosures that was effective beginning with Pepco’s March 31, 2012 financial statements. The new measurement guidance did not have a material impact on Pepco’s financial statements and the new disclosure requirements are in Note (10), “Fair Value Disclosures,” of Pepco’s financial statements.

(4) RECENTLY ISSUED ACCOUNTING STANDARDS, NOT YET ADOPTED

None.

(5) SEGMENT INFORMATION

Pepco operates its business as one regulated utility segment, which includes all of its services as described above.

(6) REGULATORY MATTERS

Rate Proceedings

Over the last several years, Pepco has proposed in each of its jurisdictions the adoption of a mechanism to decouple retail distribution revenue from the amount of power delivered to retail customers. To date, a bill stabilization adjustment (BSA) has been approved and implemented for Pepco electric service in Maryland and the District of Columbia. The Maryland Public Service Commission (MPSC) has issued an order requiring modification of the BSA in Maryland so that revenues lost as a result of major storm outages are not collected through the BSA if electric service is not restored to the pre-major storm levels within 24 hours of the start of a major storm (as discussed below). Under the BSA, customer distribution rates are subject to adjustment (through a credit or surcharge mechanism), depending on whether actual distribution revenue per customer exceeds or falls short of the revenue-per-customer amount approved by the applicable public service commission.

In an effort to reduce the shortfall in revenues due to the delay in time or lag between when costs are incurred and when they are reflected in rates (regulatory lag), Pepco has proposed, in each of its jurisdictions, a reliability investment recovery mechanism (RIM) to recover reliability-related capital expenditures incurred between base rate cases. Through the RIM, Pepco in each year would collect through a surcharge the amount of its reliability-related capital expenditures based on its budget for that year. The budgeted amount would be reconciled with actual capital expenditures on an annual basis and any over-recovery or under-recovery would be reflected in the next year’s surcharge. The work undertaken pursuant to the RIM would be subject to a prudency review by the applicable state regulatory commission in the next base rate case or at more frequent intervals as determined by such commission. Pepco’s operation and maintenance costs and other capital expenditures would remain subject to recovery through the traditional ratemaking process.

 

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Pepco also has requested in each of its jurisdictions approval of the use of fully forecasted test years in future rate cases. Traditionally, past test years with actual historical costs are used for ratemaking purposes; however, fully forecasted test years would be comprised of forward-looking costs. If approved, such fully forecasted test years would be more reflective of current costs and would mitigate the effects of regulatory lag.

District of Columbia

On July 8, 2011, Pepco filed an application with the District of Columbia Public Service Commission (DCPSC) to increase its electric distribution base rates by approximately $42 million annually, based on a requested return on equity (ROE) of 10.75%. The filing includes a request for DCPSC approval of a RIM and the use of fully forecasted test years in future Pepco rate cases. A decision by the DCPSC is expected in the third quarter of 2012.

Maryland

Electric Distribution Base Rates

On December 16, 2011, Pepco submitted an application with the MPSC to increase its electric distribution base rates. The filing seeks approval of an annual rate increase of approximately $68.4 million, based on a requested ROE of 10.75%. The filing includes a request for MPSC approval of a RIM and the use of fully forecasted test years in future Pepco rate cases. A decision by the MPSC is expected in July 2012.

Major Storm Damage Recovery Proceedings

In February 2011, the MPSC initiated proceedings involving Pepco, as well as its affiliate Delmarva Power & Light Company (DPL) and unaffiliated utilities in Maryland, for the purpose of reviewing how the BSA operates to recover revenues lost as a result of major storm outages. On January 25, 2012, the MPSC issued an order modifying the BSA to prevent the Maryland utilities, including Pepco and DPL, from collecting lost utility revenue through the BSA if electric service is not restored to the pre-major storm levels within 24 hours of the start of a major storm (defined by the MPSC as a weather-related event during which more than the lesser of 10% or 100,000 of an electric utility’s customers have a sustained outage for more than 24 hours). The period for which the lost utility revenue may not be collected through the BSA commences 24 hours after the start of the major storm and continues until all major storm-related outages are restored. The MPSC stated that waivers permitting collection of BSA revenues would be granted in rare and extraordinary circumstances where a utility can show that an outage was not due to inadequate emphasis on reliability and restoration efforts were reasonable under the circumstances. A similar provision excluding revenues lost as a result of major storm outages from the calculation of future BSA adjustments is already included in the BSA for Pepco in the District of Columbia as approved by the DCPSC. The financial impact of service interruptions due to a major storm as a result of this MPSC order would generally depend on the scope and duration of the outages.

Maryland Public Service Commission New Generation Contract Requirement

On September 29, 2009, the MPSC initiated an investigation into whether the regulated electric distribution companies (EDCs) in Maryland should be required to enter into long-term contracts with entities that construct, acquire or lease, and operate, new electric generation facilities in Maryland.

The MPSC issued an order on April 12, 2012, in which it determined that there is a need for one new power plant in the range of 650 to 700 MW beginning in 2015. The order requires Pepco, DPL and Baltimore Gas and Electric Company to negotiate and enter into a contract with the winning bidder in amounts proportionate to their relative SOS loads. Under the contract, the winning bidder will construct a 661 MW natural gas-fired combined cycle generation plant in Waldorf, Maryland, with a commercial operation date of

 

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June 1, 2015. The order acknowledges the EDCs’ concerns about the requirements of the contract and directs them to negotiate with the winning bidder and submit any proposed changes in the contract to the MPSC for approval. The order further specifies that the EDCs entering into the contract will recover the associated costs from their respective SOS customers through surcharges. Pepco is evaluating the impact of the order, and, at this time, cannot predict (i) the extent of the negative effect that the order and, once finalized, the contract for new generation, may have on its balance sheets, as well as its credit metrics, as calculated by independent rating agencies that evaluate and rate Pepco and its debt issuances, (ii) the effect on its ability to recover its associated costs of the contract for new generation if a significant number of SOS customers elect to buy their energy from alternative energy suppliers, and (iii) the effect of the order on its financial condition, results of operations and cash flows. On April 27, 2012, a group of generators operating in the PJM region filed a complaint in the United States District Court for the Northern District of Maryland challenging the MPSC’s order on the grounds that such order violated the commerce clause and the supremacy clause of the U.S. Constitution. Pepco continues to evaluate whether to seek judicial review of the MPSC’s order.

(7) PENSION AND OTHER POSTRETIREMENT BENEFITS

Pepco accounts for its participation in its parent’s single-employer plans, the Pepco Holdings, Inc. Retirement Plan (the PHI Retirement Plan) and the Pepco Holdings, Inc. Welfare Plan for Retirees, as participation in multiemployer plans. PHI’s pension and other postretirement net periodic benefit cost for the three months ended March 31, 2012 and 2011, before intercompany allocations from the PHI Service Company, were $26 million and $27 million, respectively. Pepco’s allocated share was $11 million and $10 million, respectively, for the three months ended March 31, 2012 and 2011.

In the first quarter of 2012, Pepco made a discretionary tax-deductible contribution to the PHI Retirement Plan of $85 million. In the first quarter of 2011, Pepco made a discretionary tax-deductible contribution to the PHI Retirement Plan in the amount of $40 million.

(8) DEBT

Credit Facility

PHI, Pepco, DPL and Atlantic City Electric Company (ACE) maintain an unsecured syndicated credit facility to provide for their respective liquidity needs, including obtaining letters of credit, borrowing for general corporate purposes and supporting their commercial paper programs. On August 1, 2011, PHI, Pepco, DPL and ACE entered into an amended and restated credit agreement with respect to the facility, which among other changes extended the expiration date of the facility to August 1, 2016.

The aggregate borrowing limit under the amended and restated credit facility is $1.5 billion, all or any portion of which may be used to obtain loans and up to $500 million of which may be used to obtain letters of credit. The facility also includes a swingline loan sub-facility, pursuant to which each company may make same day borrowings in an aggregate amount not to exceed 10% of the total amount of the facility. Any swingline loan must be repaid by the borrower within fourteen days of receipt. The initial credit sublimit for PHI is $750 million and $250 million for each of Pepco, DPL and ACE. The sublimits may be increased or decreased by the individual borrower during the term of the facility, except that (i) the sum of all of the borrower sublimits following any such increase or decrease must equal the total amount of the facility and (ii) the aggregate amount of credit used at any given time by (a) PHI may not exceed $1.25 billion and (b) each of Pepco, DPL or ACE may not exceed the lesser of $500 million and the maximum amount of short-term debt the company is permitted to have outstanding by its regulatory authorities. The total number of the sublimit reallocations may not exceed eight per year during the term of the facility.

The interest rate payable by each company on utilized funds is, at the borrowing company’s election, (i) the greater of the prevailing prime rate, the federal funds effective rate plus 0.5% and one month LIBOR plus 1.0%, or (ii) the prevailing Eurodollar rate, plus a margin that varies according to the credit rating of the borrower.

 

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In order for a borrower to use the facility, certain representations and warranties must be true and correct, and the borrower must be in compliance with specified financial covenants, including (i) the requirement that each borrowing company maintain a ratio of total indebtedness to total capitalization of 65% or less, computed in accordance with the terms of the credit agreement, which calculation excludes from the definition of total indebtedness certain trust preferred securities and deferrable interest subordinated debt (not to exceed 15% of total capitalization), (ii) with certain exceptions, a restriction on sales or other dispositions of assets, and (iii) a restriction on the incurrence of liens on the assets of a borrower or any of its significant subsidiaries other than permitted liens. The credit agreement contains certain covenants and other customary agreements and requirements that, if not complied with, could result in an event of default and the acceleration of repayment obligations of one or more of the borrowers thereunder. Each of the borrowers was in compliance with all covenants under this facility as of March 31, 2012.

The absence of a material adverse change in PHI’s business, property, results of operations or financial condition is not a condition to the availability of credit under the credit agreement. The credit agreement does not include any rating triggers.

At March 31, 2012 and December 31, 2011, the amount of cash plus borrowing capacity under the credit facility available to meet the liquidity needs of PHI’s utility subsidiaries in the aggregate was $452 million and $711 million, respectively. Pepco’s borrowing capacity under the credit facility at any given time depends on the amount of the subsidiary borrowing capacity being utilized by DPL and ACE and the portion of the total capacity being used by PHI.

Commercial Paper

Pepco maintains an on-going commercial paper program to address its short-term liquidity needs. As of March 31, 2012, the maximum capacity available under the program was $500 million, subject to available borrowing capacity under the credit facility.

Pepco had $204 million of commercial paper outstanding at March 31, 2012. The weighted average interest rate for commercial paper issued by Pepco during the three months ended March 31, 2012 was 0.40% and the weighted average maturity of all commercial paper issued by Pepco during the three months ended March 31, 2012 was five days.

Financing Activities Subsequent to March 31, 2012

In April 2012, Pepco issued $200 million of 3.05% first mortgage bonds due April 1, 2022. Proceeds from the issuance of the long-term debt were primarily used to repay outstanding commercial paper that was issued to temporarily fund capital expenditures and working capital, to redeem, prior to maturity, all of the $38.3 million outstanding of the 5.375% pollution control revenue refunding bonds due February 15, 2024 issued by the Industrial Development Authority of the City of Alexandria, Virginia, on Pepco’s behalf and for general corporate purposes.

On April 30, 2012, all of the $38.3 million outstanding of the 5.375% pollution control revenue refunding bonds were redeemed as noted in the preceding paragraph. In connection with such redemption, Pepco redeemed all of the $38.3 million outstanding of its 5.375% first mortgage bonds due February 15, 2024 that secured the obligations under such pollution control bonds.

 

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(9) INCOME TAXES

A reconciliation of Pepco’s effective income tax rate is as follows:

 

     Three Months Ended March 31,  
     2012     2011  
     (millions of dollars)  

Income tax at Federal statutory rate

   $ 7        35.0   $ 9        35.0

Increases (decreases) resulting from:

        

State income taxes, net of Federal effect

     1       6.3        1       4.4   

Change in estimates and interest related to uncertain and effectively settled tax positions

     (10 )     (50.5 )     —          —     

Permanent differences related to deferred compensation

     —          (1.0     (1 )     (4.4

Asset removal costs

     (3 )     (15.8     (1 )     (4.0

Amortization of software costs

     —          2.1        —          (0.4

Deferred tax basis adjustments

     —          (2.1     —          —     

Other, net

     —          (0.3     (1 )     (2.6
  

 

 

   

 

 

   

 

 

   

 

 

 

Income tax expense

   $ (5 )     (26.3 )%    $ 7       28.0
  

 

 

   

 

 

   

 

 

   

 

 

 

Pepco’s effective tax rates for the three months ended March 31, 2012 and 2011 were (26.3)% and 28.0%, respectively. The decrease in the effective tax rate primarily resulted from changes in estimates and interest related to uncertain and effectively settled tax positions in the first quarter of 2012, primarily due to the effective settlement with the Internal Revenue Service with respect to the methodology used historically to calculate deductible mixed service costs and the expiration of the statute of limitations associated with an uncertain tax position. The effective rate was further decreased as a result of the increase in asset removal costs in 2012 primarily related to a higher level of asset retirements.

(10) FAIR VALUE DISCLOSURES

Financial Instruments Measured at Fair Value on a Recurring Basis

Pepco applies FASB guidance on fair value measurement and disclosures (ASC 820) that established a framework for measuring fair value and expanded disclosures about fair value measurements. As defined in the guidance, fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). Pepco utilizes market data or assumptions that market participants would use in pricing the asset or liability, including assumptions about risk and the risks inherent in the inputs to the valuation technique. These inputs can be readily observable, market corroborated or generally unobservable. Accordingly, Pepco utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. The guidance establishes a fair value hierarchy that prioritizes the inputs used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (level 1) and the lowest priority to unobservable inputs (level 3).

The following tables set forth, by level within the fair value hierarchy, Pepco’s financial assets and liabilities that were accounted for at fair value on a recurring basis as of March 31, 2012 and December 31, 2011. As required by the guidance, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. Pepco’s assessment of the significance of a particular input to the fair value measurement requires the exercise of judgment, and may affect the valuation of fair value assets and liabilities and their placement within the fair value hierarchy levels.

 

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     Fair Value Measurements at March 31, 2012  

Description

   Total      Quoted Prices in
Active Markets
for Identical
Instruments
(Level 1) (a)
     Significant
Other
Observable
Inputs
(Level 2) (a)
     Significant
Unobservable
Inputs
(Level 3)
 
     (millions of dollars)  

ASSETS

           

Executive deferred compensation plan assets

           

Money market funds

   $ 13       $ 13       $ —         $ —     

Life insurance contracts

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