10-Q 1 phi2006q2.htm QUARTERLY REPORT ON FORM 10-Q Quarterly Report on Form 10-Q

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

For the quarter ended June 30, 2006

Commission File Number

Name of Registrant, State of Incorporation,
Address of Principal Executive Offices,
and Telephone Number

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
800 King Street, P.O. Box 231
Wilmington, Delaware 19899
Telephone: (202)872-2000

51-0084283

001-03559

ATLANTIC CITY ELECTRIC COMPANY
  (ACE), a New Jersey corporation
800 King Street, P.O. Box 231
Wilmington, Delaware 19899
Telephone: (202)872-2000

21-0398280

Continued

     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. Yes . No    .

     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act.

 

Large Accelerated Filer

Accelerated Filer

Non-Accelerated Filer

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 June 30, 2006

          Pepco Holdings

190,694,006 ($.01 par value)

          Pepco

100 ($.01 par value) (a)

          DPL

1,000 ($2.25 par value) (b)

          ACE

8,546,017 ($3 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, 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

   

Page

 

Glossary of Terms

i

PART I

FINANCIAL INFORMATION

1

  Item 1.

-

Financial Statements

1

  Item 2.

-

Management's Discussion and Analysis of
   Financial Condition and Results of Operations

103

  Item 3.

-

Quantitative and Qualitative Disclosures
   About Market Risk

174

  Item 4.

-

Controls and Procedures

177

PART II

OTHER INFORMATION

181

  Item 1.

-

Legal Proceedings

181

  Item 1A.

-

Risk Factors

182

  Item 2.

-

Unregistered Sales of Equity Securities and Use of Proceeds

184

  Item 3.

-

Defaults Upon Senior Securities

184

  Item 4.

-

Submission of Matters to a Vote of Security Holders

184

  Item 5.

-

Other Information

185

  Item 6.

-

Exhibits

185

  Signatures

203

 

TABLE OF CONTENTS - EXHIBITS

Exh. No.

Registrant(s)

Description of Exhibit

Page

12.1

PHI

Statements Re: Computation of Ratios

187

12.2

Pepco

Statements Re: Computation of Ratios

188

12.3

DPL

Statements Re: Computation of Ratios

189

12.4

ACE

Statements Re: Computation of Ratios

190

31.1

PHI

Rule 13a-14(a)/15d-14(a) Certificate of Chief Executive Officer

191

31.2

PHI

Rule 13a-14(a)/15d-14(a) Certificate of Chief Financial Officer

192

31.3

Pepco

Rule 13a-14(a)/15d-14(a) Certificate of Chief Executive Officer

193

31.4

Pepco

Rule 13a-14(a)/15d-14(a) Certificate of Chief Financial Officer

194

31.5

DPL

Rule 13a-14(a)/15d-14(a) Certificate of Chief Executive Officer

195

31.6

DPL

Rule 13a-14(a)/15d-14(a) Certificate of Chief Financial Officer

196

31.7

ACE

Rule 13a-14(a)/15d-14(a) Certificate of Chief Executive Officer

197

31.8

ACE

Rule 13a-14(a)/15d-14(a) Certificate of Chief Financial Officer

198

32.1

PHI

Certificate of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350

199

32.2

Pepco

Certificate of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350

200

32.3

DPL

Certificate of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350

201

32.4

ACE

Certificate of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350

202

 

 

 

 

           GLOSSARY OF TERMS

Term

Definition

ABO

Accumulated benefit obligation

ACE

Atlantic City Electric Company

ACE Funding

Atlantic City Electric Transition Funding LLC

ACE NUGs

Non-Utility Generation contracts between ACE and unaffiliated third parties

ACO

Administrative Consent Order

ADFIT

Accumulated deferred federal income taxes

ADITC

Accumulated deferred investment tax credits

Ancillary services

Generally, electricity generation reserves and reliability services

APB

Accounting Principles Board of the American Institute of Certified Public Accountants

APCA

New Jersey Air Pollution Control Act

Asset Purchase and
  Sale Agreement

Asset Purchase and Sale Agreement, dated as of June 7, 2000 and subsequently amended, between Pepco and Mirant (formerly Southern Energy, Inc.) relating to the sale of Pepco's generation assets

Bankruptcy Court

Bankruptcy Court for the Northern District of Texas

Bankruptcy Funds

$13.25 million in funds from the Bankruptcy Settlement

Bankruptcy Settlement

The bankruptcy settlement among the parties concerning the environmental proceedings at the Metal Bank/Cottman Avenue site

Bcf

Billion cubic feet

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)

CAA

Federal Clean Air Act

CIEP

ACE's Commercial and Industrial Energy Pricing class of customers

Competitive Energy
  Business

Consists of the business operations of Conectiv Energy and Pepco Energy Services

Conectiv

A wholly owned subsidiary of PHI, which is a PUHCA 2005 holding company. Conectiv also is the parent of DPL and ACE

Conectiv Energy

Conectiv Energy Holding Company and its subsidiaries

Cooling Degree Days

Daily difference in degrees by which the mean (high and low divided by 2) dry bulb temperature is above a base of 65 degrees Fahrenheit.

DCPSC

District of Columbia Public Service Commission

Default Electricity
  Supply

The supply of electricity within PHI's service territories 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 Default Service, SOS, BGS, or POLR service

Default Supply Revenue

Revenue received for Default Electricity Supply

District Court

U.S. District Court for the Northern District of Texas

DPL

Delmarva Power & Light Company

DPSC

Delaware Public Service Commission

EDECA

New Jersey Electric Discount and Energy Competition Act

EDIT

Excess Deferred Income Taxes

EITF

Emerging Issues Task Force

EPA

U.S. Environmental Protection Agency

ERISA

Employment Retirement Income Security Act of 1974

Exchange Act

Securities Exchange Act of 1934, as amended

FIN

FASB Interpretation Number

i

Term

Definition

FSP

FASB Staff Position

FASB

Financial Accounting Standards Board

FERC

Federal Energy Regulatory Commission

Full Requirements
  Load Service

The supply of energy by Conectiv Energy to utilities to fulfill their Default Electricity Supply obligations

GAAP

Accounting principles generally accepted in the United States of America

GCR

Gas Cost Rate

GPC

Generation Procurement Credit

GWh

Gigawatt hour

Heating Degree Days

Daily difference in degrees by which the mean (high and low divided by 2) dry bulb temperature is below a base of 65 degrees Fahrenheit.

IRS

Internal Revenue Service

LEAC Liability

ACE's $59.3 million deferred energy cost liability existing as of July 31, 1999, related to ACE's Levelized Energy Adjustment Clause and ACE's Demand Side Management Programs

MDE

Maryland Department of the Environment

MGP

Manufactured gas plant

Mirant

Mirant Corporation and its predecessors and its subsidiaries

Moody's

Moody's Investors Service

MPSC

Maryland Public Service Commission

NJBPU

New Jersey Board of Public Utilities

NJDEP

New Jersey Department of Environmental Protection

NOPR

Notice of Proposed Rulemaking

Normalization provisions

Sections of the Internal Revenue Code and related regulations that dictate how excess deferred income taxes resulting from the corporate income tax rate reduction enacted by the Tax Reform Act of 1986 and accumulated deferred investment tax credits should be treated for ratemaking purposes

Notice

Notice 2005-13 issued by the Treasury Department and IRS on February 11, 2005

NOx

Nitrogen oxide

OCI

Other Comprehensive Income

Panda

Panda-Brandywine, L.P.

Panda PPA

PPA between Pepco and Panda

PBO

Projected Benefit Obligation

PCI

Potomac Capital Investment Corporation and its subsidiaries

Pepco

Potomac Electric Power Company

Pepco Distribution

The total aggregate distribution to Pepco pursuant to the Settlement Agreement

Pepco Energy Services

Pepco Energy Services, Inc. and its subsidiaries

Pepco Holdings or PHI

Pepco Holdings, Inc.

PJM

PJM Interconnection, LLC

PLR

Private letter ruling from the IRS

POLR

Provider of Last Resort service (the supply of electricity by DPL before May 1, 2006 to retail customers in Delaware who have not elected to purchase electricity from a competitive supplier)

Power Delivery

PHI's Power Delivery Business

PPA

Power Purchase Agreement

PPA-Related
  Obligations

Mirant's obligations to purchase from Pepco the capacity and energy that Pepco is obligated to purchase under the FirstEnergy and the Panda PPAs

 

ii

 

Term

Definition

PRP

Potentially responsible party

PUHCA 1935

Public Utility Holding Company of 1935, which was repealed effective February 8, 2006

PUHCA 2005

Public Utility Holding Company Act of 2005, which became effective February 8, 2006

RAR

IRS Revenue Agent's Report

Recoverable stranded costs

The portion of stranded costs that is recoverable from ratepayers as approved by regulatory authorities

Reorganization Plan

Mirant's Plan of Reorganization

Revenue Ruling

Revenue Ruling 2005-53 issued by the IRS on August 2, 2005

RI/FS

Remedial Investigation/Feasibility Study

SAB

SEC Staff Accounting Bulletin

SEC

Securities and Exchange Commission

Settlement Agreement

Amended Settlement Agreement and Release, dated as of October 24, 2003 between Pepco and the Mirant Parties

SFAS

Statement of Financial Accounting Standards

SMECO

Southern Maryland Electric Cooperative, Inc.

SMECO Agreement

Capacity purchase agreement between Pepco and SMECO

SMECO Settlement
  Agreement

Settlement Agreement and Release entered into between Mirant and SMECO

SO2

Sulfur dioxide

SOS

Standard Offer Service (the supply of electricity by Pepco in the District of Columbia, by Pepco and DPL in Maryland and by DPL in Delaware on and after May 1, 2006, to retail customers who have not elected to purchase electricity from a competitive supplier)

Standard Offer Service
  revenue or SOS revenue

Revenue Pepco receives for the procurement of energy by Pepco for its SOS customers

Stranded costs

Costs incurred by a utility in connection with providing service which would otherwise be unrecoverable in a competitive or restructured market. Such costs may include costs for generation assets, purchased power costs, and regulatory assets and liabilities, such as accumulated deferred income taxes.

Superior Court

Appellate Division of the Superior Court of New Jersey

T&D

Transmission and distribution

Transition Bonds

Transition bonds issued by ACE Funding

Treasury lock

A hedging transaction that allows a company to "lock-in" a specific interest rate corresponding to the rate of a designated Treasury bond for a determined period of time

Utility PRPs

A group of utility PRPs including Pepco, parties to a settlement involving the environmental proceedings at the Metal Bank/Cottman Avenue site

VaR

Value at Risk

VRDB

Variable Rate Demand Bonds

VSCC

Virginia State Corporation Commission

 

iii

 

 

 

 

 

 

 

 

 

 

 

 

 

 

THIS PAGE INTENTIONALLY LEFT BLANK.

 

 

 

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 Earnings

3

47

68

85

Consolidated Statements of Comprehensive Earnings

4

N/A

N/A

N/A

Consolidated Balance Sheets

5

48

69

86

Consolidated Statements of Cash Flows

7

50

71

88

Notes to Consolidated Financial Statements

8

51

72

89

         

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

 

 

 

1

 

 

 

 

 

 

 

 

 

 

 

 

THIS PAGE INTENTIONALLY LEFT BLANK.

 

2

 

PEPCO HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF EARNINGS
(Unaudited)

 

Three Months Ended
June 30,

Six Months Ended
June 30,

 
   

2006

   

(Restated)
2005

   

2006

   

(Restated)
2005

   
   

(In millions, except earnings per share)

 
                           

Operating Revenue

                         

  Power Delivery

$

1,179.4 

 

$

981.6 

 

$

2,354.2 

 

$

2,080.0 

   

  Competitive Energy

 

711.0 

   

718.6 

   

1,467.7 

   

1,397.8 

   

  Other

 

26.2 

   

20.0 

   

46.6 

   

41.2 

   

     Total Operating Revenue

 

1,916.6 

   

1,720.2 

   

3,868.5 

   

3,519.0 

   
                           

Operating Expenses

                         

  Fuel and purchased energy

 

1,220.0 

   

1,007.6 

   

2,447.8 

   

2,095.9 

   

  Other services cost of sales

 

168.2 

   

182.5 

   

325.1 

   

353.1 

   

  Other operation and maintenance

 

209.5 

   

189.0 

   

413.9 

   

379.1 

   

  Depreciation and amortization

103.0 

101.8 

206.1 

207.5 

  Other taxes

82.6 

77.0 

164.0 

157.8 

  Deferred electric service costs

(29.6)

(18.2)

(10.2)

.8 

  Impairment loss

.2 

6.5 

  Gain on sale of assets

(.5)

(3.9)

(1.8)

(4.3)

     Total Operating Expenses

1,753.4 

1,535.8 

3,551.4 

3,189.9 

                           

Operating Income

 

163.2 

   

184.4 

   

317.1 

   

329.1 

   

Other Income (Expenses)

                         

  Interest and dividend income

 

4.2 

   

1.4 

   

7.7 

   

3.1 

   

  Interest expense

 

(85.2)

   

(85.3)

   

(166.8)

   

(168.7)

   

  (Loss) income from equity investments

 

(.2)

   

(1.9)

   

.5 

   

(3.0)

   

  Other income

 

11.6 

   

13.7 

   

32.5 

   

29.4 

   

  Other expenses

 

(2.9)

   

(2.7)

   

(7.9)

   

(3.4)

   

     Total Other Expenses

(72.5)

(74.8)

(134.0)

(142.6)

Preferred Stock Dividend Requirements of Subsidiaries

 

.3 

   

.7 

   

.7 

   

1.3 

   

Income Before Income Tax Expense and Extraordinary Item

90.4 

108.9 

182.4 

185.2 

Income Tax Expense

 

39.2 

   

42.5 

   

74.4 

   

73.1 

   
                           

Income Before Extraordinary Item

 

51.2 

   

66.4 

   

108.0 

   

112.1 

   
                           

Extraordinary Item (net of tax of $6.2 million)

 

   

   

   

9.0 

   
                           

Net Income

51.2 

66.4 

108.0 

121.1 

Retained Earnings at Beginning of Period

1,026.1 

844.0 

1,018.7 

836.4 

Dividends on Common Stock (Note 4)

(49.4)

(47.2)

(98.8)

(94.3)

Retained Earnings at End of Period

$

1,027.9 

$

863.2 

$

1,027.9 

$

863.2 

Basic and Diluted Share Information

                         

  Weighted average shares outstanding

 

190.4 

   

188.8 

   

190.2 

   

188.6 

   

  Earnings per share of common stock

                         

     Before extraordinary item

$

.27 

 

$

.35 

 

$

.56 

 

$

.59 

   

     Extraordinary item

 

-

   

   

   

.05 

   

          Total

$

.27 

 

$

.35 

 

$

.56 

 

$

.64 

   
                           

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

3

 

 

PEPCO HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE EARNINGS
(Unaudited)

 

Three Months Ended
June 30,

Six Months Ended
June 30,

 
   

2006

   

(Restated)
2005

   

2006

   

(Restated)
2005

   
   

(Millions of dollars)

 
                           

Net income

$

51.2 

 

$

66.4 

 

$

108.0 

 

$

121.1 

   
                           

Other comprehensive earnings (losses)

                         
                           

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

                         

      Unrealized holding (losses) gains arising during period

(27.6)

(4.1)

(117.2)

30.6 

      Less: reclassification adjustment for
                (losses) gains included in net earnings

(8.5)

9.1 

27.3 

13.1 

      Net unrealized (losses) gains on commodity derivatives

(19.1)

(13.2)

(144.5)

17.5 

  Realized gains on Treasury lock transactions

3.0 

3.0 

5.9 

5.9 

                           

  Unrealized gains on interest rate swap
    agreements designated as cash flow hedges:

                         

      Unrealized holding gains arising during period

 

   

   

   

1.1 

   

      Less: reclassification adjustment for (losses) gains
                included in net earnings

 

   

(.1)

   

   

.8 

   

      Net unrealized gains on interest rate swaps

 

   

.1 

   

   

.3 

   
                           

  Other comprehensive (losses) earnings, before taxes

(16.1)

(10.1)

(138.6)

23.7 

  Income tax (benefit) expense

(6.8)

(4.5)

(55.7)

9.1 

                           

Other comprehensive (losses) earnings, net of income taxes

 

(9.3)

   

(5.6)

   

(82.9)

   

14.6 

   

Comprehensive earnings

$

41.9 

$

60.8 

$

25.1 

$

135.7 

                           

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

4

 

 

PEPCO HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Unaudited)

ASSETS

June 30,
2006

December 31,
2005

     

(Millions of dollars)

 

CURRENT ASSETS

                         

  Cash and cash equivalents

           

$

32.9 

 

$

121.5 

   

  Restricted cash

             

13.0 

   

23.0 

   

  Accounts receivable, less allowance for
    uncollectible accounts of $39.1 million
    and $40.6 million, respectively

             

1,185.6 

   

1,363.1 

   

  Fuel, materials and supplies-at average cost

             

349.5 

   

340.1 

   

  Unrealized gains - derivative contracts

             

72.9 

   

185.7 

   

  Prepaid expenses and other

             

124.6 

   

118.3 

   

    Total Current Assets

             

1,778.5 

   

2,151.7 

   
                           

INVESTMENTS AND OTHER ASSETS

                         

  Goodwill

             

1,415.0 

   

1,431.3 

   

  Regulatory assets

             

1,174.6 

   

1,202.0 

   

  Investment in finance leases held in trust

             

1,312.0 

   

1,297.9 

   

  Prepaid pension expense

             

198.0 

   

208.9 

   

  Other

             

379.1 

   

414.0 

   

    Total Investments and Other Assets

             

4,478.7 

   

4,554.1 

   
                           

PROPERTY, PLANT AND EQUIPMENT

                         

  Property, plant and equipment

             

11,644.4 

   

11,384.2 

   

  Accumulated depreciation

             

(4,213.2)

   

(4,072.2)

   

    Net Property, Plant and Equipment

             

7,431.2 

   

7,312.0 

   
                           

    TOTAL ASSETS

           

$

13,688.4 

 

$

14,017.8 

   
                           

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

 

 

 

5

 

 

 

PEPCO HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Unaudited)

LIABILITIES AND SHAREHOLDERS' EQUITY

June 30,
2006

December 31,
2005

     

(Millions of dollars, except shares)

 
                           

CURRENT LIABILITIES

                         

  Short-term debt

           

$

776.1 

 

$

156.4 

   

  Current maturities of long-term debt

             

252.2 

   

469.5 

   

  Accounts payable and accrued liabilities

             

746.6 

   

1,002.2 

   

  Capital lease obligations due within one year

             

5.4 

   

5.3 

   

  Taxes accrued

             

4.9 

   

322.9 

   

  Interest accrued

             

79.5 

   

84.6 

   

  Other

             

389.6 

   

358.4 

   

    Total Current Liabilities

             

2,254.3 

   

2,399.3 

   
                           

DEFERRED CREDITS

                         

  Regulatory liabilities

             

626.2 

   

594.1 

   

  Income taxes

             

1,892.8 

   

1,935.0 

   

  Investment tax credits

             

48.6 

   

51.0 

   

  Other postretirement benefit obligations

292.4 

284.2 

  Other

             

257.0 

   

284.9 

   

    Total Deferred Credits

             

3,117.0 

   

3,149.2 

   
                           

LONG-TERM LIABILITIES

                         

  Long-term debt

             

4,142.8 

   

4,202.9 

   

  Transition Bonds issued by ACE Funding

             

480.1 

   

494.3 

   

  Long-term project funding

             

27.9 

   

25.5 

   

  Capital lease obligations

             

113.9 

   

116.6 

   

    Total Long-Term Liabilities

             

4,764.7 

   

4,839.3 

   
                           

COMMITMENTS AND CONTINGENCIES (NOTE 4)

                         
                           

PREFERRED STOCK OF SUBSIDIARIES

                         

  Serial preferred stock

             

   

21.5 

   

  Redeemable serial preferred stock

             

24.4 

   

24.4 

   

    Total Preferred Stock of Subsidiaries

             

24.4 

   

45.9 

   
                           

SHAREHOLDERS' EQUITY

                         

  Common stock, $.01 par value, authorized
    400,000,000 shares, 190,694,006 shares and
    189,817,723 shares outstanding, respectively

             

1.9 

   

1.9 

   

  Premium on stock and other capital contributions

             

2,603.9 

   

2,586.3 

   

  Accumulated other comprehensive loss

             

(105.7)

   

(22.8)

   

  Retained earnings

             

1,027.9 

   

1,018.7 

   

    Total Shareholders' Equity

             

3,528.0 

   

3,584.1 

   
                           

    TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY

           

$

13,688.4 

 

$

14,017.8 

   
                           

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

6

 

 

PEPCO HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

   

Six Months Ended
June 30,

 
               

2006

   

(Restated)
2005

   
     

   (Millions of dollars)

 

OPERATING ACTIVITIES

                         

Net income

           

$

108.0 

 

$

121.1 

   

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

                         

  Extraordinary item

             

   

(15.2)

   

  Depreciation and amortization

             

206.1 

   

207.5 

   

  Gain on sale of assets

             

(1.8)

   

(4.3)

   

  Gain on sale of other investment

             

(12.3)

   

(8.0)

   

  Impairment loss

             

6.5 

   

   

  Rents received from leveraged leases under income earned

             

(46.3)

   

(39.2)

   

  Deferred income taxes

             

46.4 

   

26.9 

   

  Changes in:

                         

    Accounts receivable

             

248.9 

   

(15.1)

   

    Regulatory assets and liabilities

             

(12.3)

   

1.8 

   

    Accounts payable and accrued liabilities

             

(297.6)

   

30.0 

   

    Interest and taxes accrued

             

(300.9)

   

35.3 

   

    Other changes in working capital

             

(40.4)

   

(46.1)

   

Net other operating

             

(22.7)

   

15.8 

   

Net Cash (Used By) From Operating Activities

             

(118.4)

   

310.5 

   
                           

INVESTING ACTIVITIES

                         

Net investment in property, plant and equipment

             

(248.3)

   

(218.2)

   

Proceeds from sale of assets

             

3.2 

   

4.6 

   

Proceeds from the sale of other investments

             

13.1 

   

23.8 

   

Changes in restricted cash

             

10.0 

   

9.4 

   

Net other investing activities

             

7.6 

   

3.4 

   

Net Cash Used By Investing Activities

             

(214.4)

   

(177.0)

   
                           

FINANCING ACTIVITIES

                         

Dividends paid on common stock

             

(98.8)

   

(94.3)

   

Dividends paid on preferred stock

             

(.7)

   

(1.3)

   

Common stock issued for the Dividend Reinvestment Plan

             

15.0 

   

14.0 

   

Preferred stock redeemed

             

(21.5)

   

   

Issuances of long-term debt

             

217.0 

   

533.7 

   

Reacquisition of long-term debt

             

(491.2)

   

(428.3)

   

Issuances (repayments) of short-term debt, net

             

619.7 

   

5.9 

   

Cost of issuances and redemptions

             

(2.9)

   

(6.0)

   

Net other financing activities

             

7.6 

   

(9.9)

   

Net Cash From Financing Activities

             

244.2 

   

13.8 

   
                           

Net (Decrease) Increase in Cash and Cash Equivalents

             

(88.6)

   

147.3 

   

Cash and Cash Equivalents at Beginning of Period

             

121.5 

   

29.5 

   
                           

CASH AND CASH EQUIVALENTS AT END OF PERIOD

           

$

32.9 

 

$

176.8 

   
                           

NONCASH ACTIVITIES

                         

Excess depreciation reserve transferred to regulatory liabilities

           

$

 

$

131.0 

   
                           

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION

                         

Cash paid for income taxes

           

$

172.8 

 

$

14.4 

   

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

 

7

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

PEPCO HOLDINGS, INC.

(1)  ORGANIZATION

     Pepco Holdings, Inc. (Pepco Holdings or PHI) is a diversified energy company that, through its operating subsidiaries, is engaged in two principal business operations:

·

electricity and natural gas delivery (Power Delivery), and

·

competitive energy generation, marketing and supply (Competitive Energy).

     PHI was incorporated in Delaware in February 2001, for the purpose of effecting the acquisition of Conectiv by Potomac Electric Power Company (Pepco). The acquisition was completed on August 1, 2002, at which time Pepco and Conectiv became wholly owned subsidiaries of PHI. Conectiv was formed in 1998 to be the holding company for Delmarva Power & Light Company (DPL) and Atlantic City Electric Company (ACE) in connection with a merger between DPL and ACE. As a result, DPL and ACE are wholly owned subsidiaries of Conectiv.

     On February 8, 2006, the Public Utility Holding Company Act of 1935 (PUHCA 1935) was repealed and the Public Utility Holding Company Act of 2005 (PUHCA 2005) went into effect. As a result, PHI has ceased to be regulated by the Securities and Exchange Commission (SEC) as a public utility holding company and is now subject to the regulatory oversight of the Federal Energy Regulatory Commission (FERC). As permitted under FERC regulations promulgated under PUHCA 2005, PHI has given notice to FERC that it will continue, until further notice, to operate pursuant to the authority granted in the financing order issued by the SEC under PUHCA 1935, which has an authorization period ending June 30, 2008, relating to the issuance of securities and guarantees, other financing transactions and the operation of the money pool.

     PHI Service Company, a subsidiary service company of PHI, provides a variety of support services, including legal, accounting, tax, financial reporting, treasury, purchasing and information technology services, to Pepco Holdings and its operating subsidiaries. These services are provided pursuant to a service agreement among PHI, PHI Service Company, and the participating operating subsidiaries that was filed with, and approved by, the SEC under PUHCA 1935. The expenses of the service company are charged to PHI and the participating operating subsidiaries in accordance with costing methodologies set forth in the service agreement. PHI is continuing to operate under the service agreement.

     The following is a description of each of PHI's two principal business operations.

Power Delivery

     The largest component of PHI's business is power delivery, which consists of the transmission and distribution of electricity and the distribution of natural gas. PHI's Power Delivery business is conducted by its three regulated utility subsidiaries: Pepco, DPL and ACE. Each subsidiary is a regulated public utility in the jurisdictions that comprise its service territory. Together the three companies constitute a single segment for financial reporting purposes. Each

8

company is responsible for the delivery of electricity and, in the case of DPL, natural gas in its service territory, for which it is paid tariff rates established by the local public service commission. Each company 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 varies by jurisdiction as follows:

 

Delaware

Provider of Last Resort service (POLR) -- before May 1, 2006
Standard Offer Service (SOS) -- on and after May 1, 2006

 

District of Columbia

SOS

 

Maryland

SOS

 

New Jersey

Basic Generation Service (BGS)

 

Virginia

Default Service

     PHI and its subsidiaries refer to this supply service in each of the jurisdictions generally as Default Electricity Supply.

     The rates each company is permitted to charge for the wholesale transmission of electricity are regulated by FERC.

     The profitability of the Power Delivery business depends on its ability to recover costs and earn a reasonable return on its capital investments through the rates it is permitted to charge.

Competitive Energy

     The Competitive Energy business provides competitive generation, marketing and supply of electricity and gas, and related energy management services, primarily in the mid-Atlantic region. PHI's Competitive Energy operations are conducted through subsidiaries of Conectiv Energy Holding Company (collectively, Conectiv Energy) and Pepco Energy Services, Inc. and its subsidiaries (collectively, Pepco Energy Services). Conectiv Energy and Pepco Energy Services are separate operating segments for financial reporting purposes.

Other Business Operations

     Through its subsidiary, Potomac Capital Investment Corporation (PCI), PHI maintains a portfolio of cross-border energy sale-leaseback transactions with a book value at June 30, 2006 of approximately $1.3 billion. This activity constitutes a fourth operating segment, which is designated as "Other Non-Regulated" for financial reporting purposes.

(2)  ACCOUNTING POLICY, PRONOUNCEMENTS, AND OTHER DISCLOSURES

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 SEC, 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 PHI's Annual Report on Form 10-K for the year ended December 31, 2005. In the opinion of PHI's management, the consolidated financial statements contain all adjustments

9

(which all are of a normal recurring nature) necessary to present fairly Pepco Holdings' financial condition as of June 30, 2006, in accordance with GAAP. The year-end balance sheet data was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. Interim results for the three and six months ended June 30, 2006 may not be indicative of PHI's results that will be realized for the full year ending December 31, 2006, since its Power Delivery subsidiaries' sales and delivery of electric energy are seasonal.

FIN 46R, "Consolidation of Variable Interest Entities"

     Subsidiaries of Pepco Holdings have power purchase agreements (PPAs) with a number of entities, including three ACE Non-Utility Generation contracts (ACE NUGs) and an agreement of Pepco (Panda PPA) with Panda-Brandywine, L.P. (Panda). Due to a variable element in the pricing structure of the ACE NUGs and the Panda PPA, the Pepco Holdings' subsidiaries potentially assume the variability in the operations of the plants related to these PPAs and therefore have a variable interest in the counterparties to these PPAs. In accordance with the provisions of Financial Accounting Standards Board (FASB) Interpretation No. 46R (revised December 2003), entitled "Consolidation of Variable Interest Entities," Pepco Holdings continued, during the six months ended June 30, 2006, to conduct exhaustive efforts to obtain information from these four entities, but was unable to obtain sufficient information to conduct the analysis required under FIN 46R to determine whether these four entities were variable interest entities or if Pepco Holdings' subsidiaries were the primary beneficiary. As a result, Pepco Holdings has applied the scope exemption from the application of FIN 46R for enterprises that have conducted exhaustive efforts to obtain the necessary information, but have not been able to obtain such information.

     Net purchase activities with the counterparties to the ACE NUGs and the Panda PPA for the three months ended June 30, 2006 and 2005 were approximately $98 million and $94 million, respectively, of which approximately $89 million and $86 million, respectively, related to power purchases under the ACE NUGs and the Panda PPA. Net purchase activities with the counterparties to the ACE NUGs and the Panda PPA for the six months ended June 30, 2006 and 2005 were approximately $201 million and $193 million, respectively, of which approximately $182 million and $177 million, respectively, related to power purchases under the ACE NUGs and the Panda PPA. Pepco Holdings' exposure to loss under the agreement with Panda entered into in 1991, pursuant to which Pepco is obligated to purchase from Panda 230 megawatts of capacity and energy annually through 2021, is discussed in Note (4), Commitments and Contingencies, under "Relationship with Mirant Corporation." Pepco Holdings does not have loss exposure under the ACE NUGs because cost recovery will be achieved from ACE's customers through regulated rates.

Components of Net Periodic Benefit Cost

     The following Pepco Holdings' information is for the three months ended June 30, 2006 and 2005.

 

10

 

   

Pension Benefits

   

Other
Postretirement
Benefits

   
   

2006

   

2005

   

2006

   

2005

   
 

(Millions of dollars)

 

Service cost

$

10.1 

 

$

9.6 

 

$

1.7 

 

$

2.1 

   

Interest cost

 

24.2 

   

23.6 

   

8.3 

   

8.4 

   

Expected return on plan assets

 

(32.5)

   

(32.1)

   

(2.7)

   

(2.9)

   

Amortization of prior service cost

 

.2 

   

.3 

   

(1.1)

   

(.9)

   

Amortization of net loss

 

4.8 

   

2.7 

   

4.2 

   

3.4 

   

Net periodic benefit cost

$

6.8 

 

$

4.1 

 

$

10.4 

 

$

10.1 

   
                           

     The following Pepco Holdings' information is for the six months ended June 30, 2006 and 2005.

   

Pension Benefits

   

Other
Postretirement
Benefits

   
   

2006

   

2005

   

2006

   

2005

   
 

(Millions of dollars)

 

Service cost

$

20.3 

 

$

19.0 

 

$

4.2 

 

$

4.2 

   

Interest cost

 

48.4 

   

47.9 

   

17.3 

   

16.8 

   

Expected return on plan assets

 

(65.0)

   

(62.8)

   

(5.8)

   

(5.4)

   

Amortization of prior service cost

 

.4 

   

.6 

   

(2.0)

   

(1.9)

   

Amortization of net loss

 

8.7 

   

5.2 

   

7.2 

   

5.9 

   

Net periodic benefit cost

$

12.8 

 

$

9.9 

 

$

20.9 

 

$

19.6 

   
                           

     Pension

     The pension net periodic benefit cost for the three months ended June 30, 2006 of $6.8 million includes $3.6 million for Pepco, $.2 million for ACE, and $(1.2) million for DPL. The pension net periodic benefit cost for the six months ended June 30, 2006 of $12.8 million includes $6.6 million for Pepco, $2.5 million for ACE, and $(3.0) million for DPL. The remaining pension net periodic benefit cost is for other PHI subsidiaries. The pension net periodic benefit cost for the three months ended June 30, 2005 of $4.1 million includes $2.5 million for Pepco, $2.0 million for ACE, and $(2.6) million for DPL. The pension net periodic benefit cost for the six months ended June 30, 2005 of $9.9 million includes $5.1 million for Pepco, $4.1 million for ACE, and $(3.9) million for DPL. The remaining pension net periodic benefit cost is for other PHI subsidiaries.

11

     Pension Contributions

     Pepco Holdings' current funding policy with regard to its defined benefit pension plan is to maintain a funding level in excess of 100% of its accumulated benefit obligation (ABO). In 2005 and 2004 PHI made discretionary tax-deductible cash contributions to the plan of $60 million and $10 million, respectively. PHI's pension plan currently meets the minimum funding requirements of the Employment Retirement Income Security Act of 1974 (ERISA) without any additional funding. PHI may elect, however, to make a discretionary tax-deductible contribution to maintain the pension plan's assets in excess of its ABO. As of June 30, 2006, no contributions have been made. The potential discretionary funding of the pension plan in 2006 will depend on many factors, including the actual investment return earned on plan assets over the remainder of the year.

     Other Postretirement Benefits

     The other postretirement net periodic benefit cost for the three months ended June 30, 2006 of $10.4 million includes $4.6 million for Pepco, $2.3 million for ACE, and $1.8 million for DPL. The other postretirement net periodic benefit cost for the six months ended June 30, 2006 of $20.9 million includes $9.4 million for Pepco, $4.6 million for ACE, and $3.4 million for DPL. The remaining other postretirement net periodic benefit cost is for other PHI subsidiaries. The other postretirement net periodic benefit cost for the three months ended June 30, 2005 of $10.1 million includes $6.0 million for Pepco, $2.0 million for ACE, and $.5 million for DPL. The other postretirement net periodic benefit cost for the six months ended June 30, 2005 of $19.6 million includes $9.0 million for Pepco, $4.4 million for ACE, and $3.0 million for DPL. The remaining other postretirement net periodic benefit cost is for other PHI subsidiaries.

Stock-Based Compensation

     In March 2005, the SEC issued Staff Accounting Bulletin (SAB) No. 107 (SAB 107), which provides implementation guidance on the interaction between Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), "Share-Based Payment" (SFAS No. 123R), and certain SEC rules and regulations, as well as guidance on the valuation of share-based payment arrangements for public companies.

     Pepco Holdings adopted and implemented SFAS No. 123R on January 1, 2006 using the modified prospective method. Under this method, Pepco Holdings began to recognize compensation expense for any stock option awards, modifications or cancellations after the effective date, based on the excess of the projected exercise date value (the option value) over the exercise price, and reduced for the percentage of total estimated forfeitures. Compensation expense is recognized over the service period (vesting period) for the options. A deferred tax asset and deferred tax benefit are also recognized concurrently with compensation expense for the tax effect of the deduction of stock options, which are deductible only upon exercise. In applying the modified prospective transition method, Pepco Holdings has not restated prior interim and annual financial results and therefore these prior periods do not reflect the revised recognition of share-based compensation cost as required by SFAS No. 123R.

     Prior to the adoption of SFAS No. 123R, Pepco Holdings accounted for its share-based employee compensation under the intrinsic value method of expense recognition and measurement prescribed by Accounting Principles Board (APB) Opinion No. 25, "Accounting

12

for Stock Issued to Employees, and related Interpretations" (APB No. 25). Under this method no compensation expense was recognized for options granted with an exercise price equal to the grant-date market price of the stock, which is the case for Pepco Holdings options.

     The issuance of SFAS No. 123, "Accounting for Stock-Based Compensation," in 1995 as amended by SFAS No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure," permitted continued application of APB No. 25, but required tabular presentation of the pro-forma stock-based employee compensation cost, net income, and basic and diluted earnings per share as if the fair-value based method of expense recognition and measurement prescribed by SFAS No. 123 had been applied to all options. This information for the three and six months ended June 30, 2005, is as follows (in millions, except per share data):

 

June 30, 2005

 
 

Three  
Months

 

Six   
Months

 

Net Income (Restated)

$

66.4 

 

$

121.1 

 

Add:  Total stock-based employee compensation expense
      included in net income as reported (net of related tax
      effect of $.6 million and $1.0 million, respectively)

 

.9 

   

1.5 

 

Deduct: Total stock-based employee compensation expense
        determined under fair value based methods for all awards
        (net of related tax effect of $.6 million and $1.0 million,
        respectively)

 

(1.0)

   

(1.6)

 

Pro forma net income

$

66.3 

$

121.0 

Basic earnings per share as reported (restated)

$

.35 

 

$

.64 

 

Pro forma basic earnings per share

$

.35 

 

$

.64 

 

Diluted earnings per share as reported (restated)

$

.35 

 

$

.64 

 

Pro forma diluted earnings per share

$

.35 

 

$

.64 

 
             

     Pepco Holdings estimates the fair value of each option award on the date of grant using the Black-Scholes-Merton option pricing model. This model uses assumptions related to expected option term, expected volatility, expected dividend yield and risk-free interest rate. Pepco Holdings uses historical data to estimate option exercise and employee termination within the valuation model; separate groups of employees that have similar historical exercise behavior are considered separately for valuation purposes. The expected term of options granted is derived from the output of the option valuation model and represents the period of time that options granted are expected to be outstanding.

     There were no options granted in 2003, 2004, 2005, or for the six month period ended June 30, 2006.

     No modifications were made to outstanding share options prior to the adoption of SFAS No. 123R, and no change in valuation methodology or assumptions in estimating the fair value of share options have occurred with this Statement's adoption.

13

     There were no cumulative adjustments recorded in the financial statements as a result of this new pronouncement; the percentage of forfeitures of outstanding options issued prior to SFAS No. 123R's adoption is estimated to be zero.

     There are 1,500 share option awards that were partially vested as of January 1, 2006. The awards vested May 1, 2006; total compensation cost recorded in 2006 related to these partially vested awards is immaterial.

     Cash received from options exercised under all share-based payment arrangements for the three months ended June 30, 2006 and the years ended December 31, 2005 and 2004, was $1.5 million, $3.7 million, and $.8 million, respectively. The actual tax benefit realized for the tax deductions from options exercised of the share-based payment arrangements totaled $.1 million, $.3 million, and zero, respectively, for the three months ended June 30, 2006 and the years ended December 31, 2005 and 2004.

     Pepco Holdings' policy for issuing shares upon exercise is to issue new shares to satisfy share option exercises.

Calculations of Earnings Per Share of Common Stock

     Reconciliations of the numerator and denominator for basic and diluted earnings per share of common stock calculations are shown below.

For the Three Months Ended June 30,

2006

2005

(In millions, except per share data)

Income (Numerator):

 

 

 

 

 

 

   

Earnings Applicable to Common Stock (2005 Restated)

 

$

51.2 

 

 

$

66.4 

 

Shares (Denominator) (a):

 

 

 

 

 

 

   

Weighted average shares outstanding for basic computation:

 

 

           

    Average shares outstanding

   

190.4 

     

188.8 

 

    Adjustment to shares outstanding

   

(.1)

     

 

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

   

190.3 

   

 

188.8 

 
                 

Weighted average shares outstanding for diluted computation:

 

 

 

 

 

 

   

    Average shares outstanding

 

 

190.4 

 

 

 

188.8 

 

    Adjustment to shares outstanding

 

 

.5 

 

 

 

.2 

 

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

 

 

190.9 

 

 

 

189.0 

 

Basic earnings per share of common stock (2005 Restated)

 

$

.27 

 

 

$

.35 

 

Diluted earnings per share of common stock (2005 Restated)

 

$

.27 

 

 

$

.35 

 
                 

(a)

 

The number of options to purchase shares of common stock that were excluded from the calculation of diluted EPS as they are considered to be anti-dilutive were approximately .6 million and 1.4 million for the three months ended June 30, 2006 and 2005, respectively.

 

 

14

 

 

 

For the Six Months Ended June 30,

     

2006

     

2005

 

(In millions, except per share data)

Income (Numerator):

 

 

 

 

 

 

   

Net Income (2005 Restated)

 

$

108.0 

 

 

$

121.1 

 

Loss on redemption of subsidiary's preferred stock

 

 

(.8)

   

 

 

Earnings Applicable to Common Stock (2005 Restated)

 

$

107.2 

 

 

$

121.1 

 

Shares (Denominator) (a):

 

 

 

 

 

 

   

Weighted average shares outstanding for basic computation:

 

 

           

    Average shares outstanding

   

190.2 

     

188.6 

 

    Adjustment to shares outstanding

   

(.1)

     

 

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

   

190.1 

   

 

188.6 

 
                 

Weighted average shares outstanding for diluted computation:

 

 

 

 

 

 

   

    Average shares outstanding

 

 

190.2 

 

 

 

188.6 

 

    Adjustment to shares outstanding

 

 

.4 

 

 

 

.2 

 

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

 

 

190.6 

 

 

 

188.8 

 

Basic earnings per share of common stock (2005 Restated)

 

$

.56 

 

 

$

.64 

 

Diluted earnings per share of common stock (2005 Restated)

 

$

.56 

 

 

$

.64 

 
                 

(a)

 

Options to purchase shares of common stock that were excluded from the calculation of diluted EPS as they are considered to be anti-dilutive were approximately .6 million and 1.4 million for the six months ended June 30, 2006 and 2005, respectively.

Impairment Loss

     During the six months ended June 30, 2006, Pepco Holdings recorded a pre-tax impairment loss of $6.5 million ($4.1 million, after-tax) on certain energy services business assets owned by Pepco Energy Services.

Goodwill

     A roll forward of PHI's goodwill balance is as follows (millions of dollars):

Balance, December 31, 2005

$1,431.3     

 

     Less:  Adjustment due to resolution of pre-merger
                     income tax contingencies

    (9.1)    

 

               Adjustment to reflect dispositions

      (7.2)    

 

Balance, June 30, 2006

$1,415.0     

 

Sale of Interest in Cogeneration Joint Venture

     During the first quarter of 2006, Conectiv Energy recognized a $12.3 million pre-tax gain ($7.9 million after-tax) on the sale of its equity interest in a joint venture which owns a wood burning cogeneration facility in California.

15

Reconciliation of Consolidated Income Tax Expense

     A reconciliation of PHI's consolidated income tax expense is as follows:

 

For the Three Months Ended June 30,

For the Six Months Ended June 30,

 
 

2006

2005 (Restated)

2006

2005 (Restated)

 
 

Amount

Rate

Amount

Rate

Amount

Rate

Amount

Rate

 
 

(Millions of dollars)

 

Income Before Income Tax Expense
and Extraordinary Item

$90.4   

-  

$108.9  

-  

$182.4  

-  

$185.2  

-  

Add: Preferred stock dividend
          requirements of subsidiaries

.3   

-  

.7  

-  

.7  

-  

1.3  

-  

 

Income Before Income Tax Expense
      Extraordinary Item, and Preferred
      Dividends

$90.7   

-  

$109.6  

-  

$183.1  

-  

$186.5  

-  

 
                   

Income tax at federal statutory rate

$31.8   

.35  

$  38.3  

.35  

$  64.1  

.35  

$  65.2  

.35  

 

  Increases (decreases) resulting from:

                 

    Depreciation

2.0   

.02  

2.2  

.02  

4.0  

.02  

4.8  

.03  

 

    Asset removal costs

(.5)  

(.01) 

(.5) 

-  

(2.0) 

(.01) 

(1.2) 

(.01) 

 

    State income taxes, net of
       federal effect

8.0   

.09  

5.5  

.05  

12.6  

.07  

9.9  

.05  

 

    Tax credits

(1.2)  

(.01) 

(1.4) 

(.01) 

(2.4) 

(.01) 

(2.8) 

(.01) 

 

    Adjustment to prior
       years' tax

.1   

-  

(.2) 

-  

(1.2) 

(.01) 

(2.8) 

(.01) 

    Company dividends reinvested
      in 401(k) Plan

(.5)  

(.01) 

(.5) 

(.01) 

(1.0) 

-  

(1.0) 

(.01) 

 

    Leveraged leases

(3.0)  

(.03) 

(2.0) 

(.02) 

(4.8) 

(.03) 

(3.9) 

(.02) 

 

    Adjustment to estimates related to
       prior years under audit

2.8   

.03  

.9  

.01  

3.7  

.02  

4.6  

.02  

    Other, net

(.3)  

-  

.2  

-  

1.4  

.01  

.3  

-  

 
                   

Total Consolidated Income Tax Expense

$39.2   

.43  

$  42.5  

.39  

$  74.4  

.41  

$  73.1  

.39  

 
                   

Resolution of Certain Internal Revenue Service Audit Matters

     In the second quarter of 2006, PHI resolved certain, but not all, tax matters that were raised in Internal Revenue Service audits related to the 2001 and 2002 tax years. Adjustments recorded during the second quarter of 2006 related to these resolved tax matters resulted in an increase in net income of $6.3 million ($2.5 million for Power Delivery and $5.4 million for Other Non-Regulated, partially offset by an unfavorable $1.6 million impact in Corporate and Other). To the extent that the matters resolved related to tax contingencies from the Conectiv heritage companies that existed at the August, 2002 merger date, in accordance with accounting rules, an additional adjustment of $9.1 million ($3.1 million related to Power Delivery and $6.0 million related to Other Non-Regulated) has been recorded in Corporate and Other to eliminate the tax benefits recorded by the Lines of Business against the goodwill balance that resulted from the merger.

Extraordinary Item

     As a result of the April 2005 settlement of ACE's electric distribution rate case, ACE reversed $15.2 million in accruals related to certain deferred costs that are now deemed recoverable. The after-tax credit to income of $9.0 million is classified as an extraordinary gain in the 2005 financial statements since the original accrual was part of an extraordinary charge in conjunction with the accounting for competitive restructuring in 1999.

16

Debt

    In April 2006, Pepco completed a tax-exempt financing in which the Maryland Economic Development Corporation issued $109.5 million of insured auction rate pollution control bonds due 2022 and loaned the proceeds to Pepco. Pepco's obligations under the insurance agreement are secured by a like amount of Pepco senior notes, which in turn are secured by a like amount of Pepco First Mortgage Bonds.

     In May 2006, Pepco used the proceeds described above to redeem at 100% of the principal amount of the following bonds:

·

$42.5 million of Montgomery County, Maryland 5.375% Tax-Exempt First Mortgage Bonds due 2024,

·

$37 million of Prince George's County, Maryland 6.375% Tax-Exempt First Mortgage Bonds due 2023, and

·

$30 million of Prince George's County, Maryland 6.0% Tax-Exempt First Mortgage Bonds due 2022.

    In April 2006, ACE Funding made principal payments of $4.8 million on Series 2002-1 Bonds, Class A-1, and $2.0 million on Series 2003-1 Bonds, Class A-1, with a weighted average interest rate of 2.89%.

     In April 2006, PHI, Pepco, DPL and ACE amended their $1.2 billion credit facility due 2010 to extend the maturity by one additional year to May 5, 2011 and to reduce the pricing of the facility by reducing the credit facility fees.

     In April 2006, PCI renegotiated a lease resulting in a $15.1 million reduction in long-term debt.

     In June 2006, DPL made a sinking fund payment of $2.9 million on its 6.95% First Mortgage Bonds due 2008.

New Accounting Standards

     FSP FTB 85-4-1, "Accounting for Life Settlement Contracts by Third-Party Investors"

     In March 2006, the FASB issued FASB Staff Position (FSP) FTB 85-4-1, "Accounting for Life Settlement Contracts by Third-Party Investors" (FSP FTB 85-4-1). This FSP provides initial and subsequent measurement guidance and financial statement presentation and disclosure guidance for investments by third-party investors in life settlement contracts. FSP FTB 85-4-1 also amends certain provisions of FASB Technical Bulletin No. 85-4, "Accounting for Purchases of Life Insurance," and FASB Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities." The guidance in FSP FTB 85-4-1 applies prospectively for all new life settlement contracts and is effective for fiscal years beginning after June 15, 2006 (the year ending December 31, 2007 for Pepco Holdings). Pepco Holdings is in the process of evaluating the impact of FSP FTB 85-4-1 and does not anticipate its adoption will have a material impact on its overall financial condition, results of operations, or cash flows.

17

     EITF 04-13, "Accounting for Purchases and Sales of Inventory with the Same Counterparty"

     In September 2005, the FASB ratified Emerging Issues Task Force (EITF) Issue No. 04-13, "Accounting for Purchases and Sales of Inventory with the Same Counterparty" (EITF 04-13), which addresses circumstances under which two or more exchange transactions involving inventory with the same counterparty should be viewed as a single exchange transaction for the purposes of evaluating the effect of APB Opinion 29, "Accounting for Nonmonetary Transactions." EITF 04-13 is effective for new arrangements entered into, or modifications or renewals of existing arrangements, beginning in the first interim or annual reporting period beginning after March 15, 2006.

     Pepco Holdings implemented EITF 04-13 on April 1, 2006. The implementation did not have a material impact on Pepco Holdings' overall financial condition, results of operations, or cash flows for the second quarter of 2006.

     SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140"

     In February 2006, the FASB issued Statement No. 155, "Accounting for Certain Hybrid Financial Instruments-an amendment of FASB Statements No. 133 and No. 140" (SFAS No. 155). SFAS No. 155 amends FASB Statements No. 133, "Accounting for Derivative Instruments and Hedging Activities," and No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." SFAS No. 155 resolves issues addressed in Statement 133 Implementation Issue No. D1, "Application of Statement 133 to Beneficial Interests in Securitized Financial Assets." SFAS No. 155 is effective for all financial instruments acquired or issued after the beginning of an entity's first fiscal year that begins after September 15, 2006 (the year ending December 31, 2007 for Pepco Holdings). Pepco Holdings has evaluated the impact of SFAS No. 155 and does not anticipate that its implementation will have a material impact on its overall financial condition, results of operations, or cash flows.

     SFAS No. 156, "Accounting for Servicing of Financial Assets"

     In March 2006, the FASB issued Statement No. 156, "Accounting for Servicing of Financial Assets" (SFAS No. 156), an amendment of SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," with respect to the accounting for separately recognized servicing assets and servicing liabilities. SFAS No. 156 requires an entity to recognize a servicing asset or servicing liability upon undertaking an obligation to service a financial asset via certain servicing contracts, and for all separately recognized servicing assets and servicing liabilities to be initially measured at fair value, if practicable. Subsequent measurement is permitted using either the amortization method or the fair value measurement method for each class of separately recognized servicing assets and servicing liabilities. SFAS No. 156 is effective as of the beginning of an entity's first fiscal year that begins after September 15, 2006 (the year ending December 31, 2007 for Pepco Holdings). Application is to be applied prospectively to all transactions following adoption of SFAS No. 156. Pepco Holdings has evaluated the impact of SFAS No. 156 and does not anticipate its adoption will have a material impact on its overall financial condition, results of operations, or cash flows.

18

     FSP FIN 46(R)-6, "Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R)"

     In April 2006, the FASB issued FSP FIN 46(R)-6, "Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R)" (FSP FIN 46(R)-6), which provides guidance on how to determine the variability to be considered in applying FIN 46(R), "Consolidation of Variable Interest Entities."

     The guidance in FSP FIN 46(R)-6 is applicable prospectively beginning the first day of the first reporting period beginning after June 15, 2006 (July 1, 2006 for PHI), although early application is permitted to financial statements not issued. Retrospective application is also permitted if so elected and must be completed no later than the end of the first annual reporting period ending after July 15, 2006 (December 31, 2006 for PHI).

     Pepco Holdings is in the process of evaluating the impact of FIN 46(R)-6.

     EITF Issue No. 06-3, "Disclosure Requirements for Taxes Assessed by a Governmental Authority on Revenue-producing Transactions"

     On June 28, 2006, the FASB ratified EITF Issue No. 06-3, "Disclosure Requirements for Taxes Assessed by a Governmental Authority on Revenue-producing Transactions" (EITF 06-3). EITF 06-3 provides guidance on an entity's disclosure of its accounting policy regarding the gross or net presentation of certain taxes and provides that if taxes included in gross revenues are significant, a company should disclose the amount of such taxes for each period for which an income statement is presented (i.e., both interim and annual periods). Taxes within the scope of EITF 06-3 are those that are imposed on and concurrent with a specific revenue-producing transaction. Taxes assessed on an entity's activities over a period of time are not within the scope of EITF 06-3.

     EITF 06-3 is effective for interim and annual reporting periods beginning after December 15, 2006 (2007 for PHI) although earlier application is permitted. Pepco Holdings is in the process of evaluating the impact of EITF 06-3.

     FSP FAS 13-2, "Accounting for a Change or Projected Change in the Timing of Cash Flows Relating to Income Taxes Generated by a Leverage Lease Transaction"

     On July 13, 2006, the FASB issued FSP FAS 13-2, "Accounting for a Change or Projected Change in the Timing of Cash Flows Relating to Income Taxes Generated by a Leverage Lease Transaction" (FSP FAS 13-2). This FSP, which amends FASB Statement No. 13, "Accounting for Leases," addresses how a change or projected change in the timing of cash flows relating to income taxes generated by a leveraged lease transaction affects the accounting by a lessor for that lease.

     FSP FAS 13-2 will not be effective until the first fiscal year beginning after December 15, 2006 (January 1, 2007 for Pepco Holdings). Pepco Holdings is in the process of evaluating the impact of FSP FAS 13-2.

19

     FIN 48, "Accounting for Uncertainty in Income Taxes"

     On July 13, 2006, the FASB issued FASB Interpretation No.48, "Accounting for Uncertainty in Income Taxes" (FIN 48). FIN 48 clarifies the criteria for recognition of tax benefits in accordance with SFAS No. 109, "Accounting for Income Taxes," and prescribes a financial statement recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return. Specifically, it clarifies that an entity's tax benefits must be "more likely than not" of being sustained prior to recording the related tax benefit in the financial statements. If the position drops below the "more likely than not" standard, the benefit can no longer be recognized. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.

     FIN 48 is effective the first fiscal year beginning after December 15, 2006 (January 1, 2007 for Pepco Holdings). Pepco Holdings is in the process of evaluating the impact of FIN 48.

20

(3)  SEGMENT INFORMATION

     Based on the provisions of SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," Pepco Holdings' management has identified its operating segments at June 30, 2006 as Power Delivery, Conectiv Energy, Pepco Energy Services, and Other Non-Regulated. Intercompany (intersegment) revenues and expenses are not eliminated at the segment level for purposes of presenting segment financial results. Elimination of these intercompany amounts is accomplished for PHI's consolidated results through the "Corporate and Other" column. Segment financial information for the three and six months ended June 30, 2006 and 2005, is as follows.

 

                                        Three Months Ended June 30, 2006                                          
(Millions of dollars)

 
   

Competitive
Energy Segments

       
 

Power
Delivery

Conectiv
Energy

Pepco
Energy
Services

Other    
Non-    
Regulated

Corp. 
& Other (a)

PHI  
Cons.

 

Operating Revenue

$1,179.4     

$  514.2 (b)

$347.5    

$28.3     

$(152.8)    

$1,916.6 

 

Operating Expense (c)

1,065.7 (b)

504.2     

333.8    

1.7     

(152.0)    

1,753.4 

 

Operating Income

113.7     

10.0     

13.7    

26.6     

(.8)    

163.2 

 

Interest Income

2.5     

9.0     

.6    

49.5     

(57.4)    

4.2 

 

Interest Expense

45.3     

15.8     

.9    

57.3     

(34.1)    

85.2 

 

Other Income

6.8     

(.3)    

.4    

1.3     

.3     

8.5 

 

Preferred Stock
   Dividends

.2     

-     

-    

.6     

(.5)    

.3 

 

Income Taxes

29.5 (d)

1.3     

5.6    

.9 (d)

1.9 (d)

39.2 

 

Net Income (Loss)

48.0     

1.6     

8.2    

18.6     

(25.2)    

51.2 

 

Total Assets

8,729.1     

1,886.7     

513.3    

1,500.6     

1,058.7     

13,688.4 

 

Construction
   Expenditures

120.6     

2.6     

1.2    

-     

3.7     

128.1 

               

Note:

 

(a)

Includes unallocated Pepco Holdings' (parent company) capital costs, such as acquisition financing costs, and the depreciation and amortization related to purchase accounting adjustments for the fair value of Conectiv assets and liabilities as of the August 1, 2002 acquisition date. Additionally, the Total Assets line item in this column includes Pepco Holdings' goodwill balance. Included in Corp. & Other are intercompany amounts of $(152.8) million for Operating Revenue, $(151.5) million for Operating Expense, $(75.3) million for Interest Income, $(74.7) million for Interest Expense, and $(.6) million for Preferred Stock Dividends.

(b)

Power Delivery purchased electric energy and capacity and natural gas from Conectiv Energy in the amount of $103.6 million for the three months ended June 30 2006.

(c)

Includes depreciation and amortization of $103.0 million, consisting of $89.6 million for Power Delivery, $9.1 million for Conectiv Energy, $2.9 million for Pepco Energy Services, and $1.4 million for Corp. & Other.

(d)

Includes the total favorable impact of $6.3 million related to tax matters that were resolved during the second quarter of 2006 ($2.5 million for Power Delivery and $5.4 million for Other Non-Regulated, partially offset by an unfavorable $1.6 million in Corp. & Other). Additionally Corp. & Other includes the elimination (against the goodwill generated by the merger) of the tax benefits recorded by the Lines of Business in the amount of $9.1 million ($3.1 million related to Power Delivery and $6.0 million related to Other Non-Regulated).

 

21

 

 

 

                                Three Months Ended June 30, 2005 (As Restated)                               
(Millions of dollars)

 
   

Competitive
Energy Segments

       
 

Power
Delivery

Conectiv
Energy

Pepco
Energy
Services

Other   
Non-   
Regulated

Corp. 
& Other (a)

PHI    
Cons.  

 

Operating Revenue

$    981.6     

$    584.2 (b)

$   320.9   

$    21.2   

$  (187.7)  

$   1,720.2 

 

Operating Expense (c)

856.2 (b)

556.5     

306.5   

1.8   

(185.2)  

1,535.8 

 

Operating Income

125.4     

27.7     

14.4   

19.4   

(2.5)  

184.4 

 

Interest Income

.8     

7.6     

.3   

25.7   

(33.0)  

1.4 

 

Interest Expense

44.2     

14.4     

.8   

35.1   

(9.2)  

85.3 

 

Other Income

7.4     

(.5)    

.5   

(1.5)  

3.2   

9.1 

 

Preferred Stock
   Dividends

.7     

-     

-   

.6   

(.6)  

.7 

 

Income Taxes

37.1     

8.0     

5.2   

.8   

(8.6)  

42.5 

 

Net Income (Loss)

51.6     

12.4     

9.2   

7.1   

(13.9)  

66.4 

 

Total Assets

8,784.4     

1,939.3     

503.3   

1,321.5   

1,173.6   

13,722.1 

 

Construction
   Expenditures

122.1     

2.8     

3.3   

-   

1.7   

129.9 

               

Note:

 

(a)

Includes unallocated Pepco Holdings' (parent company) capital costs, such as acquisition financing costs, and the depreciation and amortization related to purchase accounting adjustments for the fair value of Conectiv assets and liabilities as of the August 1, 2002 acquisition date. Additionally, the Total Assets line item in this column includes Pepco Holdings' goodwill balance. Included in Corp. & Other are intercompany amounts of $(188.5) million for Operating Revenue, $(187.0) million for Operating Expense, $(49.5) million for Interest Income, $(49.0) million for Interest Expense, and $(.6) million for Preferred Stock Dividends.

(b)

Power Delivery purchased electric energy and capacity and natural gas from Conectiv Energy in the amount of $128.9 million for the three months ended June 30, 2005.

(c)

Includes depreciation and amortization of $101.8 million, consisting of $85.1 million for Power Delivery, $11.5 million for Conectiv Energy, $3.2 million for Pepco Energy Services, and $2.0 million for Corp. & Other.

 

22

 

 

                                            Six Months Ended June 30, 2006                                               
(Millions of dollars)

 
   

Competitive
Energy Segments

       
 

Power
Delivery

Conectiv
Energy

Pepco
Energy
Services

Other    
Non-    
Regulated

Corp. 
& Other (a)

PHI    
Cons.  

 

Operating Revenue

$2,354.2     

$1,065.5 (b)

$717.2     

$49.2    

$(317.6)   

$3,868.5 

 

Operating Expense (c)

2,136.6 (b)

1,032.3     

694.2 (e)

3.3    

(315.0)   

3,551.4 

 

Operating Income

217.6     

33.2     

23.0     

45.9    

(2.6)   

317.1 

 

Interest Income

4.8     

17.6     

1.0     

84.3    

(100.0)   

7.7 

 

Interest Expense

88.7     

30.9     

1.7     

100.1    

(54.6)   

166.8 

 

Other Income

9.3     

11.7 (d)

.6     

2.6    

.9    

25.1 

 

Preferred Stock
   Dividends

1.5     

-     

-     

1.2    

(2.0)   

.7 

 

Income Taxes

55.9     

12.9     

9.2     

3.3    

(6.9)   

74.4 

 

Net Income (Loss)

85.6  (f)

18.7     

13.7     

28.2 (f)

(38.2)(f)

108.0 

 

Total Assets

8,729.1     

1,886.7     

513.3     

1,500.6    

1,058.7   

13,688.4 

 

Construction
   Expenditures

233.5     

5.0     

3.9     

-    

5.9   

248.3 

               

Note:

 

(a)

Includes unallocated Pepco Holdings' (parent company) capital costs, such as acquisition financing costs, and the depreciation and amortization related to purchase accounting adjustments for the fair value of Conectiv assets and liabilities as of the August 1, 2002 acquisition date. Additionally, the Total Assets line item in this column includes Pepco Holdings' goodwill balance. Included in Corp. & Other are intercompany amounts of $(319.1) million for Operating Revenue, $(316.4) million for Operating Expense, $(136.9) million for Interest Income, $(135.7) million for Interest Expense, and $(1.2) million for Preferred Stock Dividends.

(b)

Power Delivery purchased electric energy and capacity and natural gas from Conectiv Energy in the amount of $226.3 million for the six months ended June 30, 2006.

(c)

Includes depreciation and amortization of $206.1 million, consisting of $179.6 million for Power Delivery, $18.2 million for Conectiv Energy, $5.8 million for Pepco Energy Services, and $2.5 million for Corp. & Other.

(d)

Includes $12.3 million gain ($7.9 million after tax) on the sale of its equity interest in a joint venture which owns a wood burning cogeneration facility in California.

(e)

Includes $6.5 million impairment loss ($4.1 million after tax) on certain energy services business assets.

(f)

Includes the total favorable impact of $6.3 million related to tax matters that were resolved during the second quarter of 2006 ($2.5 million for Power Delivery and $5.4 million for Other Non-Regulated, partially offset by an unfavorable $1.6 million in Corp. & Other). Additionally Corp. & Other includes the elimination (against the goodwill generated by the merger) of the tax benefits recorded by the Lines of Business in the amount of $9.1 million ($3.1 million related to Power Delivery and $6.0 million related to Other Non-Regulated).

 

23

 

 

                                Six Months Ended June 30, 2005 (As Restated)                                 
(Millions of dollars)

 
   

Competitive
Energy Segments

       
 

Power
Delivery

Conectiv
Energy

Pepco
Energy
Services

Other   
Non-   
Regulated

Corp. 
& Other (a)

PHI    
Cons.  

 

Operating Revenue

$ 2,080.0     

$ 1,093.6 (b)

$ 673.8   

$     42.3   

$  (370.7)  

$  3,519.0 

 

Operating Expense (c)

1,846.1 (b)

1,051.5     

655.0   

2.8   

(365.5)  

3,189.9 

 

Operating Income

233.9     

42.1     

18.8   

39.5   

(5.2)  

329.1 

 

Interest Income

1.8     

14.7     

.7   

47.1   

(61.2)  

3.1 

 

Interest Expense

86.4     

28.3     

1.7   

65.7   

(13.4)  

168.7 

 

Other Income

11.5     

.2     

1.0   

5.0   

5.3   

23.0 

 

Preferred Stock
   Dividends

1.3     

-     

-   

1.2   

(1.2)  

1.3 

 

Income Taxes

66.9     

11.8     

7.0   

5.0   

(17.6)  

73.1 

 

Extraordinary Item
   (net of income tax
   of $6.2 million)

9.0 (d)

-     

-   

-   

-   

9.0 

 

Net Income (Loss)

101.6     

16.9     

11.8   

19.7   

(28.9)  

121.1 

 

Total Assets

8,784.4     

1,939.3     

503.3   

1,321.5   

1,173.6   

13,722.1 

 

Construction
   Expenditures

207.1     

4.4     

4.2   

-   

2.5   

218.2 

               

Note:

 

(a)

Includes unallocated Pepco Holdings' (parent company) capital costs, such as acquisition financing costs, and the depreciation and amortization related to purchase accounting adjustments for the fair value of Conectiv assets and liabilities as of the August 1, 2002 acquisition date. Additionally, the Total Assets line item in this column includes Pepco Holdings' goodwill balance. Included in Corp. & Other are intercompany amounts of $(373.1) million for Operating Revenue, $(370.2) million for Operating Expense, $(93.8) million for Interest Income, $(92.7) million for Interest Expense, and $(1.2) million for Preferred Stock Dividends.

(b)

Power Delivery purchased electric energy and capacity and natural gas from Conectiv Energy in the amount of $250.7 million for the six months ended June 30, 2005.

(c)

Includes depreciation and amortization of $207.5 million, consisting of $173.9 million for Power Delivery, $22.8 million for Conectiv Energy, $6.7 million for Pepco Energy Services, and $4.1 million for Corp. & Other.

(d)

Relates to ACE's electric distribution rate case settlement that was accounted for in the first quarter of 2005. This resulted in ACE's reversal of $9.0 million in after tax accruals related to certain deferred costs that are now deemed recoverable. This amount is classified as extraordinary since the original accrual was part of an extraordinary charge in conjunction with the accounting for competitive restructuring in 1999.

 

(4)  COMMITMENTS AND CONTINGENCIES

REGULATORY AND OTHER MATTERS

Relationship with Mirant Corporation

     In 2000, Pepco sold substantially all of its electricity generation assets to Mirant Corporation, formerly Southern Energy, Inc. In July 2003, Mirant filed a voluntary petition for reorganization under Chapter 11 of the U.S. Bankruptcy Code in the U.S. Bankruptcy Court for the Northern District of Texas (the Bankruptcy Court). On December 9, 2005, the Bankruptcy Court approved Mirant's Plan of Reorganization (the Reorganization Plan), and the Mirant business emerged from bankruptcy on January 3, 2006, as a new corporation of the same name (together with its predecessors, Mirant).

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     As part of the bankruptcy proceeding, Mirant had been seeking to reject the ongoing contractual arrangements under the Asset Purchase and Sale Agreement entered into by Pepco and Mirant for the sale of the generation assets that are described below. The Reorganization Plan did not resolve the issues relating to Mirant's efforts to reject these obligations nor did it resolve certain Pepco damage claims against the Mirant bankruptcy estate.

     Power Purchase Agreement

     Under a power purchase agreement with Panda-Brandywine, L.P. (Panda) Pepco is obligated to purchase from Panda 230 megawatts of energy and capacity annually through 2021 (the Panda PPA). At the time of the sale of Pepco's generation assets to Mirant, the purchase price of the energy and capacity under the Panda PPA was, and since that time has continued to be, substantially in excess of the market price. As a part of the Asset Purchase and Sale Agreement, Pepco entered into a "back-to-back" arrangement with Mirant. Under this arrangement, Mirant is obligated through 2021 to purchase from Pepco the capacity and energy that Pepco is obligated to purchase under the Panda PPA at a price equal to Pepco's purchase price from Panda (the PPA-Related Obligations).

     The SMECO Agreement

     Under the Asset Purchase and Sale Agreement, Pepco assigned to Mirant a Facility and Capacity Agreement entered into by Pepco with Southern Maryland Electric Cooperative, Inc. (SMECO), under which Pepco was obligated to purchase from SMECO the capacity of an 84-megawatt combustion turbine installed and owned by SMECO at a former Pepco generating facility at a cost of approximately $500,000 per month until 2015 (the SMECO Agreement). Pepco is responsible to SMECO for the performance of the SMECO Agreement if Mirant fails to perform its obligations thereunder.

     Settlement Agreements with Mirant

     On May 30, 2006, Pepco, PHI, and certain affiliated companies entered into a Settlement Agreement and Release (the Settlement Agreement) with Mirant, which, subject to court approval, settles all outstanding issues between the parties arising from or related to the Mirant bankruptcy. Under the terms of the Settlement Agreement:

·

Mirant will assume the Asset Purchase and Sale Agreement, except for the PPA-Related Obligations, which Mirant will be permitted to reject.

·

Pepco will receive an allowed claim under the Reorganization Plan in an amount that will result in a total aggregate distribution to Pepco, net of certain transaction expenses, of $520 million, consisting of (i) $450 million in damages resulting from the rejection of the PPA-Related Obligations and (ii) $70 million in settlement of other Pepco damage claims against the Mirant bankruptcy estate (the Pepco Distribution).

·

Except as described below, the $520 million distribution to Pepco will be effected by means of the issuance to Pepco of shares of Mirant common stock (consisting of an initial distribution of 13.5 million shares of Mirant common stock, followed thereafter by a number of shares of Mirant common stock to be determined), which Pepco will be obligated to resell promptly in one or more block sale transactions. If the net proceeds that Pepco receives from the resale of the shares of Mirant common stock are less than

25

 

$520 million, Pepco will receive a cash payment from Mirant equal to the difference, and if the net proceeds that Pepco receives from the resale of the shares of Mirant common stock are more than $520 million, Pepco will make a cash payment to Mirant equal to the difference.

·

If the Settlement Agreement is approved by the Bankruptcy Court, but is appealed, Mirant will pay Pepco $70 million in cash as part of the Pepco Distribution (plus 4% interest if the order approving the Settlement Agreement is stayed pending appeal, calculated from the date of entry of the order to the date of Pepco's receipt of the $70 million). If the order then becomes a final order after the exhaustion of appeals, the payment will be taken into account as if it were proceeds from the resale by Pepco of shares of the Mirant common stock.

·

If the closing price of shares of Mirant common stock is less than $16.00 per share for four business days in a twenty consecutive business day period, and Mirant has not made a distribution of shares of Mirant common stock to Pepco under the Settlement Agreement, Mirant has the one-time option to elect to assume, rather than reject, the PPA-Related Obligations. If Mirant elects to assume the PPA-Related Obligations, the Pepco Distribution will be reduced to $70 million.

     All pending appeals, adversary actions or other contested matters between Pepco and Mirant will be dismissed with prejudice, and each will release the other from any and all claims relating to the Mirant bankruptcy.

     Separately, Mirant and SMECO have entered into a Settlement Agreement and Release (the SMECO Settlement Agreement). The SMECO Settlement Agreement provides that Mirant will assume, rather than reject, the SMECO Agreement. This assumption ensures that Pepco will not incur liability to SMECO as the guarantor of the SMECO Agreement due to the rejection of the SMECO Agreement, although Pepco will continue to guarantee to SMECO the future performance of Mirant under the SMECO Agreement.

     On May 31, 2006, Mirant submitted the Settlement Agreement and the SMECO Settlement Agreement to the Bankruptcy Court and to the U.S. District Court for the Northern District of Texas (the District Court) for approval. On May 31, 2006, the District Court entered an order referring the Settlement Agreement and the SMECO Settlement Agreement to the Bankruptcy Court for approval. The Settlement Agreement and the SMECO Settlement Agreement will become effective when the Bankruptcy Court or the District Court, as applicable, has entered a final order, not subject to appeal or rehearing, approving both the Settlement Agreement and the SMECO Settlement Agreement.

     On July 5, 2006, the Bankruptcy Court held a full evidentiary hearing on the Settlement Agreement and the SMECO Settlement Agreement. The Bankruptcy Court has not yet issued an order.

     Until the Settlement Agreement and the SMECO Settlement Agreement are approved, Mirant is required to continue to perform all of its contractual obligations to Pepco and SMECO. Pepco intends to place the $450 million portion of the Pepco Distribution related to the rejection of the PPA-Related Obligations in a special purpose account, which will be invested in stable financial instruments to be used to pay for future capacity and energy purchases under the Panda PPA.

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     On July 19, 2006, the United States Court of Appeals for the Fifth Circuit issued an opinion affirming the District Court's orders from which Mirant appealed. The District Court's orders had denied Mirant's attempt to reject the PPA-Related Obligations and directed Mirant to resume making payments to Pepco pursuant to the PPA-Related Obligations. Under the circumstances presented in the record on appeal, the court ruled that Mirant may not reject the PPA-Related Obligations and required that Mirant continue to perform.

Rate Proceedings

     Delaware

     In October 2005, DPL submitted its 2005 Gas Cost Rate (GCR) filing to the Delaware Public Service Commission (DPSC), which permits DPL to recover gas procurement costs through customer rates. The proposed increase of approximately 38% in anticipation of increasing natural gas commodity costs became effective November 1, 2005, subject to refund pending final DPSC approval after evidentiary hearings. DPSC staff, the Delaware Division of the Public Advocate and DPL entered into a written settlement agreement in April 2006, that the GCR should be approved as filed. On July 11, 2006, the DPSC approved the settlement agreement.

     District of Columbia and Maryland

     In February 2006, Pepco filed an update to the District of Columbia Generation Procurement Credit (GPC) for the periods February 8, 2002 through February 7, 2004 and February 8, 2004 through February 7, 2005; and an update to its Maryland GPC for the period July 1, 2003 through June 30, 2004. The GPC provides for sharing of the profit from SOS sales. The updates to the GPC in both the District of Columbia and Maryland take into account the $112.4 million in proceeds received by Pepco from the December 2005 sale of an allowed bankruptcy claim against Mirant arising from a settlement agreement entered into with Mirant relating to Mirant's obligation to supply energy and capacity to fulfill Pepco's SOS obligations in the District of Columbia and Maryland. The filings also incorporate true-ups to previous disbursements in the GPC for both states. In the filings, Pepco requested that $24.3 million be credited to District of Columbia customers and $17.7 million be credited to Maryland customers during the twelve-month period beginning April 2006. The Maryland Public Service Commission (MPSC) approved the updated Maryland GPC in March 2006.

     On June 15, 2006, the District of Columbia Public Service Commission (DCPSC) granted conditional approval of the GPC update as filed, effective July 1, 2006, and directed Pepco to respond to certain questions set forth in the order. Pepco responded to the DCPSC's questions on July 13, 2006. The DCPSC has provided a schedule for comments on Pepco's responses and for replies to those comments, concluding by the end of August. Final approval of the District of Columbia GPC update is pending.

     Federal Energy Regulatory Commission

     On May 15, 2006, Pepco, ACE and DPL updated their FERC-approved formula transmission rates based on the FERC Form 1 data for 2005 for each of the utilities. These rates became effective on June 1, 2006, as follows: for Pepco, $12,009 per megawatt per year; for ACE, $14,155 per megawatt per year; and for DPL, $10,034 per megawatt per year. By operation of the formula rate process, the new rates incorporate true-ups from the 2005 formula rates that were effective June 1, 2005 and the new 2005 customer demand or peak load. Also, beginning

27

in January 2007, the new rates will be applied to 2006 customer demand data, replacing the 2005 demand data that is currently used. This demand component is driven by the prior year peak loads experienced in each respective zone. Further, the rate changes will be positively impacted by changes to distribution rates for Pepco and DPL based on the merger settlements in Maryland and the District of Columbia. The net earnings impact expected from the network transmission rate changes is estimated to be a reduction of approximately $4 million year over year (2005 to 2006).

Restructuring Deferral

     Pursuant to orders issued by the New Jersey Board of Public Utilities (NJBPU) under the New Jersey Electric Discount and Energy Competition Act (EDECA), beginning August 1, 1999, ACE was obligated to provide BGS to retail electricity customers in its service territory who did not choose a competitive energy supplier. For the period August 1, 1999 through July 31, 2003, ACE's aggregate costs that it was allowed to recover from customers exceeded its aggregate revenues from supplying BGS. These under-recovered costs were partially offset by a $59.3 million deferred energy cost liability existing as of July 31, 1999 (LEAC Liability) that was related to ACE's Levelized Energy Adjustment Clause and ACE's Demand Side Management Programs. ACE established a regulatory asset in an amount equal to the balance of under-recovered costs.

     In August 2002, ACE filed a petition with the NJBPU for the recovery of approximately $176.4 million in actual and projected deferred costs relating to the provision of BGS and other restructuring related costs incurred by ACE over the four-year period August 1, 1999 through July 31, 2003, net of the $59.3 million offset for the LEAC Liability. The petition also requested that ACE's rates be reset as of August 1, 2003 so that there would be no under-recovery of costs embedded in the rates on or after that date. The increase sought represented an overall 8.4% annual increase in electric rates. ACE's recovery of the deferred costs is subject to review and approval by the NJBPU in accordance with EDECA.

     In July 2004, the NJBPU issued a final order in the restructuring deferral proceeding confirming a July 2003 summary order, which (i) permitted ACE to begin collecting a portion of the deferred costs and reset rates to recover on-going costs incurred as a result of EDECA, (ii) approved the recovery of $125 million of the deferred balance over a ten-year amortization period beginning August 1, 2003, (iii) transferred to ACE's then pending base rate case for further consideration approximately $25.4 million of the deferred balance, and (iv) estimated the overall deferral balance as of July 31, 2003 at $195 million, of which $44.6 million was disallowed recovery by ACE. ACE believes the record does not justify the level of disallowance imposed by the NJBPU in the final order. In August 2004, ACE filed with the Appellate Division of the Superior Court of New Jersey (the Superior Court), which hears appeals of the decisions of New Jersey administrative agencies, including the NJBPU, a Notice of Appeal with respect to the July 2004 final order. Briefs were filed by the parties (ACE, as appellant, and the Division of the New Jersey Ratepayer Advocate and Cogentrix Energy Inc., the co-owner of two cogeneration power plants with contracts to sell ACE approximately 397 megawatts of electricity, as cross-appellants) between August 2005 and January 2006. The Superior Court has not yet set the schedule for oral argument.

28

Divestiture Cases

     District of Columbia

     Final briefs on Pepco's District of Columbia divestiture proceeds sharing application were filed with the DCPSC in July 2002 following an evidentiary hearing in June 2002. That application was filed to implement a provision of Pepco's DCPSC-approved divestiture settlement that provided for a sharing of any net proceeds from the sale of Pepco's generation-related assets. One of the principal issues in the case is whether Pepco should be required to share with customers the excess deferred income taxes (EDIT) and accumulated deferred investment tax credits (ADITC) associated with the sold assets and, if so, whether such sharing would violate the normalization provisions of the Internal Revenue Code and its implementing regulations. As of June 30, 2006, the District of Columbia allocated portions of EDIT and ADITC associated with the divested generation assets were approximately $6.5 million and $5.8 million, respectively.

     Pepco believes that a sharing of EDIT and ADITC would violate the Internal Revenue Service (IRS) normalization rules. Under these rules, Pepco could not transfer the EDIT and the ADITC benefit to customers more quickly than on a straight line basis over the book life of the related assets. Since the assets are no longer owned there is no book life over which the EDIT and ADITC can be returned. If Pepco were required to share EDIT and ADITC and, as a result, the normalization rules were violated, Pepco would be unable to use accelerated depreciation on District of Columbia allocated or assigned property. In addition to sharing with customers the generation-related EDIT and ADITC balances, Pepco would have to pay to the IRS an amount equal to Pepco's District of Columbia jurisdictional generation-related ADITC balance ($5.8 million as of June 30, 2006), as well as its District of Columbia jurisdictional transmission and distribution-related ADITC balance ($5.0 million as of June 30, 2006) in each case as those balances exist as of the later of the date a DCPSC order is issued and all rights to appeal have been exhausted or lapsed, or the date the DCPSC order becomes operative.

     In March 2003, the IRS issued a notice of proposed rulemaking (NOPR), which would allow for the sharing of EDIT and ADITC related to divested assets with utility customers on a prospective basis and at the election of the taxpayer on a retroactive basis. In December 2005 a revised NOPR was issued which, among other things, withdrew the March 2003 NOPR and eliminated the taxpayer's ability to elect to apply the regulation retroactively. Comments on the revised NOPR were filed in March 2006, and a public hearing was held in April 2006. Pepco filed a letter with the DCPSC in January 2006, in which it has reiterated that the DCPSC should continue to defer any decision on the ADITC and EDIT issues until the IRS issues final regulations or states that its regulations project related to this issue will be terminated without the issuance of any regulations. Other issues in the divestiture proceeding deal with the treatment of internal costs and cost allocations as deductions from the gross proceeds of the divestiture.

     Pepco believes that its calculation of the District of Columbia customers' share of divestiture proceeds is correct. However, depending on the ultimate outcome of this proceeding, Pepco could be required to make additional gain-sharing payments to District of Columbia customers, including the payments described above related to EDIT and ADITC. Such additional payments (which, other than the EDIT and ADITC related payments, cannot be estimated) would be charged to expense in the quarter and year in which a final decision is rendered and could have a material adverse effect on Pepco's and PHI's results of operations for those periods. However,

29

neither PHI nor Pepco believes that additional gain-sharing payments, if any, or the ADITC-related payments to the IRS, if required, would have a material adverse impact on its financial position or cash flows.

     Maryland

    Pepco filed its divestiture proceeds plan application with the MPSC in April 2001. The principal issue in the Maryland case is the same EDIT and ADITC sharing issue that has been raised in the District of Columbia case. See the discussion above under "Divestiture Cases - District of Columbia." As of June 30, 2006, the Maryland allocated portions of EDIT and ADITC associated with the divested generation assets were approximately $9.1 million and $10.4 million, respectively. Other issues deal with the treatment of certain costs as deductions from the gross proceeds of the divestiture. In November 2003, the Hearing Examiner in the Maryland proceeding issued a proposed order with respect to the application that concluded that Pepco's Maryland divestiture settlement agreement provided for a sharing between Pepco and customers of the EDIT and ADITC associated with the sold assets. Pepco believes that such a sharing would violate the normalization rules (discussed above) and would result in Pepco's inability to use accelerated depreciation on Maryland allocated or assigned property. If the proposed order is affirmed, Pepco would have to share with its Maryland customers, on an approximately 50/50 basis, the Maryland allocated portion of the generation-related EDIT ($9.1 million as of June 30, 2006), and the Maryland-allocated portion of generation-related ADITC. Furthermore, Pepco would have to pay to the IRS an amount equal to Pepco's Maryland jurisdictional generation-related ADITC balance ($10.4 million as of June 30, 2006), as well as its Maryland retail jurisdictional ADITC transmission and distribution-related balance ($8.9 million as of June 30, 2006), in each case as those balances exist as of the later of the date a MPSC order is issued and all rights to appeal have been exhausted or lapsed, or the date the MPSC order becomes operative. The Hearing Examiner decided all other issues in favor of Pepco, except for the determination that only one-half of the severance payments that Pepco included in its calculation of corporate reorganization costs should be deducted from the sales proceeds before sharing of the net gain between Pepco and customers. Pepco filed a letter with the MPSC in January 2006, in which it has reiterated that the MPSC should continue to defer any decision on the ADITC and EDIT issues until the IRS issues final regulations or states that its regulations project related to this issue will be terminated without the issuance of any regulations.

     Pepco has appealed to the MPSC the Hearing Examiner's decision as it relates to the treatment of EDIT and ADITC and corporate reorganization costs. Pepco believes that its calculation of the Maryland customers' share of divestiture proceeds is correct. However, depending on the ultimate outcome of this proceeding, Pepco could be required to share with its customers approximately 50 percent of the EDIT and ADITC balances described above and make additional gain-sharing payments related to the disallowed severance payments. Such additional payments would be charged to expense in the quarter and year in which a final decision is rendered and could have a material adverse effect on results of operations for those periods. However, neither PHI nor Pepco believes that additional gain-sharing payments, if any, or the ADITC-related payments to the IRS, if required, would have a material adverse impact on its financial position or cash flows.

30

     New Jersey

     In connection with the divestiture by ACE of its nuclear generation assets, the NJBPU in July 2000 preliminarily determined that the amount of stranded costs associated with the divested assets that ACE could recover from ratepayers should be reduced by the amount of the accumulated deferred federal income taxes (ADFIT) associated with the divested nuclear assets. However, due to uncertainty under federal tax law regarding whether the sharing of federal income tax benefits associated with the divested assets, including ADFIT, with ACE's customers would violate the normalization rules, ACE submitted a request to the IRS for a Private Letter Ruling (PLR) to clarify the applicable law. The NJBPU has delayed its final determination of the amount of recoverable stranded costs until after the receipt of the PLR.

     On May 25, 2006, the IRS issued a PLR in which it stated that returning to ratepayers any of the unamortized ADFIT attributable to accelerated depreciation on the divested assets after the sale of the assets by means of a reduction of the amount of recoverable stranded costs would violate the normalization rules.

     On June 9, 2006, ACE submitted a letter to the NJBPU to request that the NJBPU conduct proceedings to finalize the determination of the stranded costs associated with the sale of ACE's nuclear assets in accordance with the PLR.

Default Electricity Supply Proceedings

     Delaware

     In October 2005, the DPSC approved DPL as the SOS provider to Delaware customers after May 1, 2006, when DPL's fixed-rate POLR obligation ended. DPL obtains the electricity to fulfill its SOS supply obligation under contracts entered into by DPL pursuant to a competitive bid procedure approved by the DPSC. The bids received for the May 1, 2006, through May 31, 2007, period have had the effect of increasing rates significantly for all customer classes, including an average residential customer increase of 59%.

     One of the successful bidders for SOS supply was Conectiv Energy, an affiliate of DPL. Consequently, the affiliate sales from Conectiv Energy to DPL are subject to approval of FERC. FERC issued its order approving the affiliate sales in April 2006. Because DPL is a public utility incorporated in Virginia, with Virginia retail customers, the affiliate sales from Conectiv Energy to DPL are subject to approval of the Virginia State Corporation Commission (VSCC) under the Virginia Affiliates Act. On May 1, 2006, the VSCC approved the affiliate transaction by granting an exemption to DPL for the 2006 agreement and for future power supply agreements between DPL and Conectiv Energy for DPL's non-Virginia SOS load requirements awarded pursuant to a state regulatory commission supervised solicitation process.

     In April 2006, Delaware enacted legislation that provides for a deferral of the financial impact of the increases through a three-step phase-in of the rate increases, with 15% of the increase taking effect on May 1, 2006, 25% of the increase taking effect on January 1, 2007, and any remaining balance taking effect on June 1, 2007. The program is an "opt-out" program, where a customer may make an election not to participate. On April 25, 2006, the DPSC approved several tariff filings implementing the legislation, including DPL's agreement not to charge customers any interest on the deferred balances. As of July 31, 2006, approximately 53% of the eligible Delaware customers have opted not to participate in the deferral of the SOS rates

31

offered by DPL. With approximately 47% of the eligible customers participating in the phase-in program, DPL anticipates a deferral balance of approximately $51.4 million and an estimated interest expense of approximately $3.0 million, net of taxes. The estimated total interest expense is based on a projected interest cost of 5% accrued over the combined 37-month deferral and recovery period.

     The legislation also requires DPL to file an integrated resource plan, in which DPL will evaluate all available supply options (including generation, transmission and demand-side management programs) during the planning period to ensure that DPL acquires sufficient and reliable supply resources to meet its customers' needs at minimal cost.

     Maryland

     Under settlements approved by the MPSC in April 2003 addressing SOS service in Maryland following the expiration of the fixed-rate default supply obligations of Pepco and DPL in mid-2004, each of Pepco and DPL is required to provide default electricity supply to residential and small commercial customers through May 2008 and to medium-sized commercial customers through May 2006 (the obligation to provide default electricity supply to large commercial customers ended in May 2005). In accordance with the respective settlements, each of Pepco and DPL purchases the power supply required to satisfy its default supply obligations from wholesale suppliers under contracts entered into pursuant to a competitive bid procedure approved and supervised by the MPSC.

     In March 2006, Pepco and DPL each announced the results of competitive bids to supply electricity to its Maryland SOS customers for one year beginning June 1, 2006. Due to significant increases in the cost of fuels used to generate electricity, the auction results had the effect of increasing the average monthly electric bill by about 38.5% and 35% for Pepco's and DPL's Maryland residential customers, respectively. One of the successful bidders for SOS supply to both Pepco and DPL was their affiliate, Conectiv Energy. FERC issued its order approving the affiliate sales to both Pepco and DPL on May 18, 2006. Because DPL is a public utility incorporated in Virginia, with Virginia retail customers, the affiliate sales from Conectiv Energy to DPL are also subject to approval of the VSCC under the Virginia Affiliates Act. On May 1, 2006, the VSCC approved the affiliate transaction by granting an exemption to DPL for the 2006 agreement and for future power supply agreements between DPL and Conectiv Energy for DPL's non-Virginia SOS load requirements awarded pursuant to a state regulatory commission supervised solicitation process.

     On April 21, 2006, the MPSC approved a settlement agreement among Pepco, DPL, the staff of the MPSC and the Office of Peoples Counsel of Maryland, which provides for a rate mitigation plan for the residential customers of each company. Under the plan, the full increase for each company's residential customers who affirmatively elect to participate will be phased-in in increments of 15% on June 1, 2006, 15.7% on March 1, 2007 and the remainder on June 1, 2007. Customers electing to participate in the rate deferral plan will be required to pay the deferred amounts over an 18-month period beginning June 1, 2007. Both Pepco and DPL will accrue the interest cost to fund the deferral program. The interest cost will be absorbed by Pepco and DPL, during the period that the deferred balance is accumulated and collected from customers, to the extent of and offset against the margins that the companies otherwise would earn for providing SOS to residential customers. To implement the settlement, Pepco and DPL filed tariff riders with the MPSC on May 2, 2006, which were approved by the MPSC on

32

May 24, 2006, giving customers the opportunity to opt-in to the phase-in of their rates, as described above. As of July 31, 2006, approximately 2% of Pepco's residential customers and approximately 1% of DPL's residential customers have made the decision to participate in the phase-in program.

     On June 23, 2006, Maryland enacted legislation that extended the period for customers to elect to participate in the phase-in of higher rates, revised the obligation to provide SOS to residential and small commercial customers until further action of the General Assembly, and provided for a customer refund reflecting the difference in projected interest expense on the deferred balance at a 25% customer participation level versus such interest expense at the actual participation levels of approximately 2% for Pepco and approximately 1% for DPL. The total amount of the refund is approximately $1.1 million for Pepco customers and approximately $.3 million for DPL customers. At Pepco's 2% level of participation, Pepco estimates that the deferral balance, net of taxes, will be approximately $1.4 million. At DPL's 1% level of participation, DPL estimates that the deferral balance, net of taxes, will be approximately $.2 million. Pepco and DPL each filed a revised tariff rider on June 30, 2006 to implement the legislation.

     Virginia

     Under amendments to the Virginia Electric Utility Restructuring Act implemented in March 2004, DPL is obligated to offer Default Service to customers in Virginia for an indefinite period until relieved of that obligation by the VSCC. Until January 1, 2005, DPL obtained all of the energy and capacity needed to fulfill its Default Service obligations in Virginia under a supply agreement with its affiliate, Conectiv Energy. In the fall of 2004, DPL conducted a competitive bidding process to provide energy and capacity for its Virginia default supply customers for the seventeen-month period January 1, 2005 through May 30, 2006. Prior to the expiration of that contract, DPL completed a subsequent competitive bid procedure for Default Service supply for the period June 2006 through May 2007, and entered into a new supply agreement for that period with Conectiv Energy, awarded as a result of the bid process. FERC issued its order approving the affiliate sales from Conectiv Energy to DPL for its Virginia Default Service load on May 18, 2006. DPL and Conectiv Energy also filed an application with the VSCC for approval of their affiliate transaction under the Virginia Affiliates Act. The VSCC found that its approval was not needed in this case because the affiliate sale was for a period of one year or less.

     On March 10, 2006, DPL filed for a rate increase with the VSCC for its Virginia Default Service customers to take effect on June 1, 2006, which was intended to allow DPL to recover its higher cost for energy established by the competitive bid procedure. The VSCC directed DPL to address whether the proxy rate calculation as required by a memorandum of agreement entered into by DPL and VSCC staff in June 2000 should be applied to the fuel factor in DPL's rate increase filing. The proxy rate calculation is an approximation of what the cost of power would have been if DPL had not divested its generation units. The proxy rate calculation is a component of a memorandum of agreement entered into by DPL, the staff of the VSCC and the Virginia Attorney General's office in the docket approving the asset divestiture, and was a condition of that divestiture. The Virginia Attorney General's office and VSCC staff each filed testimony in April 2006, in which both argued that the 2000 memorandum of agreement requires that the proxy rate fuel factor calculation set forth therein must operate as a cap on recoverable purchased power costs. DPL filed its response in May 2006, rebutting the testimony of the

33

Attorney General and VSCC staff and arguing that retail rates should not be set at a level below what is necessary to recover its prudently incurred costs of procuring the supply necessary for its Default Service obligation. On June 19, 2006, the VSCC issued an order that granted a rate increase for DPL of $11.5 million ($8.5 million less than requested by DPL in its March 2006 filing), to go into effect July 1, 2006. The estimated after-tax earnings and cash flow impacts of the decision are reductions of approximately $3.6 million in 2006 (including the loss of revenue in June 2006 associated with the Default Service rate increase being deferred from June 1 until July 1) and $2.0 million in 2007. The order also mandated that DPL file an application by March 1, 2007, for Default Service rates to become effective June 1, 2007, which should include a calculation of the fuel factor procedure that is consistent with the procedures set forth in the order.

     New Jersey

     On October 12, 2005, the NJBPU, following the evaluation of proposals submitted by ACE and the other three electric distribution companies operating in New Jersey, issued an order reaffirming the current BGS auction process for the annual period from June 1, 2006 through May 2007. The NJBPU order maintained the current size and make up of the Commercial and Industrial Energy Pricing class (CIEP) and approved the electric distribution companies' recommended approach for the CIEP auction product, but deferred a decision on the level of the retail margin funds.

Proposed Shut Down of B.L. England Generating Facility

    In April 2004, pursuant to a NJBPU order, ACE filed a report with the NJBPU recommending that ACE's B.L. England generating facility, a 447 megawatt plant, be shut down. The report stated that, while operation of the B.L. England generating facility was necessary at the time of the report to satisfy reliability standards, those reliability standards could also be satisfied in other ways. The report concluded that, based on B.L. England's current and projected operating costs resulting from compliance with more restrictive environmental requirements, the most cost-effective way in which to meet reliability standards is to shut down the B.L. England generating facility and construct additional transmission enhancements in southern New Jersey.

     In December 2004, ACE filed a petition with the NJBPU requesting that the NJBPU establish a proceeding that would consist of a Phase I and Phase II and that the procedural process for the Phase I proceeding require intervention and participation by all persons interested in the prudence of the decision to shut down B.L. England generating facility and the categories of stranded costs associated with shutting down and dismantling the facility and remediation of the site. ACE contemplates that Phase II of this proceeding, which would be initiated by an ACE filing in 2008 or 2009, would establish the actual level of prudently incurred stranded costs to be recovered from customers in rates. The NJBPU has not acted on this petition.

     ACE has commenced several construction projects to enhance the transmission system, which will ensure that the reliability of the electric transmission system will be maintained upon the shut down of B.L. England. To date, two projects have been completed and the remaining projects are under construction or are scheduled to be completed prior to December 15, 2007.

     As more fully described below under "Environmental Litigation," ACE, along with PHI and Conectiv, on January 24, 2006, entered into an Administrative Consent Order (ACO) with the

34

New Jersey Department of Environmental Protection (NJDEP) and the Attorney General of New Jersey, which contemplates that ACE will shut down and permanently cease operations at the B.L. England generating facility by December 15, 2007, if ACE does not sell the plant before that time. ACE recorded an asset retirement obligation of $60 million during the first quarter of 2006 (this is reflected as a regulatory liability in PHI's consolidated balance sheet). The shut-down of the B.L. England generating facility will be subject to necessary approvals from the relevant agencies and the outcome of the auction process, discussed under "ACE Auction of Generation Assets," below.

ACE Auction of Generation Assets

     In May 2005, ACE announced that it would auction its electric generation assets, consisting of its B.L. England generating facility and its ownership interests in the Keystone and Conemaugh generating stations. In November 2005, ACE announced an agreement to sell its interests in the Keystone and Conemaugh generating stations to Duquesne Light Holdings Inc. for $173.1 million. On July 19, 2006, the NJBPU issued the final approval needed to complete the sale. ACE expects the sale to be completed in early September. Approximately $80 million, the net gain from the sale, will be used to offset the remaining unamortized aggregate adjusted deferred balance, which ACE has been recovering in rates, and approximately $54.2 million will be returned to ratepayers over a 33-month period as a credit on their bills.

     ACE received final bids for B.L. England in April 2006 and continues to evaluate those bids, working toward completion of a purchase and sale agreement. Any successful bid for B.L. England must comply with NJBPU approved auction standards.

     Any sale of B.L. England will not affect the stranded costs associated with the plant that already have been securitized. If B.L. England is sold, ACE anticipates that, subject to regulatory approval in Phase II of the proceeding described above, approximately $9 to $10 million of additional assets may be eligible for recovery as stranded costs.

General Litigation

     Asbestos Litigation

     During 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 are not entirely clear, it appears that each plaintiff sought $2 million in compensatory damages and $4 million in punitive damages from each defendant.

     Since the initial filings in 1993, additional individual suits have been filed against Pepco, and significant numbers of cases have been dismissed. As a result of two motions to dismiss, numerous hearings and meetings and one motion for summary judgment, Pepco has had approximately 400 of these cases successfully dismissed with prejudice, either voluntarily by the plaintiff or by the court. As of June 30, 2006, there were approximately 220 cases still pending against Pepco in the State Courts of Maryland; of those approximately 220 remaining asbestos

35

cases, approximately 85 cases were filed after December 19, 2000, and have been tendered to Mirant for defense and indemnification pursuant to the terms of the Asset Purchase and Sale Agreement. Mirant's Plan of Reorganization, as approved by the Bankruptcy Court in connection with the Mirant bankruptcy, does not alter Mirant's indemnification obligations.

     While the aggregate amount of monetary damages sought in the remaining suits (excluding those tendered to Mirant) exceeds $400 million, PHI and Pepco believe the amounts claimed by current plaintiffs are greatly exaggerated. The amount of total liability, if any, and any related insurance recovery cannot be determined at this time; however, based on information and relevant circumstances known at this time, PHI and Pepco do not believe these suits will have a material adverse effect on its financial position, results of operations or cash flows. However, if an unfavorable decision were rendered against Pepco, it could have a material adverse effect on Pepco's and PHI's financial position, results of operations or cash flows.

     Cash Balance Plan Litigation

     On September 26, 2005, three management employees of PHI Service Company filed suit in the United States District Court for the District of Delaware against the PHI Retirement Plan, PHI and Conectiv, alleging violations of ERISA, on behalf of a class of management employees who did not have enough age and service when the Cash Balance Sub-Plan was implemented in 1999 to assure that their accrued benefits would be calculated pursuant to the terms of the predecessor plans sponsored by ACE and DPL.

     The plaintiffs have challenged the design of the Cash Balance Sub-Plan and are seeking a declaratory judgment that the Cash Balance Sub-Plan is invalid and that the accrued benefits of each member of the class should be calculated pursuant to the terms of the predecessor plans sponsored by ACE and DPL. Specifically, the complaint alleges that the use of a variable rate to compute the plaintiffs' accrued benefit under the Cash Balance Sub-Plan results in reductions in the accrued benefits that violate ERISA. The complaint also alleges that the benefit accrual rates and the minimal accrual requirements of the Cash Balance Sub-Plan violate ERISA as did the notice that was given to plan participants upon implementation of the Cash Balance Sub-Plan.

     PHI, Conectiv and the PHI Retirement Plan filed a motion to dismiss the suit, which was denied by the court on July 11, 2006. The court stayed one count of the complaint regarding alleged age discrimination pending a decision in another case before the U.S. Court of Appeals for the Third Circuit. While PHI believes it has a strong legal position in the case and that it is therefore unlikely that the plaintiffs will prevail, PHI estimates that the SFAS No. 87 ABO and Projected Benefit Obligation (PBO) would each increase by approximately $12 million, assuming no change in benefits for persons who have already retired or whose employment has been terminated and using actuarial valuation data as of the time the suit was filed. (The ABO represents the present value that participants have earned as of the date of calculation. This means that only service already worked and compensation already earned and paid is considered. The PBO is similar to the ABO, except that the PBO includes recognition of the effect that estimated future pay increases would have on the pension plan obligation.)

Environmental Litigation

     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

36

water quality control, solid and hazardous waste disposal, and limitations on land use. In addition, federal and state statutes authorize governmental agencies to compel responsible parties to clean up certain abandoned or unremediated hazardous waste sites. PHI's subsidiaries may incur costs to clean up currently or formerly owned facilities or sites found to be contaminated, as well as other facilities or sites that may have been contaminated due to past disposal practices. Although penalties assessed for violations of environmental laws and regulations are not recoverable from customers of the operating utilities, environmental clean-up costs incurred by Pepco, DPL and ACE would be included by each company in its respective cost of service for ratemaking purposes.

     In July 2004, DPL entered into an ACO with the Maryland Department of the Environment (MDE) to perform a Remedial Investigation/Feasibility Study (RI/FS) to further identify the extent of soil, sediment and ground and surface water contamination related to former manufactured gas plant (MGP) operations at the Cambridge, Maryland site on DPL-owned property and to investigate the extent of MGP contamination on adjacent property. The MDE has approved the RI and DPL has completed and submitted the FS to MDE. The costs for completing the RI/FS for this site were approximately $150,000. Although the costs of cleanup resulting from the RI/FS will not be determinable until MDE approves the final remedy, DPL currently anticipates that the costs of removing MGP impacted soils and adjacent creek sediments will be in the range of $1.5 to $2.5 million.

     In the early 1970s, both Pepco and DPL sold scrap transformers, some of which may have contained some level of PCBs, to a metal reclaimer operating at the Metal Bank/Cottman Avenue site in Philadelphia, Pennsylvania, owned by a nonaffiliated company. In December 1987, Pepco and DPL were notified by U.S. Environmental Protection Agency (EPA) that they, along with a number of other utilities and non-utilities, were potentially responsible parties (PRPs) in connection with the PCB contamination at the site. Below is a summary of the proceedings and related matters concerning the Metal Bank/Cottman Avenue site:

·

In 1994, an RI/FS including a number of possible remedies was submitted to the EPA. In 1997, the EPA issued a Record of Decision that set forth a selected remedial action plan with estimated implementation costs of approximately $17 million.

·

In 1998, the EPA issued a unilateral administrative order to Pepco and 12 other PRPs directing them to conduct the design and actions called for in its decision. In May 2003, two of the potentially liable owner/operator entities filed for reorganization under Chapter 11 of the U.S. Bankruptcy Code. In October 2003, the bankruptcy court confirmed a reorganization plan that incorporates the terms of a settlement among the two debtor owner/operator entities, the United States and a group of utility PRPs including Pepco (the Utility PRPs). Under the bankruptcy settlement, the reorganized entity/site owner will pay a total of $13.25 million to remediate the site (the Bankruptcy Settlement).

·

In March 2006, the U.S. District Court for the Eastern District of Pennsylvania approved global consent decrees for the Metal Bank/Cottman Avenue site involving the Utility PRPs, the U.S. Department of Justice, EPA, The City of Philadelphia and two owner/operators of the site. Under the terms of the settlement, the two owner/operators will make payments totaling $5.55 million to the U.S. and totaling $4.05 million to the Utility PRPs. The Utility PRPs will perform the remedy at the site and will be able to

37

 

draw on the $13.25 million from the Bankruptcy Settlement to accomplish the remediation (the Bankruptcy Funds). The Utility PRPs will contribute funds to the extent remediation costs exceed the Bankruptcy Funds available. The Utility PRPs also will be liable for EPA costs associated with overseeing the monitoring and operation of the site remedy after the remedy construction is certified to be complete and also the cost of performing the "5 year" review of site conditions required by the Comprehensive Environmental Response, Compensation, and Liability Act of 1980. Any Bankruptcy Funds not spent on the remedy may be used to cover the Utility PRPs' liabilities for future costs. No parties are released from potential liability for damages to natural resources.

·

As of June 30, 2006, Pepco had accrued $1.7 million to meet its liability for a remedy at the Metal Bank/Cottman Avenue site. While final costs to Pepco of the settlement have not been determined, Pepco believes that its liability at this site will not have a material adverse effect on its financial position, results of operations or cash flows.

·

In 1999, DPL entered into a de minimis settlement with EPA and paid approximately $107,000 to resolve its liability for cleanup costs at the Metal Bank/Cottman Avenue site. The de minimis settlement did not resolve DPL's responsibility for natural resource damages, if any, at the site. DPL believes that any liability for natural resource damages at this site will not have a material adverse effect on its financial position, results of operations or cash flows.

     In June 1992, EPA identified ACE as a PRP at the Bridgeport Rental and Oil Services Superfund site in Logan Township, New Jersey. In September 1996, ACE along with other PRPs signed a consent decree with EPA and NJDEP to address remediation of the site. ACE's liability is limited to .232 percent of the aggregate remediation liability and thus far ACE has made contributions of approximately $105,000. Based on information currently available, ACE anticipates that it may be required to contribute approximately an additional $52,000. ACE believes that its liability at this site will not have a material adverse effect on its financial position, results of operations or cash flows.

     In November 1991, NJDEP identified ACE as a PRP at the Delilah Road Landfill site in Egg Harbor Township, New Jersey. In 1993, ACE, along with other PRPs, signed an ACO with NJDEP to remediate the site. The soil cap remedy for the site has been completed and the NJDEP conditionally approved the report submitted by the parties on the implementation of the remedy in January 2003. In March 2004, NJDEP approved a Ground Water Sampling and Analysis Plan. Positive results of groundwater monitoring events have resulted in a reduced level of groundwater monitoring. In March 2003, EPA demanded from the PRP group reimbursement for EPA's past costs at the site, totaling $168,789. The PRP group objected to the demand for certain costs, but agreed to reimburse EPA approximately $19,000. Based on information currently available, ACE anticipates that its share of additional cost associated with this site will be approximately $555,000 to $600,000. ACE believes that its liability for post-remedy operation and maintenance costs will not have a material adverse effect on its financial position, results of operations or cash flows.

     On January 24, 2006, PHI, Conectiv and ACE entered into an ACO with NJDEP and the Attorney General of New Jersey resolving New Jersey's claim for alleged violations of the Federal Clean Air Act (CAA) and the NJDEP's concerns regarding ACE's compliance with New

 

38

Source Review (NSR) requirements and the New Jersey Air Pollution Control Act (APCA) with respect to the B.L. England generating facility and various other environmental issues relating to ACE and Conectiv Energy facilities in New Jersey. Among other things, the ACO provides that:

·

Contingent upon the receipt of necessary approvals for the construction of substation and transmission facilities to compensate for the shut down of B.L. England, ACE will permanently cease operation of the B.L. England generating facility by December 15, 2007 if ACE does not sell the facility. In the event that ACE is unable to shut down the B.L. England facility by December 15, 2007 through no fault of its own, (i) ACE may operate B.L. England Unit 1 after December 15, 2007 for certain limited purposes and/or for electric system reliability during the summer months in the years 2008 to 2012, and (ii) B.L. England Units 1 and 2 would be required to comply with stringent emissions limits by December 15, 2012 and May 1, 2010, respectively. If ACE fails to meet those 2010 and 2012 deadlines for reducing emissions, ACE would be required to pay up to $10 million in civil penalties.

·

If B.L. England is shut down by December 15, 2007, ACE will surrender to NJDEP certain sulfur dioxide (SO2) and nitrogen oxide (NOx) allowances allocated to B.L. England Units 1 and 2, contingent upon approval by the NJBPU recognizing cost impacts of the surrender.

·

In the event that ACE is unable to shut down B.L. England Units 1 and 2 by December 15, 2007 through no fault of its own, ACE will surrender NOx and SO2 allowances not needed to satisfy the operational needs of B.L. England Units 1 and 2, contingent upon approval by the NJBPU recognizing cost impacts of the surrender.

·

To resolve any possible civil liability (and without admitting liability) for violations of APCA and the Prevention of Significant Deterioration NSR provisions of the CAA, ACE paid a $750,000 civil penalty to NJDEP in June 2004 and will undertake environmental projects that are beneficial to the state of New Jersey and approved by the NJDEP or donate property valued at $2 million.

·

To resolve any possible civil liability (and without admitting liability) for natural resource damages resulting from groundwater contamination at ACE's B.L. England facility, Conectiv Energy's Deepwater facility and ACE's operations center near Pleasantville, New Jersey, ACE and Conectiv Energy paid NJDEP $674,162 and will remediate the groundwater contamination at all three sites.

·

The ACO allows the sale of the B.L. England facility through the B.L. England auction process to a third party that is not committing to repower or otherwise meet the ACO's emissions limits, subject to a 45-day right of first refusal in favor of NJDEP for purchase of B.L. England on terms and conditions no less favorable to ACE than those offered by the third party. In the event that ACE enters into a third-party agreement through the B.L. England auction process with an entity that commits to repower B.L. England or otherwise meet the ACO's emission limits, NJDEP does not have a right of first refusal.

·

If ACE does not sell B.L. England and the facility is shut down by December 15, 2007, ACE will give NJDEP or a charitable conservancy six months to negotiate an agreement

39

 

to purchase B.L. England. If no agreement is reached, ACE may seek bids for B.L. England from third parties, subject to a 45-day right of first refusal in favor of NJDEP for purchase of B.L. England on terms and conditions no less favorable to ACE than those offered by a third party.

     The ACO does not resolve any federal claims for alleged violations at the B.L. England generating station or any federal or state claims regarding alleged violations at Conectiv Energy's Deepwater generating station, about which EPA and NJDEP sought information beginning in February 2000 pursuant to CAA Section 114, or any other facilities. PHI does not believe that any of its subsidiaries has any liability with respect thereto, but cannot predict the consequences of the federal and state inquiries.

     As more fully described above under "Proposed Shut Down of B.L. England Generating Facility," ACE expects that the transmission enhancements necessary to meet reliability standards in lieu of B.L. England will be completed on or before December 15, 2007 and that B.L. England will be shut down by that date, if ACE has not sold the plant before that time.

Federal Tax Treatment of Cross-Border Leases

     PCI maintains a portfolio of cross-border energy sale-leaseback transactions, which, as of June 30, 2006, had a book value of approximately $1.3 billion, and from which PHI currently derives approximately $55 million per year in tax benefits in the form of interest and depreciation deductions.

     On February 11, 2005, the Treasury Department and IRS issued Notice 2005-13 informing taxpayers that the IRS intends to challenge on various grounds the purported tax benefits claimed by taxpayers entering into certain sale-leaseback transactions with tax-indifferent parties (i.e., municipalities, tax-exempt and governmental entities), including those entered into on or prior to March 12, 2004 (the Notice). All of PCI's cross-border energy leases are with tax indifferent parties and were entered into prior to 2004. In addition, on June 29, 2005 the IRS published a Coordinated Issue Paper concerning the resolution of audit issues related to such transactions. PCI's cross-border energy leases are similar to those sale-leaseback transactions described in the Notice and the Coordinated Issue Paper.

     PCI's leases have been under examination by the IRS as part of the normal PHI tax audit. On June 9, 2006, the IRS issued its final Revenue Agent's Report (RAR) for its audit of PHI's 2001 and 2002 income tax returns. In the RAR, the IRS disallowed the tax benefits claimed by PHI with respect to these leases for those years. The tax benefits claimed by PHI with respect to these leases from 2001 through June 30, 2006 were approximately $259 million. The ultimate outcome of this issue is uncertain; however, if the IRS prevails, PHI would be subject to additional taxes, along with interest and possibly penalties on the additional taxes, which could have a material adverse effect on PHI's financial condition, results of operations, and cash flows. PHI believes that its tax position related to these transactions was proper based on applicable statutes, regulations and case law, and intends to contest any final adjustments proposed by the IRS; however, there is no assurance that PHI's position will prevail.

     In November 2005, the U.S. Senate passed The Tax Relief Act of 2005 (S.2020) which would have applied passive loss limitation rules to leases similar to PCI's cross-border energy leases, effective for taxable years beginning after December 31, 2005. This provision, however,

40

was not included in the final tax legislation, the Tax Increase Prevention and Reconciliation Act of 2005, which was signed into law by President Bush on May 17, 2006.

     On July 13, 2006, the FASB issued FSP FAS 13-2, which amends SFAS No. 13 effective for fiscal years beginning after December 15, 2006. This amendment requires a lease to be repriced and the book value adjusted when there is a change or probable change in the timing of tax benefits of the lease regardless of whether the change results in a deferral or permanent loss of tax benefits. Accordingly, a material change in the timing of cash flows under PHI's cross-border leases as the result of a settlement with the IRS would require an adjustment to the book value of the leases and a charge to earnings equal to the repricing impact of the disallowed deductions which could result in a material adverse effect on PHI's financial condition, results of operations, and cash flows.

IRS Mixed Service Cost Issue

     During 2001, Pepco, DPL, and ACE changed their methods of accounting with respect to capitalizable construction costs for income tax purposes. The change allowed the companies to accelerate the deduction of certain expenses that were previously capitalized and depreciated. Through December 31, 2005, these accelerated deductions have generated incremental tax cash flow benefits of approximately $205 million (consisting of $94 million for Pepco, $62 million for DPL, and $49 million for ACE) for the companies, primarily attributable to their 2001 tax returns.

     On August 2, 2005, the Treasury Department released regulations that, if adopted in their current form, would require Pepco, DPL, and ACE to change their method of accounting with respect to capitalizable construction costs for income tax purposes for future tax periods beginning in 2005. Under these regulations, Pepco, DPL, and ACE will have to capitalize and depreciate a portion of the construction costs that they have previously deducted and include the impact of this adjustment in taxable income over a two-year period beginning with tax year 2005. PHI is in the process of finalizing an alternative method of accounting for capitalizable construction costs that management believes will be acceptable to the IRS to replace the method disallowed by the proposed regulations.

     On the same day that the new regulations were released, the IRS issued Revenue Ruling 2005-53 (the Revenue Ruling) which is intended to limit the ability of certain taxpayers to utilize the method of accounting for income tax purposes they utilized on their tax returns for 2004 and prior years. In line with this Revenue Ruling, the IRS issued its RAR, which disallows substantially all of the incremental tax benefits that Pepco, DPL and ACE had claimed on their 2001 and 2002 tax returns by requiring the companies to capitalize and depreciate certain expenses rather than treat such expenses as current deductions.

     In February 2006, PHI paid approximately $121 million of taxes to cover the amount of taxes management estimates will be payable once a new final method of tax accounting is adopted on its 2005 tax return, due to the proposed regulations. PHI intends to contest the adjustments that the IRS has proposed to the 2001 and 2002 tax returns, under the Revenue Ruling referenced above. However, if the IRS is successful in requiring Pepco, DPL and ACE to capitalize and depreciate construction costs that result in a tax and interest assessment greater than management's estimate of $121 million, PHI will be required to pay additional taxes and interest only to the extent these adjustments exceed the $121 million payment made in February 2006.

41

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

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

     As of June 30, 2006, Pepco Holdings and its subsidiaries were parties to a variety of agreements pursuant to which they were guarantors for standby letters of credit, performance residual value, and other commitments and obligations. The fair value of these commitments and obligations was not required to be recorded in Pepco Holdings' Consolidated Balance Sheets; however, certain energy marketing obligations of Conectiv Energy were recorded. The commitments and obligations, in millions of dollars, were as follows:

 

Guarantor

     
   

PHI

 

DPL

 

ACE

 

Other

 

Total

 

Energy marketing obligations of Conectiv Energy (1)

$

141.2

$

-

$

-

$

-

$

141.2

 

Energy procurement obligations of Pepco Energy Services (1)

 

31.3

 

-

 

-

 

-

 

31.3

 

Guaranteed lease residual values (2)

 

.8

 

3.3

 

3.2

 

-

 

7.3

 

Other (3)

 

3.1

 

-

 

-

 

2.2

 

5.3

 

  Total

$

176.4

$

3.3

$

3.2

$

2.2

$

185.1

 
                       

1.

Pepco Holdings has contractual commitments for performance and related payments of Conectiv Energy and Pepco Energy Services to counterparties related to routine energy sales and procurement obligations, including requirements under BGS contracts entered into with ACE.

2.

Subsidiaries of Pepco Holdings have guaranteed residual values in excess of fair value related to certain equipment and fleet vehicles held through lease agreements. As of June 30, 2006, obligations under the guarantees were approximately $7.3 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 minimal. As such, Pepco Holdings believes the likelihood of payment being required under the guarantee is remote.

3.

Other guarantees consist of:

   

·

Pepco Holdings has guaranteed a subsidiary building lease of $3.1 million. Pepco Holdings does not expect to fund the full amount of the exposure under the guarantee.

 

·

PCI has guaranteed facility rental obligations related to contracts entered into by Starpower Communications, LLC. As of June 30, 2006, the guarantees cover the remaining $2.2 million in rental obligations.

     Pepco Holdings 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,

42

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.

Dividends

     On July 27, 2006, Pepco Holdings' Board of Directors declared a dividend on common stock of 26 cents per share payable September 29, 2006, to shareholders of record on September 10, 2006.

(5) USE OF DERIVATIVES IN ENERGY AND INTEREST RATE HEDGING ACTIVITIES

     PHI accounts for its derivative activities in accordance with SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" (SFAS No. 133), as amended by subsequent pronouncements. See "Accounting for Derivatives" in Note 2 and "Use of Derivatives in Energy and Interest Rate Hedging Activities" in Note 13 to the Consolidated Financial Statements of PHI included in PHI's Annual Report on Form 10-K for the year ended December 31, 2005, for a discussion of the accounting treatment of the derivatives used by PHI and its subsidiaries.

     The table below provides detail on effective cash flow hedges under SFAS No. 133 included in PHI's Consolidated Balance Sheet as of June 30, 2006. Under SFAS No. 133, cash flow hedges are marked-to-market on the balance sheet with corresponding adjustments to Accumulated Other Comprehensive Loss. The data in the table indicates the magnitude of the effective cash flow hedges by hedge type (i.e., other energy commodity and interest rate hedges), maximum term, and portion expected to be reclassified to earnings during the next 12 months.

Cash Flow Hedges Included in Accumulated Other Comprehensive Loss
As of June 30, 2006
(Millions of dollars)

Contracts

Accumulated
OCI (Loss)
After Tax 
(1)

Portion Expected
to be Reclassified
to Earnings during
the Next 12 Months

Maximum    Term   

 

Other Energy Commodity

$

(61.9)   

 

$

(50.8)     

 

 51 months

 

Interest Rate

(36.5)   

(7.1)     

314 months

     Total

$

(98.4)   

$

(57.9)     

(1)

Accumulated Other Comprehensive Loss as of June 30, 2006, includes $(7.3) million for an adjustment for minimum pension liability. This adjustment is not included in this table as it is not a cash flow hedge.

     The following table shows, in millions of dollars, the net pre-tax gain (loss) recognized in earnings for cash flow hedge ineffectiveness for the three and six months ended June 30, 2006 and 2005, and where they were reported in PHI's Consolidated Statements of Earnings during the periods.

 

43

 

 

Three Months Ended

Six Months Ended

 
   

2006

   

2005

   

2006

   

2005

 

Operating Revenue

$

.3   

 

$

1.3   

 

$

-   

 

$

2.4   

 

Fuel and Purchased Energy

 

(.3)  

   

-   

   

(.5)  

   

(.9)  

 

     Total

$

-   

$

1.3   

$

(.5)  

$

1.5   

     In connection with their energy commodity activities, the Competitive Energy businesses designate certain derivatives as fair value hedges. The net pre-tax gains (losses) recognized during the three and six months ended June 30, and included in the Consolidated Statements of Earnings for fair value hedges and the associated hedged items are shown in the following table (in millions of dollars).

 

Three Months Ended

Six Months Ended

 
   

2006

   

2005

   

2006

   

2005

 

Loss on Derivative Instruments

$

(.4)  

 

$

-   

 

$

(5.8)  

 

$

-   

 

Gain on Hedged Items

 

.1   

 

$

-   

 

$

5.8   

 

$

-   

 

     During the three and six months ended June 30, 2006 and 2005, there were no forecasted hedged transactions or firm commitments deemed to be no longer probable.

     In connection with their other energy commodity activities, the Competitive Energy businesses hold certain derivatives that do not qualify as hedges. Under SFAS No. 133, these derivatives are marked-to-market through earnings with corresponding adjustments on the balance sheet. The pre-tax gains (losses) on these derivatives are included in "Competitive Energy Operating Revenues" and are summarized in the following table, in millions of dollars, for the three and six months ended June 30, 2006 and 2005.

 

Three Months Ended

Six Months Ended

 
   

2006

   

2005

   

2006

   

2005

 

Proprietary Trading (1)

$

-  

 

$

.1  

 

$

-   

 

$

.1  

 

Other Energy Commodity

 

5.5  

   

4.8  

   

22.5  

   

8.6  

 

     Total

$

5.5  

$

4.9  

$

22.5  

$

8.7  

(1) PHI discontinued its proprietary trading activity in 2003.

 

 

44

 

(6) RESTATEMENT

     As reported in Pepco Holdings' Annual Report on Form 10-K for the year ended December 31, 2005, Pepco Holdings restated its previously reported consolidated financial statements for the three and six months ended June 30, 2005, to correct the accounting for certain deferred compensation arrangements. The restatement includes the correction of other errors for the same period, primarily relating to unbilled revenue, taxes, and various accrual accounts, which were considered by management to be immaterial. These other errors would not themselves have required a restatement absent the restatement to correct the accounting for deferred compensation arrangements. This restatement was required solely because the cumulative impact of the correction for deferred compensation, if recorded in the fourth quarter of 2005, would have been material to that period's reported net income. The following table sets forth for Pepco Holdings' results of operations for the three and six months ended June 30, 2005, its financial position at June 30, 2005, and its cash flows for the six months ended June 30, 2005, the impact of the restatement to correct the accounting for the deferred compensation arrangements and the other errors noted above (millions of dollars):

Three Months Ended
June 30, 2005

Six Months Ended
June 30, 2005

Previously
Reported

Restated

Previously
Reported

Restated

Consolidated Statements of Earnings

     Total Operating Revenue

$

1,712.1 

$

1,720.2 

$

3,516.9 

$

3,519.0 

     Total Operating Expenses

 

1,533.3 

 

1,535.8 

 

3,190.0 

 

3,189.9 

     Total Operating Income

 

178.8 

 

184.4 

 

326.9 

 

329.1 

     Other Income (Expenses)

 

(73.9)

 

(74.8)

 

(140.8)

 

(142.6)

     Income Before Income Tax Expense

 

104.2 

 

108.9 

 

184.8 

 

185.2 

     Net Income

 

64.0 

 

66.4 

 

119.5 

 

121.1 

     Earnings Per Share (Basic and Diluted)

$

.34 

$

.35 

$

.63 

$

.64 

Consolidated Balance Sheet (at June 30)

               

     Total Current Assets

$

$

$

1,873.6 

$

1,875.0 

     Total Investments and Other Assets

 

 

 

4,635.3 

 

4,598.3 

     Total Assets

$

$

$

13,757.7 

$

13,722.1 

     Total Current Liabilities

$

$

$

2,147.9 

$

2,111.4 

     Total Deferred Credits

 

 

 

3,105.6 

 

3,132.2 

     Retained Earnings

$

$

$

888.9 

$

863.2 

     Total Shareholders' Equity

 

 

 

3,424.9 

 

3,399.2 

     Total Liabilities and Shareholders' Equity

$

$

$

13,757.7 

$

13,722.1 

Consolidated Statement of Cash Flows

               

     Net Cash From Operating Activities

$

$

$

305.9 

$

310.5 

     Net Cash Used By Investing Activities

 

 

 

(179.4)

 

(177.0)

     Net Cash From Financing Activities

21.0 

13.8 

                 

 

 

45

 

 

 

 

 

 

 

 

 

 

 

 

THIS PAGE INTENTIONALLY LEFT BLANK.

 

 

 

46

 

 

POTOMAC ELECTRIC POWER COMPANY
STATEMENTS OF EARNINGS
(Unaudited)

 

Three Months Ended
June 30,

Six Months Ended
June 30,

 
   

2006

   

(Restated)
2005

   

2006

   

(Restated)
2005

   
   

(Millions of dollars)

 
                           

Operating Revenue

$

520.5 

 

$

403.5 

 

$

995.7 

 

$

823.4 

   
                           

Operating Expenses

                         

  Fuel and purchased energy

 

294.6 

   

179.0 

   

560.3 

   

395.8 

   

  Other operation and maintenance

 

73.2 

   

64.6 

   

144.3 

   

129.6 

   

  Depreciation and amortization

40.8 

39.8 

81.5 

79.6 

  Other taxes

66.0 

61.1 

130.1 

125.8 

  Gain on sale of assets

(2.8)

(2.8)

     Total Operating Expenses

474.6 

341.7 

916.2 

728.0 

                           

Operating Income

 

45.9 

   

61.8 

   

79.5 

   

95.4 

   

Other Income (Expenses)

                         

  Interest and dividend income

 

1.5 

   

.3 

   

3.0 

   

1.1 

   

  Interest expense

 

(19.3)

   

(20.5)

   

(38.2)

   

(40.1)

   

  Other income

 

4.5 

   

6.4 

   

8.0 

   

8.9 

   

  Other expenses

 

(.3)

   

   

(.3)

   

(.5)

   

     Total Other Expenses

(13.6)

(13.8)

(27.5)

(30.6)

Income Before Income Tax Expense

32.3 

48.0 

52.0 

64.8 

Income Tax Expense

 

13.4 

   

20.3 

   

22.5 

   

28.0 

   
                           

Net Income

18.9 

27.7 

29.5 

36.8 

Dividends on Redeemable Serial Preferred Stock

.3 

1.0 

.6 

Earnings Available for Common Stock

18.9 

27.4 

28.5 

36.2 

Retained Earnings at Beginning of Period

568.9 

467.4 

574.3 

473.5 

Dividends paid to Pepco Holdings

(49.0)

(64.0)

(14.9)

Retained Earnings at End of Period

$

538.8 

$

494.8 

$

538.8 

$

494.8 

                           

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

 

47

 

 

POTOMAC ELECTRIC POWER COMPANY
BALANCE SHEETS
(Unaudited)

ASSETS

June 30,
2006

December 31,
2005

     

(Millions of dollars)

 

CURRENT ASSETS

                         

  Cash and cash equivalents

           

$

8.1 

 

$

131.4 

   

  Accounts receivable, less allowance for
    uncollectible accounts of $16.4 million
    and $14.1 million, respectively

             

350.3 

   

339.0 

   

  Materials and supplies-at average cost

             

41.1 

   

36.8 

   

  Prepaid expenses and other

             

21.8 

   

11.7 

   

    Total Current Assets

             

421.3 

   

518.9 

   
                           

INVESTMENTS AND OTHER ASSETS

                         

  Regulatory assets

             

149.6 

   

150.7 

   

  Prepaid pension expense

             

155.2 

   

161.3 

   

  Investment in trust

             

55.9 

   

53.1 

   

  Other

             

47.6 

   

50.7 

   

    Total Investments and Other Assets

             

408.3 

   

415.8 

   
                           

PROPERTY, PLANT AND EQUIPMENT

                         

  Property, plant and equipment

             

5,070.9 

   

4,990.0 

   

  Accumulated depreciation

             

(2,136.6)

   

(2,068.0)

   

    Net Property, Plant and Equipment

             

2,934.3 

   

2,922.0 

   
                           

    TOTAL ASSETS

           

$

3,763.9 

 

$

3,856.7 

   
                           

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

 

48

 

 

POTOMAC ELECTRIC POWER COMPANY
BALANCE SHEETS
(Unaudited)

LIABILITIES AND SHAREHOLDER'S EQUITY

June 30,
2006

December 31,
2005

     

(Millions of dollars, except shares)

 

CURRENT LIABILITIES

                         

  Short-term debt

           

$

52.4 

 

$

   

  Current maturities of long-term debt

             

85.0 

   

50.0 

   

  Accounts payable and accrued liabilities

             

213.1 

   

185.3 

   

  Accounts payable to associated companies

             

47.6 

   

40.3 

   

  Capital lease obligations due within one year

             

5.3 

   

5.1 

   

  Taxes accrued

             

63.9 

   

154.9 

   

  Interest accrued

             

16.7 

   

18.9 

   

  Other

             

81.9 

   

81.2 

   

    Total Current Liabilities

             

565.9 

   

535.7 

   
                           

DEFERRED CREDITS

                         

  Regulatory liabilities

             

129.4 

   

145.2 

   

  Income taxes

             

607.2 

   

622.0 

   

  Investment tax credits

             

15.5 

   

16.5 

   

  Other postretirement benefit obligation

             

48.9 

   

46.7 

   

  Other

             

75.8 

   

75.9 

   

    Total Deferred Credits

             

876.8 

   

906.3 

   
                           

LONG-TERM LIABILITIES

                         

  Long-term debt

             

1,164.8 

   

1,198.9 

   

  Capital lease obligations

             

113.6 

   

116.3 

   

    Total Long-Term Liabilities

             

1,278.4 

   

1,315.2 

   
                           

COMMITMENTS AND CONTINGENCIES (NOTE 4)

                         
                           

SERIAL PREFERRED STOCK

             

   

21.5 

   
                           

SHAREHOLDER'S EQUITY

                         

  Common stock, $.01 par value, authorized
    400,000,000 shares, issued 100 shares

             

   

   

  Premium on stock and other capital contributions

             

507.4 

   

507.1 

   

  Accumulated other comprehensive loss

             

(3.4)

   

(3.4)

   

  Retained earnings

             

538.8 

   

574.3 

   

    Total Shareholder's Equity

             

1,042.8 

   

1,078.0 

   
                           

    TOTAL LIABILITIES AND SHAREHOLDER'S EQUITY

           

$

3,763.9 

 

$

3,856.7 

   
                           

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

 

49

 

 

POTOMAC ELECTRIC POWER COMPANY
STATEMENTS OF CASH FLOWS
(Unaudited)

   

Six Months Ended
June 30,

 
               

2006

   

(Restated)
2005

   
     

(Millions of dollars)

 

OPERATING ACTIVITIES

                         

Net income

           

$

29.5 

 

$

36.8 

   

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

                         

  Depreciation and amortization

             

81.5 

   

79.6 

   

  Deferred income taxes

             

(.4)

   

2.5 

   

  Gain on sale of assets

             

   

(2.8)

   

  Changes in:

                         

    Accounts receivable

             

(11.3)

   

(34.4)

   

    Regulatory assets and liabilities

             

(12.1)

   

(26.3)

   

    Accounts payable and accrued liabilities

             

20.6 

   

47.0 

   

    Interest and taxes accrued

             

(106.2)

   

15.7 

   

    Other changes in working capital

             

(1.4)

   

1.1 

   

Net other operating

             

13.6 

   

5.1 

   

Net Cash From Operating Activities

             

13.8 

   

124.3 

   
                           

INVESTING ACTIVITIES

                         

Net investment in property, plant and equipment

             

(102.5)

   

(81.3)

   

Proceeds from sale of assets

             

   

2.8 

   

Net other investing activities

             

(2.0)

   

.7 

   

Net Cash Used By Investing Activities

             

(104.5)

   

(77.8)

   
                           

FINANCING ACTIVITIES

                         

Dividends paid to Pepco Holdings

             

(64.0)

   

(14.9)

   

Dividends paid on preferred stock

             

(1.0)

   

(.6)

   

Issuances of long-term debt

             

109.5 

   

175.0 

   

Reacquisition of long-term debt

             

(109.5)

   

   

Issuances (repayments) of short-term debt, net

             

52.4 

   

(14.0)

   

Redemption of preferred stock

             

(21.5)

   

   

Net other financing activities

             

1.5 

   

(5.8)

   

Net Cash (Used By) From Financing Activities

             

(32.6)

   

139.7 

   
                           

Net (Decrease) Increase in Cash and Cash Equivalents

             

(123.3)

   

186.2 

   

Cash and Cash Equivalents at Beginning of Period

             

131.4 

   

1.5 

   
                           

CASH AND CASH EQUIVALENTS AT END OF PERIOD

           

$

8.1 

 

$

187.7 

   
                           

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION

                         

Cash paid for income taxes
   (includes payments to PHI for Federal income taxes)

           

$

70.8 

 

$

2.9 

   
                           

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

 

50

 

 

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 Washington, D.C. and major portions of Prince George's and Montgomery Counties in suburban Maryland. Pepco provides Default Electricity Supply, which is the supply of electricity at regulated rates to retail customers in its territories who do not elect to purchase electricity from a competitive supplier, in both the District of Columbia and Maryland. Default Electricity Supply is known as Standard Offer Service (SOS) in both the District of Columbia and Maryland. Pepco's service territory covers approximately 640 square miles and has a population of approximately 2.1 million. Pepco is a wholly owned subsidiary of Pepco Holdings, Inc. (Pepco Holdings or PHI). Because PHI is a public utility holding company subject to the Public Utility Holding Company Act of 2005 (PUHCA 2005), the relationship between PHI and Pepco and certain activities of Pepco are subject to the regulatory oversight of the Federal Energy Regulatory Commission (FERC) under PUHCA 2005.

(2)  ACCOUNTING POLICY, PRONOUNCEMENTS, AND OTHER DISCLOSURES

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, 2005. In the opinion of Pepco's management, the financial statements contain all adjustments (which all are of a normal recurring nature) necessary to present fairly Pepco's financial condition as of June 30, 2006, in accordance with GAAP. The year-end balance sheet data was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. Interim results for the three and six months ended June 30, 2006 may not be indicative of results that will be realized for the full year ending December 31, 2006 since the sales of electric energy are seasonal.

FIN 46R, "Consolidation of Variable Interest Entities"

     Due to a variable element in the pricing structure of Pepco's purchase power agreement (Panda PPA) with Panda-Brandywine, L.P. (Panda), Pepco potentially assumes the variability in the operations of the plants related to this PPA and therefore has a variable interest in the entity. In accordance with the provisions of Financial Accounting Standards Board (FASB) Interpretation No. (FIN) 46R (revised December 2003) (FIN 46R), entitled "Consolidation of Variable Interest Entities," Pepco continued, during the six months ended June 30, 2006, to conduct exhaustive efforts to obtain information from this entity, but was unable to obtain sufficient information to conduct the analysis required under FIN 46R to determine whether the

51

entity was a variable interest entity or if Pepco was the primary beneficiary. As a result, Pepco has applied the scope exemption from the application of FIN 46R for enterprises that have conducted exhaustive efforts to obtain the necessary information, but have not been able to obtain such information.

     Power purchases related to the Panda PPA for the three months ended June 30, 2006 and 2005 were approximately $19 million and $20 million, respectively. Power purchases related to the Panda PPA for the six months ended June 30, 2006 and 2005 were approximately $38 million and $39 million, respectively. Pepco's exposure to loss under the Panda PPA is discussed in Note (4), Commitments and Contingencies, under "Relationship with Mirant Corporation."

Components of Net Periodic Benefit Cost

     The following Pepco Holdings' information is for the three months ended June 30, 2006 and 2005.

   

Pension Benefits

   

Other
Postretirement
Benefits

   
   

2006

   

2005

   

2006

   

2005

   
 

(Millions of dollars)

 

Service cost

$

10.1 

 

$

9.6 

 

$

1.7 

 

$

2.1 

   

Interest cost

 

24.2 

   

23.6 

   

8.3 

   

8.4 

   

Expected return on plan assets

 

(32.5)

   

(32.1)

   

(2.7)

   

(2.9)

   

Amortization of prior service cost

 

.2 

   

.3 

   

(1.1)

   

(.9)

   

Amortization of net loss

 

4.8 

   

2.7 

   

4.2 

   

3.4 

   

Net periodic benefit cost

$

6.8 

 

$

4.1 

 

$

10.4 

 

$

10.1 

   
                           

     The following Pepco Holdings' information is for the six months ended June 30, 2006 and 2005.

   

Pension Benefits

   

Other
Postretirement
Benefits

   
   

2006

   

2005

   

2006

   

2005

   
 

(Millions of dollars)

 

Service cost

$

20.3 

 

$

19.0 

 

$

4.2 

 

$

4.2 

   

Interest cost

 

48.4 

   

47.9 

   

17.3 

   

16.8 

   

Expected return on plan assets

 

(65.0)

   

(62.8)

   

(5.8)

   

(5.4)

   

Amortization of prior service cost

 

.4 

   

.6 

   

(2.0)

   

(1.9)

   

Amortization of net loss

 

8.7 

   

5.2 

   

7.2 

   

5.9 

   

Net periodic benefit cost

$

12.8 

 

$

9.9 

 

$

20.9 

 

$

19.6 

   
                           

52

     Pension

     The pension net periodic benefit cost for the three months ended June 30, 2006 of $6.8 million includes $3.6 million for Pepco. The pension net periodic benefit cost for the six months ended June 30, 2006 of $12.8 million includes $6.6 million for Pepco. The remaining pension net periodic benefit cost is for other PHI subsidiaries. The pension net periodic benefit cost for the three months ended June 30, 2005 of $4.1 million includes $2.5 million for Pepco. The pension net periodic benefit cost for the six months ended June 30, 2005 of $9.9 million includes $5.1 million for Pepco. The remaining pension net periodic benefit cost is for other PHI subsidiaries.

     Pension Contributions

     Pepco Holdings' current funding policy with regard to its defined benefit pension plan is to maintain a funding level in excess of 100% of its accumulated benefit obligation (ABO). In 2005 and 2004, PHI made discretionary tax-deductible cash contributions to the plan of $60 million and $10 million, respectively. PHI's pension plan currently meets the minimum funding requirements of the Employment Retirement Income Security Act of 1974 without any additional funding. PHI may elect, however, to make a discretionary tax-deductible contribution to maintain the pension plan's assets in excess of its ABO. As of June 30, 2006, no contributions have been made. The potential discretionary funding of the pension plan in 2006 will depend on many factors, including the actual investment return earned on plan assets over the remainder of the year.

     Other Postretirement Benefits

     The other postretirement net periodic benefit cost for the three months ended June 30, 2006 of $10.4 million includes $4.6 million for Pepco. The other postretirement net periodic benefit cost for the six months ended June 30, 2006 of $20.9 million includes $9.4 million for Pepco. The remaining other postretirement net periodic benefit cost is for other PHI subsidiaries. The other postretirement net periodic benefit cost for the three months ended June 30, 2005 of $10.1 million includes $6.0 million for Pepco. The other postretirement net periodic benefit cost for the six months ended June 30, 2005 of $19.6 million includes $9.0 million for Pepco. The remaining other postretirement net periodic benefit cost is for other PHI subsidiaries.

 

53

Reconciliation of Income Tax Expense

     A reconciliation of Pepco's income tax expense is as follows:

 

For the Three Months Ended June 30,

For the Six Months Ended June 30,

 
 

2006

2005 (Restated)

2006

2005 (Restated)

 
 

Amount

Rate

Amount

Rate

Amount

Rate

Amount

Rate

 
 

(Millions of dollars)

 

Income Before Income Tax Expense

$32.3  

-  

$48.0  

-  

$52.0  

-  

$64.8  

-  

 
                   

Income tax at federal statutory rate

$11.3  

.35  

$16.8  

.35  

$18.2  

.35  

$22.7  

.35  

 

  Increases (decreases) resulting from:

                 

    Depreciation

1.5  

.05  

1.6  

.03  

3.0  

.06  

3.3  

.05  

 

    Accrued asset removal costs

(.5) 

(.02) 

(.5) 

(.01) 

(1.9) 

(.04) 

(1.2) 

(.02) 

 

    State income taxes, net of
         federal effect

1.9  

.06  

2.7  

.06  

3.2  

.06  

3.9  

.06  

 

    Software amortization

.7  

.02  

.1  

-   

1.4  

.03  

.2  

.01  

 

    Tax credits

(.5) 

(.01) 

(.6) 

(.02) 

(1.0) 

(.02) 

(1.2) 

(.02) 

 

    Change in estimates related to
        tax liabilities of prior years

.1  

-  

.4  

.01  

.2  

-  

.7  

.01  

 

    Corporate owned life insurance

(.8) 

(.02) 

.1  

-  

(.1) 

-  

.2  

-  

 

    Other, net

(.3) 

(.01) 

(.3) 

-  

(.5) 

(.01) 

(.6) 

(.01) 

 
                   

Total Income Tax Expense

$13.4  

.42  

$20.3  

.42  

$22.5  

.43  

$28.0  

.43  

 
                   

Debt

     In April 2006, Pepco completed a tax-exempt financing in which the Maryland Economic Development Corporation issued $109.5 million of insured auction rate pollution control bonds due 2022 and loaned the proceeds to Pepco. Pepco's obligations under the insurance agreement are secured by a like amount of Pepco senior notes, which in turn are secured by a like amount of Pepco First Mortgage Bonds.

     In May 2006, Pepco used the proceeds described above to redeem at 100% of the principal amount of the following bonds:

·

$42.5 million of Montgomery County, Maryland 5.375% Tax-Exempt First Mortgage Bonds due 2024,

·

$37 million of Prince George's County, Maryland 6.375% Tax-Exempt First Mortgage Bonds due 2023, and

·

$30 million of Prince George's County, Maryland 6.0% Tax-Exempt First Mortgage Bonds due 2022.

     In April 2006, PHI, Pepco, Delmarva Power & Light Company (DPL) and Atlantic City Electric Company amended their $1.2 billion credit facility due 2010 to extend the maturity by one additional year to May 5, 2011 and to reduce the pricing of the facility by reducing the credit facility fees.

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Related Party Transactions

     PHI Service Company provides various administrative and professional services to PHI and its regulated and unregulated subsidiaries, including Pepco, pursuant to a service agreement. The cost of these services is allocated in accordance with cost allocation methodologies set forth in the service agreement using a variety of factors, including the subsidiaries' share of employees, operating expenses, assets, and other cost causal methods. These intercompany transactions are eliminated in consolidation and no profit results from these transactions. PHI Service Company costs directly charged or allocated to Pepco for the three and six months ended June 30, 2006 and 2005 were approximately $31.0 million and $60.6 million, and $27.3 million and $53.5 million, respectively.

     Certain subsidiaries of Pepco Energy Services perform utility services, including services that are treated as capital costs, for Pepco. Amounts paid by Pepco to these companies for the three and six months ended June 30, 2006 and 2005 were approximately $2.6 million and $4.9 million, and $2.4 million and $4.9 million, respectively.

     In addition to the PHI Service Company charges and utility maintenance services described above, Pepco's Statements of Earnings include the following related party transactions:

 

For the Three Months Ended
June 30,

For the Six Months Ended
June 30,

2006

2005

2006

2005

Income (Expense)

(Millions of dollars)

Intercompany power purchases - Conectiv Energy Supply
  (included in fuel and purchased energy)

$(5.7)  

$   -  

$(5.7)  

$   -  

Intercompany lease transactions related to computer services and
  facility and building maintenance (included in other operation and
  maintenance)

(.6)  

(1.2)

(1.4)  

(2.1)

     As of June 30, 2006 and December 31, 2005, Pepco had the following balances on its Balance Sheets due (to) from related parties:

 

2006

2005

Asset (Liability)

(Millions of dollars)

Payable to Related Party (current)

   

  PHI Service Company

$(14.6)  

$(15.3)  

  Pepco Energy Services (a)

(27.3)  

(25.0)  

  Conectiv Energy Supply

(5.7)  

-   

       Total Payable to Related Parties

$(47.6)  

$(40.3)  

Money Pool Balance with Pepco Holdings
  (included in cash and cash equivalents on the balance sheet)

$     .1   

$ 73.1   

     

(a)

Pepco bills customers on behalf of Pepco Energy Services where customers have selected Pepco Energy Services as their alternative supplier or where Pepco Energy Services has performed work for certain government agencies under a General Services Administration area-wide agreement.

55

New Accounting Standards

     FSP FTB 85-4-1, "Accounting for Life Settlement Contracts by Third-Party Investors"

     In March 2006, the FASB issued FASB Staff Position (FSP) FTB 85-4-1, "Accounting for Life Settlement Contracts by Third-Party Investors" (FSP FTB 85-4-1). This FSP provides initial and subsequent measurement guidance and financial statement presentation and disclosure guidance for investments by third-party investors in life settlement contracts. FSP FTB 85-4-1 also amends certain provisions of FASB Technical Bulletin No. 85-4, "Accounting for Purchases of Life Insurance," and FASB Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities." The guidance in FSP FTB 85-4-1 applies prospectively for all new life settlement contracts and is effective for fiscal years beginning after June 15, 2006 (the year ending December 31, 2007 for Pepco). Pepco is in the process of evaluating the impact of FSP FTB 85-4-1 and does not anticipate its adoption will have a material impact on its overall financial condition, results of operations, or cash flows.

     EITF 04-13, "Accounting for Purchases and Sales of Inventory with the Same Counterparty"

     In September 2005, the FASB ratified Emerging Issues Task Force (EITF) Issue No. 04-13, "Accounting for Purchases and Sales of Inventory with the Same Counterparty" (EITF 04-13), which addresses circumstances under which two or more exchange transactions involving inventory with the same counterparty should be viewed as a single exchange transaction for the purposes of evaluating the effect of APB Opinion 29, "Accounting for Nonmonetary Transactions." EITF 04-13 is effective for new arrangements entered into, or modifications or renewals of existing arrangements, beginning in the first interim or annual reporting period beginning after March 15, 2006.

     Pepco implemented EITF 04-13 on April 1, 2006. The implementation did not impact Pepco's overall financial condition, results of operations, or cash flows for the second quarter of 2006.

     FSP FIN 46(R)-6, "Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R)"

     In April 2006, the FASB issued FSP FIN 46(R)-6, "Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R)" (FSP FIN 46(R)-6), which provides guidance on how to determine the variability to be considered in applying FIN 46(R), "Consolidation of Variable Interest Entities."

     The guidance in FSP FIN 46(R)-6 is applicable prospectively beginning the first day of the first reporting period beginning after June 15, 2006 (July 1, 2006 for Pepco), although early application is permitted to financial statements not issued. Retrospective application is also permitted if so elected and must be completed no later than the end of the first annual reporting period ending after July 15, 2006 (December 31, 2006 for Pepco).

     Pepco is in the process of evaluating the impact of FIN 46(R)-6.

56

     EITF Issue No. 06-3, "Disclosure Requirements for Taxes Assessed by a Governmental Authority on Revenue-producing Transactions"

     On June 28, 2006, the FASB ratified EITF Issue No. 06-3, "Disclosure Requirements for Taxes Assessed by a Governmental Authority on Revenue-producing Transactions" (EITF 06-3). EITF 06-3 provides guidance on an entity's disclosure of its accounting policy regarding the gross or net presentation of certain taxes and provides that if taxes included in gross revenues are significant, a company should disclose the amount of such taxes for each period for which an income statement is presented (i.e., both interim and annual periods). Taxes within the scope of EITF 06-3 are those that are imposed on and concurrent with a specific revenue-producing transaction. Taxes assessed on an entity's activities over a period of time are not within the scope of EITF 06-3.

     EITF 06-3 is effective for interim and annual reporting periods beginning after December 15, 2006 (2007 for Pepco) although earlier application is permitted. Pepco is in the process of evaluating the impact of EITF 06-3.

     FIN 48, "Accounting for Uncertainty in Income Taxes"

     On July 13, 2006, the FASB issued FASB Interpretation No.48, "Accounting for Uncertainty in Income Taxes" (FIN 48). FIN 48 clarifies the criteria for recognition of tax benefits in accordance with SFAS No. 109, "Accounting for Income Taxes," and prescribes a financial statement recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return. Specifically, it clarifies that an entity's tax benefits must be "more likely than not" of being sustained prior to recording the related tax benefit in the financial statements. If the position drops below the "more likely than not" standard, the benefit can no longer be recognized. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.

     FIN 48 is effective the first fiscal year beginning after December 15, 2006 (January 1, 2007 for Pepco). Pepco is in the process of evaluating the impact of FIN 48.

(3)  SEGMENT INFORMATION

     In accordance with Statement of Financial Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information," Pepco has one segment, its regulated utility business.

(4)  COMMITMENTS AND CONTINGENCIES

REGULATORY AND OTHER MATTERS

Relationship with Mirant Corporation

     In 2000, Pepco sold substantially all of its electricity generation assets to Mirant Corporation, formerly Southern Energy, Inc. In July 2003, Mirant filed a voluntary petition for reorganization under Chapter 11 of the U.S. Bankruptcy Code in the U.S. Bankruptcy Court for the Northern District of Texas (the Bankruptcy Court). On December 9, 2005, the Bankruptcy Court approved Mirant's Plan of Reorganization (the Reorganization Plan), and the Mirant business emerged from bankruptcy on January 3, 2006, as a new corporation of the same name (together with its predecessors, Mirant).

     As part of the bankruptcy proceeding, Mirant had been seeking to reject the ongoing contractual arrangements under the Asset Purchase and Sale Agreement entered into by Pepco

57

and Mirant for the sale of the generation assets that are described below. The Reorganization Plan did not resolve the issues relating to Mirant's efforts to reject these obligations nor did it resolve certain Pepco damage claims against the Mirant bankruptcy estate.

     Power Purchase Agreement

     Under a power purchase agreement with Panda-Brandywine, L.P. (Panda) Pepco is obligated to purchase from Panda 230 megawatts of energy and capacity annually through 2021 (the Panda PPA). At the time of the sale of Pepco's generation assets to Mirant, the purchase price of the energy and capacity under the Panda PPA was, and since that time has continued to be, substantially in excess of the market price. As a part of the Asset Purchase and Sale Agreement, Pepco entered into a "back-to-back" arrangement with Mirant. Under this arrangement, Mirant is obligated through 2021 to purchase from Pepco the capacity and energy that Pepco is obligated to purchase under the Panda PPA at a price equal to Pepco's purchase price from Panda (the PPA-Related Obligations).

     The SMECO Agreement

     Under the Asset Purchase and Sale Agreement, Pepco assigned to Mirant a Facility and Capacity Agreement entered into by Pepco with Southern Maryland Electric Cooperative, Inc. (SMECO), under which Pepco was obligated to purchase from SMECO the capacity of an 84-megawatt combustion turbine installed and owned by SMECO at a former Pepco generating facility at a cost of approximately $500,000 per month until 2015 (the SMECO Agreement). Pepco is responsible to SMECO for the performance of the SMECO Agreement if Mirant fails to perform its obligations thereunder.

     Settlement Agreements with Mirant

     On May 30, 2006, Pepco, PHI, and certain affiliated companies entered into a Settlement Agreement and Release (the Settlement Agreement) with Mirant, which, subject to court approval, settles all outstanding issues between the parties arising from or related to the Mirant bankruptcy. Under the terms of the Settlement Agreement:

·

Mirant will assume the Asset Purchase and Sale Agreement, except for the PPA-Related Obligations, which Mirant will be permitted to reject.

·

Pepco will receive an allowed claim under the Reorganization Plan in an amount that will result in a total aggregate distribution to Pepco, net of certain transaction expenses, of $520 million, consisting of (i) $450 million in damages resulting from the rejection of the PPA-Related Obligations and (ii) $70 million in settlement of other Pepco damage claims against the Mirant bankruptcy estate (the Pepco Distribution).

·

Except as described below, the $520 million distribution to Pepco will be effected by means of the issuance to Pepco of shares of Mirant common stock (consisting of an initial distribution of 13.5 million shares of Mirant common stock, followed thereafter by a number of shares of Mirant common stock to be determined), which Pepco will be obligated to resell promptly in one or more block sale transactions. If the net proceeds that Pepco receives from the resale of the shares of Mirant common stock are less than $520 million, Pepco will receive a cash payment from Mirant equal to the difference, and if the net proceeds that Pepco receives from the resale of the shares of Mirant common

58

 

stock are more than $520 million, Pepco will make a cash payment to Mirant equal to the difference.

·

If the Settlement Agreement is approved by the Bankruptcy Court, but is appealed, Mirant will pay Pepco $70 million in cash as part of the Pepco Distribution (plus 4% interest if the order approving the Settlement Agreement is stayed pending appeal, calculated from the date of entry of the order to the date of Pepco's receipt of the $70 million). If the order then becomes a final order after the exhaustion of appeals, the payment will be taken into account as if it were proceeds from the resale by Pepco of shares of the Mirant common stock.

·

If the closing price of shares of Mirant common stock is less than $16.00 per share for four business days in a twenty consecutive business day period, and Mirant has not made a distribution of shares of Mirant common stock to Pepco under the Settlement Agreement, Mirant has the one-time option to elect to assume, rather than reject, the PPA-Related Obligations. If Mirant elects to assume the PPA-Related Obligations, the Pepco Distribution will be reduced to $70 million.

     All pending appeals, adversary actions or other contested matters between Pepco and Mirant will be dismissed with prejudice, and each will release the other from any and all claims relating to the Mirant bankruptcy.

     Separately, Mirant and SMECO have entered into a Settlement Agreement and Release (the SMECO Settlement Agreement). The SMECO Settlement Agreement provides that Mirant will assume, rather than reject, the SMECO Agreement. This assumption ensures that Pepco will not incur liability to SMECO as the guarantor of the SMECO Agreement due to the rejection of the SMECO Agreement, although Pepco will continue to guarantee to SMECO the future performance of Mirant under the SMECO Agreement.

     On May 31, 2006, Mirant submitted the Settlement Agreement and the SMECO Settlement Agreement to the Bankruptcy Court and to the U.S. District Court for the Northern District of Texas (the District Court) for approval. On May 31, 2006, the District Court entered an order referring the Settlement Agreement and the SMECO Settlement Agreement to the Bankruptcy Court for approval. The Settlement Agreement and the SMECO Settlement Agreement will become effective when the Bankruptcy Court or the District Court, as applicable, has entered a final order, not subject to appeal or rehearing, approving both the Settlement Agreement and the SMECO Settlement Agreement.

     On July 5, 2006, the Bankruptcy Court held a full evidentiary hearing on the Settlement Agreement and the SMECO Settlement Agreement. The Bankruptcy Court has not yet issued an order.

     Until the Settlement Agreement and the SMECO Settlement Agreement are approved, Mirant is required to continue to perform all of its contractual obligations to Pepco and SMECO. Pepco intends to place the $450 million portion of the Pepco Distribution related to the rejection of the PPA-Related Obligations in a special purpose account, which will be invested in stable financial instruments to be used to pay for future capacity and energy purchases under the Panda PPA.

     On July 19, 2006, the United States Court of Appeals for the Fifth Circuit issued an opinion affirming the District Court's orders from which Mirant appealed. The District Court's orders

59

had denied Mirant's attempt to reject the PPA-Related Obligations and directed Mirant to resume making payments to Pepco pursuant to the PPA-Related Obligations. Under the circumstances presented in the record on appeal, the court ruled that Mirant may not reject the PPA-Related Obligations and required that Mirant continue to perform.

Rate Proceedings

     District of Columbia and Maryland

     In February 2006, Pepco filed an update to the District of Columbia Generation Procurement Credit (GPC) for the periods February 8, 2002 through February 7, 2004 and February 8, 2004 through February 7, 2005; and an update to its Maryland GPC for the period July 1, 2003 through June 30, 2004. The GPC provides for sharing of the profit from SOS sales. The updates to the GPC in both the District of Columbia and Maryland take into account the $112.4 million in proceeds received by Pepco from the December 2005 sale of an allowed bankruptcy claim against Mirant arising from a settlement agreement entered into with Mirant relating to Mirant's obligation to supply energy and capacity to fulfill Pepco's SOS obligations in the District of Columbia and Maryland. The filings also incorporate true-ups to previous disbursements in the GPC for both states. In the filings, Pepco requested that $24.3 million be credited to District of Columbia customers and $17.7 million be credited to Maryland customers during the twelve-month period beginning April 2006. The Maryland Public Service Commission (MPSC) approved the updated Maryland GPC in March 2006.

     On June 15, 2006, the District of Columbia Public Service Commission (DCPSC) granted conditional approval of the GPC update as filed, effective July 1, 2006, and directed Pepco to respond to certain questions set forth in the order. Pepco responded to the DCPSC's questions on July 13, 2006. The DCPSC has provided a schedule for comments on Pepco's responses and for replies to those comments, concluding by the end of August. Final approval of the District of Columbia GPC update is pending.

     Federal Energy Regulatory Commission

     On May 15, 2006, Pepco updated its FERC-approved formula transmission rates based on its FERC Form 1 data for 2005. This new rate of $12,009 per megawatt per year became effective on June 1, 2006 at. By operation of the formula rate process, the new rate incorporates true-ups from the 2005 formula rate that was effective June 1, 2005 and the new 2005 customer demand or peak load. Also, beginning in January 2007, the new rates will be applied to 2006 customer demand data, replacing the 2005 demand data that is currently used. This demand component is driven by Pepco's prior year peak load. Further, the rate change will be positively impacted by changes to distribution rates based on the merger settlements in Maryland and the District of Columbia. The net earnings impact expected from the network transmission rate changes is estimated to be a reduction of approximately $1 million year over year (2005 to 2006).

Divestiture Cases

     District of Columbia

     Final briefs on Pepco's District of Columbia divestiture proceeds sharing application were filed with the DCPSC in July 2002 following an evidentiary hearing in June 2002. That application was filed to implement a provision of Pepco's DCPSC-approved divestiture settlement that provided for a sharing of any net proceeds from the sale of Pepco's generation-

60

related assets. One of the principal issues in the case is whether Pepco should be required to share with customers the excess deferred income taxes (EDIT) and accumulated deferred investment tax credits (ADITC) associated with the sold assets and, if so, whether such sharing would violate the normalization provisions of the Internal Revenue Code and its implementing regulations. As of June 30, 2006, the District of Columbia allocated portions of EDIT and ADITC associated with the divested generation assets were approximately $6.5 million and $5.8 million, respectively.

     Pepco believes that a sharing of EDIT and ADITC would violate the Internal Revenue Service (IRS) normalization rules. Under these rules, Pepco could not transfer the EDIT and the ADITC benefit to customers more quickly than on a straight line basis over the book life of the related assets. Since the assets are no longer owned there is no book life over which the EDIT and ADITC can be returned. If Pepco were required to share EDIT and ADITC and, as a result, the normalization rules were violated, Pepco would be unable to use accelerated depreciation on District of Columbia allocated or assigned property. In addition to sharing with customers the generation-related EDIT and ADITC balances, Pepco would have to pay to the IRS an amount equal to Pepco's District of Columbia jurisdictional generation-related ADITC balance ($5.8 million as of June 30, 2006), as well as its District of Columbia jurisdictional transmission and distribution-related ADITC balance ($5.0 million as of June 30, 2006) in each case as those balances exist as of the later of the date a DCPSC order is issued and all rights to appeal have been exhausted or lapsed, or the date the DCPSC order becomes operative.

     In March 2003, the IRS issued a notice of proposed rulemaking (NOPR), which would allow for the sharing of EDIT and ADITC related to divested assets with utility customers on a prospective basis and at the election of the taxpayer on a retroactive basis. In December 2005 a revised NOPR was issued which, among other things, withdrew the March 2003 NOPR and eliminated the taxpayer's ability to elect to apply the regulation retroactively. Comments on the revised NOPR were filed in March 2006, and a public hearing was held in April 2006. Pepco filed a letter with the DCPSC in January 2006, in which it has reiterated that the DCPSC should continue to defer any decision on the ADITC and EDIT issues until the IRS issues final regulations or states that its regulations project related to this issue will be terminated without the issuance of any regulations. Other issues in the divestiture proceeding deal with the treatment of internal costs and cost allocations as deductions from the gross proceeds of the divestiture.

     Pepco believes that its calculation of the District of Columbia customers' share of divestiture proceeds is correct. However, depending on the ultimate outcome of this proceeding, Pepco could be required to make additional gain-sharing payments to District of Columbia customers, including the payments described above related to EDIT and ADITC. Such additional payments (which, other than the EDIT and ADITC related payments, cannot be estimated) would be charged to expense in the quarter and year in which a final decision is rendered and could have a material adverse effect on Pepco's results of operations for those periods. However, Pepco does not believe that additional gain-sharing payments, if any, or the ADITC-related payments to the IRS, if required, would have a material adverse impact on its financial position or cash flows.

     Maryland

    Pepco filed its divestiture proceeds plan application with the MPSC in April 2001. The principal issue in the Maryland case is the same EDIT and ADITC sharing issue that has been raised in the District of Columbia case. See the discussion above under "Divestiture Cases -

61

District of Columbia." As of June 30, 2006, the Maryland allocated portions of EDIT and ADITC associated with the divested generation assets were approximately $9.1 million and $10.4 million, respectively. Other issues deal with the treatment of certain costs as deductions from the gross proceeds of the divestiture. In November 2003, the Hearing Examiner in the Maryland proceeding issued a proposed order with respect to the application that concluded that Pepco's Maryland divestiture settlement agreement provided for a sharing between Pepco and customers of the EDIT and ADITC associated with the sold assets. Pepco believes that such a sharing would violate the normalization rules (discussed above) and would result in Pepco's inability to use accelerated depreciation on Maryland allocated or assigned property. If the proposed order is affirmed, Pepco would have to share with its Maryland customers, on an approximately 50/50 basis, the Maryland allocated portion of the generation-related EDIT ($9.1 million as of June 30, 2006), and the Maryland-allocated portion of generation-related ADITC. Furthermore, Pepco would have to pay to the IRS an amount equal to Pepco's Maryland jurisdictional generation-related ADITC balance ($10.4 million as of June 30, 2006), as well as its Maryland retail jurisdictional ADITC transmission and distribution-related balance ($8.9 million as of June 30, 2006), in each case as those balances exist as of the later of the date a MPSC order is issued and all rights to appeal have been exhausted or lapsed, or the date the MPSC order becomes operative. The Hearing Examiner decided all other issues in favor of Pepco, except for the determination that only one-half of the severance payments that Pepco included in its calculation of corporate reorganization costs should be deducted from the sales proceeds before sharing of the net gain between Pepco and customers. Pepco filed a letter with the MPSC in January 2006, in which it has reiterated that the MPSC should continue to defer any decision on the ADITC and EDIT issues until the IRS issues final regulations or states that its regulations project related to this issue will be terminated without the issuance of any regulations.

     Pepco has appealed to the MPSC the Hearing Examiner's decision as it relates to the treatment of EDIT and ADITC and corporate reorganization costs. Pepco believes that its calculation of the Maryland customers' share of divestiture proceeds is correct. However, depending on the ultimate outcome of this proceeding, Pepco could be required to share with its customers approximately 50 percent of the EDIT and ADITC balances described above and make additional gain-sharing payments related to the disallowed severance payments. Such additional payments would be charged to expense in the quarter and year in which a final decision is rendered and could have a material adverse effect on results of operations for those periods. However, Pepco does not believe that additional gain-sharing payments, if any, or the ADITC-related payments to the IRS, if required, would have a material adverse impact on its financial position or cash flows.

Default Electricity Supply Proceedings

     Under a settlement approved by the MPSC in April 2003 addressing SOS service in Maryland following the expiration of Pepco's fixed-rate default supply obligations in mid-2004, Pepco is required to provide default electricity supply to residential and small commercial customers through May 2008 and to medium-sized commercial customers through May 2006 (the obligation to provide default electricity supply to large commercial customers ended in May 2005). In accordance the settlement, Pepco purchases the power supply required to satisfy its default supply obligations from wholesale suppliers under contracts entered into pursuant to a competitive bid procedure approved and supervised by the MPSC.

62

     In March 2006, Pepco announced the results of competitive bids to supply electricity to its Maryland SOS customers for one year beginning June 1, 2006. Due to significant increases in the cost of fuels used to generate electricity, the auction results had the effect of increasing the average monthly electric bill by about 38.5% for Pepco's Maryland residential customers. One of the successful bidders for SOS supply to Pepco was its affiliate, a subsidiary of Conectiv Energy Holding Company (Conectiv Energy). FERC issued its order approving the affiliate sales to Pepco on May 18, 2006.

     On April 21, 2006, the MPSC approved a settlement agreement among Pepco, DPL, the staff of the MPSC and the Office of Peoples Counsel of Maryland, which provides for a rate mitigation plan for Pepco's residential customers. Under the plan, the full increase for Pepco's residential customers who affirmatively elect to participate will be phased-in in increments of 15% on June 1, 2006, 15.7% on March 1, 2007 and the remainder on June 1, 2007. Customers electing to participate in the rate deferral plan will be required to pay the deferred amounts over an 18-month period beginning June 1, 2007. Pepco will accrue the interest cost to fund the deferral program. The interest cost will be absorbed by Pepco, during the period that the deferred balance is accumulated and collected from customers, to the extent of and offset against the margins that Pepco otherwise would earn for providing SOS to residential customers. To implement the settlement, Pepco filed tariff riders with the MPSC on May 2, 2006, which were approved by the MPSC on May 24, 2006, giving customers the opportunity to opt-in to the phase-in of their rates, as described above. As of July 31, 2006, approximately 2% of Pepco's residential customers have made the decision to participate in the phase-in program.

     On June 23, 2006, Maryland enacted legislation that extended the period for customers to elect to participate in the phase-in of higher rates, revised the obligation to provide SOS to residential and small commercial customers until further action of the General Assembly, and provided for a customer refund reflecting the difference in projected interest expense on the deferred balance at a 25% customer participation level versus such interest expense at the actual participation levels of approximately 2% for Pepco. The total amount of the refund is approximately $1.1 million for Pepco customers. At Pepco's 2% level of participation, Pepco estimates that the deferral balance, net of taxes, will be approximately $1.4 million. Pepco filed a revised tariff rider on June 30, 2006 to implement the legislation.

General Litigation

     During 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 are not entirely clear, it appears that each plaintiff sought $2 million in compensatory damages and $4 million in punitive damages from each defendant.

     Since the initial filings in 1993, additional individual suits have been filed against Pepco, and significant numbers of cases have been dismissed. As a result of two motions to dismiss, numerous hearings and meetings and one motion for summary judgment, Pepco has had approximately 400 of these cases successfully dismissed with prejudice, either voluntarily by the

63

plaintiff or by the court. As of June 30, 2006, there were approximately 220 cases still pending against Pepco in the State Courts of Maryland; of those approximately 220 remaining asbestos cases, approximately 85 cases were filed after December 19, 2000, and have been tendered to Mirant for defense and indemnification pursuant to the terms of the Asset Purchase and Sale Agreement. Mirant's Plan of Reorganization, as approved by the Bankruptcy Court in connection with the Mirant bankruptcy, does not alter Mirant's indemnification obligations.

     While the aggregate amount of monetary damages sought in the remaining suits (excluding those tendered to Mirant) exceeds $400 million, Pepco believes the amounts claimed by current plaintiffs are greatly exaggerated. The amount of total liability, if any, and any related insurance recovery cannot be determined at this time; however, based on information and relevant circumstances known at this time, Pepco does not believe these suits will have a material adverse effect on its financial position, results of operations or cash flows. However, if an unfavorable decision were rendered against Pepco, it could have a material adverse effect on Pepco's financial position, results of operations or cash flows.

Environmental Litigation

     Pepco 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. In addition, federal and state statutes authorize governmental agencies to compel responsible parties to clean up certain abandoned or unremediated hazardous waste sites. Pepco may incur costs to clean up currently or formerly owned facilities or sites found to be contaminated, as well as other facilities or sites that may have been contaminated due to past disposal practices. Although penalties assessed for violations of environmental laws and regulations are not recoverable from Pepco's customers, environmental clean-up costs incurred by Pepco would be included in its cost of service for ratemaking purposes.

     In the early 1970s, Pepco sold scrap transformers, some of which may have contained some level of PCBs, to a metal reclaimer operating at the Metal Bank/Cottman Avenue site in Philadelphia, Pennsylvania, owned by a nonaffiliated company. In December 1987, Pepco was notified by U.S. Environmental Protection Agency (EPA) that it, along with a number of other utilities and non-utilities, was a potentially responsible party (PRP) in connection with the PCB contamination at the site. Below is a summary of the proceedings and related matters concerning the Metal Bank/Cottman Avenue site:

·

In 1994, a Remedial Investigation/Feasibility Study including a number of possible remedies was submitted to the EPA. In 1997, the EPA issued a Record of Decision that set forth a selected remedial action plan with estimated implementation costs of approximately $17 million.

·

In 1998, the EPA issued a unilateral administrative order to Pepco and 12 other PRPs directing them to conduct the design and actions called for in its decision. In May 2003, two of the potentially liable owner/operator entities filed for reorganization under Chapter 11 of the U.S. Bankruptcy Code. In October 2003, the bankruptcy court confirmed a reorganization plan that incorporates the terms of a settlement among the two debtor owner/operator entities, the United States and a group of utility PRPs including Pepco (the Utility PRPs). Under the bankruptcy settlement, the reorganized

64

 

entity/site owner will pay a total of $13.25 million to remediate the site (the Bankruptcy Settlement).

·

In March 2006, the U.S. District Court for the Eastern District of Pennsylvania approved global consent decrees for the Metal Bank/Cottman Avenue site involving the Utility PRPs, the U.S. Department of Justice, EPA, The City of Philadelphia and two owner/operators of the site. Under the terms of the settlement, the two owner/operators will make payments totaling $5.55 million to the U.S. and totaling $4.05 million to the Utility PRPs. The Utility PRPs will perform the remedy at the site and will be able to draw on the $13.25 million from the Bankruptcy Settlement to accomplish the remediation (the Bankruptcy Funds). The Utility PRPs will contribute funds to the extent remediation costs exceed the Bankruptcy Funds available. The Utility PRPs also will be liable for EPA costs associated with overseeing the monitoring and operation of the site remedy after the remedy construction is certified to be complete and also the cost of performing the "5 year" review of site conditions required by the Comprehensive Environmental Response, Compensation, and Liability Act of 1980. Any Bankruptcy Funds not spent on the remedy may be used to cover the Utility PRPs' liabilities for future costs. No parties are released from potential liability for damages to natural resources.

·

As of June 30, 2006, Pepco had accrued $1.7 million to meet its liability for a remedy at the Metal Bank/Cottman Avenue site. While final costs to Pepco of the settlement have not been determined, Pepco believes that its liability at this site will not have a material adverse effect on its financial position, results of operations or cash flows.

IRS Mixed Service Cost Issue

     During 2001, Pepco changed its method of accounting with respect to capitalizable construction costs for income tax purposes. The change allowed Pepco to accelerate the deduction of certain expenses that were previously capitalized and depreciated. Through December 31, 2005, these accelerated deductions have generated incremental tax cash flow benefits of approximately $94 million for Pepco, primarily attributable to its 2001 tax return.

     On August 2, 2005, the Treasury Department released regulations that, if adopted in their current form, would require Pepco to change its method of accounting with respect to capitalizable construction costs for income tax purposes for future tax periods beginning in 2005. Under these regulations, Pepco will have to capitalize and depreciate a portion of the construction costs that they have previously deducted and include the impact of this adjustment in taxable income over a two-year period beginning with tax year 2005. Pepco is in the process of finalizing an alternative method of accounting for capitalizable construction costs that management believes will be acceptable to the IRS to replace the method disallowed by the proposed regulations.

     On the same day that the new regulations were released, the IRS issued Revenue Ruling 2005-53 (the Revenue Ruling) which is intended to limit the ability of certain taxpayers to utilize the method of accounting for income tax purposes they utilized on their tax returns for 2004 and prior years. In line with this Revenue Ruling, the IRS issued its RAR, which disallows substantially all of the incremental tax benefits that Pepco claimed on their 2001 and 2002 tax returns by requiring the companies to capitalize and depreciate certain expenses rather than treat such expenses as current deductions.

65

     In February 2006, Pepco's parent, PHI paid approximately $121 million of taxes (a portion of which is attributable to Pepco) to cover the amount of taxes management estimates will be payable once a new final method of tax accounting is adopted on its 2005 tax return, due to the proposed regulations. PHI intends to contest the adjustments that the IRS has proposed to the 2001 and 2002 tax returns, under the Revenue Ruling referenced above. However, if the IRS is successful in requiring Pepco to capitalize and depreciate construction costs that result in a tax and interest assessment greater than management's estimate of $121 million, PHI will be required to pay additional taxes and interest only to the extent these adjustments exceed the $121 million payment made in February 2006.

(5)  RESTATEMENT

     As reported in Pepco's Annual Report on Form 10-K for the year ended December 31, 2005, Pepco restated its previously reported financial statements for the three and six months ended June 30, 2005, to correct the accounting for certain deferred compensation arrangements. The restatement includes the correction of other errors for the same period, primarily relating to unbilled revenue, taxes, and various accrual accounts, which were considered by management to be immaterial. These other errors would not themselves have required a restatement absent the restatement to correct the accounting for deferred compensation arrangements. This restatement was required solely because the cumulative impact of the correction for deferred compensation, if recorded in the fourth quarter of 2005, would have been material to that period's reported net income. The following table sets forth for Pepco's results of operations for the three and six months ended June 30, 2005, its financial position at June 30, 2005, and its cash flows for the six months ended June 30, 2005, the impact of the restatement to correct the accounting for the deferred compensation arrangements and the other errors noted above (millions of dollars):

Three Months Ended
June 30, 2005

Six Months Ended
June 30, 2005

Previously
Reported

Restated

Previously
Reported

Restated

Statements of Earnings

     Total Operating Revenue

$

396.1 

$

403.5 

$

821.6 

$

823.4 

     Total Operating Expenses

 

341.1 

 

341.7 

 

729.6 

 

728.0 

     Total Operating Income

 

55.0 

 

61.8 

 

92.0 

 

95.4 

     Other Income (Expenses)

 

(13.5)

 

(13.8)

 

(29.9)

 

(30.6)

     Income Before Income Tax Expense

 

41.5 

 

48.0 

 

62.1 

 

64.8 

     Net Income

$

23.9 

$

27.7 

$

35.4 

$

36.8 

Balance Sheet (at June 30)

               

     Total Current Assets

$

$

$

578.0 

$

580.7 

     Total Investments and Other Assets

 

 

 

440.8 

 

406.5 

     Total Assets

$

$

$

3,942.9 

$

3,911.3 

     Total Current Liabilities

$

$

$

561.7 

$

550.4 

     Total Deferred Credits

 

 

 

914.8 

 

916.0 

     Retained Earnings

$

$

$

516.3 

$

494.8 

     Total Shareholder's Equity

 

 

 

1,022.6 

 

1,001.1 

     Total Liabilities and Shareholder's Equity

$

$

$

3,942.9 

$

3,911.3 

Statement of Cash Flows

               

     Net Cash From Operating Activities

$

$

$

123.1 

$

124.3 

     Net Cash Used By Investing Activities

 

 

 

(78.2)

 

(77.8)

     Net Cash From By Financing Activities

 

 

 

141.3 

 

139.7 

                 

66

 

 

 

 

 

 

 

 

 

 

 

 

 

THIS PAGE INTENTIONALLY LEFT BLANK.

67

 

DELMARVA POWER & LIGHT COMPANY
STATEMENTS OF EARNINGS
(Unaudited)

 

Three Months Ended
June 30,

Six Months Ended
June 30,

 
   

2006

   

(Restated)
2005

   

2006

   

(Restated)
2005

   
   

(Millions of dollars)

 

Operating Revenue

                         

  Electric

$

289.8 

 

$

241.4 

 

$

547.9 

 

$

501.1 

   

  Natural Gas

 

49.5 

   

47.5 

   

159.9 

   

158.5 

   

     Total Operating Revenue

 

339.3 

   

288.9 

   

707.8 

   

659.6 

   
                           

Operating Expenses

                         

  Fuel and purchased energy

 

205.4 

   

155.9 

   

367.2 

   

318.1 

   

  Gas purchased

 

39.0 

   

35.8 

   

127.7 

   

120.9 

   

  Other operation and maintenance

 

45.4 

   

42.4 

   

90.6 

   

85.1 

   

  Depreciation and amortization

18.8 

18.4 

38.2 

37.4 

  Other taxes

9.1 

8.1 

18.8 

17.5 

  Gain on sale of assets

(.3)

(.9)

(1.1)

(.9)

     Total Operating Expenses

317.4 

259.7 

641.4 

578.1 

                           

Operating Income

 

21.9 

   

29.2 

   

66.4 

   

81.5 

   

Other Income (Expenses)

                         

  Interest and dividend income

 

.2 

   

.3 

   

.5 

   

.5 

   

  Interest expense

 

(10.0)

   

(9.2)

   

(19.3)

   

(17.8)

   

  Other income

 

2.0 

   

2.2 

   

3.7 

   

2.7 

   

  Other expense

 

(1.0)

   

(1.1)

   

(2.2)

   

(1.1)

   

     Total Other Expenses

(8.8)

(7.8)

(17.3)

(15.7)

Income Before Income Tax Expense

13.1 

21.4 

49.1 

65.8 

Income Tax Expense

 

6.2 

   

8.9 

   

21.4 

   

27.2 

   
                           

Net Income

6.9 

12.5 

27.7 

38.6 

Dividends on Redeemable Serial Preferred Stock

.2 

.2 

.4 

.5 

Earnings Available for Common Stock

6.7 

12.3 

27.3 

38.1 

Retained Earnings at Beginning of Period

405.3 

363.8 

399.7 

362.4 

Dividends paid to Pepco Holdings

(12.0)

(15.0)

(36.4)

Retained Earnings at End of Period

$

412.0 

$

364.1 

$

412.0 

$

364.1 

                           

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

 

68

 

 

DELMARVA POWER & LIGHT COMPANY
BALANCE SHEETS
(Unaudited)

ASSETS

June 30,
2006

December 31,
2005

     

(Millions of dollars)

 

CURRENT ASSETS

                         

  Cash and cash equivalents

           

$

7.0 

 

$

7.4 

   

  Accounts receivable, less allowance for
    uncollectible accounts of $7.4 million
    and $9.2 million, respectively

             

187.2 

   

181.4 

   

  Fuel, materials and supplies-at average cost

             

32.9 

   

41.8 

   

  Prepaid expenses and other

             

16.3 

   

28.4 

   

    Total Current Assets

             

243.4 

   

259.0 

   
                           

INVESTMENTS AND OTHER ASSETS

                         

  Goodwill

             

48.5 

   

48.5 

   

  Regulatory assets

             

124.0 

   

140.9 

   

  Prepaid pension expense

             

216.5 

   

213.3 

   

  Other

             

31.5 

   

32.7 

   

    Total Investments and Other Assets

             

420.5 

   

435.4 

   
                           

PROPERTY, PLANT AND EQUIPMENT

                         

  Property, plant and equipment

             

2,471.5 

   

2,409.5 

   

  Accumulated depreciation

             

(819.9)

   

(800.3)

   

    Net Property, Plant and Equipment

             

1,651.6 

   

1,609.2 

   
                           

    TOTAL ASSETS

           

$

2,315.5 

 

$

2,303.6 

   
                           

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

 

69

 

 

DELMARVA POWER & LIGHT COMPANY
BALANCE SHEETS
(Unaudited)

LIABILITIES AND SHAREHOLDER'S EQUITY

June 30,
2006

December 31,
2005

     

(Millions of dollars, except shares)

 

CURRENT LIABILITIES

                         

  Short-term debt

           

$

241.5 

 

$

165.5 

   

  Current maturities of long-term debt

             

84.7 

   

22.9 

   

  Accounts payable and accrued liabilities

             

95.1 

   

74.0 

   

  Accounts payable due to associated companies

             

29.6 

   

57.3 

   

  Capital lease obligations due within one year

             

.1 

   

.2 

   

  Taxes accrued

             

2.6 

   

33.7 

   

  Interest accrued

             

6.6 

   

6.4 

   

  Other

             

50.6 

   

48.2 

   

    Total Current Liabilities

             

510.8 

   

408.2 

   
                           

DEFERRED CREDITS

                         

  Regulatory liabilities

             

231.1 

   

242.5 

   

  Income taxes

             

393.7 

   

413.7 

   

  Investment tax credits

             

10.3 

   

10.7 

   

  Above-market purchased energy contracts and other
     electric restructuring liabilities

             

24.6 

   

25.8 

   

  Other

             

27.7 

   

33.0 

   

    Total Deferred Credits

             

687.4 

   

725.7 

   
                           

LONG-TERM LIABILITIES

                         

  Long-term debt

             

451.7 

   

516.4 

   

  Capital lease obligations

             

   

   

    Total Long-Term Liabilities

             

451.7 

   

516.4 

   
                           

COMMITMENTS AND CONTINGENCIES (NOTE 4)

                         
                           

REDEEMABLE SERIAL PREFERRED STOCK

             

18.2 

   

18.2 

   
                           

SHAREHOLDER'S EQUITY

                         

  Common stock, $2.25 par value, authorized
    1,000,000 shares, issued 1,000 shares

             

   

   

  Premium on stock and other capital contributions

             

235.4 

   

235.4 

   

  Retained earnings

             

412.0 

   

399.7 

   

    Total Shareholder's Equity

             

647.4 

   

635.1 

   
                           

    TOTAL LIABILITIES AND SHAREHOLDER'S EQUITY

           

$

2,315.5 

 

$

2,303.6 

   
                           

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

 

 

70

 

DELMARVA POWER & LIGHT COMPANY
STATEMENTS OF CASH FLOWS
(Unaudited)

   

Six Months Ended
June 30,

 
               

2006

   

(Restated)
2005

   
     

(Millions of dollars)

 

OPERATING ACTIVITIES

                         

Net income

           

$

27.7 

 

$

38.6 

   

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

                         

  Depreciation and amortization

             

38.2 

   

37.4 

   

  Gain on sale of assets

             

(1.1)

   

(.9)

   

  Investment tax credit adjustments

             

(.4)

   

(.5)

   

  Deferred income taxes

             

(18.0)

   

(2.8)

   

  Changes in:

                         

    Accounts receivable

             

(5.9)

   

(3.3)

   

    Regulatory assets, net

             

9.4 

   

25.5 

   

    Accounts payable and accrued liabilities

             

(2.3)

   

(10.7)

   

    Interest and taxes accrued

             

(36.5)

   

10.6 

   

    Other changes in working capital

             

15.5 

   

2.5 

   

Net other operating

             

(9.5)

   

(1.9)

   

Net Cash From Operating Activities

             

17.1 

   

94.5 

   
                           

INVESTING ACTIVITIES

                         

Net investment in property, plant and equipment

             

(75.1)

   

(64.0)

   

Proceeds from sale of property

             

2.2 

   

1.2 

   

Net other investing activities

             

(1.6)

   

5.1 

   

Net Cash Used By Investing Activities

             

(74.5)

   

(57.7)

   
                           

FINANCING ACTIVITIES

                         

Dividends paid to Pepco Holdings

             

(15.0)

   

(36.4)

   

Dividends paid on preferred stock

             

(.4)

   

(.5)

   

Issuance of long-term debt

             

   

100.0 

   

Reacquisition of long-term debt

             

(2.9)

   

(102.7)

   

Issuances (Repayments) of short-term debt, net

             

76.0 

   

3.4 

   

Net other financing activities

             

(.7)

   

   

Net Cash From (Used By) Financing Activities

             

57.0 

   

(36.2)

   
                           

Net (Decrease) Increase in Cash and Cash Equivalents

             

(.4)

   

.6 

   

Cash and Cash Equivalents at Beginning of Period

             

7.4 

   

3.6 

   
                           

CASH AND CASH EQUIVALENTS AT END OF PERIOD

           

$

7.0 

 

$

4.2 

   
                           

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION

                         

Cash paid for income taxes
   (includes payments to PHI for Federal income taxes)

           

$

40.6 

 

$

12.3 

   
                           

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

71

 

 

NOTES TO FINANCIAL STATEMENTS

DELMARVA POWER & LIGHT COMPANY

(1)  ORGANIZATION

     Delmarva Power & Light Company (DPL) is engaged in the transmission and distribution of electricity in Delaware and portions of Maryland and Virginia, and provides gas distribution service in northern Delaware. Additionally, DPL supplies electricity at regulated rates to retail customers in its territories who do not elect to purchase electricity from a competitive supplier. The regulatory term for this service varies by jurisdiction as follows:

 

Delaware

Provider of Last Resort service (POLR) -- before May 1, 2006
Standard Offer Service (SOS) -- on and after May 1, 2006

 

Maryland

SOS

 

Virginia

Default Service

     DPL also refers to this supply service in each of its jurisdictions generally as Default Electricity Supply.

     DPL's electricity distribution service territory covers approximately 6,000 square miles and has a population of approximately 1.3 million. DPL's natural gas distribution service territory covers approximately 275 square miles and has a population of approximately .5 million. DPL is a wholly owned subsidiary of Conectiv, which is wholly owned by Pepco Holdings, Inc. (Pepco Holdings or PHI). Because PHI is a public utility holding company subject to the Public Utility Holding Company Act of 2005 (PUHCA 2005), the relationship between PHI and DPL and certain activities of DPL are subject to the regulatory oversight of the Federal Energy Regulatory Commission (FERC) under PUHCA 2005.

(2)  ACCOUNTING POLICY, PRONOUNCEMENTS, AND OTHER DISCLOSURES

Financial Statement Presentation

     DPL'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 DPL's Annual Report on Form 10-K for the year ended December 31, 2005. In the opinion of DPL's management, the financial statements contain all adjustments (which all are of a normal recurring nature) necessary to present fairly DPL's financial condition as of June 30, 2006, in accordance with GAAP. The year-end balance sheet data was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. Interim results for the three and six months ended June 30, 2006 may not be indicative of results that will be realized for the full year ending December 31, 2006 since the sales of electric energy are seasonal.

72

Components of Net Periodic Benefit Cost

     The following Pepco Holdings' information is for the three months ended June 30, 2006 and 2005.

   

Pension Benefits

   

Other
Postretirement
Benefits

   
   

2006

   

2005

   

2006

   

2005

   
 

(Millions of dollars)

 

Service cost

$

10.1 

 

$

9.6 

 

$

1.7 

 

$

2.1 

   

Interest cost

 

24.2 

   

23.6 

   

8.3 

   

8.4 

   

Expected return on plan assets

 

(32.5)

   

(32.1)

   

(2.7)

   

(2.9)

   

Amortization of prior service cost

 

.2 

   

.3 

   

(1.1)

   

(.9)

   

Amortization of net loss

 

4.8 

   

2.7 

   

4.2 

   

3.4 

   

Net periodic benefit cost

$

6.8 

 

$

4.1 

 

$

10.4 

 

$

10.1 

   
                           

     The following Pepco Holdings' information is for the six months ended June 30, 2006 and 2005.

   

Pension Benefits

   

Other
Postretirement
Benefits

   
   

2006

   

2005

   

2006

   

2005

   
 

(Millions of dollars)

 

Service cost

$

20.3 

 

$

19.0 

 

$

4.2 

 

$

4.2 

   

Interest cost

 

48.4 

   

47.9 

   

17.3 

   

16.8 

   

Expected return on plan assets

 

(65.0)

   

(62.8)

   

(5.8)

   

(5.4)

   

Amortization of prior service cost

 

.4 

   

.6 

   

(2.0)

   

(1.9)

   

Amortization of net loss

 

8.7 

   

5.2 

   

7.2 

   

5.9 

   

Net periodic benefit cost

$

12.8 

 

$

9.9 

 

$

20.9 

 

$

19.6 

   
                           

     Pension

     The pension net periodic benefit cost (income) for the three months ended June 30, 2006 of $6.8 million includes $(1.2) million for DPL. The pension net periodic benefit cost (income) for the six months ended June 30, 2006 of $12.8 million includes $(3.0) million for DPL. The remaining pension net periodic benefit cost is for other PHI subsidiaries. The pension net periodic benefit cost (income) for the three months ended June 30, 2005 of $4.1 million includes $(2.6) million for DPL. The pension net periodic benefit cost (income) for the six months ended June 30, 2005 of $9.9 million includes $(3.9) million for DPL. The remaining pension net periodic benefit cost is for other PHI subsidiaries.

     Pension Contributions

     Pepco Holdings' current funding policy with regard to its defined benefit pension plan is to maintain a funding level in excess of 100% of its accumulated benefit obligation (ABO). In 2005

73

and 2004, PHI made discretionary tax-deductible cash contributions to the plan of $60 million and $10 million, respectively. PHI's pension plan currently meets the minimum funding requirements of the Employment Retirement Income Security Act of 1974 without any additional funding. PHI may elect, however, to make a discretionary tax-deductible contribution to maintain the pension plan's assets in excess of its ABO. As of June 30, 2006, no contributions have been made. The potential discretionary funding of the pension plan in 2006 will depend on many factors, including the actual investment return earned on plan assets over the remainder of the year.

     Other Postretirement Benefits

     The other postretirement net periodic benefit cost for the three months ended June 30, 2006 of $10.4 million includes $1.8 million for DPL. The other postretirement net periodic benefit cost for the six months ended June 30, 2006 of $20.9 million includes $3.4 million for DPL. The remaining other postretirement net periodic benefit cost is for other PHI subsidiaries. The other postretirement net periodic benefit cost for the three months ended June 30, 2005 of $10.1 million includes $.5 million for DPL. The other postretirement net periodic benefit cost for the six months ended June 30, 2005 of $19.6 million includes $3.0 million for DPL. The remaining other postretirement net periodic benefit cost is for other PHI subsidiaries.

Reconciliation of Income Tax Expense

     A reconciliation of DPL's income tax expense is as follows:

 

For the Three Months Ended June 30,

For the Six Months Ended June 30,

 
 

2006

2005 (Restated)

2006

2005 (Restated)

 
 

Amount

Rate

Amount

Rate

Amount

Rate

Amount

Rate

 
 

(Millions of dollars)

 

Income Before Income Tax Expense

$13.1   

-  

$21.4   

-  

$49.1   

-  

$65.8   

-  

 
                   

Income tax at federal statutory rate

$  4.6   

.35  

$  7.5   

.35  

$17.2   

.35  

$23.0   

.35  

 

  Increases (decreases) resulting from:

                 

    State income taxes, net
        of federal benefit

.6   

.05  

1.0   

.05  

3.4   

.07  

3.3   

.05  

 

    Plant basis difference

.5   

.04  

.5   

.02  

.9   

.02  

1.0   

.01  

 

    Investment tax credit
        amortization

(.2)  

(.02) 

(.2)  

(.01) 

(.4)  

(.01) 

(.5)  

(.01) 

 

   Adjustment to prior years' tax

-   

-  

-   

-  

(.8)  

(.02) 

-   

-  

 

    Change in estimates related to
        prior year tax liabilities

.8   

.06  

.2   

.01  

1.2   

.03  

.5   

.01  

 

    Other, net

(.1)  

(.01) 

(.1)  

-  

(.1)  

-  

(.1)  

-  

 

Total Income Tax Expense

$  6.2   

.47  

$  8.9   

.42  

$21.4   

.44  

$27.2   

.41  

 

Debt

     In April 2006, PHI, Potomac Electric Power Company (Pepco), DPL and Atlantic City Electric Company (ACE) amended their $1.2 billion credit facility due 2010 to extend the maturity by one additional year to May 5, 2011 and to reduce the pricing of the facility by reducing the credit facility fees.

     In June 2006, DPL redeemed through sinking fund provisions, $2.9 million of 6.95% First Mortgage Bonds due 2008.

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Related Party Transactions

     PHI Service Company provides various administrative and professional services to PHI and its regulated and unregulated subsidiaries, including DPL, pursuant to a service agreement. The cost of these services is allocated in accordance with cost allocation methodologies set forth in the service agreement using a variety of factors, including the subsidiaries' share of employees, operating expenses, assets, and other cost causal methods. These intercompany transactions are eliminated in consolidation and no profit results from these transactions. PHI Service Company costs directly charged or allocated to DPL for the three and six months ended June 30, 2006 and 2005 were $25.7 million and $50.7 million, and $24.7 million and $48.6 million, respectively.

     In addition to the PHI Service Company charges described above, DPL's Statements of Earnings include the following related party transactions:

 

For the Three Months Ended
June 30,

For the Six Months Ended
June 30,

2006

2005

2006

2005

Income (Expense)

(Millions of dollars)

Full Requirements Contract with Conectiv Energy Supply for power,
        capacity and ancillary services to service POLR (included in fuel
        and purchased energy expenses)

$(30.7)

$(100.2)

$(122.2)

$(195.3)

SOS agreement with Conectiv Energy Supply (included in fuel and
       purchased energy expenses)

(46.9)

(11.2)

(59.3)

(24.6)

Intercompany lease transactions related to computer services and
       facilities (included in electric revenue)

1.4 

1.4 

2.6 

2.7 

Sublease of Merrill Creek Water Rights to Conectiv Delmarva
       Generation (included in electric revenue)

.8 

.7 

1.4 

1.4 

Transcompany pipeline gas purchase with Conectiv Energy Supply
       (included in gas purchased expenses)

(.8)

(.2)

(1.2)

(1.3)

     As of June 30, 2006 and December 31, 2005, DPL had the following balances on its Balance Sheets due from (to) related parties:

   

2006

   

2005

   

Asset (Liability)

 

(Millions of dollars)

   

Receivable from Related Party (current)

             

  ACE

$

11.3 

 

$

.2 

   

Payable to Related Party (current)

             

  PHI Service Company

$

(10.4)

 

$

(12.2)

   

  Conectiv Energy Supply

 

(25.6)

   

(45.3)

   

  Pepco Energy Services

 

(5.5)

   

   

  Other Related Party Activity

 

.6 

   

   

       Total Net Payable to Related Parties

$

(29.6)

 

$

(57.3)

   

Money Pool Balance with Pepco Holdings
  (included in short-term debt on the balance sheet)

$

(41.5)

 

$

(60.7)

   
               

75

New Accounting Standards

     FSP FTB 85-4-1, "Accounting for Life Settlement Contracts by Third-Party Investors"

     In March 2006, the FASB issued FASB Staff Position (FSP) FTB 85-4-1, "Accounting for Life Settlement Contracts by Third-Party Investors" (FSP FTB 85-4-1). This FSP provides initial and subsequent measurement guidance and financial statement presentation and disclosure guidance for investments by third-party investors in life settlement contracts. FSP FTB 85-4-1 also amends certain provisions of FASB Technical Bulletin No. 85-4, "Accounting for Purchases of Life Insurance," and FASB Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities." The guidance in FSP FTB 85-4-1 applies prospectively for all new life settlement contracts and is effective for fiscal years beginning after June 15, 2006 (the year ending December 31, 2007 for DPL). DPL is in the process of evaluating the impact of FSP FTB 85-4-1 and does not anticipate its adoption will have a material impact on its overall financial condition, results of operations, or cash flows.

     EITF 04-13, "Accounting for Purchases and Sales of Inventory with the Same Counterparty"

     In September 2005, the FASB ratified Emerging Issues Task Force (EITF) Issue No. 04-13, "Accounting for Purchases and Sales of Inventory with the Same Counterparty" (EITF 04-13), which addresses circumstances under which two or more exchange transactions involving inventory with the same counterparty should be viewed as a single exchange transaction for the purposes of evaluating the effect of APB Opinion 29, "Accounting for Nonmonetary Transactions." EITF 04-13 is effective for new arrangements entered into, or modifications or renewals of existing arrangements, beginning in the first interim or annual reporting period beginning after March 15, 2006.

     DPL implemented EITF 04-13 on April 1, 2006. The implementation did not impact DPL's overall financial condition, results of operations, or cash flows for the second quarter of 2006.

     FSP FIN 46(R)-6, "Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R)"

     In April 2006, the FASB issued FSP FIN 46(R)-6, "Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R)" (FSP FIN 46(R)-6), which provides guidance on how to determine the variability to be considered in applying FIN 46(R), "Consolidation of Variable Interest Entities."

     The guidance in FSP FIN 46(R)-6 is applicable prospectively beginning the first day of the first reporting period beginning after June 15, 2006 (July 1, 2006 for DPL), although early application is permitted to financial statements not issued. Retrospective application is also permitted if so elected and must be completed no later than the end of the first annual reporting period ending after July 15, 2006 (December 31, 2006 for DPL).

     DPL is in the process of evaluating the impact of FIN 46(R)-6.

76

     EITF Issue No. 06-3, "Disclosure Requirements for Taxes Assessed by a Governmental Authority on Revenue-producing Transactions"

     On June 28, 2006, the FASB ratified EITF Issue No. 06-3, "Disclosure Requirements for Taxes Assessed by a Governmental Authority on Revenue-producing Transactions" (EITF 06-3). EITF 06-3 provides guidance on an entity's disclosure of its accounting policy regarding the gross or net presentation of certain taxes and provides that if taxes included in gross revenues are significant, a company should disclose the amount of such taxes for each period for which an income statement is presented (i.e., both interim and annual periods). Taxes within the scope of EITF 06-3 are those that are imposed on and concurrent with a specific revenue-producing transaction. Taxes assessed on an entity's activities over a period of time are not within the scope of EITF 06-3.

     EITF 06-3 is effective for interim and annual reporting periods beginning after December 15, 2006 (2007 for DPL) although earlier application is permitted. DPL is in the process of evaluating the impact of EITF 06-3.

     FIN 48, "Accounting for Uncertainty in Income Taxes"

     On July 13, 2006, the FASB issued FASB Interpretation No.48, "Accounting for Uncertainty in Income Taxes" (FIN 48). FIN 48 clarifies the criteria for recognition of tax benefits in accordance with SFAS No. 109, "Accounting for Income Taxes," and prescribes a financial statement recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return. Specifically, it clarifies that an entity's tax benefits must be "more likely than not" of being sustained prior to recording the related tax benefit in the financial statements. If the position drops below the "more likely than not" standard, the benefit can no longer be recognized. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.

     FIN 48 is effective the first fiscal year beginning after December 15, 2006 (January 1, 2007 for DPL). DPL is in the process of evaluating the impact of FIN 48.

(3) SEGMENT INFORMATION

     In accordance with Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information," DPL has one segment, its regulated utility business.

(4)  COMMITMENTS AND CONTINGENCIES

REGULATORY AND OTHER MATTERS

Rate Proceedings

     Delaware

     In October 2005, DPL submitted its 2005 Gas Cost Rate (GCR) filing to the Delaware Public Service Commission (DPSC), which permits DPL to recover gas procurement costs through customer rates. The proposed increase of approximately 38% in anticipation of increasing natural gas commodity costs became effective November 1, 2005, subject to refund pending final DPSC approval after evidentiary hearings. DPSC staff, the Delaware Division of the

77

Public Advocate and DPL entered into a written settlement agreement in April 2006, that the GCR should be approved as filed. On July 11, 2006, the DPSC approved the settlement agreement.

     Federal Energy Regulatory Commission

     On May 15, 2006, DPL updated its FERC-approved formula transmission rates based on its FERC Form 1 data for 2005. This new rate of $10,034 per megawatt per year became effective on June 1, 2006. By operation of the formula rate process, the new rate incorporates true-ups from the 2005 formula rate that was effective June 1, 2005 and the new 2005 customer demand or peak load. Also, beginning in January 2007, the new rate will be applied to 2006 customer demand data, replacing the 2005 demand data that is currently used. This demand component is driven by DPL's prior year peak load. Further, the rate changes will be positively impacted by changes to distribution rates based on the merger settlements in Maryland. The net earnings impact expected from the network transmission rate changes is estimated to be a reduction of approximately $3 million year over year (2005 to 2006).

Default Electricity Supply Proceedings

     Delaware

     In October 2005, the DPSC approved DPL as the SOS provider to Delaware customers after May 1, 2006, when DPL's fixed-rate POLR obligation ended. DPL obtains the electricity to fulfill its SOS supply obligation under contracts entered into by DPL pursuant to a competitive bid procedure approved by the DPSC. The bids received for the May 1, 2006, through May 31, 2007, period have had the effect of increasing rates significantly for all customer classes, including an average residential customer increase of 59%.

     One of the successful bidders for SOS supply was a subsidiary of Conectiv Energy Holding Company (Conectiv Energy), an affiliate of DPL. Consequently, the affiliate sales from Conectiv Energy to DPL are subject to approval of FERC. FERC issued its order approving the affiliate sales in April 2006. Because DPL is a public utility incorporated in Virginia, with Virginia retail customers, the affiliate sales from Conectiv Energy to DPL are subject to approval of the Virginia State Corporation Commission (VSCC) under the Virginia Affiliates Act. On May 1, 2006, the VSCC approved the affiliate transaction by granting an exemption to DPL for the 2006 agreement and for future power supply agreements between DPL and Conectiv Energy for DPL's non-Virginia SOS load requirements awarded pursuant to a state regulatory commission supervised solicitation process.

     In April 2006, Delaware enacted legislation that provides for a deferral of the financial impact of the increases through a three-step phase-in of the rate increases, with 15% of the increase taking effect on May 1, 2006, 25% of the increase taking effect on January 1, 2007, and any remaining balance taking effect on June 1, 2007. The program is an "opt-out" program, where a customer may make an election not to participate. On April 25, 2006, the DPSC approved several tariff filings implementing the legislation, including DPL's agreement not to charge customers any interest on the deferred balances. As of July 31, 2006, approximately 53% of the eligible Delaware customers have opted not to participate in the deferral of the SOS rates offered by DPL. With approximately 47% of the eligible customers participating in the phase-in program, DPL anticipates a deferral balance of approximately $51.4 million and an estimated interest expense of approximately $3.0 million, net of taxes. The estimated total interest expense

78

is based on a projected interest cost of 5% accrued over the combined 37-month deferral and recovery period.

     The legislation also requires DPL to file an integrated resource plan, in which DPL will evaluate all available supply options (including generation, transmission and demand-side management programs) during the planning period to ensure that DPL acquires sufficient and reliable supply resources to meet its customers' needs at minimal cost.

     Maryland

     Under a settlement approved by the MPSC in April 2003 addressing SOS service in Maryland following the expiration of DPL's fixed-rate default supply obligations in mid-2004, DPL is required to provide default electricity supply to residential and small commercial customers through May 2008 and to medium-sized commercial customers through May 2006 (the obligation to provide default electricity supply to large commercial customers ended in May 2005). In accordance with the settlement, DPL purchases the power supply required to satisfy its default supply obligations from wholesale suppliers under contracts entered into pursuant to a competitive bid procedure approved and supervised by the MPSC.

     In March 2006, DPL announced the results of competitive bids to supply electricity to its Maryland SOS customers for one year beginning June 1, 2006. Due to significant increases in the cost of fuels used to generate electricity, the auction results had the effect of increasing the average monthly electric bill by about 35% for DPL's Maryland residential customers. One of the successful bidders for SOS supply to DPL was its affiliate, Conectiv Energy. FERC issued its order approving the affiliate sales to DPL on May 18, 2006. Because DPL is a public utility incorporated in Virginia, with Virginia retail customers, the affiliate sales from Conectiv Energy to DPL are also subject to approval of the VSCC under the Virginia Affiliates Act. On May 1, 2006, the VSCC approved the affiliate transaction by granting an exemption to DPL for the 2006 agreement and for future power supply agreements between DPL and Conectiv Energy for DPL's non-Virginia SOS load requirements awarded pursuant to a state regulatory commission supervised solicitation process.

     On April 21, 2006, the MPSC approved a settlement agreement among Pepco, DPL, the staff of the MPSC and the Office of Peoples Counsel of Maryland, which provides for a rate mitigation plan for DPL's residential customers. Under the plan, the full increase for DPL's residential customers who affirmatively elect to participate will be phased-in in increments of 15% on June 1, 2006, 15.7% on March 1, 2007 and the remainder on June 1, 2007. Customers electing to participate in the rate deferral plan will be required to pay the deferred amounts over an 18-month period beginning June 1, 2007. DPL will accrue the interest cost to fund the deferral program. The interest cost will be absorbed by DPL, during the period that the deferred balance is accumulated and collected from customers, to the extent of and offset against the margins that the companies otherwise would earn for providing SOS to residential customers. To implement the settlement, DPL filed tariff riders with the MPSC on May 2, 2006, which were approved by the MPSC on May 24, 2006, giving customers the opportunity to opt-in to the phase-in of their rates, as described above. As of July 31, 2006, approximately 1% of DPL's residential customers have made the decision to participate in the phase-in program.

     On June 23, 2006, Maryland enacted legislation that extended the period for customers to elect to participate in the phase-in of higher rates, revised the obligation to provide SOS to

79

residential and small commercial customers until further action of the General Assembly, and provided for a customer refund reflecting the difference in projected interest expense on the deferred balance at a 25% customer participation level versus such interest expense at the actual participation levels of approximately 1% for DPL. The total amount of the refund is approximately $.3 million for DPL customers. At DPL's 1% level of participation, DPL estimates that the deferral balance, net of taxes, will be approximately $.2 million. DPL filed a revised tariff rider on June 30, 2006 to implement the legislation.

     Virginia

     Under amendments to the Virginia Electric Utility Restructuring Act implemented in March 2004, DPL is obligated to offer Default Service to customers in Virginia for an indefinite period until relieved of that obligation by the VSCC. Until January 1, 2005, DPL obtained all of the energy and capacity needed to fulfill its Default Service obligations in Virginia under a supply agreement with its affiliate, Conectiv Energy. In the fall of 2004, DPL conducted a competitive bidding process to provide energy and capacity for its Virginia default supply customers for the seventeen-month period January 1, 2005 through May 30, 2006. Prior to the expiration of that contract, DPL completed a subsequent competitive bid procedure for Default Service supply for the period June 2006 through May 2007, and entered into a new supply agreement for that period with Conectiv Energy, awarded as a result of the bid process. FERC issued its order approving the affiliate sales from Conectiv Energy to DPL for its Virginia Default Service load on May 18, 2006. DPL and Conectiv Energy also filed an application with the VSCC for approval of their affiliate transaction under the Virginia Affiliates Act. The VSCC found that its approval was not needed in this case because the affiliate sale was for a period of one year or less.

     On March 10, 2006, DPL filed for a rate increase with the VSCC for its Virginia Default Service customers to take effect on June 1, 2006, which was intended to allow DPL to recover its higher cost for energy established by the competitive bid procedure. The VSCC directed DPL to address whether the proxy rate calculation as required by a memorandum of agreement entered into by DPL and VSCC staff in June 2000 should be applied to the fuel factor in DPL's rate increase filing. The proxy rate calculation is an approximation of what the cost of power would have been if DPL had not divested its generation units. The proxy rate calculation is a component of a memorandum of agreement entered into by DPL, the staff of the VSCC and the Virginia Attorney General's office in the docket approving the asset divestiture, and was a condition of that divestiture. The Virginia Attorney General's office and VSCC staff each filed testimony in April 2006, in which both argued that the 2000 memorandum of agreement requires that the proxy rate fuel factor calculation set forth therein must operate as a cap on recoverable purchased power costs. DPL filed its response in May 2006, rebutting the testimony of the Attorney General and VSCC staff and arguing that retail rates should not be set at a level below what is necessary to recover its prudently incurred costs of procuring the supply necessary for its Default Service obligation. On June 19, 2006, the VSCC issued an order that granted a rate increase for DPL of $11.5 million ($8.5 million less than requested by DPL in its March 2006 filing), to go into effect July 1, 2006. The estimated after-tax earnings and cash flow impacts of the decision are reductions of approximately $3.6 million in 2006 (including the loss of revenue in June 2006 associated with the Default Service rate increase being deferred from June 1 until July 1) and $2.0 million in 2007. The order also mandated that DPL file an application by March 1, 2007, for Default Service rates to become effective June 1, 2007, which should include

80

a calculation of the fuel factor procedure that is consistent with the procedures set forth in the order.

Environmental Litigation

     DPL 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. In addition, federal and state statutes authorize governmental agencies to compel responsible parties to clean up certain abandoned or unremediated hazardous waste sites. DPL may incur costs to clean up currently or formerly owned facilities or sites found to be contaminated, as well as other facilities or sites that may have been contaminated due to past disposal practices. Although penalties assessed for violations of environmental laws and regulations are not recoverable from DPL's customers, environmental clean-up costs incurred by DPL would be included in its cost of service for ratemaking purposes.

     In July 2004, DPL entered into an Administrative Consent Order with the Maryland Department of the Environment (MDE) to perform a Remedial Investigation/Feasibility Study (RI/FS) to further identify the extent of soil, sediment and ground and surface water contamination related to former manufactured gas plant (MGP) operations at the Cambridge, Maryland site on DPL-owned property and to investigate the extent of MGP contamination on adjacent property. The MDE has approved the RI and DPL has completed and submitted the FS to MDE. The costs for completing the RI/FS for this site were approximately $150,000. Although the costs of cleanup resulting from the RI/FS will not be determinable until MDE approves the final remedy, DPL currently anticipates that the costs of removing MGP impacted soils and adjacent creek sediments will be in the range of $1.5 to $2.5 million.

     In the early 1970s, DPL sold scrap transformers, some of which may have contained some level of PCBs, to a metal reclaimer operating at the Metal Bank/Cottman Avenue site in Philadelphia, Pennsylvania, owned by a nonaffiliated company. In December 1987, DPL was notified by U.S. Environmental Protection Agency (EPA) that it, along with a number of other utilities and non-utilities, was a potentially responsible party (PRP) in connection with the PCB contamination at the site. In 1999, DPL entered into a de minimis settlement with EPA and paid approximately $107,000 to resolve its liability for cleanup costs at the Metal Bank/Cottman Avenue site. The de minimis settlement did not resolve DPL's responsibility for natural resource damages, if any, at the site. DPL believes that any liability for natural resource damages at this site will not have a material adverse effect on its financial position, results of operations or cash flows.

IRS Mixed Service Cost Issue

     During 2001, DPL changed its method of accounting with respect to capitalizable construction costs for income tax purposes. The change allowed DPL to accelerate the deduction of certain expenses that were previously capitalized and depreciated. Through December 31, 2005, these accelerated deductions have generated incremental tax cash flow benefits of approximately $62 million for DPL, primarily attributable to its 2001 tax return.

     On August 2, 2005, the Treasury Department released regulations that, if adopted in their current form, would require DPL to change its method of accounting with respect to capitalizable construction costs for income tax purposes for future tax periods beginning in

81

2005. Under these regulations, DPL will have to capitalize and depreciate a portion of the construction costs that they have previously deducted and include the impact of this adjustment in taxable income over a two-year period beginning with tax year 2005. DPL is in the process of finalizing an alternative method of accounting for capitalizable construction costs that management believes will be acceptable to the IRS to replace the method disallowed by the proposed regulations.

     On the same day that the new regulations were released, the IRS issued Revenue Ruling 2005-53 (the Revenue Ruling) which is intended to limit the ability of certain taxpayers to utilize the method of accounting for income tax purposes they utilized on their tax returns for 2004 and prior years. In line with this Revenue Ruling, the IRS issued its RAR, which disallows substantially all of the incremental tax benefits that DPL claimed on their 2001 and 2002 tax returns by requiring the companies to capitalize and depreciate certain expenses rather than treat such expenses as current deductions.

     In February 2006, DPL's parent, PHI paid approximately $121 million of taxes (a portion of which is attributable to DPL) to cover the amount of taxes management estimates will be payable once a new final method of tax accounting is adopted on its 2005 tax return, due to the proposed regulations. PHI intends to contest the adjustments that the IRS has proposed to the 2001 and 2002 tax returns, under the Revenue Ruling referenced above. However, if the IRS is successful in requiring DPL to capitalize and depreciate construction costs that result in a tax and interest assessment greater than management's estimate of $121 million, PHI will be required to pay additional taxes and interest only to the extent these adjustments exceed the $121 million payment made in February 2006.

 

 

82

(5)  RESTATEMENT

     As reported in DPL's Annual Report on Form 10-K for the year ended December 31, 2005, our parent company, Pepco Holdings, restated its previously reported financial statements for the three and six months ended June 30, 2005, to correct the accounting for certain deferred compensation arrangements. The restatement includes the correction of other errors for the same period, primarily relating to unbilled revenue, taxes, and various accrual accounts, which were considered by management to be immaterial. These other errors would not themselves have required a restatement absent the restatement to correct the accounting for deferred compensation arrangements. The restatement of Pepco Holdings consolidated financial statements was required solely because the cumulative impact of the correction for deferred compensation, if recorded in the fourth quarter of 2005, would have been material to that period's reported net income. The restatement to correct the accounting for the deferred compensation arrangements had no impact on DPL; however, DPL restated its previously reported financial statements for the three and six months ended June 30, 2005, to reflect the correction of other errors. The correction of these other errors, primarily relating to unbilled revenue, taxes, and various accrual accounts, was considered by management to be immaterial. The following table sets forth for DPL's results of operations for the three and six months ended June 30, 2005, its financial position at June 30, 2005, and its cash flows for the six months ended June 30, 2005, the impact of the restatement to correct the errors noted above (millions of dollars):

Three Months Ended
June 30, 2005

Six Months Ended
June 30, 2005

Previously
Reported

Restated

Previously
Reported

Restated

Statements of Earnings

     Total Operating Revenue

$

288.9 

$

288.9 

$

659.2 

$

659.6 

     Total Operating Expenses

 

259.7 

 

259.7 

 

577.8 

 

578.1 

     Total Operating Income

 

29.2 

 

29.2 

 

81.4 

 

81.5 

     Income Before Income Tax Expense

 

21.4 

 

21.4 

 

65.7 

 

65.8 

     Net Income

$

12.5 

$

12.5 

$

36.3 

$

38.6 

Balance Sheet (at June 30)

               

     Total Current Assets

$

$

$

221.3 

$

221.2 

     Total Assets

$

$

$

2,205.2 

$

2,205.1 

     Total Deferred Credits

 

 

 

727.3 

 

727.2 

     Total Liabilities and Shareholder's Equity

$

$

$

2,205.2 

$

2,205.1 

Statement of Cash Flows

               

     Net Cash From Operating Activities

$

$

$

95.8 

$

94.5 

     Net Cash Used By Investing Activities

 

 

 

(58.0)

 

(57.7)

     Net Cash Used By Financing Activities

 

 

 

(37.2)

 

(36.2)

                 

 

 

83

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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ATLANTIC CITY ELECTRIC COMPANY
CONSOLIDATED STATEMENTS OF EARNINGS
(Unaudited)

 

Three Months Ended
June 30,

Six Months Ended
June 30,

 
   

2006

   

(Restated)
2005

   

2006

   

(Restated)
2005

   
   

(Millions of dollars)

 
                           

Operating Revenue

$

321.8 

 

$

290.7 

 

$

655.5 

 

$

600.0 

   

Operating Expenses

  Fuel and purchased energy

 

224.6 

   

199.0 

   

431.1 

   

387.1 

   

  Other operation and maintenance

 

48.1 

   

45.0 

   

95.9 

   

90.4 

   

  Depreciation and amortization

29.9 

27.0 

59.8 

56.9 

  Other taxes

5.4 

5.0 

10.5 

10.2 

  Deferred electric service costs

(29.6)

(18.3)

(10.2)

.8 

     Total Operating Expenses

278.4 

257.7 

587.1 

545.4 

                           

Operating Income

 

43.4 

   

33.0 

   

68.4 

   

54.6 

   

Other Income (Expenses)

                         

  Interest and dividend income

 

.1 

   

.2 

   

.3 

   

.3 

   

  Interest expense

 

(16.0)

   

(14.5)

   

(31.2)

   

(28.6)

   

  Other income

 

1.5 

   

1.8 

   

2.9 

   

3.5 

   

  Other expense

 

(.1)

   

   

(3.1)

   

   

     Total Other Expenses

(14.5)

(12.5)

(31.1)

(24.8)

Income Before Income Tax Expense
    and Extraordinary Item

28.9 

20.5 

37.3 

29.8 

Income Tax Expense

 

8.4 

   

8.2 

   

10.6 

   

12.2 

   
                           

Income Before Extraordinary Item

 

20.5 

   

12.3 

   

26.7 

   

17.6 

   
                           

Extraordinary Item (net of tax of $6.2 million)

 

   

   

   

9.0 

   
                           

Net Income

20.5 

12.3 

26.7 

26.6 

Dividends on Redeemable Serial Preferred Stock

.1 

.1 

.1 

.1 

Earnings Available for Common Stock

20.4 

12.2 

26.6 

26.5 

Retained Earnings at Beginning of Period

165.8 

218.5 

178.6 

211.6 

Dividends paid to Pepco Holdings

(40.5)

(19.0)

(47.9)

Retained Earnings at End of Period

$

186.2 

$

190.2 

$

186.2 

$

190.2 

                           

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

 

85

 

 

ATLANTIC CITY ELECTRIC COMPANY
CONSOLIDATED BALANCE SHEETS
(Unaudited)

ASSETS

June 30,
2006

December 31,
2005

     

(Millions of dollars)

 

CURRENT ASSETS

                         

  Cash and cash equivalents

           

$

5.8 

 

$

8.2 

   

  Restricted cash

             

9.9 

   

11.5 

   

  Accounts receivable, less allowance for
    uncollectible accounts of $5.4 million
    and $5.2 million, respectively

             

173.7 

   

206.0 

   

  Fuel, materials and supplies-at average cost

             

48.5 

   

39.6 

   

  Prepaid expenses and other

             

64.0 

   

12.3 

   

    Total Current Assets

             

301.9 

   

277.6 

   
                           

INVESTMENTS AND OTHER ASSETS

                         

  Regulatory assets

             

901.0 

   

910.4 

   

  Restricted funds held by trustee

             

13.7 

   

11.1 

   

  Prepaid pension expense

             

5.6 

   

8.0 

   

  Other

             

22.1 

   

22.6 

   

    Total Investments and Other Assets

             

942.4 

   

952.1 

   
                           

PROPERTY, PLANT AND EQUIPMENT

                         

  Property, plant and equipment

             

2,021.8 

   

1,915.6 

   

  Accumulated depreciation

             

(616.4)

   

(585.3)

   

    Net Property, Plant and Equipment

             

1,405.4 

   

1,330.3 

   
                           

    TOTAL ASSETS

           

$

2,649.7 

 

$

2,560.0 

   
                           

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

 

86

 

 

ATLANTIC CITY ELECTRIC COMPANY
CONSOLIDATED BALANCE SHEETS
(Unaudited)

LIABILITIES AND SHAREHOLDER'S EQUITY

June 30,
2006

December 31,
2005

     

(Millions of dollars, except shares)

 

CURRENT LIABILITIES

                         

  Short-term debt

           

$

113.0 

 

$

22.6 

   

  Current maturities of long-term debt

             

45.5 

   

94.0 

   

  Accounts payable and accrued liabilities

             

128.3 

   

182.2 

   

  Accounts payable to associated companies

             

32.5 

   

38.3 

   

  Taxes accrued

             

39.1 

   

75.8 

   

  Interest accrued

             

13.4 

   

12.9 

   

  Other

             

36.9 

   

37.3 

   

    Total Current Liabilities

             

408.7 

   

463.1 

   
                           

DEFERRED CREDITS

                         

  Regulatory liabilities

             

265.7 

   

206.3 

   

  Income taxes

             

432.0 

   

432.5 

   

  Investment tax credits

             

15.8 

   

16.5 

   

  Other postretirement benefit obligation

             

49.1 

   

46.4 

   

  Other

             

21.0 

   

20.2 

   

    Total Deferred Credits

             

783.6 

   

721.9 

   
                           

LONG-TERM LIABILITIES

                         

  Long-term debt

             

465.7 

   

376.7 

   

  Transition Bonds issued by ACE Funding

             

480.1 

   

494.3 

   

  Capital lease obligations

             

.2 

   

.2 

   

    Total Long-Term Liabilities

             

946.0 

   

871.2 

   
                           

COMMITMENTS AND CONTINGENCIES (NOTE 4)

                         
                           

REDEEMABLE SERIAL PREFERRED STOCK

             

6.2 

   

6.2 

   
                           

SHAREHOLDER'S EQUITY

                         

  Common stock, $3.00 par value, authorized
    25,000,000 shares, and 8,546,017 shares outstanding

             

25.6 

   

25.6 

   

  Premium on stock and other capital contributions

             

293.4 

   

293.4 

   

  Retained earnings

             

186.2 

   

178.6 

   

    Total Shareholder's Equity

             

505.2 

   

497.6 

   
                           

    TOTAL LIABILITIES AND SHAREHOLDER'S EQUITY

           

$

2,649.7 

 

$

2,560.0 

   
                           

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

 

 

87

 

ATLANTIC CITY ELECTRIC COMPANY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

   

Six Months Ended
June 30,

 
               

2006

   

(Restated)
2005

   
     

(Millions of dollars)

 

OPERATING ACTIVITIES

                         

Net income

           

$

26.7 

 

$

26.6 

   

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

                         

  Extraordinary item

             

   

(15.2)

   

  Depreciation and amortization

             

59.8 

   

56.9 

   

  Deferred income taxes

             

.3 

   

(2.7)

   

  Changes in:

                         

    Accounts receivable

             

32.3 

   

(20.0)

   

    Accounts payable and accrued liabilities

             

(69.8)

   

31.3 

   

    Prepaid New Jersey sales and excise tax

             

(48.7)

   

(43.6)

   

    Regulatory assets, net

             

(9.6)

   

2.7 

   

    Interest and taxes accrued

             

(40.2)

   

11.1 

   

    Other changes in working capital

             

(5.4)

   

(.6)

   

Net other operating

             

1.3 

   

3.3 

   

Net Cash (Used By) From Operating Activities

             

(53.3)

   

49.8 

   
                           

INVESTING ACTIVITIES

                         

Net investment in property, plant and equipment

             

(55.9)

   

(61.8)

   

Net other investing activities

             

1.7 

   

4.7 

   

Net Cash Used By Investing Activities

             

(54.2)

   

(57.1)

   
                           

FINANCING ACTIVITIES

                         

Dividends paid to Pepco Holdings

             

(19.0)

   

(47.9)

   

Dividends paid on preferred stock

             

(.1)

   

(.1)

   

Issuance of long-term debt

             

105.0 

   

   

Reacquisition of long-term debt

             

(78.8)

   

(25.6)

   

Issuances (repayments) of short-term debt, net

             

90.4 

   

84.4 

   

Net other financing activities

             

7.6 

   

(3.7)

   

Net Cash From Financing Activities

             

105.1 

   

7.1 

   
                           

Net decrease in Cash and Cash Equivalents

             

(2.4)

   

(.2)

   

Cash and Cash Equivalents at Beginning of Period

             

8.2 

   

4.3 

   
                           

CASH AND CASH EQUIVALENTS AT END OF PERIOD

           

$

5.8 

 

$

4.1 

   
                           

NONCASH ACTIVITIES

                         

Excess depreciation reserve transferred to regulatory liabilities

           

$

 

$

131.0 

   
                           

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION

Cash paid for income taxes
   (includes payments to PHI for Federal income taxes)

           

$

28.2 

 

$

14.1 

   
                           

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

 

88

 

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

ATLANTIC CITY ELECTRIC COMPANY

(1) ORGANIZATION

     Atlantic City Electric Company (ACE) is engaged in the generation, transmission and distribution of electricity in southern New Jersey. ACE provides Default Electricity Supply, which is the supply of electricity at regulated rates to retail customers in its service territory who do not elect to purchase electricity from a competitive supplier. Default Electricity Supply is also known as Basic Generation Service (BGS) in New Jersey. ACE's service territory covers approximately 2,700 square miles and has a population of approximately 1.0 million. ACE is a wholly owned subsidiary of Conectiv, which is wholly owned by Pepco Holdings, Inc. (Pepco Holdings or PHI). Because PHI is a public utility holding company subject to the Public Utility Holding Company Act of 2005 (PUHCA 2005), the relationship between PHI and ACE and certain activities of ACE are subject to the regulatory oversight of the Federal Energy Regulatory Commission (FERC) under PUHCA 2005.

(2)  ACCOUNTING POLICY, PRONOUNCEMENTS, AND OTHER DISCLOSURES

Financial Statement Presentation

     ACE's 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 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 ACE's Annual Report on Form 10-K for the year ended December 31, 2005. In the opinion of ACE's management, the consolidated financial statements contain all adjustments (which all are of a normal recurring nature) necessary to present fairly ACE's financial condition as of June 30, 2006, in accordance with GAAP. The year-end balance sheet data was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. Interim results for the three and six months ended June 30, 2006 may not be indicative of results that will be realized for the full year ending December 31, 2006 since the sales of electric energy are seasonal.

FIN 46R, "Consolidation of Variable Interest Entities"

     ACE has power purchase agreements (PPAs) with a number of entities, including three nonutility generation contracts (NUGs). Due to a variable element in the pricing structure of the NUGs, ACE potentially assumes the variability in the operations of the plants related to these PPAs and, therefore, has a variable interest in the entities. In accordance with the provisions of Financial Accounting Standards Board (FASB) Interpretation No. (FIN) 46R (revised December 2003) (FIN 46R), entitled "Consolidation of Variable Interest Entities," ACE continued, during the six months ended June 30, 2006, to conduct exhaustive efforts to obtain information from these entities, but was unable to obtain sufficient information to conduct the analysis required under FIN 46R to determine whether these three entities were variable interest entities or if ACE

89

was the primary beneficiary. As a result, ACE has applied the scope exemption from the application of FIN 46R for enterprises that have conducted exhaustive efforts to obtain the necessary information, but have not been able to obtain such information.

     Net power purchase activities with the counterparties to the NUGs for the three months ended June 30, 2006 and 2005 were approximately $79 million and $74 million, respectively, of which $70 million and $67 million, respectively, related to power purchases under the NUGs. Net power purchase activities with the counterparties to the NUGs for the six months ended June 30, 2006 and 2005 were approximately $163 million and $154 million, respectively, of which $144 million and $138 million, respectively, related to power purchases under the NUGs. ACE does not have exposure to loss under the PPA agreements since cost recovery will be achieved from its customers through regulated rates.

Components of Net Periodic Benefit Cost

     The following Pepco Holdings' information is for the three months ended June 30, 2006 and 2005.

   

Pension Benefits

   

Other
Postretirement
Benefits

   
   

2006

   

2005

   

2006

   

2005

   
 

(Millions of dollars)

 

Service cost

$

10.1 

 

$

9.6 

 

$

1.7 

 

$

2.1 

   

Interest cost

 

24.2 

   

23.6 

   

8.3 

   

8.4 

   

Expected return on plan assets

 

(32.5)

   

(32.1)

   

(2.7)

   

(2.9)

   

Amortization of prior service cost

 

.2 

   

.3 

   

(1.1)

   

(.9)

   

Amortization of net loss

 

4.8 

   

2.7 

   

4.2 

   

3.4 

   

Net periodic benefit cost

$

6.8 

 

$

4.1 

 

$

10.4 

 

$

10.1 

   
                           

     The following Pepco Holdings' information is for the six months ended June 30, 2006 and 2005.

   

Pension Benefits

   

Other
Postretirement
Benefits

   
   

2006

   

2005

   

2006

   

2005

   
 

(Millions of dollars)

 

Service cost

$

20.3 

 

$

19.0 

 

$

4.2 

 

$

4.2 

   

Interest cost

 

48.4 

   

47.9 

   

17.3 

   

16.8 

   

Expected return on plan assets

 

(65.0)

   

(62.8)

   

(5.8)

   

(5.4)

   

Amortization of prior service cost

 

.4 

   

.6 

   

(2.0)

   

(1.9)

   

Amortization of net loss

 

8.7 

   

5.2 

   

7.2 

   

5.9 

   

Net periodic benefit cost

$

12.8 

 

$

9.9 

 

$

20.9 

 

$

19.6 

   
                           

90

     Pension

     The pension net periodic benefit cost for the three months ended June 30, 2006 of $6.8 million includes $.2 million for ACE. The pension net periodic benefit cost for the six months ended June 30, 2006 of $12.8 million includes $2.5 million for ACE. The remaining pension net periodic benefit cost is for other PHI subsidiaries. The pension net periodic benefit cost for the three months ended June 30, 2005 of $4.1 million includes $2.0 million for ACE. The pension net periodic benefit cost for the six months ended June 30, 2005 of $9.9 million includes $4.1 million for ACE. The remaining pension net periodic benefit cost is for other PHI subsidiaries.

     Pension Contributions

     Pepco Holdings' current funding policy with regard to its defined benefit pension plan is to maintain a funding level in excess of 100% of its accumulated benefit obligation (ABO). In 2005 and 2004 PHI made discretionary tax-deductible cash contributions to the plan of $60 million and $10 million, respectively. PHI's pension plan currently meets the minimum funding requirements of the Employment Retirement Income Security Act of 1974 without any additional funding. PHI may elect, however, to make a discretionary tax-deductible contribution to maintain the pension plan's assets in excess of its ABO. As of June 30, 2006, no contributions have been made. The potential discretionary funding of the pension plan in 2006 will depend on many factors, including the actual investment return earned on plan assets over the remainder of the year.

     Other Postretirement Benefits

     The other postretirement net periodic benefit cost for the three months ended June 30, 2006 of $10.4 million includes $2.3 million for ACE. The other postretirement net periodic benefit cost for the six months ended June 30, 2006 of $20.9 million includes $4.6 million for ACE. The remaining other postretirement net periodic benefit cost is for other PHI subsidiaries. The other postretirement net periodic benefit cost for the three months ended June 30, 2005 of $10.1 million includes $2.0 million for ACE. The other postretirement net periodic benefit cost for the six months ended June 30, 2005 of $19.6 million includes $4.4 million for ACE. The remaining other postretirement net periodic benefit cost is for other PHI subsidiaries.

91

Reconciliation of Income Tax Expense

     A reconciliation of ACE's consolidated income tax expense is as follows:

 

For the Three Months Ended June 30,

For the Six Months Ended June 30,

 
 

2006

2005 (Restated)

2006

2005 (Restated)

 
 

Amount

Rate

Amount

Rate

Amount

Rate

Amount

Rate

 
 

(Millions of dollars)

 

Income Before Income Tax Expense
    and Extraordinary Item

$28.9   

-  

$20.5   

-  

$37.3   

-  

$29.8   

-  

 
                   

Income tax at federal statutory rate

$10.1   

.35  

$7.2   

.35  

$13.1   

.35  

$10.4   

.35  

 

  Increases (decreases) resulting from:

                 

    State income taxes,
        net of federal benefit

2.0   

.07  

1.4   

.07  

2.8   

.07  

2.1   

.07  

 

    Plant basis differences

-   

-  

-   

-  

-   

-  

.5   

.01  

 

    Investment tax credit
        amortization

(.3)  

(.01) 

(.5)  

(.02) 

(.7)  

(.02) 

(1.0)  

(.03) 

 

    Adjustment to prior years' tax

-   

-  

-   

-  

(1.6)  

(.04) 

-   

-  

 

    Change in estimates related to
        prior year tax liabilities

(3.4)  

(.12) 

.3   

.01  

(3.0)  

(.08) 

.6   

.02  

 

    Other, net

-   

-  

(.2)  

(.01) 

-   

-  

(.4)  

(.01) 

 

Total Consolidated Income
  Tax Expense

$8.4   

.29  

$8.2   

.40  

$10.6   

.28  

$12.2   

.41  

 

Extraordinary Item

     As a result of the April 2005 settlement of ACE's electric distribution rate case, ACE reversed $15.2 million in accruals related to certain deferred costs that are now deemed recoverable. The after-tax credit to income of $9.0 million is classified as an extraordinary gain in the 2005 financial statements since the original accrual was part of an extraordinary charge in conjunction with the accounting for competitive restructuring in 1999.

Debt

      In April 2006, ACE Funding made principal payments of $4.8 million on Series 2002-1 Bonds, Class A-1, and $2.0 million on Series 2003-1 Bonds, Class A-1, with a weighted average interest rate of 2.89%.

     In April 2006, PHI, Potomac Electric Power Company, Delmarva Power & Light Company (DPL) and ACE amended their $1.2 billion credit facility due 2010 to extend the maturity by one additional year to May 5, 2011 and to reduce the pricing of the facility by reducing the credit facility fees.

 

92

Related Party Transactions

     PHI Service Company provides various administrative and professional services to PHI and its regulated and unregulated subsidiaries, including ACE, pursuant to a service agreement. The cost of these services is allocated in accordance with cost allocation methodologies set forth in the service agreement using a variety of factors, including the subsidiaries' share of employees, operating expenses, assets, and other cost causal methods. These intercompany transactions are eliminated in consolidation and no profit results from these transactions. PHI Service Company costs directly charged or allocated to ACE for the three and six months ended June 30, 2006 and 2005 were $20.2 million and $41.4 million, and $20.6 million and $40.7 million, respectively.

     In addition to the PHI Service Company charges described above, ACE's Consolidated Statements of Earnings include the following related party transactions:

 

For the Three Months Ended
June 30,

For the Six Months Ended
June 30,

 

2006

2005

2006

2005

Income (Expense)

(Millions of dollars)

Purchased power from Conectiv Energy Supply (included in
  fuel and purchased energy expenses)

$(20.3)

$(17.5)

$(39.1)

$(30.8)

     As of June 30, 2006 and December 31, 2005, ACE had the following balances on its Consolidated Balance Sheets due (to) from related parties:

   

2006

   

2005

   

Asset (Liability)

 

(Millions of dollars)

   

Payable to Related Party (current)

             

  PHI Service Company

$

(9.4)

 

$

(7.2)

   

  Conectiv Energy Supply

 

(11.6)

   

(30.9)

   

  DPL

 

(11.3)

   

(.2)

   

  Other Related Party Activity

 

(.2)

   

   

       Total Net Payable to Related Parties

$

(32.5)

 

$

(38.3)

   

Money Pool Balance with Pepco Holdings
  (included in cash and cash equivalents on the balance sheet)

$

.5 

 

$

4.0 

   
               

New Accounting Standards

     FSP FTB 85-4-1, "Accounting for Life Settlement Contracts by Third-Party Investors"

     In March 2006, the FASB issued FASB Staff Position (FSP) FTB 85-4-1, "Accounting for Life Settlement Contracts by Third-Party Investors" (FSP FTB 85-4-1). This FSP provides initial and subsequent measurement guidance and financial statement presentation and disclosure guidance for investments by third-party investors in life settlement contracts. FSP FTB 85-4-1 also amends certain provisions of FASB Technical Bulletin No. 85-4, "Accounting for Purchases of Life Insurance," and FASB Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities." The guidance in FSP FTB 85-4-1 applies prospectively for all new life settlement contracts and is effective for fiscal years beginning after June 15, 2006 (the year ending December 31, 2007 for ACE). ACE is in the process of evaluating the impact of FSP FTB 85-4-1 and does not anticipate its adoption will have a material impact on its overall financial condition, results of operations, or cash flows.

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     EITF 04-13, "Accounting for Purchases and Sales of Inventory with the Same Counterparty"

     In September 2005, the FASB ratified Emerging Issues Task Force (EITF) Issue No. 04-13, "Accounting for Purchases and Sales of Inventory with the Same Counterparty" (EITF 04-13), which addresses circumstances under which two or more exchange transactions involving inventory with the same counterparty should be viewed as a single exchange transaction for the purposes of evaluating the effect of APB Opinion 29, "Accounting for Nonmonetary Transactions." EITF 04-13 is effective for new arrangements entered into, or modifications or renewals of existing arrangements, beginning in the first interim or annual reporting period beginning after March 15, 2006.

     ACE implemented EITF 04-13 on April 1, 2006. The implementation did not impact ACE's overall financial condition, results of operations, or cash flows for the second quarter of 2006.

     FSP FIN 46(R)-6, "Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R)"

     In April 2006, the FASB issued FSP FIN 46(R)-6, "Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R)" (FSP FIN 46(R)-6), which provides guidance on how to determine the variability to be considered in applying FIN 46(R), "Consolidation of Variable Interest Entities."

     The guidance in FSP FIN 46(R)-6 is applicable prospectively beginning the first day of the first reporting period beginning after June 15, 2006 (July 1, 2006 for ACE), although early application is permitted to financial statements not issued. Retrospective application is also permitted if so elected and must be completed no later than the end of the first annual reporting period ending after July 15, 2006 (December 31, 2006 for ACE).

     ACE is in the process of evaluating the impact of FIN 46(R)-6.

     EITF Issue No. 06-3, "Disclosure Requirements for Taxes Assessed by a Governmental Authority on Revenue-producing Transactions"

     On June 28, 2006, the FASB ratified EITF Issue No. 06-3, "Disclosure Requirements for Taxes Assessed by a Governmental Authority on Revenue-producing Transactions" (EITF 06-3). EITF 06-3 provides guidance on an entity's disclosure of its accounting policy regarding the gross or net presentation of certain taxes and provides that if taxes included in gross revenues are significant, a company should disclose the amount of such taxes for each period for which an income statement is presented (i.e., both interim and annual periods). Taxes within the scope of EITF 06-3 are those that are imposed on and concurrent with a specific revenue-producing transaction. Taxes assessed on an entity's activities over a period of time are not within the scope of EITF 06-3.

     EITF 06-3 is effective for interim and annual reporting periods beginning after December 15, 2006 (2007 for ACE) although earlier application is permitted. ACE is in the process of evaluating the impact of EITF 06-3.

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     FIN 48, "Accounting for Uncertainty in Income Taxes"

     On July 13, 2006, the FASB issued FASB Interpretation No.48, "Accounting for Uncertainty in Income Taxes" (FIN 48). FIN 48 clarifies the criteria for recognition of tax benefits in accordance with SFAS No. 109, "Accounting for Income Taxes," and prescribes a financial statement recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return. Specifically, it clarifies that an entity's tax benefits must be "more likely than not" of being sustained prior to recording the related tax benefit in the financial statements. If the position drops below the "more likely than not" standard, the benefit can no longer be recognized. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.

     FIN 48 is effective the first fiscal year beginning after December 15, 2006 (January 1, 2007 for ACE). ACE is in the process of evaluating the impact of FIN 48.

(3) SEGMENT INFORMATION

     In accordance with Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information," ACE has one segment, its regulated utility business.

(4)  COMMITMENTS AND CONTINGENCIES

REGULATORY AND OTHER MATTERS

Rate Proceedings

     On May 15, 2006, ACE updated its FERC-approved formula transmission rates based on its FERC Form 1 data for 2005. This new rate of $14,155 per megawatt per year became effective on June 1, 2006. By operation of the formula rate process, the new rate incorporates true-ups from the 2005 formula rate that was effective June 1, 2005 and the new 2005 customer demand or peak load. Also, beginning in January 2007, the new rates will be applied to 2006 customer demand data, replacing the 2005 demand data that is currently used. This demand component is driven by ACE's prior year peak load. The net earnings impact from the network transmission rate changes year over year (2005 to 2006) is not expected to be material to ACE's overall financial condition, results of operations, or cash flows.

Restructuring Deferral

     Pursuant to orders issued by the New Jersey Board of Public Utilities (NJBPU) under the New Jersey Electric Discount and Energy Competition Act (EDECA), beginning August 1, 1999, ACE was obligated to provide BGS to retail electricity customers in its service territory who did not choose a competitive energy supplier. For the period August 1, 1999 through July 31, 2003, ACE's aggregate costs that it was allowed to recover from customers exceeded its aggregate revenues from supplying BGS. These under-recovered costs were partially offset by a $59.3 million deferred energy cost liability existing as of July 31, 1999 (LEAC Liability) that was related to ACE's Levelized Energy Adjustment Clause and ACE's Demand Side Management Programs. ACE established a regulatory asset in an amount equal to the balance of under-recovered costs.

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     In August 2002, ACE filed a petition with the NJBPU for the recovery of approximately $176.4 million in actual and projected deferred costs relating to the provision of BGS and other restructuring related costs incurred by ACE over the four-year period August 1, 1999 through July 31, 2003, net of the $59.3 million offset for the LEAC Liability. The petition also requested that ACE's rates be reset as of August 1, 2003 so that there would be no under-recovery of costs embedded in the rates on or after that date. The increase sought represented an overall 8.4% annual increase in electric rates. ACE's recovery of the deferred costs is subject to review and approval by the NJBPU in accordance with EDECA.

     In July 2004, the NJBPU issued a final order in the restructuring deferral proceeding confirming a July 2003 summary order, which (i) permitted ACE to begin collecting a portion of the deferred costs and reset rates to recover on-going costs incurred as a result of EDECA, (ii) approved the recovery of $125 million of the deferred balance over a ten-year amortization period beginning August 1, 2003, (iii) transferred to ACE's then pending base rate case for further consideration approximately $25.4 million of the deferred balance, and (iv) estimated the overall deferral balance as of July 31, 2003 at $195 million, of which $44.6 million was disallowed recovery by ACE. ACE believes the record does not justify the level of disallowance imposed by the NJBPU in the final order. In August 2004, ACE filed with the Appellate Division of the Superior Court of New Jersey (the Superior Court), which hears appeals of the decisions of New Jersey administrative agencies, including the NJBPU, a Notice of Appeal with respect to the July 2004 final order. Briefs were filed by the parties (ACE, as appellant, and the Division of the New Jersey Ratepayer Advocate and Cogentrix Energy Inc., the co-owner of two cogeneration power plants with contracts to sell ACE approximately 397 megawatts of electricity, as cross-appellants) between August 2005 and January 2006. The Superior Court has not yet set the schedule for oral argument.

Divestiture Case

     In connection with the divestiture by ACE of its nuclear generation assets, the NJBPU in July 2000 preliminarily determined that the amount of stranded costs associated with the divested assets that ACE could recover from ratepayers should be reduced by the amount of the accumulated deferred federal income taxes (ADFIT) associated with the divested nuclear assets. However, due to uncertainty under federal tax law regarding whether the sharing of federal income tax benefits associated with the divested assets, including ADFIT, with ACE's customers would violate the normalization rules, ACE submitted a request to the Internal Revenue Service (IRS) for a Private Letter Ruling (PLR) to clarify the applicable law. The NJBPU has delayed its final determination of the amount of recoverable stranded costs until after the receipt of the PLR.

     On May 25, 2006, the IRS issued a PLR in which it stated that returning to ratepayers any of the unamortized ADFIT attributable to accelerated depreciation on the divested assets after the sale of the assets by means of a reduction of the amount of recoverable stranded costs would violate the normalization rules.

     On June 9, 2006, ACE submitted a letter to the NJBPU to request that the NJBPU conduct proceedings to finalize the determination of the stranded costs associated with the sale of ACE's nuclear assets in accordance with the PLR.

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Default Electricity Supply Proceedings

     On October 12, 2005, the NJBPU, following the evaluation of proposals submitted by ACE and the other three electric distribution companies operating in New Jersey, issued an order reaffirming the current BGS auction process for the annual period from June 1, 2006 through May 2007. The NJBPU order maintained the current size and make up of the Commercial and Industrial Energy Pricing class (CIEP) and approved the electric distribution companies' recommended approach for the CIEP auction product, but deferred a decision on the level of the retail margin funds.

Proposed Shut Down of B.L. England Generating Facility

    In April 2004, pursuant to a NJBPU order, ACE filed a report with the NJBPU recommending that ACE's B.L. England generating facility, a 447 megawatt plant, be shut down. The report stated that, while operation of the B.L. England generating facility was necessary at the time of the report to satisfy reliability standards, those reliability standards could also be satisfied in other ways. The report concluded that, based on B.L. England's current and projected operating costs resulting from compliance with more restrictive environmental requirements, the most cost-effective way in which to meet reliability standards is to shut down the B.L. England generating facility and construct additional transmission enhancements in southern New Jersey.

     In December 2004, ACE filed a petition with the NJBPU requesting that the NJBPU establish a proceeding that would consist of a Phase I and Phase II and that the procedural process for the Phase I proceeding require intervention and participation by all persons interested in the prudence of the decision to shut down B.L. England generating facility and the categories of stranded costs associated with shutting down and dismantling the facility and remediation of the site. ACE contemplates that Phase II of this proceeding, which would be initiated by an ACE filing in 2008 or 2009, would establish the actual level of prudently incurred stranded costs to be recovered from customers in rates. The NJBPU has not acted on this petition.

     ACE has commenced several construction projects to enhance the transmission system, which will ensure that the reliability of the electric transmission system will be maintained upon the shut down of B.L. England. To date, two projects have been completed and the remaining projects are under construction or are scheduled to be completed prior to December 15, 2007.

     As more fully described below under "Environmental Litigation," ACE, along with PHI and Conectiv, on January 24, 2006, entered into an Administrative Consent Order (ACO) with the New Jersey Department of Environmental Protection (NJDEP) and the Attorney General of New Jersey, which contemplates that ACE will shut down and permanently cease operations at the B.L. England generating facility by December 15, 2007, if ACE does not sell the plant before that time. ACE recorded an asset retirement obligation of $60 million during the first quarter of 2006 (this is reflected as a regulatory liability in PHI's consolidated balance sheet). The shut-down of the B.L. England generating facility will be subject to necessary approvals from the relevant agencies and the outcome of the auction process, discussed under "ACE Auction of Generation Assets," below.

ACE Auction of Generation Assets

     In May 2005, ACE announced that it would auction its electric generation assets, consisting of its B.L. England generating facility and its ownership interests in the Keystone and

 

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Conemaugh generating stations. In November 2005, ACE announced an agreement to sell its interests in the Keystone and Conemaugh generating stations to Duquesne Light Holdings Inc. for $173.1 million. On July 19, 2006, the NJBPU issued the final approval needed to complete the sale. ACE expects the sale to be completed in early September. Approximately $80 million, the net gain from the sale, will be used to offset the remaining unamortized aggregate adjusted deferred balance, which ACE has been recovering in rates, and approximately $54.2 million will be returned to ratepayers over a 33-month period as a credit on their bills.

     ACE received final bids for B.L. England in April 2006 and continues to evaluate those bids, working toward completion of a purchase and sale agreement. Any successful bid for B.L. England must comply with NJBPU approved auction standards.

     Any sale of B.L. England will not affect the stranded costs associated with the plant that already have been securitized. If B.L. England is sold, ACE anticipates that, subject to regulatory approval in Phase II of the proceeding described above, approximately $9 to $10 million of additional assets may be eligible for recovery as stranded costs.

Environmental Litigation

     ACE 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. In addition, federal and state statutes authorize governmental agencies to compel responsible parties to clean up certain abandoned or unremediated hazardous waste sites. ACE may incur costs to clean up currently or formerly owned facilities or sites found to be contaminated, as well as other facilities or sites that may have been contaminated due to past disposal practices. Although penalties assessed for violations of environmental laws and regulations are not recoverable from customers of the operating utilities, environmental clean-up costs incurred by ACE would be included in its cost of service for ratemaking purposes.

     In June 1992, the U.S. Environmental Protection Agency (EPA) identified ACE as a potentially responsible party (PRP) at the Bridgeport Rental and Oil Services Superfund site in Logan Township, New Jersey. In September 1996, ACE along with other PRPs signed a consent decree with EPA and NJDEP to address remediation of the site. ACE's liability is limited to .232 percent of the aggregate remediation liability and thus far ACE has made contributions of approximately $105,000. Based on information currently available, ACE anticipates that it may be required to contribute approximately an additional $52,000. ACE believes that its liability at this site will not have a material adverse effect on its financial position, results of operations or cash flows.

     In November 1991, NJDEP identified ACE as a PRP at the Delilah Road Landfill site in Egg Harbor Township, New Jersey. In 1993, ACE, along with other PRPs, signed an ACO with NJDEP to remediate the site. The soil cap remedy for the site has been completed and the NJDEP conditionally approved the report submitted by the parties on the implementation of the remedy in January 2003. In March 2004, NJDEP approved a Ground Water Sampling and Analysis Plan. Positive results of groundwater monitoring events have resulted in a reduced level of groundwater monitoring. In March 2003, EPA demanded from the PRP group reimbursement for EPA's past costs at the site, totaling $168,789. The PRP group objected to the demand for certain costs, but agreed to reimburse EPA approximately $19,000. Based on

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information currently available, ACE anticipates that its share of additional cost associated with this site will be approximately $555,000 to $600,000. ACE believes that its liability for post-remedy operation and maintenance costs will not have a material adverse effect on its financial position, results of operations or cash flows.

     On January 24, 2006, PHI, Conectiv and ACE entered into an ACO with NJDEP and the Attorney General of New Jersey resolving New Jersey's claim for alleged violations of the Federal Clean Air Act (CAA) and the NJDEP's concerns regarding ACE's compliance with New Source Review (NSR) requirements and the New Jersey Air Pollution Control Act (APCA) with respect to the B.L. England generating facility and various other environmental issues relating to ACE and Conectiv Energy facilities in New Jersey. Among other things, the ACO provides that:

·

Contingent upon the receipt of necessary approvals for the construction of substation and transmission facilities to compensate for the shut down of B.L. England, ACE will permanently cease operation of the B.L. England generating facility by December 15, 2007 if ACE does not sell the facility. In the event that ACE is unable to shut down the B.L. England facility by December 15, 2007 through no fault of its own, (i) ACE may operate B.L. England Unit 1 after December 15, 2007 for certain limited purposes and/or for electric system reliability during the summer months in the years 2008 to 2012, and (ii) B.L. England Units 1 and 2 would be required to comply with stringent emissions limits by December 15, 2012 and May 1, 2010, respectively. If ACE fails to meet those 2010 and 2012 deadlines for reducing emissions, ACE would be required to pay up to $10 million in civil penalties.

·

If B.L. England is shut down by December 15, 2007, ACE will surrender to NJDEP certain sulfur dioxide (SO2) and nitrogen oxide (NOx) allowances allocated to B.L. England Units 1 and 2, contingent upon approval by the NJBPU recognizing cost impacts of the surrender.

·

In the event that ACE is unable to shut down B.L. England Units 1 and 2 by December 15, 2007 through no fault of its own, ACE will surrender NOx and SO2 allowances not needed to satisfy the operational needs of B.L. England Units 1 and 2, contingent upon approval by the NJBPU recognizing cost impacts of the surrender.

·

To resolve any possible civil liability (and without admitting liability) for violations of APCA and the Prevention of Significant Deterioration NSR provisions of the CAA, ACE paid a $750,000 civil penalty to NJDEP in June 2004 and will undertake environmental projects that are beneficial to the state of New Jersey and approved by the NJDEP or donate property valued at $2 million.

·

To resolve any possible civil liability (and without admitting liability) for natural resource damages resulting from groundwater contamination at ACE's B.L. England facility, Conectiv Energy's Deepwater facility and ACE's operations center near Pleasantville, New Jersey, ACE and Conectiv Energy paid NJDEP $674,162 and will remediate the groundwater contamination at all three sites.

·

The ACO allows the sale of the B.L. England facility through the B.L. England auction process to a third party that is not committing to repower or otherwise meet the ACO's emissions limits, subject to a 45-day right of first refusal in favor of NJDEP for purchase of B.L. England on terms and conditions no less favorable to ACE than those offered by the third party. In the event that ACE enters into a third-party agreement through the

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