10-Q 1 d404768d10q.htm FORM 10-Q Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

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

THE SECURITIES EXCHANGE ACT OF 1934

For the quarter ended September 30, 2012

 

 

 

Commission File Number

  

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

Address of Principal Executive Offices, Zip Code

and Telephone Number (Including Area Code)

  

I.R.S. Employer
Identification
Number

001-31403

  

PEPCO HOLDINGS, INC.

(Pepco Holdings or PHI), a Delaware corporation

701 Ninth Street, N.W.

Washington, D.C. 20068

Telephone: (202)872-2000

   52-2297449

001-01072

  

POTOMAC ELECTRIC POWER COMPANY

(Pepco), a District of Columbia and Virginia corporation

701 Ninth Street, N.W.

Washington, D.C. 20068

Telephone: (202)872-2000

   53-0127880

001-01405

  

DELMARVA POWER & LIGHT COMPANY

(DPL), a Delaware and Virginia corporation

500 North Wakefield Drive

Newark, DE 19702

Telephone: (202)872-2000

   51-0084283

001-03559

  

ATLANTIC CITY ELECTRIC COMPANY

(ACE), a New Jersey corporation

500 North Wakefield Drive

Newark, DE 19702

Telephone: (202)872-2000

   21-0398280

 

 

Indicate by check mark whether each registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months and (2) has been subject to such filing requirements for the past 90 days.

 

Pepco Holdings

   Yes  x    No  ¨   

Pepco

   Yes  x    No  ¨

DPL

   Yes  x    No  ¨   

ACE

   Yes  x    No  ¨

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

 

Pepco Holdings

   Yes  x    No  ¨   

Pepco

   Yes  x    No  ¨

DPL

   Yes  x    No  ¨   

ACE

   Yes  x    No  ¨

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

 

     Large
Accelerated
Filer
   Accelerated
Filer
   Non-
Accelerated
Filer
   Smaller
Reporting
Company

Pepco Holdings

   x    ¨    ¨    ¨

Pepco

   ¨    ¨    x    ¨

DPL

   ¨    ¨    x    ¨

ACE

   ¨    ¨    x    ¨

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

 

Pepco Holdings

   Yes  ¨    No  x   

Pepco

   Yes  ¨    No  x

DPL

   Yes  ¨    No  x   

ACE

   Yes  ¨    No  x

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

 

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

Pepco Holdings

     229,471,971 ($.01 par value)   

Pepco

     100 ($.01 par value) (a)   

DPL

     1,000 ($2.25 par value) (b)   

ACE

     8,546,017 ($3.00 par value) (b)   

 

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

 

 

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

 

 

 


Table of Contents

TABLE OF CONTENTS

 

             Page  
 

Glossary of Terms

     i  
 

Forward-Looking Statements

     1  
 

Investor Information

     2   

PART I

 

FINANCIAL INFORMATION

     3  

Item 1.

  – Financial Statements      3  

Item 2.

  – Management’s Discussion and Analysis of Financial Condition and Results of Operations      119  

Item 3.

  – Quantitative and Qualitative Disclosures About Market Risk      185  

Item 4.

  – Controls and Procedures      187  

PART II

 

OTHER INFORMATION

     187  

Item 1.

  – Legal Proceedings      187  

Item 1A

  – Risk Factors      188  

Item 2.

  – Unregistered Sales of Equity Securities and Use of Proceeds      191  

Item 3.

  – Defaults Upon Senior Securities      191  

Item 4.

  – Mine Safety Disclosures      191  

Item 5.

  – Other Information      192  

Item 6.

  – Exhibits      193  

Signatures

     195  


Table of Contents

GLOSSARY OF TERMS

 

Term

    

Definition

2011 Form 10-K      The Annual Report on Form 10-K for the year ended December 31, 2011, as amended, for each Reporting Company, as applicable
ACE      Atlantic City Electric Company
ACE Funding      Atlantic City Electric Transition Funding LLC
AMI      Advanced metering infrastructure
AOCL      Accumulated Other Comprehensive Loss
ASC      Accounting Standards Codification
BGS      Basic Generation Service (the supply of electricity by ACE to retail customers in New Jersey who have not elected to purchase electricity from a competitive supplier)
Bondable Transition Property      The principal and interest payments on the Transition Bonds and related taxes, expenses and fees
BSA      Bill Stabilization Adjustment
Calpine      Calpine Corporation
CERCLA      Comprehensive Environmental Response, Compensation, and Liability Act of 1980
Conectiv      Conectiv, LLC, a wholly owned subsidiary of PHI and the parent of DPL and ACE
Conectiv Energy      Subsidiaries of Conectiv Energy Holding Company, a disposition plan for which was approved by PHI’s Board of Directors in April 2010 and has been completed
CRMC      PHI’s Corporate Risk Management Committee
CSA      Credit Support Annex
DCPSC      District of Columbia Public Service Commission
DDOE      District of Columbia Department of the Environment
Default Electricity Supply      The supply of electricity by PHI’s electric utility subsidiaries at regulated rates to retail customers who do not elect to purchase electricity from a competitive supplier, and which, depending on the jurisdiction, is also known as Standard Offer Service or BGS
Default Electricity Supply Revenue      Revenue primarily from Default Electricity Supply
Derecho      A rapidly moving thunderstorm with hurricane-force winds
DOE      U.S. Department of Energy
DPL      Delmarva Power & Light Company
DPSC      Delaware Public Service Commission
EDCs      Electric distribution companies
EmPower Maryland      A Maryland demand-side management program for Pepco and DPL
EPA      U.S. Environmental Protection Agency
EPS      Earnings per share
Excess Depreciation Rider     

A credit rider in New Jersey expected to expire August 31, 2013, which is designed

to refund to customers certain excess depreciation reserve funds as previously

directed by the NJBPU

Exchange Act      Securities Exchange Act of 1934, as amended
FASB      Financial Accounting Standards Board
FERC      Federal Energy Regulatory Commission
GAAP      Accounting principles generally accepted in the United States of America
GCR      Gas Cost Rate
GWh      Gigawatt hour
IIP      ACE’s Infrastructure Investment Program
IRS      Internal Revenue Service
ISDA      International Swaps and Derivatives Association Master Agreement
ISRA      New Jersey’s Industrial Site Recovery Act
LIBOR      London Interbank Offered Rate

 

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Term

    

Definition

MAPP      Mid-Atlantic Power Pathway
Market Transition Charge Tax      Revenue ACE receives and pays to ACE Funding to recover income taxes associated with Transition Bond Charge revenue
MDC      MDC Industries, Inc.
MFVRD      Modified fixed variable rate design
MMBtu      One Million British Thermal Units
MPSC      Maryland Public Service Commission
MW     

Megawatt

MWh      Megawatt hour
NERC      North American Electric Reliability
New Jersey Settlement      A stipulation of settlement signed by the parties to ACE’s electric distribution base rate case, which was approved by the NJBPU on October 23, 2012
NJBPU      New Jersey Board of Public Utilities
NPCC      Northeast Power Coordinating Council
NUGs      Non-utility generators
NYMEX      New York Mercantile Exchange
PCI      Potomac Capital Investment Corporation and its subsidiaries
Pepco      Potomac Electric Power Company
Pepco Energy Services      Pepco Energy Services, Inc. and its subsidiaries
Pepco Holdings or PHI      Pepco Holdings, Inc.
PHI Retirement Plan      PHI’s noncontributory retirement plan
PJM      PJM Interconnection, LLC
PJM RTO      PJM regional transmission organization
Power Delivery      PHI’s Power Delivery Business
PPA      Power purchase agreement
PRP      Potentially responsible party
PUHCA 2005      Public Utility Holding Company Act of 2005
RECs      Renewable energy credits
Regulated T&D Electric Revenue      Revenue from the transmission and the distribution of electricity to PHI’s customers within its service territories at regulated rates
Reporting Company      PHI, Pepco, DPL or ACE
RFC      ReliabilityFirst Corporation
RI/FS      Remedial investigation and feasibility study
RIM      Reliability investment recovery mechanism
ROE      Return on equity
RPS      Renewable Energy Portfolio Standards
SEC      Securities and Exchange Commission
SOCAs      Standard Offer Capacity Agreements required to be entered into by ACE pursuant to a New Jersey law enacted to promote the construction of qualified electric generation facilities in New Jersey
SOS     

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

the District of Columbia and Maryland

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

 

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FORWARD-LOOKING STATEMENTS

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

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

 

 

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

 

 

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

 

 

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

 

 

Possible fines, penalties or other sanctions assessed by regulatory authorities against a Reporting Company or its subsidiaries;

 

 

The impact of adverse publicity and media exposure, which could render one or more Reporting Companies vulnerable to increased regulatory oversight and negative customer perception;

 

 

Weather conditions affecting usage and emergency restoration costs;

 

 

Population growth rates and changes in demographic patterns;

 

 

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

 

 

General economic conditions, including the impact of an economic downturn or recession on electricity and natural gas usage;

 

 

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

 

 

Changes in tax rates or policies;

 

 

Changes in rates of inflation;

 

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Changes in accounting standards or practices;

 

 

Unanticipated changes in operating expenses and capital expenditures;

 

 

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

 

 

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

 

 

Pace of entry into new markets;

 

 

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

 

 

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

These forward-looking statements are also qualified by, and should be read together with, the risk factors included in Part I, Item 1A. Risk Factors and other statements in each Reporting Company’s annual report on Form 10-K for the year ended December 31, 2011, as amended to include the executive compensation and other information required by Part III of Form 10-K (which information originally had been omitted as permitted by that form) (the 2011 Form 10-K), as filed with the Securities and Exchange Commission (SEC), in each Reporting Company’s quarterly report on Form 10-Q for the quarters ended March 31, 2012 and June 30, 2012, as filed with the SEC, and in this Form 10-Q, and investors should refer to such risk factors and other statements in evaluating the forward-looking statements contained in this Form 10-Q.

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

*    *    *

INVESTOR INFORMATION

PHI routinely makes available important information with respect to each Reporting Company, including copies of each Reporting Company’s annual, periodic and current reports filed or furnished with the Securities and Exchange Commission under the Securities Exchange Act of 1934, free of charge on PHI’s website at http://www.pepcoholdings.com/investors. PHI recognizes its website as a key channel of distribution to reach public investors and as a means of disclosing material non-public information to comply with each Reporting Company’s disclosure obligations under SEC Regulation FD. Information contained on PHI’s website shall not be deemed incorporated into, or to be part of, this Quarterly Report, and any website references are not intended to be made through active hyperlinks.

 

2


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PART I FINANCIAL INFORMATION

 

Item 1. FINANCIAL STATEMENTS

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

 

     Registrants  

Item

   Pepco
Holdings
     Pepco*      DPL*      ACE  

Consolidated Statements of Income

     4        55        75        99  

Consolidated Statements of Comprehensive Income

     5        N/A        N/A        N/A  

Consolidated Balance Sheets

     6        56        76        100  

Consolidated Statements of Cash Flows

     8        58        78        102  

Consolidated Statement of Equity

     9        59        79        103  

Notes to Consolidated Financial Statements

     10        60        80        104  

 

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

 

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PEPCO HOLDINGS

 

PEPCO HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2012     2011     2012     2011  
     (millions of dollars, except per share data)  

Operating Revenue

        

Power Delivery

   $ 1,335     $ 1,329     $ 3,374     $ 3,671  

Pepco Energy Services

     131       317       544       1,005  

Other

     10       2       29       22  
  

 

 

   

 

 

   

 

 

   

 

 

 

Total Operating Revenue

     1,476       1,648       3,947       4,698  
  

 

 

   

 

 

   

 

 

   

 

 

 

Operating Expenses

        

Fuel and purchased energy

     709       948       1,948       2,759  

Other services cost of sales

     38       42       132       128  

Other operation and maintenance

     230       239       679       682  

Depreciation and amortization

     122       115       343       325  

Other taxes

     121       126       330       346  

Gain on early termination of finance leases held in trust

     (39     —          (39 )     (39 )

Deferred electric service costs

     29       (17 )     (6 )     (49 )

Impairment losses

     2       —          5       —     
  

 

 

   

 

 

   

 

 

   

 

 

 

Total Operating Expenses

     1,212       1,453       3,392       4,152  
  

 

 

   

 

 

   

 

 

   

 

 

 

Operating Income

     264       195       555       546  
  

 

 

   

 

 

   

 

 

   

 

 

 

Other Income (Expenses)

        

Interest expense

     (68 )     (64 )     (198 )     (189 )

Loss from equity investments

     —          (3 )     —          (4 )

Other income

     9       7       27       27  
  

 

 

   

 

 

   

 

 

   

 

 

 

Total Other Expenses

     (59 )     (60 )     (171 )     (166 )
  

 

 

   

 

 

   

 

 

   

 

 

 

Income from Continuing Operations Before Income Tax Expense

     205       135       384       380  

Income Tax Expense Related to Continuing Operations

     93       55       142       143  
  

 

 

   

 

 

   

 

 

   

 

 

 

Net Income from Continuing Operations

     112       80       242       237  

Income from Discontinued Operations, net of Income Taxes

     —          —          —          1  
  

 

 

   

 

 

   

 

 

   

 

 

 

Net Income

   $ 112     $ 80     $ 242     $ 238  
  

 

 

   

 

 

   

 

 

   

 

 

 

Basic and Diluted Share Information

        

Weighted average shares outstanding – Basic (millions)

     229       226       228       226  
  

 

 

   

 

 

   

 

 

   

 

 

 

Weighted average shares outstanding – Diluted (millions)

     231       226       229       226  
  

 

 

   

 

 

   

 

 

   

 

 

 

Earnings per share of common stock from Continuing Operations – Basic and Diluted

   $ 0.49     $ 0.35     $ 1.06     $ 1.05  

Earnings per share of common stock from Discontinued Operations – Basic and Diluted

     —          —          —          —     
  

 

 

   

 

 

   

 

 

   

 

 

 

Earnings per share – Basic and Diluted

   $ 0.49     $ 0.35     $ 1.06     $ 1.05  
  

 

 

   

 

 

   

 

 

   

 

 

 

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

 

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PEPCO HOLDINGS

 

PEPCO HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2012      2011     2012     2011  
     (millions of dollars)  

Net Income

   $ 112      $ 80     $ 242     $ 238  
  

 

 

    

 

 

   

 

 

   

 

 

 

Other Comprehensive Income (Loss) from Continuing Operations

         

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

         

Gains arising during period

     —           —          —          2  

Amount of losses reclassified into income

     6        16       31       62  
  

 

 

    

 

 

   

 

 

   

 

 

 

Net gains on commodity derivatives

     6        16       31       64  

Losses on treasury rate locks reclassified into income

     1        1       1       1  

Pension and other postretirement benefit plans

     1        (2 )     (4 )     (6 )
  

 

 

    

 

 

   

 

 

   

 

 

 

Other comprehensive income, before income taxes

     8        15       28       59  

Income tax expense related to other comprehensive income

     4        6       12       24  
  

 

 

    

 

 

   

 

 

   

 

 

 

Other comprehensive income, net of income taxes

     4        9       16       35  
  

 

 

    

 

 

   

 

 

   

 

 

 

Comprehensive Income

   $ 116      $ 89     $ 258     $ 273  
  

 

 

    

 

 

   

 

 

   

 

 

 

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

 

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PEPCO HOLDINGS

 

PEPCO HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Unaudited)

 

     September 30,
2012
    December 31,
2011
 
     (millions of dollars)  

ASSETS

    

CURRENT ASSETS

    

Cash and cash equivalents

   $ 114      $ 109   

Restricted cash equivalents

     14       11  

Accounts receivable, less allowance for uncollectible accounts of $42 million and $49 million, respectively

     940       929  

Inventories

     168       132  

Derivative assets

     2       5  

Prepayments of income taxes

     53       74  

Deferred income tax assets, net

     43       59  

Prepaid expenses and other

     153       120  
  

 

 

   

 

 

 

Total Current Assets

     1,487       1,439  
  

 

 

   

 

 

 

INVESTMENTS AND OTHER ASSETS

    

Goodwill

     1,407       1,407  

Regulatory assets

     2,421       2,196  

Investment in finance leases held in trust

     1,226       1,349  

Income taxes receivable

     218       84  

Restricted cash equivalents

     15       15  

Assets and accrued interest related to uncertain tax positions

     76       37  

Derivative assets

     8       —     

Other

     164       163  
  

 

 

   

 

 

 

Total Investments and Other Assets

     5,535       5,251  
  

 

 

   

 

 

 

PROPERTY, PLANT AND EQUIPMENT

    

Property, plant and equipment

     13,349       12,855  

Accumulated depreciation

     (4,749 )     (4,635 )
  

 

 

   

 

 

 

Net Property, Plant and Equipment

     8,600       8,220  
  

 

 

   

 

 

 

TOTAL ASSETS

   $ 15,622     $ 14,910  
  

 

 

   

 

 

 

 

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

 

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PEPCO HOLDINGS

 

PEPCO HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Unaudited)

 

     September 30,
2012
    December 31,
2011
 
     (millions of dollars, except shares)  

LIABILITIES AND EQUITY

    

CURRENT LIABILITIES

    

Short-term debt

   $ 848     $ 732  

Current portion of long-term debt and project funding

     118       112  

Accounts payable and accrued liabilities

     548       549  

Capital lease obligations due within one year

     12       8  

Taxes accrued

     97       110  

Interest accrued

     84       47  

Liabilities and accrued interest related to uncertain tax positions

     9       3  

Derivative liabilities

     13       26  

Other

     274       274  
  

 

 

   

 

 

 

Total Current Liabilities

     2,003       1,861  
  

 

 

   

 

 

 

DEFERRED CREDITS

    

Regulatory liabilities

     528       526  

Deferred income taxes, net

     3,213       2,863  

Investment tax credits

     22       22  

Pension benefit obligation

     299       424  

Other postretirement benefit obligations

     450       469  

Liabilities and accrued interest related to uncertain tax positions

     6       32  

Derivative liabilities

     10       6  

Other

     189       191  
  

 

 

   

 

 

 

Total Deferred Credits

     4,717       4,533  
  

 

 

   

 

 

 

LONG-TERM LIABILITIES

    

Long-term debt

     4,100       3,794  

Transition bonds issued by ACE Funding

     267       295  

Long-term project funding

     12       13  

Capital lease obligations

     70       78  
  

 

 

   

 

 

 

Total Long-Term Liabilities

     4,449       4,180  
  

 

 

   

 

 

 

COMMITMENTS AND CONTINGENCIES (NOTE 15)

    

EQUITY

    

Common stock, $.01 par value, 400,000,000 shares authorized, 229,438,681 and 227,500,190 shares outstanding, respectively

     2       2  

Premium on stock and other capital contributions

     3,369       3,325  

Accumulated other comprehensive loss

     (47 )     (63 )

Retained earnings

     1,129       1,072  
  

 

 

   

 

 

 

Total Equity

     4,453       4,336  
  

 

 

   

 

 

 

TOTAL LIABILITIES AND EQUITY

   $ 15,622      $ 14,910   
  

 

 

   

 

 

 

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

 

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PEPCO HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

     Nine Months  Ended
September 30,
 
     2012     2011  
     (millions of dollars)  

OPERATING ACTIVITIES

    

Net income

   $ 242      $ 238   

Income from discontinued operations

     —          (1 )

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

    

Depreciation and amortization

     343       325  

Non-cash rents from cross-border energy lease investments

     (39 )     (35 )

Gain on early termination of finance leases held in trust

     (39 )     (39 )

Deferred income taxes

     279       165  

Net unrealized (gains) losses on derivatives

     (20 )     11  

Impairment losses

     5       —     

Other

     (11 )     (9 )

Changes in:

    

Accounts receivable

     (26 )     86  

Inventories

     (36 )     (20 )

Prepaid expenses

     (30 )     (14 )

Regulatory assets and liabilities, net

     (104 )     (108 )

Accounts payable and accrued liabilities

     2       (106 )

Pension contributions

     (200 )     (110 )

Pension benefit obligation, excluding contributions

     49       39  

Cash collateral related to derivative activities

     76       5  

Income tax-related prepayments, receivables and payables

     (133 )     (14 )

Interest accrued

     38       34  

Other assets and liabilities

     23       40  

Conectiv Energy net assets held for sale

     —          44  
  

 

 

   

 

 

 

Net Cash From Operating Activities

     419       531  
  

 

 

   

 

 

 

INVESTING ACTIVITIES

    

Investment in property, plant and equipment

     (888 )     (639 )

Department of Energy capital reimbursement awards received

     25       27  

Proceeds from early termination of finance leases held in trust

     202       161  

Changes in restricted cash equivalents

     (2 )     (10 )

Net other investing activities

     1       (10 )
  

 

 

   

 

 

 

Net Cash Used By Investing Activities

     (662 )     (471 )
  

 

 

   

 

 

 

FINANCING ACTIVITIES

    

Dividends paid on common stock

     (185 )     (183 )

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

     40       36  

Redemption of preferred stock of subsidiaries

     —          (6 )

Issuances of long-term debt

     450       235  

Reacquisitions of long-term debt

     (165 )     (60 )

Issuances of short-term debt, net

     116       11  

Cost of issuances

     (8 )     (10 )

Net other financing activities

     —          (1 )
  

 

 

   

 

 

 

Net Cash From Financing Activities

     248       22  
  

 

 

   

 

 

 

Net Increase in Cash and Cash Equivalents

     5       82  

Cash and Cash Equivalents at Beginning of Period

     109       21  
  

 

 

   

 

 

 

CASH AND CASH EQUIVALENTS AT END OF PERIOD

   $ 114     $ 103  
  

 

 

   

 

 

 

SUPPLEMENTAL CASH FLOW INFORMATION

    

Cash received for income taxes, net

   $ (2 )   $ —     

Non-cash activities:

    

Reclassification of property, plant and equipment to regulatory assets

     90       —     

Reclassification of asset removal costs regulatory liability to accumulated depreciation

     61        —     

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

 

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PEPCO HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF EQUITY

(Unaudited)

 

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

BALANCE, DECEMBER 31, 2011

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

Net income

     —           —           —          —          68       68  

Other comprehensive income

     —           —           —          8       —          8  

Dividends on common stock ($0.27 per share)

     —           —           —          —          (61 )     (61 )

Issuance of common stock:

              

Original issue shares, net

     319,037        —           9       —          —          9  

Shareholder DRP original shares

     424,888        —           8       —          —          8  

Net activity related to stock-based awards

     —           —           (2 )     —          —          (2 )
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

BALANCE, MARCH 31, 2012

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

Net income

     —           —           —          —          62       62  

Other comprehensive income

     —           —           —          4       —          4  

Dividends on common stock ($0.27 per share)

     —           —           —          —          (62 )     (62 )

Issuance of common stock:

              

Original issue shares, net

     186,820        —           3       —          —          3  

Shareholder DRP original shares

     420,880        —           8       —          —          8  

Net activity related to stock-based awards

     —           —           3       —          —          3  
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

BALANCE, JUNE 30, 2012

     228,851,815        2         3,354       (51 )     1,079       4,384  

Net income

     —           —           —          —          112       112  

Other comprehensive income

     —           —           —          4       —          4  

Dividends on common stock ($0.27 per share)

     —           —           —          —          (62 )     (62 )

Issuance of common stock:

              

Original issue shares, net

     177,383        —           4       —          —          4  

Shareholder DRP original shares

     409,483        —           8       —          —          8  

Net activity related to stock-based awards

     —           —           3       —          —          3  
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

BALANCE, SEPTEMBER 30, 2012

     229,438,681      $ 2       $ 3,369      $ (47 )   $ 1,129     $ 4,453  
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

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

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

PEPCO HOLDINGS, INC.

(1) ORGANIZATION

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

 

   

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

 

   

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

 

   

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

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

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

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

Power Delivery

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

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

 

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Pepco Energy Services

Pepco Energy Services is engaged in the following businesses:

 

   

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

 

   

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

 

   

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

Pepco Energy Services deactivated its Buzzard Point oil-fired generation facility on May 31, 2012 and its Benning Road oil-fired generation facility on June 30, 2012.

In December 2009, PHI announced the wind-down of the retail energy supply component of the Pepco Energy Services business. Pepco Energy Services is implementing this wind-down by not entering into any new retail energy supply contracts while continuing to perform under its existing supply contracts through their respective expiration dates, the last of which is June 1, 2014. The retail energy supply business has historically generated a substantial portion of the operating revenues and net income of the Pepco Energy Services segment. Operating revenues related to the retail energy supply business for the three months ended September 30, 2012 and 2011 were $77 million and $222 million, respectively, while operating income for the same periods was $13 million and $5 million, respectively. Operating revenues related to the retail energy supply business for the nine months ended September 30, 2012 and 2011 were $349 million and $765 million, respectively, while operating income for the same periods was $44 million and $21 million, respectively.

In connection with the operation of the retail energy supply business, Pepco Energy Services provided letters of credit of less than $1 million and posted net cash collateral of $38 million as of September 30, 2012. These collateral requirements, which are based on existing wholesale energy purchase and sale contracts and current market prices, will decrease as the contracts expire, with the collateral expected to be fully released by June 1, 2014. The energy services business will not be affected by the wind-down of the retail energy supply business.

Other Business Operations

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

Discontinued Operations

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

 

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(2) SIGNIFICANT ACCOUNTING POLICIES

Financial Statement Presentation

Pepco Holdings’ unaudited consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States of America (GAAP). Pursuant to the rules and regulations of the Securities and Exchange Commission, certain information and footnote disclosures normally included in annual consolidated financial statements prepared in accordance with GAAP have been omitted. Therefore, these consolidated financial statements should be read along with the annual consolidated financial statements included in PHI’s annual report on Form 10-K for the year ended December 31, 2011, as amended to include the executive compensation and other information required by Part III of Form 10-K (which information originally had been omitted as permitted by that form). In the opinion of PHI’s management, the consolidated financial statements contain all adjustments (which all are of a normal recurring nature) necessary to state fairly Pepco Holdings’ financial condition as of September 30, 2012, in accordance with GAAP. The year-end December 31, 2011 consolidated balance sheet included herein was derived from audited consolidated financial statements, but does not include all disclosures required by GAAP. Interim results for the three and nine months ended September 30, 2012 may not be indicative of PHI’s results that will be realized for the full year ending December 31, 2012.

Use of Estimates

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

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

Storm Restoration Costs

On June 29, 2012, the respective service territories of Pepco, DPL and ACE were affected by a rapidly moving thunderstorm with hurricane-force winds, known as a “derecho,” which resulted in widespread customer outages in each of the service territories. The derecho caused extensive damage to the electric transmission and distribution systems of Pepco, DPL and ACE. Storm restoration activity commenced immediately following the storm and continued into July 2012, with the majority of the incremental storm restoration costs occurring in the third quarter of 2012.

Total incremental storm restoration costs incurred by PHI through September 30, 2012 were $81 million, with $40 million incurred for repair work and $41 million incurred as capital expenditures. Costs incurred for

 

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repair work of $35 million were deferred as regulatory assets to reflect the probable recovery of these storm restoration costs in Maryland and New Jersey, and $5 million was charged to Other operation and maintenance expense. As of September 30, 2012, total incremental storm restoration costs include $27 million of estimated costs for unbilled restoration services provided by certain outside contractors. Actual costs for these services may vary from the estimates. PHI’s utility subsidiaries will be pursuing recovery of the incremental storm restoration costs in their respective jurisdictions during the next cycle of distribution base rate cases.

General and Auto Liability

During the second quarter of 2011, PHI’s utility subsidiaries reduced their self-insurance reserves for general and auto liability claims by approximately $4 million, based on obtaining an actuarial estimate of the unpaid losses attributed to general and auto liability claims for each of PHI’s utility subsidiaries at June 30, 2011. A similar evaluation was performed in the third quarter of 2012 and no material adjustments were made to these reserves.

Consolidation of Variable Interest Entities

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

ACE Power Purchase Agreements

PHI, through its ACE subsidiary, is a party to three power purchase agreements (PPAs) with unaffiliated, non-utility generators (NUGs) totaling 459 megawatts (MWs). One of the agreements ends in 2016 and the other two end in 2024. As of September 30, 2012, PHI was unable to obtain sufficient information to determine whether these three entities were variable interest entities or if ACE was the primary beneficiary. As a result, PHI applied the scope exemption from the consolidation guidance for enterprises that have not been able to obtain such information.

Net purchase activities with the NUGs for the three months ended September 30, 2012 and 2011 were approximately $56 million and $57 million, respectively, of which approximately $53 million and $55 million, respectively, consisted of power purchases under the PPAs. Net purchase activities with the NUGs for the nine months ended September 30, 2012 and 2011 were approximately $156 million and $169 million, respectively, of which approximately $151 million and $159 million, respectively, consisted of power purchases under the PPAs. The power purchase costs are recoverable from ACE’s customers through regulated rates.

DPL Renewable Energy Transactions

DPL is subject to Renewable Energy Portfolio Standards (RPS) in the state of Delaware that require it to obtain renewable energy credits (RECs) for energy delivered to its customers. DPL’s costs associated with obtaining RECs to fulfill its RPS obligations are recoverable from its customers by law. As of September 30, 2012, PHI, through its DPL subsidiary, has entered into three land-based wind PPAs in the aggregate amount of 128 MWs and one solar PPA with a 10 MW facility. Each of the facilities associated with these PPAs are operational, and DPL is obligated to purchase energy and RECs in amounts generated and delivered by the wind facilities and solar renewable energy credits (SRECs) from the solar facility up to certain amounts (as set forth below) at rates that are primarily fixed under the PPAs. PHI has concluded that consolidation is not required for any of these PPAs under the FASB guidance on the consolidation of variable interest entities.

DPL is obligated to purchase energy and RECs from one of the wind facilities through 2024 in amounts not to exceed 50 MWs, from the second wind facility through 2031 in amounts not to exceed 40 MWs, and from the

 

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third wind facility through 2031 in amounts not to exceed 38 MWs, in each case at the rates primarily fixed by the PPA. DPL’s purchases under the three wind PPAs totaled $4 million and $3 million for the three months ended September 30, 2012 and 2011, respectively, and $20 million and $12 million for the nine months ended September 30, 2012 and 2011, respectively.

The term of the agreement with the solar facility is 20 years and DPL is obligated to purchase SRECs in an amount up to 70 percent of the energy output at a fixed price. DPL’s purchases under the solar agreement were $1 million and $2 million for the three and nine months ended September 30, 2012, respectively.

On October 18, 2011, the Delaware Public Service Commission (DPSC) approved a tariff submitted by DPL in accordance with the requirements of the RPS specific to fuel cell facilities totaling 30 MWs to be constructed by a qualified fuel cell provider. The tariff and the RPS establish that DPL would be an agent to collect payments in advance from its distribution customers and remit them to the qualified fuel cell provider for each MW hour (MWh) of energy produced by the fuel cell facilities over 21 years. DPL would have no liability to the qualified fuel cell provider other than to remit payments collected from its distribution customers pursuant to the tariff. The RPS provides for a reduction in DPL’s REC requirements based upon the actual energy output of the facilities. In June 2012, a 3 MW fuel cell generation facility was placed into service under the tariff. DPL billed less than $1 million to distribution customers during the three and nine months ended September 30, 2012. A 27 MW fuel cell generation facility is expected to be placed into service in 5 MW increments beginning in January 2013. DPL is accounting for this arrangement as an agency transaction.

Atlantic City Electric Transition Funding LLC

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

ACE Standard Offer Capacity Agreements

In April 2011, ACE entered into three Standard Offer Capacity Agreements (SOCAs) by order of the NJBPU, each with a different generation company. The SOCAs were established under a New Jersey law enacted to promote the construction of qualified electric generation facilities in New Jersey. The SOCAs are 15-year, financially settled transactions approved by the NJBPU that allow generation companies to receive payments from, or require them to make payments to, ACE based on the difference between the fixed price in the SOCAs and the price for capacity that clears PJM Interconnection, LLC (PJM). Each of the other electric distribution companies (EDCs) in New Jersey has entered into SOCAs having the same terms with the same generation companies. The annual share of payments to or receipts by ACE and the other EDCs is based upon each company’s annual proportion of the total New Jersey load attributable to all EDCs, which is currently estimated to be approximately 15 percent for ACE. The NJBPU has approved full recovery from distribution customers of payments made by ACE and the other EDCs, and distribution customers would be entitled to any payments received from the generation companies. For additional discussion about the SOCAs, see Note (7), “Regulatory Matters.”

 

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In May 2012, all three generation companies under the SOCAs bid into the PJM 2015-2016 capacity auction and two of the generators cleared that capacity auction. ACE recorded a derivative asset (liability) for the estimated fair value of each SOCA and recorded an offsetting regulatory liability (asset) as described in more detail in Note (13), “Derivative Instruments and Hedging Activities,” and Note (14), “Fair Value Disclosures.” FASB guidance on derivative accounting and the accounting for regulated operations would apply to ACE’s obligations under the third SOCA once the related capacity has cleared a PJM auction. The next PJM capacity auction is scheduled for May 2013. PHI has concluded that consolidation is not required for the SOCAs under the FASB guidance on the consolidation of variable interest entities.

Goodwill

Goodwill represents the excess of the purchase price of an acquisition over the fair value of the net assets acquired at the acquisition date. Substantially all of Pepco Holdings’ goodwill was generated by Pepco’s acquisition of Conectiv (now Conectiv, LLC (Conectiv)) in 2002 and is allocated entirely to Power Delivery for purposes of impairment testing based on the aggregation of its components because its utilities have similar characteristics. Pepco Holdings tests its goodwill for impairment annually as of November 1 and whenever an event occurs or circumstances change in the interim that would more likely than not reduce the fair value of a reporting unit below the carrying amount of its net assets. Factors that may result in an interim impairment test include, but are not limited to: a change in the identified reporting units; an adverse change in business conditions; a protracted decline in PHI’s stock price causing market capitalization to fall below book value; an adverse regulatory action; or an impairment of long-lived assets in the reporting unit. PHI concluded that an interim impairment test was not required during the nine months ended September 30, 2012.

Taxes Assessed by a Governmental Authority on Revenue-Producing Transactions

Taxes included in Pepco Holdings’ gross revenues were $110 million and $111 million for the three months ended September 30, 2012 and 2011, respectively, and $293 million and $302 million for the nine months ended September 30, 2012 and 2011, respectively.

Reclassifications and Adjustments

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

Pepco Energy Services Derivative Accounting Reclassifications and Adjustments

In the third quarter of 2012, PHI recorded an adjustment to reclassify certain 2011 mark-to-market losses from Operating revenue to Fuel and purchased energy expenses for Pepco Energy Services. The reclassification resulted in an increase in Operating revenue and an increase in Fuel and purchased energy expenses of $5 million and $12 million for the three and nine months ended September 30, 2011, respectively. This reclassification did not result in a change to net income.

During the first quarter of 2011, PHI recorded an adjustment associated with an increase in the value of certain derivatives from October 1, 2010 to December 31, 2010, which had been erroneously recorded in other comprehensive income at December 31, 2010. This adjustment resulted in an increase in revenue and pre-tax earnings of $2 million for the nine months ended September 30, 2011.

 

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DPL Operating Revenue Adjustment

In the second quarter of 2012, DPL recorded an adjustment to correct an overstatement of unbilled revenue in its natural gas distribution business related to prior periods. The adjustment resulted in a decrease in Operating revenue of $1 million for the nine months ended September 30, 2012.

DPL Default Electricity Supply Revenue and Cost Adjustments

During 2011, DPL recorded adjustments to correct certain errors associated with the accounting for Default Electricity Supply revenue and costs. These adjustments primarily arose from the under-recognition of allowed returns on the cost of working capital and resulted in a pre-tax decrease in Other operation and maintenance expense of $1 million and $9 million for the three and nine months ended September 30, 2011, respectively.

Income Tax Expense Adjustments

During the first quarter of 2011, Pepco recorded an adjustment to correct certain income tax errors related to prior periods associated with interest on uncertain tax positions. The adjustment resulted in an increase in Income tax expense of $1 million for the nine months ended September 30, 2011.

During the second quarter of 2011, ACE completed a reconciliation of its deferred taxes associated with certain regulatory assets and recorded adjustments that resulted in an increase to Income tax expense of $1 million for the nine months ended September 30, 2011.

(3) NEWLY ADOPTED ACCOUNTING STANDARDS

Fair Value Measurements and Disclosures (ASC 820)

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

Comprehensive Income (ASC 220)

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

Goodwill (ASC 350)

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

 

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(4) RECENTLY ISSUED ACCOUNTING STANDARDS, NOT YET ADOPTED

Balance Sheet (ASC 210)

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

(5) SEGMENT INFORMATION

Pepco Holdings’ management has identified its operating segments at September 30, 2012 as Power Delivery, Pepco Energy Services and Other Non-Regulated. In the tables below, the Corporate and Other column is included to reconcile the segment data with consolidated data and includes unallocated Pepco Holdings’ (parent company) capital costs, such as financing costs. Segment financial information for continuing operations for the three and nine months ended September 30, 2012 and 2011 is as follows:

 

     Three Months Ended September 30, 2012  
     (millions of dollars)  
     Power
Delivery
     Pepco
Energy
Services
    Other
Non-
Regulated
    Corporate
and
Other  (a)
    PHI
Consolidated
 

Operating Revenue

   $ 1,335      $ 131     $ 13     $ (3   $ 1,476   

Operating Expenses (b)

     1,136        125 (c)     (38 )(d)     (11     1,212   

Operating Income

     199         6       51       8       264   

Interest Income

     —           1       1       (2     —     

Interest Expense

     56         —          3       9       68   

Other Income (Expenses)

     8         1       (1 )     1       9   

Preferred Stock Dividends

     —           —          1       (1     —     

Income Tax Expense

     59         3       31 (e)     —          93   

Net Income (Loss) from Continuing Operations

     92         5       16 (d)     (1     112   

Total Assets

     12,039         442       1,483       1,658       15,622   

Construction Expenditures

   $ 289       $ 1     $ —        $ 9     $ 299   

 

(a) Total Assets in this column includes Pepco Holdings’ goodwill balance of $1.4 billion, all of which is allocated to Power Delivery for purposes of assessing impairment. Total assets also include capital expenditures related to certain hardware and software expenditures which primarily benefit Power Delivery. These expenditures are recorded as incurred in the Corporate and Other segment and are allocated to Power Delivery once the assets are placed in service. Corporate and Other includes intercompany amounts of $(3) million for Operating Revenue, $(4) million for Operating Expenses, $(7) million for Interest Income, $(5) million for Interest Expense and $(1) million for Preferred Stock Dividends.
(b) Includes depreciation and amortization expense of $122 million, consisting of $114 million for Power Delivery, $2 million for Pepco Energy Services and $6 million for Corporate and Other.
(c) Includes impairment losses of $2 million pre-tax ($1 million after-tax) at Pepco Energy Services associated with the combustion turbines at Buzzard Point.
(d) Includes $39 million pre-tax ($9 million after-tax) gain from the early termination of finance leases held in trust.
(e) Includes a $16 million reversal of previously recognized tax benefits associated with the early termination of finance leases held in trust.

 

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     Three Months Ended September 30, 2011  
     (millions of dollars)  
     Power
Delivery
     Pepco
Energy
Services
     Other
Non-
Regulated
    Corporate
and
Other  (a)
    PHI
Consolidated
 

Operating Revenue

   $ 1,329      $ 317       $ 7      $ (5   $ 1,648   

Operating Expenses (b)

     1,167        305         2        (21     1,453   

Operating Income

     162         12         5        16       195   

Interest Income

     1         1         —          (2     —     

Interest Expense

     53         1         3        7       64   

Other Income (Expenses)

     7         1         (3 )     (1     4   

Preferred Stock Dividends

     —           —           1        (1     —     

Income Tax Expense (Benefit)

     51         5         (7 )     6       55   

Net Income from Continuing Operations

     66         8         5        1       80   

Total Assets (excluding Assets Held For Sale)

     11,015         611         1,467        1,475       14,568   

Construction Expenditures

   $ 239       $ 4       $ —        $ 9     $ 252   

 

(a) Total Assets in this column includes Pepco Holdings’ goodwill balance of $1.4 billion, all of which is allocated to Power Delivery for purposes of assessing impairment. Total assets also include capital expenditures related to certain hardware and software expenditures which primarily benefit Power Delivery. These expenditures are recorded as incurred in the Corporate and Other segment and are allocated to Power Delivery once the assets are placed in service. Corporate and Other includes intercompany amounts of $(5) million for Operating Revenue, $(6) million for Operating Expenses, $(7) million for Interest Income, $(6) million for Interest Expense and $(1) million for Preferred Stock Dividends.
(b) Includes depreciation and amortization expense of $115 million, consisting of $107 million for Power Delivery, $4 million for Pepco Energy Services and $4 million for Corporate and Other.

 

     Nine Months Ended September 30, 2012  
     (millions of dollars)  
     Power
Delivery
     Pepco
Energy
Services
    Other
Non-
Regulated
    Corporate
and
Other  (a)
    PHI
Consolidated
 

Operating Revenue

   $ 3,374      $ 544      $ 40     $ (11 )   $ 3,947  

Operating Expenses (b)

     2,950        507 (c)     (35 )(d)      (30 )     3,392  

Operating Income

     424        37       75       19       555  

Interest Income

     —           1       3       (4 )     —     

Interest Expense

     162        1       10       25       198  

Other Income

     24        1       —          2       27  

Preferred Stock Dividends

     —           —          2       (2 )     —     

Income Tax Expense

     93        15       33 (e)      1       142  

Net Income (Loss) from Continuing Operations

     193        23       33 (d)      (7 )     242  

Total Assets

     12,039        442       1,483       1,658       15,622  

Construction Expenditures

   $ 854      $ 11     $ —        $ 23     $ 888  

 

(a) Total Assets in this column includes Pepco Holdings’ goodwill balance of $1.4 billion, all of which is allocated to Power Delivery for purposes of assessing impairment. Total assets also include capital expenditures related to certain hardware and software expenditures which primarily benefit Power Delivery. These expenditures are recorded as incurred in the Corporate and Other segment and are allocated to Power Delivery once the assets are placed in service. Corporate and Other includes intercompany amounts of $(11) million for Operating Revenue, $(11) million for Operating Expenses, $(18) million for Interest Income, $(15) million for Interest Expense and $(2) million for Preferred Stock Dividends.
(b) Includes depreciation and amortization expense of $343 million, consisting of $313 million for Power Delivery, $12 million for Pepco Energy Services, $1 million for Other Non-Regulated and $17 million for Corporate and Other.
(c) Includes impairment losses of $5 million pre-tax ($3 million after-tax) at Pepco Energy Services associated primarily with an investment in a landfill gas-fired electric generation facility, and the combustion turbines at Buzzard Point.
(d) Includes $39 million pre-tax ($9 million after-tax) gain from the early termination of finance leases held in trust.
(e) Includes a $16 million reversal of previously recognized tax benefits associated with the early termination of finance leases held in trust.

 

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     Nine Months Ended September 30, 2011  
     (millions of dollars)  
     Power
Delivery
     Pepco
Energy
Services
     Other
Non-
Regulated
    Corporate
and
Other  (a)
    PHI
Consolidated
 

Operating Revenue

   $ 3,671      $ 1,005      $ 35     $ (13 )   $ 4,698  

Operating Expenses (b)

     3,255        964        (34 )(c)      (33 )     4,152  

Operating Income

     416        41        69       20       546  

Interest Income

     1         1        2       (4 )     —     

Interest Expense

     155        3        10       21       189  

Other Income (Expenses)

     23        3        (4 )     1       23  

Preferred Stock Dividends

     —           —           2       (2 )     —     

Income Tax Expense (d)

     100        16        25       2       143  

Net Income (Loss) from Continuing Operations

     185        26        30 (c)      (4 )     237  

Total Assets (excluding Assets Held For Sale)

     11,015        611        1,467       1,475       14,568   

Construction Expenditures

   $ 603      $ 11      $ —        $ 25     $ 639  

 

(a) Total Assets in this column includes Pepco Holdings’ goodwill balance of $1.4 billion, all of which is allocated to Power Delivery for purposes of assessing impairment. Total assets also include capital expenditures related to certain hardware and software expenditures which primarily benefit Power Delivery. These expenditures are recorded as incurred in the Corporate and Other segment and are allocated to Power Delivery once the assets are placed in service. Corporate and Other includes intercompany amounts of $(13) million for Operating Revenue, $(12) million for Operating Expenses, $(17) million for Interest Income, $(15) million for Interest Expense and $(2) million for Preferred Stock Dividends.
(b) Includes depreciation and amortization expense of $325 million, consisting of $301 million for Power Delivery, $13 million for Pepco Energy Services, $1 million for Other Non-Regulated and $10 million for Corporate and Other.
(c) Includes $39 million pre-tax ($3 million after-tax) gain from the early termination of finance leases held in trust.
(d) Includes tax benefits of $14 million for Power Delivery primarily associated with an interest benefit related to federal tax liabilities and a $22 million reversal of previously recognized tax benefits for Other Non-Regulated associated with the early termination of finance leases held in trust.

(6) GOODWILL

PHI’s goodwill balance of $1.4 billion was unchanged during the nine months ended September 30, 2012. Substantially all of PHI’s goodwill balance was generated by Pepco’s acquisition of Conectiv in 2002 and is allocated entirely to the Power Delivery reporting unit based on the aggregation of its regulated public utility company components for purposes of assessing impairment under FASB guidance on goodwill and other intangibles (ASC 350).

PHI’s annual impairment test as of November 1, 2011 indicated that goodwill was not impaired. For the nine months ended September 30, 2012, PHI concluded that there were no events requiring it to perform an interim goodwill impairment test. PHI will perform its next annual impairment test as of November 1, 2012.

(7) REGULATORY MATTERS

Rate Proceedings

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

 

 

A bill stabilization adjustment (BSA) was approved and implemented for Pepco and DPL electric service in Maryland and for Pepco electric service in the District of Columbia. The Maryland Public Service Commission (MPSC) later modified the BSA in Maryland so that revenues lost as a result of major storm outages are not collected through the BSA if electric service is not restored to the pre-major storm levels within 24 hours of the start of a major storm. For further information on the BSA in Maryland, see “Maryland – BSA Proceeding” below.

 

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A modified fixed variable rate design (MFVRD) has been approved in concept for DPL electric and natural gas service in Delaware, but the implementation has been deferred by the DPSC pending the development of an implementation plan and a customer education plan, as well as the resolution of various matters relating to development of a statewide energy efficiency plan and attendant legislation.

 

 

In New Jersey, a BSA proposed by ACE in 2009 was not approved and there is no BSA proposal currently pending.

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

In an effort to reduce the shortfall in revenues due to the delay in time or lag between when costs are incurred and when they are reflected in rates (regulatory lag), Pepco and DPL proposed, in each of their respective jurisdictions, (i) a reliability investment recovery mechanism (RIM) to recover reliability-related capital expenditures incurred between base rate cases, and (ii) the use of fully forecasted test years in future rate cases (which are comprised of forward-looking costs in lieu of historical test years, and if approved, would be more reflective of current costs and would mitigate the effects of regulatory lag). The status of these proposals is discussed below in connection with the discussions of Pepco’s and DPL’s respective electric distribution base rate proceedings.

Delaware

Gas Cost Rates

DPL makes an annual Gas Cost Rate (GCR) filing with the DPSC for the purpose of allowing DPL to recover natural gas procurement costs through customer rates. In August 2011, DPL made its 2011 GCR filing. The filing includes the second year of the effect of a two-year amortization of under-recovered gas costs proposed by DPL in its 2010 GCR filing (the settlement approved by the DPSC in its 2010 GCR case included only the first year of the proposed two-year amortization). The rates proposed in the 2011 GCR would result in a GCR decrease of approximately 5.6%. On August 21, 2012, the DPSC issued a final order approving the rates as filed.

In August 2012, DPL made its 2012 GCR filing. The rates proposed in the 2012 GCR would result in a GCR decrease of approximately 22.3%. On September 18, 2012, the DPSC issued an order allowing DPL to place the new rates into effect on November 1, 2012, subject to refund and pending final DPSC approval.

Electric Distribution Base Rates

On December 2, 2011, DPL submitted an application with the DPSC to increase its electric distribution base rates. The filing sought approval of an annual rate increase of approximately $31.8 million, based on a requested return on equity (ROE) of 10.75%, and requested approval of implementation of the MFVRD. The filing included a request for DPSC approval of a RIM and the use of fully forecasted test years in future DPL rate cases. On January 10, 2012, the DPSC entered an order suspending the full increase and allowing a temporary rate increase of $2.5 million to go into effect on January 31, 2012, subject to refund and pending final DPSC approval. On July 3, 2012, in accordance with an agreement with DPSC staff, DPL placed an additional $22.3 million of the requested rate increase into effect, also subject to refund and pending final DPSC order. On August 17, 2012, DPL and the other parties to the proceeding entered into a proposed settlement

 

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that provides for an annual rate increase of $22 million, based on an ROE of 9.75%. The settlement agreement also permits DPL to collect from its standard offer service (SOS) customers (retail customers who do not elect to purchase electricity from a competitive supplier but instead purchase such electricity from DPL at regulated rates) approximately $3.4 million related to various state and local taxes that were assessed upon DPL’s SOS customers, but actually paid by DPL rather than by the SOS customers upon whom they were assessed. These taxes would be collected over a three-year period. In addition, the settlement agreement allows for the phase-in of the recovery of costs associated with DPL’s advanced metering infrastructure (AMI) project. The settlement agreement does not include approval of a RIM or the use of fully forecasted test years in future DPL rate cases, but it does provide that the parties will meet and discuss alternate regulatory methodologies for the mitigation of regulatory lag. The settlement agreement is subject to approval by the DPSC. Once approved by the DPSC, DPL will refund the billed amounts that exceeded the increase approved by the DPSC. DPL expects the DPSC to issue a decision on the settlement agreement in the fourth quarter of 2012.

District of Columbia

On July 8, 2011, Pepco filed an application with the District of Columbia Public Service Commission (DCPSC) to increase its electric distribution base rates by approximately $42 million annually, based on a requested ROE of 10.75%, of which approximately $9 million was sought so that Pepco could recover its costs associated with the AMI project. The filing included a request for DCPSC approval of a RIM and the use of fully forecasted test years in future Pepco rate cases. On September 26, 2012, the DCPSC issued its decision approving a rate increase of $24 million, based on an ROE of 9.5%, of which approximately $9 million allows Pepco to recover costs associated with the AMI project. The DCPSC denied Pepco’s request for approval of a RIM, and reserved final judgment on the appropriateness of the use by Pepco of a fully forecasted test year in future rate cases. In addition, the DCPSC approved an adjustment by Pepco to normalize operation and maintenance expenses associated with storm restoration efforts to its three-year average, but added approximately $2 million of costs associated with Hurricane Irene from August 2011 in the calculation of the three-year average storm costs. On October 31, 2012, the District of Columbia Office of the People’s Counsel filed a motion with the DCPSC for reconsideration of a portion of the order, objecting to (i) the percentage of the rate increase allocated to residential customers, and (ii) the decision not to adjust Pepco’s base rates downward because of the quality and reliability of Pepco’s electric distribution service. Pepco also filed a motion for reconsideration and clarification on that date (i) objecting to provisions requiring Pepco to perform studies and report certain information three months in advance of its next base rate case filing, and (ii) requesting clarification concerning the timing of certain reporting requirements. The filing of these motions does not stay the order or delay the rate increase from going into effect.

Maryland

DPL Electric Distribution Base Rates

On December 9, 2011, DPL submitted an application with the MPSC to increase its electric distribution base rates. The filing sought approval of an annual rate increase of approximately $25.2 million (subsequently reduced by DPL to $23.5 million), based on a requested ROE of 10.75%. The filing included a request for MPSC approval of a RIM and the use of fully forecasted test years in future DPL rate cases. On July 20, 2012, the MPSC issued an order approving an annual rate increase of approximately $11.3 million, based on an ROE of 9.81%. The MPSC reduced DPL’s depreciation rates, which is expected to lower annual depreciation and amortization expenses by an estimated $4.1 million. The order did not approve DPL’s request to implement a RIM and did not endorse the use by DPL of fully forecasted test years in future rate cases. The order also authorizes DPL to recover in rates over a five-year period $4.3 million of the $4.6 million of incremental storm restoration costs associated with Hurricane Irene that had been deferred previously as a regulatory asset by DPL. The new revenue rates and lower depreciation rates were effective on July 20, 2012. DPL has determined not to appeal the MPSC order.

Pepco Electric Distribution Base Rates

On December 16, 2011, Pepco submitted an application with the MPSC to increase its electric distribution base rates. The filing sought approval of an annual rate increase of approximately $68.4 million (subsequently reduced by Pepco to $66.2 million), based on a requested ROE of 10.75%. The filing included a request for MPSC approval of a RIM and the use of fully forecasted test years in future Pepco rate cases. On July 20, 2012, the MPSC issued an order approving an annual rate increase of approximately $18.1 million, based on an ROE of 9.31%. The MPSC also directed Pepco to reduce the amount of the rate increase by approximately $1.6 million, the annual costs of certain energy advisory programs, resulting in a final rate increase of approximately $16.5 million. Pepco would be required to seek recovery of these annual costs through the EmPower

 

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Maryland Program. The MPSC reduced Pepco’s depreciation rates, which is expected to lower annual depreciation and amortization expenses by an estimated $27.3 million. The order did not approve Pepco’s request to implement a RIM and did not endorse the use by Pepco of fully forecasted test years in future rate cases. The order authorizes Pepco to recover in rates over a five-year period $18.5 million of incremental storm restoration costs associated with major weather events in 2011, including $9.7 million of the $9.9 million of incremental storm restoration costs associated with Hurricane Irene that had been deferred previously as a regulatory asset by Pepco and $8.8 million of incremental storm restoration costs incurred by Pepco associated with a severe winter storm in the first quarter of 2011 that had been expensed previously through other operation and maintenance expense in 2011. The incremental storm restoration costs of $8.8 million were reversed and deferred as a regulatory asset in the third quarter of 2012. The order also authorizes Pepco to recover the actual cost of AMI meters installed during the test year and states that cost recovery for AMI deployment will only be allowed in future rate cases in which Pepco demonstrates that the system is proven to be cost effective. The new revenue rates and lower depreciation rates were effective on July 20, 2012. Pepco has determined not to appeal the MPSC order. The Maryland Office of People’s Counsel has sought rehearing on the portion of the order allowing Pepco to recover the costs of installed AMI meters; that motion remains pending.

BSA Proceeding

As in effect for electric utilities in Maryland prior to October 26, 2012, including Pepco and DPL, a utility was not permitted to collect through the BSA distribution revenues lost as a result of major storm outages, beginning 24 hours after the commencement of a major storm, if electric service is not restored to the pre-major storm levels within 24 hours of the start of the storm. On October 26, 2012, the MPSC issued an order that no longer permits certain Maryland utilities, including Pepco and DPL, to collect a BSA surcharge for revenues lost during the first 24 hours of a major storm.

New Jersey

Electric Distribution Base Rates

On August 5, 2011, ACE filed a petition with the NJBPU to increase its electric distribution rates by the net amount of approximately $54.6 million (which was increased to approximately $74.3 million on February 24, 2012, to reflect the 2011 test year), based on a requested ROE of 10.75%. The modified net increase consists of a rate increase proposal of approximately $90.3 million, less a deduction from base rates of approximately $16 million through a credit rider expected to expire August 31, 2013, which is designed to refund to customers certain excess depreciation reserve funds as previously directed by the NJBPU (the Excess Depreciation Rider). ACE also proposed an increase of approximately $6.3 million in sales-and-use taxes related to the increase in base rates. On October 23, 2012, the NJBPU approved a stipulation of settlement signed by the parties (the New Jersey Settlement), which provides for an annual increase in ACE’s electric distribution base rates by the net amount of approximately $28 million, based on an ROE that, as part of the overall settlement, is deemed to be 9.75%. The net increase consists of a rate increase of approximately $44 million, less a deduction from base rates of approximately $16 million through the Excess Depreciation Rider. Upon expiration of the Excess Depreciation Rider, ACE will not realize an increase in operating income because the resulting increase in revenues will be offset by a substantially similar increase in depreciation expense. The New Jersey Settlement also provides for an increase of approximately $2 million in sales-and-use taxes related to the increase in base rates, and allows ACE to fully amortize over a three-year period the approximately $7.7 million in costs incurred as a result of Hurricane Irene in August 2011. The new rates will become effective for utility services rendered on and after November 1, 2012.

 

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Infrastructure Investment Program

In July 2009, the NJBPU approved certain rate recovery mechanisms in connection with ACE’s Infrastructure Investment Program (the IIP). In exchange for the increase in infrastructure investment, the NJBPU, through the IIP, allowed recovery by ACE of its infrastructure investment capital expenditures through a special rate outside the normal rate recovery mechanism of a base rate filing. The IIP was designed to stimulate the New Jersey economy and provide incremental employment in ACE’s service territory by increasing the infrastructure expenditures to a level above otherwise normal budgeted levels. In an October 18, 2011 petition (subsequently amended December 16, 2011) filed with the NJBPU, ACE requested an extension and expansion to the IIP. The New Jersey Settlement provides for full cost recovery of ACE’s initial IIP, but requires ACE to withdraw its request for extension and expansion to the IIP, without prejudice to file such request again in the future.

Update and Reconciliation of Certain Under-Recovered Balances

In February 2012, ACE filed a petition with the NJBPU seeking to reconcile and update (i) charges related to the recovery of above-market costs associated with ACE’s long-term power purchase contracts with the NUGs, (ii) costs related to surcharges that fund several statewide social programs and ACE’s uncollected accounts, and (iii) operating costs associated with ACE’s residential appliance cycling program. The filing proposed to recover the projected deferred under-recovered balance related to the NUGs of $113.8 million as of May 31, 2012 through a four-year amortization schedule. The net impact of adjusting the charges as proposed (consisting of both the annual impact of the proposed four-year amortization of the historical under-recovered NUG balances and the going-forward cost recovery of all the other charges for the period June 1, 2012 through May 31, 2013, and including associated changes in sales-and-use taxes) is an overall annual rate increase of approximately $55.3 million. On June 18, 2012, the NJBPU approved a stipulation of settlement signed by the parties, which provided for provisional rates to go into effect on July 1, 2012. The rates are deemed “provisional” because ACE’s filing will not be updated for actual revenues and expenses (if necessary) for May and June 2012 until after July 1, 2012 and a review of the final underlying costs for reasonableness and prudency will be completed after such filing.

MPSC New Generation Contract Requirement

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

In April 2012, the MPSC issued an order determining that there is a need for one new power plant in the range of 650 to 700 MW beginning in 2015. The order requires certain Maryland EDCs, including Pepco and DPL, to negotiate and enter into a contract with the winning bidder of a competitive bidding process in amounts proportional to their relative SOS loads. Under the contract, the winning bidder will construct a 661 MW natural gas-fired combined cycle generation plant in Waldorf, Maryland, with an expected commercial operation date of June 1, 2015. The order acknowledges certain of the EDCs’ concerns about the requirements of the contract and directs them to negotiate with the winning bidder and submit any proposed changes in the contract to the MPSC for approval. The order further specifies that the EDCs entering into the contract will recover the associated costs, in amounts proportional to their relative SOS loads, through surcharges on their respective SOS customers.

Until the final form of the contract with the winning bidder and associated cost recovery are approved, PHI cannot predict (i) the extent of the negative effect that the order and, once finalized, the contract for new generation, may have on PHI’s, Pepco’s and DPL’s balance sheets, as well as their respective credit metrics, as calculated by independent rating agencies that evaluate and rate PHI, Pepco and DPL and each of their debt issuances, (ii) the effect on Pepco’s and DPL’s ability to recover their associated costs of the contract for new

 

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generation if a significant number of SOS customers elect to buy their energy from alternative energy suppliers, and (iii) the effect of the order on the financial condition, results of operations and cash flows of each of PHI, Pepco and DPL.

On April 27, 2012, a group of generating companies operating in the PJM region filed a complaint in the U.S. District Court for the Northern District of Maryland challenging the MPSC’s order on the grounds that it violates the Commerce Clause and the Supremacy Clause of the U.S. Constitution. On May 4, 2012, Pepco, DPL, and other parties filed notices of appeal in circuit courts in Maryland requesting judicial review of the MPSC’s order. These appeals have been consolidated in the Circuit Court for Baltimore City and are set for hearing on January 24, 2013.

Maryland Governor’s Grid Resiliency Task Force

In July 2012, the Maryland governor signed an Executive Order directing his energy advisor, in collaboration with certain state agencies, to solicit input and recommendations from experts on how to improve the resiliency and reliability of the electric distribution system in Maryland. The resulting Grid Resiliency Task Force issued its report in September 2012, in which the Task Force made 11 recommendations. The governor forwarded the report to the MPSC in October 2012, urging the MPSC to quickly implement the first four recommendations: (i) strengthen existing reliability and storm restoration regulations; (ii) accelerate the investment necessary to meet the enhanced metrics; (iii) allow surcharge recovery for the accelerated investment; and (iv) implement clearly defined performance metrics into the traditional ratemaking scheme. Pepco and DPL are currently evaluating the report and its recommendations to determine what effect, if any, they may have on proposals to be made in their future electric distribution base rate cases in Maryland. The form and substance of any such proposals will also depend, in part, on how the MPSC responds to the report and the governor’s request.

ACE Standard Offer Capacity Agreements

In April 2011, ACE entered into three SOCAs by order of the NJBPU, each with a different generation company, as more fully described in Note (2), “Significant Accounting Policies – Consolidation of Variable Interest Entities – ACE Standard Offer Capacity Agreements” and Note (13), “Derivative Instruments and Hedging Activities.” ACE and the other New Jersey EDCs entered into the SOCAs under protest based on concerns about the potential cost to distribution customers. In May 2011, the NJBPU denied a joint motion for reconsideration of its order requiring each of the EDCs to enter into the SOCAs. In June 2011, ACE and the other EDCs filed appeals related to the NJBPU orders with the Appellate Division of the New Jersey Superior Court. On March 5, 2012, the court remanded the case to the NJBPU with instructions to refer the case to an Administrative Law Judge for further consideration. The matter has been transmitted by the NJBPU to the Office of Administrative Law and remains pending.

In February 2011, ACE joined other plaintiffs in an action filed in the U.S. District Court for the District of New Jersey challenging the constitutionality of the New Jersey law under which the SOCAs were established. On September 28, 2012, the District Court denied motions for summary judgment filed by ACE and the other plaintiffs, as well as cross-motions filed by defendants. The litigation remains pending.

In October 2011 and January 2012, respectively, two of the three generation companies sent notices of dispute under the SOCA to ACE. The notices of dispute alleged that certain actions taken by PJM will have an adverse effect on the generation company’s ability to clear their transactions in the PJM auction, which is required for payment under the SOCA. The two generation companies filed separate petitions with the NJBPU seeking to amend their respective SOCAs and, in April 2012, the NJBPU issued an order consolidating the two matters. In May 2012, the NJBPU denied all of the generation companies’ requests without prejudice to their right to raise the issues at a later date.

 

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Termination of the MAPP Project

In 2007, PJM (the regional transmission organization that is responsible for planning the transmission grid and coordinating the movement of wholesale electricity within a region consisting of all or parts of 13 states and the District of Columbia) directed PHI to construct a high-voltage interstate transmission line to address the reliability needs of the region’s transmission system. In its most recent configuration, the transmission line, which PHI referred to as the Mid-Atlantic Power Pathway (MAPP), would have covered 152 miles, originating at the Possum Point substation in northern Virginia, traversing under the Chesapeake Bay and ending at the Indian River substation in Delaware.

On August 24, 2012, the board of PJM notified PHI, on behalf of its subsidiaries Pepco and DPL, that the MAPP project has been terminated and removed from PJM’s regional transmission expansion plan.

As a result of PJM’s decision, on October 2, 2012, Pepco and DPL filed with the MPSC a notice withdrawing their pending applications related to the MAPP project. PHI had included in its five-year projected capital expenditures $205 million of MAPP-related expenditures for the period from 2012 to 2016. PHI has updated its five-year projected capital expenditures to remove MAPP-related expenditures to reflect the PJM decision.

As of September 30, 2012, PHI’s total capital expenditures for the MAPP project were approximately $101 million. Under the terms of the Federal Energy Regulatory Commission (FERC) order approving an incentive rate for the MAPP project, FERC authorized the recovery of abandoned costs prudently incurred in connection with the MAPP project. Consistent with this order, PHI intends to seek recovery of abandoned MAPP capital expenditures through a filing expected to be submitted to the FERC in the fourth quarter of 2012. The FERC filing is expected to address, among other things, the period over which the abandoned costs are to be recovered and the rate of return on these costs during the recovery period. Under an order issued by the FERC in 2008, PHI has been allowed to include its MAPP capital expenditures in its rate base, earning an incentive rate of return of 12.8% during the construction period.

As of September 30, 2012, PHI had placed in service $11 million of its total capital expenditures with respect to the MAPP project, which represented upgrades of existing substation assets that were expected to support the MAPP transmission line, and reclassified the remaining $90 million of capital expenditures to a regulatory asset. The regulatory asset includes the costs of land, land rights, supplies and materials, engineering and design, environmental services, and project management and administration. PHI intends to reduce the regulatory asset by any amounts recovered from the sale or alternative use of the land, land rights, supplies and materials.

(8) LEASING ACTIVITIES

Investment in Finance Leases Held in Trust

PHI has a portfolio of cross-border energy lease investments (the lease portfolio) consisting of hydroelectric generation facilities, coal-fired electric generation facilities and natural gas distribution networks located outside of the United States. Each lease investment is comprised of a number of leases. As of September 30, 2012 and December 31, 2011, the lease portfolio consisted of six and seven investments with an aggregate book value of $1.2 billion and $1.3 billion, respectively.

During the third quarter of 2012, PHI entered into early termination agreements with two lessees involving all of the leases comprising one of the seven remaining lease investments. The early terminations of the leases were negotiated at the request of the lessees and were completed in September 2012. PHI received net cash proceeds of $202 million (net of a termination payment of $520 million used to retire the non-recourse debt associated with the terminated leases) and recorded a pre-tax gain of $39 million, representing the excess of the net cash proceeds over the carrying value of the lease investments.

 

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During the second quarter of 2011, PHI entered into early termination agreements with two lessees involving all of the leases comprising one of the original eight lease investments and a small portion of the leases comprising a second lease investment. The early terminations of the leases were negotiated at the request of the lessees and were completed in June 2011. PHI received net cash proceeds of $161 million (net of a termination payment of $423 million used to retire the non-recourse debt associated with the terminated leases) and recorded a pre-tax gain of $39 million, representing the excess of the net cash proceeds over the carrying value of the lease investments.

With respect to the terminated leases, PHI had previously made certain business assumptions regarding foreign investment opportunities available at the end of the full lease terms. Because the leases were terminated in each case earlier than full term, management decided not to pursue these opportunities and certain income tax benefits recognized previously were reversed in the amounts of $16 million and $22 million for the nine months ended September 30, 2012 and 2011, respectively. The after-tax gain on the lease terminations was $9 million and $3 million for the nine months ended September 30, 2012 and 2011, respectively, including the income tax benefit reversal and an income tax provision at the statutory Federal rate of $14 million for each early lease termination. PHI has no intent to terminate early any other leases in the lease portfolio. With respect to certain of these remaining leases, management’s assumption continues to be that the foreign earnings recognized at the end of the lease term will remain invested abroad.

In the third quarter of 2011, PHI modified its tax cash flow assumptions for two of the investments in the lease portfolio associated with the change in tax laws in the District of Columbia. Accordingly, PHI recalculated the equity investment and recorded a non-cash $7 million pre-tax ($3 million after-tax) charge.

The components of the cross-border energy lease investments as of September 30, 2012 and December 31, 2011 are summarized below:

 

     September 30,
2012
    December 31,
2011
 
     (millions of dollars)  

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

   $ 1,852     $ 2,120  

Less: Unearned and deferred income

     (626 )     (771 )
  

 

 

   

 

 

 

Investment in finance leases held in trust

     1,226       1,349  

Less: Deferred income tax liabilities

     (738 )     (793 )
  

 

 

   

 

 

 

Net investment in finance leases held in trust

   $ 488     $ 556  
  

 

 

   

 

 

 

Income recognized from cross-border energy lease investments, excluding the gains on terminated leases discussed above, was comprised of the following for the three and nine months ended September 30, 2012 and 2011:

 

     Three Months  Ended
September 30,
    Nine Months  Ended
September 30,
 
     2012      2011     2012      2011  
     (millions of dollars)  

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

   $ 13       $ 7     $ 39       $ 35   

Income tax expense (benefit) related to cross-border energy lease investments

     3        (3 )     7        7  
  

 

 

    

 

 

   

 

 

    

 

 

 

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

   $ 10       $ 10     $ 32      $ 28   
  

 

 

    

 

 

   

 

 

    

 

 

 

To ensure credit quality, PHI regularly monitors the financial performance and condition of the lessees under its cross-border energy lease investments. Changes in credit quality are also assessed to determine if they should be reflected in the carrying value of the leases. PHI compares each lessee’s performance to annual compliance requirements set by the terms and conditions of the leases. This includes a comparison of

 

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published credit ratings to minimum credit rating requirements in the leases for lessees with public credit ratings. In addition, PHI routinely meets with senior executives of the lessees to discuss their company and asset performance. If the annual compliance requirements or minimum credit ratings are not met, remedies are available under the leases. At September 30, 2012, all lessees were in compliance with the terms and conditions of their lease agreements.

The table below shows PHI’s net investment in these leases by the published credit ratings of the lessees as of September 30, 2012 and December 31, 2011:

 

Lessee Rating (a)

   September 30,
2012
     December 31,
2011
 
     (millions of dollars)  

Rated Entities

  

AA/Aa and above

   $ 759       $ 737   

A

     467         612   
  

 

 

    

 

 

 

Total

   $ 1,226       $ 1,349   
  

 

 

    

 

 

 

 

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

(9) PENSION AND OTHER POSTRETIREMENT BENEFITS

The following Pepco Holdings information is for the three months ended September 30, 2012 and 2011:

 

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

Service cost

   $ 8     $ 10     $ 2     $ 1  

Interest cost

     27       27       9       10  

Expected return on plan assets

     (33 )     (32 )     (5 )     (5 )

Amortization of prior service cost (benefit)

     1       —          (1 )     (1 )

Amortization of net actuarial loss

     16       11       4       3  
  

 

 

   

 

 

   

 

 

   

 

 

 

Net periodic benefit cost

   $ 19      $ 16      $ 9     $ 8  
  

 

 

   

 

 

   

 

 

   

 

 

 

The following Pepco Holdings information is for the nine months ended September 30, 2012 and 2011:

 

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

Service cost

   $ 26     $ 27     $ 6     $ 4  

Interest cost

     80       80       26       28  

Expected return on plan assets

     (99 )     (96 )     (14     (14 )

Amortization of prior service cost (benefit)

     2       (1 )     (3 )     (3 )

Amortization of net actuarial loss

     48       35       11       9  

Termination benefits

     —          —          1       1  
  

 

 

   

 

 

   

 

 

   

 

 

 

Net periodic benefit cost

   $ 57      $ 45      $ 27     $ 25  
  

 

 

   

 

 

   

 

 

   

 

 

 

 

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Pension and Other Postretirement Benefits

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

Pension Contributions

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

(10) DEBT

Credit Facility

PHI, Pepco, DPL and ACE maintain an unsecured syndicated credit facility to provide for their respective liquidity needs, including obtaining letters of credit, borrowing for general corporate purposes and supporting their commercial paper programs. On August 1, 2011, PHI, Pepco, DPL and ACE entered into an amended and restated credit agreement, which among other changes, extended the expiration date of the facility to August 1, 2016. On August 2, 2012, the amended and restated credit agreement was amended to extend the term of the credit facility to August 1, 2017 and to amend the pricing schedule to decrease certain fees and interest rates payable to the lenders under the facility.

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

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

In order for a borrower to use the facility, certain representations and warranties must be true and correct, and the borrower must be in compliance with specified financial and other covenants, including (i) the requirement that each borrowing company maintain a ratio of total indebtedness to total capitalization of 65% or less, computed in accordance with the terms of the credit agreement, which calculation excludes from the definition of total indebtedness certain trust preferred securities and deferrable interest subordinated debt (not

 

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to exceed 15% of total capitalization), (ii) with certain exceptions, a restriction on sales or other dispositions of assets, and (iii) a restriction on the incurrence of liens on the assets of a borrower or any of its significant subsidiaries other than permitted liens. The credit agreement contains certain covenants and other customary agreements and requirements that, if not complied with, could result in an event of default and the acceleration of repayment obligations of one or more of the borrowers thereunder. Each of the borrowers was in compliance with all covenants under this facility as of September 30, 2012.

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

At September 30, 2012 and December 31, 2011, the amount of cash plus unused borrowing capacity under the credit facility available to meet the future liquidity needs of PHI and its utility subsidiaries on a consolidated basis totaled $1,078 million and $994 million, respectively. PHI’s utility subsidiaries had combined cash and unused borrowing capacity under the credit facility of $563 million and $711 million at September 30, 2012 and December 31, 2011, respectively.

Term Loan Agreement

On April 24, 2012, PHI entered into a $200 million term loan agreement, pursuant to which PHI has borrowed (and may not reborrow) $200 million at a rate of interest equal to the prevailing Eurodollar rate, which is determined by reference to LIBOR with respect to the relevant interest period, all as defined in the loan agreement, plus a margin of 0.875%. PHI’s Eurodollar borrowings under the loan agreement may be converted into floating rate loans under certain circumstances, and, in that event, for so long as any loan remains a floating rate loan, interest would accrue on that loan at a rate per year equal to (i) the highest of (a) the prevailing prime rate, (b) the federal funds effective rate plus 0.5%, or (c) the one-month Eurodollar rate plus 1%, plus (ii) a margin of 0.875%. As of September 30, 2012, outstanding borrowings under the loan agreement bore interest at an annual rate of 1.095%, which is subject to adjustment from time to time. All borrowings under the loan agreement are unsecured, and the aggregate principal amount of all loans, together with any accrued but unpaid interest due under the loan agreement, must be repaid in full on or before April 23, 2013.

PHI used the net proceeds of the borrowings under the term loan agreement to repay outstanding commercial paper obligations and for general corporate purposes. Under the terms of the term loan agreement, PHI must maintain compliance with specified covenants, including (i) the requirement that PHI maintain a ratio of total indebtedness to total capitalization of 65% or less, computed in accordance with the terms of the loan agreement, which calculation excludes from the definition of total indebtedness certain trust preferred securities and deferrable interest subordinated debt (not to exceed 15% of total capitalization), (ii) a restriction on sales or other dispositions of assets, other than certain permitted sales and dispositions, and (iii) a restriction on the incurrence of liens (other than liens permitted by the loan agreement) on the assets of PHI or any of its significant subsidiaries. The loan agreement does not include any rating triggers. PHI was in compliance with all covenants under this agreement as of September 30, 2012.

Commercial Paper

PHI, Pepco, DPL and ACE maintain on-going commercial paper programs to address short-term liquidity needs. As of September 30, 2012, the maximum capacity available under these programs was $875 million, $500 million, $500 million and $250 million, respectively, subject to available borrowing capacity under the credit facility.

 

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PHI, Pepco and ACE had $293 million, $134 million and $93 million, respectively, of commercial paper outstanding at September 30, 2012. DPL had no commercial paper outstanding at September 30, 2012. The weighted average interest rate for commercial paper issued by PHI, Pepco, DPL and ACE during the nine months ended September 30, 2012 was 0.87%, 0.42%, 0.43% and 0.42%, respectively. The weighted average maturity of all commercial paper issued by PHI, Pepco, DPL and ACE during the nine months ended September 30, 2012 was ten, four, four and three days, respectively.

Other Financing Activities

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

On August 6, 2012, DPL redeemed, prior to maturity, $31 million of its 5.20% tax-exempt pollution control refunding revenue bonds due 2019, issued by the Delaware Economic Development Authority for DPL’s benefit. Contemporaneously with this redemption, DPL redeemed $31 million of its outstanding 5.20% first mortgage bonds due 2019 that secured the obligations under the pollution control bonds.

On September 28, 2012, ACE redeemed, prior to maturity, $4 million of its 5.60% tax-exempt pollution control revenue bonds due 2025 issued by the Industrial Pollution Control Financing Authority of Salem County, New Jersey for ACE’s benefit. Contemporaneously with this redemption, ACE redeemed, prior to maturity, $4 million of its outstanding 5.60% first mortgage bonds due 2025 that secured the obligations under the pollution control bonds.

Collateral Requirements of Pepco Energy Services

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

As of September 30, 2012, Pepco Energy Services had posted net cash collateral of $38 million and letters of credit of less than $1 million. At December 31, 2011, Pepco Energy Services had posted net cash collateral of $112 million and letters of credit of $1 million.

At September 30, 2012 and December 31, 2011, the amount of cash, plus borrowing capacity under PHI’s credit facility available to meet the future liquidity needs of Pepco Energy Services, totaled $515 million and $283 million, respectively.

 

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(11) INCOME TAXES

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

 

     Three Months Ended September 30,     Nine Months Ended September 30,  
     2012     2011     2012     2011  
     (millions of dollars)  

Income tax at Federal statutory rate

   $ 72       35.0   $ 47       35.0   $ 134       35.0   $ 133       35.0

Increases (decreases) resulting from:

                

State income taxes, net of Federal effect

     9       4.4        9       6.7        19       5.0        19       5.0   

Asset removal costs

     (1 )     (0.5     (2 )     (1.5     (8 )     (2.1     (4 )     (1.1

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

     —          —          5       3.7        (10 )     (2.6     (11 )     (2.9

Cross-border energy lease investments

     15       7.3        (5 )     (3.7     13       3.4        15        3.9   

Other, net

     (2 )     (0.8     1       0.5        (6 )     (1.7     (9 )     (2.3
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Consolidated income tax expense related to continuing operations

   $ 93       45.4   $ 55       40.7   $ 142       37.0   $ 143       37.6
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Three Months Ended September 30, 2012 and 2011

PHI’s consolidated effective income tax rates for the three months ended September 30, 2012 and 2011 were 45.4% and 40.7%, respectively. The increase in the effective rate for the three months ended September 30, 2012 primarily reflects the reversal of income tax benefits associated with cross-border energy lease investments in the third quarter of 2012, partially offset by changes in estimates and interest related to uncertain and effectively settled tax positions recorded in 2011.

As discussed further in Note (8), “Leasing Activities,” during the third quarter of 2012, PHI terminated early its interest in certain cross-border energy leases. As a result of the early terminations, PHI reversed $16 million of previously recognized income tax benefits which will not be realized due to the early termination.

Nine Months Ended September 30, 2012 and 2011

PHI’s consolidated effective income tax rates for the nine months ended September 30, 2012 and 2011 were 37.0% and 37.6%, respectively. The effective income tax rates for the nine months ended September 30, 2012 and 2011 reflect the reversal of income tax benefits associated with the early termination of cross-border energy leases in the third quarter of 2012 and in the second quarter of 2011 of $16 million and $22 million, respectively, as discussed in Note (8), “Leasing Activities.”

In addition, the effective income tax rate for the nine months ended September 30, 2012 includes income tax benefits of $10 million related to uncertain and effectively settled tax positions, primarily due to the effective settlement with the Internal Revenue Service (IRS) in the first quarter of 2012 with respect to the methodology used historically to calculate deductible mixed service costs and the expiration of the statute of limitations associated with an uncertain tax position in Pepco. During the nine months ended September 30, 2011, PHI recorded tax benefits of $11 million related to uncertain and effectively settled tax positions, primarily resulting from the settlement with the IRS on interest due on its 1996 through 2002 tax years.

The rate for the nine months ended September 30, 2012 also reflects an increase in deductible asset removal costs for Pepco in 2012 related to a higher level of asset retirements.

 

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(12) EQUITY AND EARNINGS PER SHARE

Basic and Diluted Earnings Per Share

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

 

     Three Months
Ended September 30,
 
     2012      2011  
     (millions of dollars, except
per share data)
 

Income (Numerator):

     

Net income from continuing operations

   $ 112      $ 80   

Net income from discontinued operations

     —           —     
  

 

 

    

 

 

 

Net income

   $ 112      $ 80  
  

 

 

    

 

 

 

Shares (Denominator) (in millions):

     

Weighted average shares outstanding for basic computation:

     

Average shares outstanding

     229        226  

Adjustment to shares outstanding

     —           —     
  

 

 

    

 

 

 

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

     229        226  

Net effect of potentially dilutive shares (a)

     2        —     
  

 

 

    

 

 

 

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

     231        226  
  

 

 

    

 

 

 

Basic and Diluted Earnings per Share

     

Earnings per share of common stock from continuing operations

   $ 0.49      $ 0.35  

Earnings per share of common stock from discontinued operations

     —           —     
  

 

 

    

 

 

 

Basic and diluted earnings per share

   $ 0.49      $ 0.35  
  

 

 

    

 

 

 

 

(a) The number of options to purchase shares of common stock that were excluded from the calculation of diluted EPS because they were anti-dilutive was zero and 119,766 for the three months ended September 30, 2012 and 2011, respectively.

 

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     Nine Months
Ended September 30,
 
     2012      2011  
     (millions of dollars, except
per share data)
 

Income (Numerator):

     

Net income from continuing operations

   $ 242      $ 237   

Net income from discontinued operations

     —           1  
  

 

 

    

 

 

 

Net income

   $ 242      $ 238  
  

 

 

    

 

 

 

Shares (Denominator) (in millions):

     

Weighted average shares outstanding for basic computation:

     

Average shares outstanding

     228        226  

Adjustment to shares outstanding

     —           —     
  

 

 

    

 

 

 

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

     228        226  

Net effect of potentially dilutive shares (a)

     1        —     
  

 

 

    

 

 

 

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

     229        226  
  

 

 

    

 

 

 

Basic and Diluted Earnings per Share

     

Earnings per share of common stock from continuing operations

   $ 1.06      $ 1.05  

Earnings per share of common stock from discontinued operations

     —           —     
  

 

 

    

 

 

 

Basic and diluted earnings per share

   $ 1.06      $ 1.05  
  

 

 

    

 

 

 

 

(a) The number of options to purchase shares of common stock that were excluded from the calculation of diluted EPS because they were anti-dilutive was zero and 119,766 for the nine months ended September 30, 2012 and 2011, respectively.

Equity Forward Transaction

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

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

The equity forward transaction had no initial fair value since it was entered into at the then market price of the common stock. PHI will not receive any proceeds from the sale of common stock until the equity forward transaction is settled, and at that time PHI will record the proceeds, if any, in equity. PHI concluded that the equity forward transaction was an equity instrument based on the accounting guidance in ASC 480 and ASC 815 and that it qualified for an exception from derivative accounting under ASC 815 because the forward sale transaction was indexed to its own stock. PHI anticipates settling the equity forward transaction through physical settlement before March 5, 2013.

 

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At September 30, 2012, the equity forward transaction could have been settled with physical delivery of the shares to the forward counterparty in exchange for cash of $317 million. At September 30, 2012, the equity forward transaction could also have been cash settled, with delivery of cash of approximately $18 million to the forward counterparty, or net share settled with delivery of approximately 965,000 shares of common stock to the forward counterparty.

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

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

For the three and nine months ended September 30, 2012, the equity forward transaction did not have a material dilutive effect on PHI’s earnings per share.

(13) DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

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

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

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

In Power Delivery, DPL uses derivative instruments in the form of swaps and over-the-counter options primarily to reduce natural gas commodity price volatility and to limit its customers’ exposure to increases in the market price of natural gas under a hedging program approved by the DPSC. DPL uses these derivatives to manage the commodity price risk associated with its physical natural gas purchase contracts. The natural gas purchase contracts qualify as normal purchases, which are not required to be recorded in the financial statements until settled. All premiums paid and other transaction costs incurred as part of DPL’s natural gas hedging activity, in addition to all gains and losses related to hedging activities, are deferred under FASB guidance on regulated operations (ASC 980) until recovered from its customers through a fuel adjustment clause approved by the DPSC.

 

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ACE was ordered to enter into the SOCAs by the NJBPU, and under the SOCAs, ACE would receive payments from or make payments to electric generation facilities based on i) the difference between the fixed price in the SOCAs and the price for capacity that clears PJM, and ii) ACE’s annual proportion of the total New Jersey load relative to the other EDCs in New Jersey, which is currently estimated to be approximately 15 percent. ACE began applying derivative accounting to two of its SOCAs as of June 30, 2012 because the generators cleared the 2015-2016 PJM capacity auction in May 2012. Changes in the fair value of the derivatives embedded in the SOCAs are deferred as regulatory assets or liabilities because the NJBPU has allowed full recovery from ACE’s distribution customers for all payments made by ACE and ACE’s distribution customers would be entitled to all payments received by ACE.

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

The tables below identify the balance sheet location and fair values of derivative instruments as of September 30, 2012 and December 31, 2011:

 

     As of September 30, 2012  

Balance Sheet Caption

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

Derivative assets (current assets)

   $ —        $ 3     $ 3     $ (1 )   $ 2  

Derivative assets (non-current assets)

     —          8       8       —          8  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total Derivative assets

     —          11       11       (1 )     10  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Derivative liabilities (current liabilities)

     (16 )     (21 )     (37 )     24       (13 )

Derivative liabilities (non-current liabilities)

     (2 )     (11 )     (13 )     3       (10 )
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total Derivative liabilities

     (18 )     (32 )     (50 )     27       (23 )
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net Derivative (liability) asset

   $ (18 )   $ (21 )   $ (39 )   $ 26     $ (13 )
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(a) Amounts included in Derivatives Designated as Hedging Instruments primarily consist of derivatives that were designated as cash flow hedges prior to Pepco Energy Services’ election to discontinue cash flow hedge accounting for these derivatives.

 

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     As of December 31, 2011  

Balance Sheet Caption

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

Derivative assets (current assets)

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

Derivative assets (non-current assets)

     —          1       1       (1 )     —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total Derivative assets

     17       7       24       (19 )     5  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Derivative liabilities (current liabilities)

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

Derivative liabilities (non-current liabilities)

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

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total Derivative liabilities

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

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net Derivative (liability) asset

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

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(a) Amounts included in Derivatives Designated as Hedging Instruments primarily consist of derivatives that were designated as cash flow hedges prior to Pepco Energy Services’ election to discontinue cash flow hedge accounting for these derivatives.

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

 

     September 30,
2012
    December 31,
2011
 
     (millions of dollars)  

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

   $ 27      $ 73  

Cash collateral received from counterparties with the obligation to return

     (1     —     

 

(a) Includes cash deposits on commodity brokerage accounts

As of September 30, 2012 and December 31, 2011, all PHI cash collateral pledged related to derivative instruments accounted for at fair value was entitled to offset under master netting agreements.

 

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Derivatives Designated as Hedging Instruments

Cash Flow Hedges

Pepco Energy Services

For energy commodity contracts that are designated and qualify as cash flow hedges, the effective portion of the gain or loss on the derivative is reported as a component of AOCL and is reclassified into income in the same period or periods during which the hedged transactions affect income. Gains and losses on the derivative that are related to hedge ineffectiveness or the forecasted hedged transaction being probable not to occur, are recognized in income. Pepco Energy Services has elected to no longer apply cash flow hedge accounting to its electricity derivatives and all of its natural gas derivatives. Amounts included in AOCL for these cash flow hedges as of September 30, 2012 represent net losses on derivatives prior to the election to discontinue cash flow hedge accounting less amounts reclassified into income as the hedged transactions occur or because the hedged transactions were deemed probable not to occur. Gains or losses on these derivatives after the election to discontinue cash flow hedge accounting are recognized directly in income.

The cash flow hedge activity during the three and nine months ended September 30, 2012 and 2011 is provided in the tables below:

 

     Three Months  Ended
September 30,
     Nine Months  Ended
September 30,
 
     2012      2011      2012      2011  
     (millions of dollars)  

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

   $ —         $ —         $ —         $ 2  
  

 

 

    

 

 

    

 

 

    

 

 

 

Amount of net pre-tax loss reclassified into income:

           

Effective portion:

           

Fuel and purchased energy expense

     6        15        31        61  

Ineffective portion: (a)

           

Revenue

     —           1        —           1  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total net pre-tax loss reclassified into income

     6        16        31        62  
  

 

 

    

 

 

    

 

 

    

 

 

 

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

   $ 6      $ 16      $ 31      $ 64  
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(a) For the three and nine months ended September 30, 2011, $1 million was reclassified from AOCL to income because the forecasted hedged transactions were deemed probable not to occur.

As of September 30, 2012 and December 31, 2011, Pepco Energy Services had the following types and quantities of outstanding energy commodity contracts employed as cash flow hedges of forecasted purchases and forecasted sales.

 

     Quantities  

Commodity

   September 30,
2012
     December 31,
2011
 

Forecasted Purchases Hedges

     

Electricity (MWh)

     —           614,560   

Forecasted Sales Hedges

     

Electricity (MWh)

     —           614,560   

 

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Power Delivery

All premiums paid and other transaction costs incurred as part of DPL’s natural gas hedging activity, in addition to all of DPL’s gains and losses related to hedging activities, are deferred under FASB guidance on regulated operations until recovered from customers based on the fuel adjustment clause approved by the DPSC. The following table indicates the net unrealized derivative losses arising during the period that were deferred as Regulatory assets and the net realized losses recognized in the consolidated statements of income (through Fuel and purchased energy expense) that were also deferred as Regulatory assets for the three and nine months ended September 30, 2012 and 2011 associated with cash flow hedges:

 

     Three Months Ended
September 30,
    Nine Months  Ended
September 30,
 
     2012      2011     2012      2011  
     (millions of dollars)  

Net unrealized loss arising during the period

   $ —         $ (1 )   $ —         $ (1 )

Net realized loss recognized during the period

     —           (2 )     —           (5 )

Cash Flow Hedges Included in Accumulated Other Comprehensive Loss

The tables below provide details regarding effective cash flow hedges included in PHI’s consolidated balance sheets as of September 30, 2012 and 2011. Cash flow hedges are marked to market on the consolidated balance sheets with corresponding adjustments to AOCL for effective cash flow hedges. As of September 30, 2012, $18 million of the losses in AOCL were associated with derivatives that Pepco Energy Services previously designated as cash flow hedges. Although Pepco Energy Services no longer designates these derivatives as cash flow hedges, gains or losses previously deferred in AOCL prior to the decision to discontinue cash flow hedge accounting will remain in AOCL until the hedged forecasted transaction occurs unless it is deemed probable that the hedged forecasted transaction will not occur. The data in the following tables indicate the cumulative net loss after-tax related to effective cash flow hedges by contract type included in AOCL, the portion of AOCL expected to be reclassified to income during the next 12 months, and the maximum hedge or deferral term:

 

     As of September 30, 2012         

Contracts

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

Energy commodity (a)

   $ 11       $ 10         20 months   

Interest rate

     10         1        239 months  
  

 

 

    

 

 

    

Total

   $ 21       $ 11      
  

 

 

    

 

 

    

 

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

 

     As of September 30, 2011         

Contracts

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

Energy commodity (a)

   $ 40      $ 28        32 months   

Interest rate

     10        1        251 months   
  

 

 

    

 

 

    

Total

   $ 50      $ 29     
  

 

 

    

 

 

    

 

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

Other Derivative Activity

Pepco Energy Services

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

For the three and nine months ended September 30, 2012 and 2011, the amount of the derivative gain (loss) for Pepco Energy Services recognized in income is provided in the table below:

 

     Three Months  Ended
September 30,
    Nine Months  Ended
September 30,
 
     2012      2011     2012     2011  
     (millions of dollars)  

Reclassification of mark-to-market to realized on settlement of contracts

   $ 5      $ 1     $ 22     $ (1

Unrealized mark-to-market gain (loss)

     3        (5 )     (2 )     (10
  

 

 

    

 

 

   

 

 

   

 

 

 

Total net gain (loss)

   $ 8      $ (4 )   $ 20      $ (11
  

 

 

    

 

 

   

 

 

   

 

 

 

 

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As of September 30, 2012 and December 31, 2011, Pepco Energy Services had the following net outstanding commodity forward contract quantities and net positions on derivatives that did not qualify for hedge accounting:

 

     September 30, 2012      December 31, 2011  

Commodity

   Quantity      Net Position      Quantity      Net Position  

Financial transmission rights (MWh)

     254,601        Long         267,480        Long  

Electric capacity (MW – Days)

     —           —           12,920        Long  

Electricity (MWh)

     261,240         Long         788,280         Long  

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

     6,176,711        Long         24,550,257        Long  

Power Delivery

DPL and ACE have certain derivatives that are not in hedge accounting relationships and are not designated as normal purchases or normal sales. These derivatives are recorded at fair value on the consolidated balance sheets with the gain or loss for changes in fair value recorded in income. In accordance with FASB guidance on regulated operations, offsetting regulatory liabilities or regulatory assets are recorded on the consolidated balance sheets and the recognition of the derivative gain or loss is deferred because of the DPSC-approved fuel adjustment clause for DPL’s derivatives and the NJBPU order pertaining to the SOCAs within which ACE’s capacity derivatives are embedded. The following table indicates the net unrealized derivative losses arising during the period that were deferred as Regulatory assets and the net realized losses recognized in the consolidated statements of income (through Fuel and purchased energy expense) that were also deferred as Regulatory assets for the three and nine months ended September 30, 2012 and 2011 associated with these derivatives:

 

     Three Months  Ended
September 30,
    Nine Months  Ended
September 30,
 
     2012     2011     2012     2011  
     (millions of dollars)  

Net unrealized gain (loss) arising during the period

   $ 2      $ (4   $ (3   $ (6 )

Net realized loss recognized during the period

     (2     (3 )     (13     (14 )

As of September 30, 2012 and December 31, 2011, the quantities and positions of DPL’s net outstanding natural gas commodity forward contracts and ACE’s capacity derivatives associated with the SOCAs that did not qualify for hedge accounting were:

 

     September 30, 2012      December 31, 2011  

Commodity

   Quantity      Net Position      Quantity      Net Position  

DPL – Natural gas (MMBtu)

     3,571,000         Long        6,161,200         Long   

ACE – Capacity (MWs)

     180        Long        —           —     

Contingent Credit Risk Features

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

 

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

The gross fair values of PHI’s derivative liabilities with credit risk-related contingent features as of September 30, 2012 and December 31, 2011, were $14 million and $54 million, respectively, before giving effect to offsetting transactions or collateral under master netting agreements. As of September 30, 2012, PHI had posted no cash collateral against its gross derivative liability, resulting in a net liability of $14 million. As of December 31, 2011, PHI had posted cash collateral of $1 million against its gross derivative liability, resulting in a net liability of $53 million. If PHI’s and DPL’s debt ratings had been downgraded below investment grade as of September 30, 2012 and December 31, 2011, PHI’s net settlement amounts, including both the fair value of its derivative liabilities and its normal purchase and normal sale contracts would have been approximately $56 million and $124 million, respectively, and PHI would have been required to post collateral with the counterparties of approximately $56 million and $123 million, respectively, in addition to that which was posted as of September 30, 2012 and December 31, 2011. The net settlement and additional collateral amounts reflect the effect of offsetting transactions under master netting agreements.

PHI’s primary source for posting cash collateral or letters of credit is its credit facility. At September 30, 2012 and December 31, 2011, the aggregate amount of cash plus borrowing capacity under the credit facility available to meet the future liquidity needs of PHI and its subsidiaries totaled $1,078 million and $994 million, respectively, of which $515 million and $283 million, respectively, was available to Pepco Energy Services.

(14) FAIR VALUE DISCLOSURES

Financial Instruments Measured at Fair Value on a Recurring Basis

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

 

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The following tables set forth, by level within the fair value hierarchy, PHI’s financial assets and liabilities that were accounted for at fair value on a recurring basis as of September 30, 2012 and December 31, 2011. As required by the guidance, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. PHI’s assessment of the significance of a particular input to the fair value measurement requires the exercise of judgment, and may affect the valuation of fair value assets and liabilities and their placement within the fair value hierarchy levels.

 

     Fair Value Measurements at September 30, 2012  

Description

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

ASSETS

           

Derivative instruments (b)

           

Electricity (c)

   $ 2      $ —         $ 2      $ —     

Natural gas (d)

     1        1        —           —     

Capacity (e)

     8        —           —           8  

Cash equivalents

           

Treasury fund

     128        128        —           —     

Executive deferred compensation plan assets

           

Money market funds

     19        19        —           —     

Life insurance contracts

     58        —           41        17  
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ 216      $ 148       $ 43       $ 25   
  

 

 

    

 

 

    

 

 

    

 

 

 

LIABILITIES

           

Derivative instruments (b)

           

Electricity (c)

   $ 15       $ —         $ 15       $ —     

Natural gas (d)

     26         18        —           8  

Capacity (e)

     9        —           —           9  

Executive deferred compensation plan liabilities

           

Life insurance contracts

     28        —           28        —     
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ 78       $ 18       $ 43       $ 17   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(a) There were no transfers of instruments between level 1 and level 2 valuation categories during the nine months ended September 30, 2012.
(b) The fair values of derivative assets and liabilities reflect netting by counterparty before the impact of collateral.
(c) Represents wholesale electricity futures and swaps that are used mainly as part of Pepco Energy Services’ retail energy supply business.
(d) Level 1 instruments represent wholesale gas futures and swaps that are used mainly as part of Pepco Energy Services’ retail energy supply business and level 3 instruments represent natural gas options purchased by DPL as part of a natural gas hedging program approved by the DPSC, as well as Pepco Energy Services physical basis contracts.
(e) Represents derivatives associated with ACE SOCAs.

 

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     Fair Value Measurements at December 31, 2011  

Description

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

ASSETS

           

Cash equivalents

           

Treasury fund

   $ 114      $ 114       $ —         $ —     

Executive deferred compensation plan assets

           

Money market funds

     18        18         —           —     

Life insurance contracts

     60        —           43        17  
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ 192       $ 132       $ 43      $ 17   
  

 

 

    

 

 

    

 

 

    

 

 

 

LIABILITIES

           

Derivative instruments (b)

           

Electricity (c)

   $ 32       $ —         $ 32       $ —     

Natural gas (d)

     67        50         —           17  

Capacity

     1        —           1         —     

Executive deferred compensation plan liabilities

           

Life insurance contracts

     28        —           28        —     
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ 128       $ 50       $ 61       $ 17   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(a) There were no transfers of instruments between level 1 and level 2 valuation categories during the year ended December 31, 2011.
(b) The fair value of derivative liabilities reflect netting by counterparty before the impact of collateral.
(c) Represents wholesale electricity futures and swaps that are used mainly as part of Pepco Energy Services’ retail energy supply business.
(d) Level 1 instruments represent wholesale gas futures and swaps that are used mainly as part of Pepco Energy Services’ retail energy supply business and level 3 instruments represent natural gas options purchased by DPL as part of a natural gas hedging program approved by the DPSC.

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

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

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

PHI’s level 2 derivative instruments primarily consist of electricity derivatives at September 30, 2012. Level 2 power swaps are provided by a pricing service that uses liquid trading hub prices or liquid hub prices plus a congestion adder to estimate the fair value at zonal locations within trading hubs.

 

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Executive deferred compensation plan assets consist of life insurance policies and certain employment agreement obligations. The life insurance policies are categorized as level 2 assets because they are valued based on the assets underlying the policies, which consist of short-term cash equivalents and fixed income securities that are priced using observable market data and can be liquidated for the value of the underlying assets as of September 30, 2012. The level 2 liability associated with the life insurance policies represents a deferred compensation obligation, the value of which is tracked via underlying insurance sub-accounts. The sub-accounts are designed to mirror existing mutual funds and money market funds that are observable and actively traded.

The value of certain employment agreement obligations is derived using a discounted cash flow valuation technique. The discounted cash flow calculations are based on a known and certain stream of payments to be made over time that are discounted to determine their net present value. The primary variable input, the discount rate, is based on market-corroborated and observable published rates. These obligations have been classified as level 2 within the fair value hierarchy because the payment streams represent contractually known and certain amounts and the discount rate is based on published, observable data.

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

Derivative instruments categorized as level 3 include natural gas options used by DPL as part of a natural gas hedging program approved by the DPSC, natural gas physical basis contracts held by Pepco Energy Services, and capacity under the SOCAs entered into by ACE:

 

 

DPL applies a Black-Scholes model to value its options with inputs, such as the forward price curves, contract prices, contract volumes, the risk-free rate and the implied volatility factors, that are based on a range of historical NYMEX option prices. DPL maintains valuation policies and procedures and reviews the validity and relevance of the inputs used to estimate the fair value of its options.

 

 

The natural gas physical basis contracts held by Pepco Energy Services are valued using liquid hub prices plus a congestion adder. The congestion adder is an internally derived adder based on historical data and experience. Pepco Energy Services obtains the liquid hub prices from a third party and reviews the valuation methodologies, inputs, and reasonableness of the congestion adder on a quarterly basis.

 

 

ACE used a discounted cash flow methodology to estimate the fair value of the capacity derivatives embedded in the SOCAs. ACE utilized an external consulting firm to estimate annual zonal PJM capacity prices through the 2030-2031 auction. The capacity price forecast was based on various assumptions that impact the cost of constructing new generation facilities, including zonal load forecasts, zonal fuel and energy prices, generation capacity and transmission planning, and environmental legislation and regulation. ACE reviewed the assumptions and resulting capacity price forecast for reasonableness. ACE used the capacity price forecast to estimate future cash flows. A significant change in the forecasted prices would have a significant impact on the estimated fair value of the SOCAs. ACE employed a discount rate reflective of the estimated weighted average cost of capital for merchant generation companies since payments under the SOCAs are contingent on providing generation capacity.

The table below summarizes the primary unobservable inputs used to determine the fair value of PHI’s level 3 instruments and the range of values that could be used for those inputs as of September 30, 2012:

 

Type of Instrument

  Fair Value at
September 30, 2012
    Valuation Technique   Unobservable Input   Range
    (millions of dollars)              

Natural gas options

  $ (7   Option model   Volatility factor   0.82 - 2.76

Capacity contracts, net

    (1   Discounted cash flow   Discount rate   5% - 9%

Natural gas physical basis contracts

    (1   Market comparable   Congestion adder   $(0.04) - $0.72

 

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PHI used values within these ranges as part of its fair value estimates. A significant change in any of the unobservable inputs within these ranges would have an insignificant impact on the reported fair value as of September 30, 2012.

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

Reconciliations of the beginning and ending balances of PHI’s fair value measurements using significant unobservable inputs (level 3) for the nine months ended September 30, 2012 and 2011 are shown below:

 

     Nine Months Ended
September 30, 2012
 
     Natural
Gas
    Life
Insurance
Contracts
    Capacity  
     (millions of dollars)  

Beginning balance as of January 1

   $ (17 )   $ 17     $ —     

Total gains (losses) (realized and unrealized):

      

Included in income

     —          3       —     

Included in accumulated other comprehensive loss

     —          —          —     

Included in regulatory assets

     (2 )     —          (1 )

Purchases

     —          —          —     

Issuances

     —          (3 )     —     

Settlements

     11       —          —     

Transfers in (out) of level 3

     —          —          —     
  

 

 

   

 

 

   

 

 

 

Ending balance as of September 30

   $ (8 )   $ 17     $ (1 )
  

 

 

   

 

 

   

 

 

 

 

     Nine Months Ended
September 30, 2011
 
     Natural
Gas
    Life
Insurance
Contracts
 
     (millions of dollars)  

Beginning balance as of January 1

   $ (23   $ 19   

Total gains (losses) (realized and unrealized):

    

Included in income

     —          5  

Included in accumulated other comprehensive loss

     —          —     

Included in regulatory assets

     (6 )     —     

Purchases

     —          —     

Issuances

     —          (3 )

Settlements

     11       (4 )

Transfers in (out) of level 3

     1       —     
  

 

 

   

 

 

 

Ending balance as of September 30

   $ (17   $ 17  
  

 

 

   

 

 

 

 

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

 

     Nine Months Ended September 30,  
     2012      2011  
     (millions of dollars)  

Total net gains included in income for the period

   $ 3      $ 5  
  

 

 

    

 

 

 

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

   $ 3      $ 2  
  

 

 

    

 

 

 

Other Financial Instruments

The estimated fair values of PHI’s debt instruments that are measured at amortized cost in PHI’s consolidated financial statements and the associated level of the estimates within the fair value hierarchy as of September 30, 2012 are shown in the table below. As required by the fair value measurement guidance, debt instruments are classified in their entirety within the fair value hierarchy based on the lowest level of input that is significant to the fair value measurement. PHI’s assessment of the significance of a particular input to the fair value measurement requires the exercise of judgment, which may affect the valuation of fair value debt instruments and their placement within the fair value hierarchy levels.

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

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

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

 

     Fair Value Measurements at September 30, 2012  

Description

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

LIABILITIES

           

Debt instruments

           

Long-term debt (a)

   $ 5,068       $ 990      $ 3,584      $ 494   

Transition Bonds issued by ACE Funding (b)

     355        —           355        —     

Long-term project funding

     14        —           —           14  
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ 5,437       $ 990      $ 3,939      $ 508   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(a) The carrying amount for Long-term debt is $4,177 million as of September 30, 2012.
(b) The carrying amount for Transition Bonds issued by ACE Funding, including amounts due within one year, is $306 million as of September 30, 2012.

 

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

 

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

Long-term debt

   $ 3,867      $ 4,577  

Transition Bonds issued by ACE Funding

     332        380  

Long-term project funding

     15        15  

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

(15) COMMITMENTS AND CONTINGENCIES

General Litigation

In September 2011, an asbestos complaint was filed in the New Jersey Superior Court, Law Division, against ACE (among other defendants) asserting claims under New Jersey’s Wrongful Death and Survival statutes. The complaint, filed by the estate of a decedent who was the wife of a former employee of ACE, alleges that the decedent’s mesothelioma was caused by exposure to asbestos brought home by her husband on his work clothes. New Jersey courts have recognized a cause of action against a premise owner in a so-called “take home” case if it can be shown that the harm was foreseeable. In this case, the complaint seeks recovery of an unspecified amount of damages for, among other things, the decedent’s past medical expenses, loss of earnings, and pain and suffering between the time of injury and death, and asserts a punitive damage claim. At this time, ACE has concluded that a loss is reasonably possible with respect to this matter, but ACE was unable to estimate an amount or range of reasonably possible loss because (i) the damages sought are indeterminate, (ii) the proceedings are in the early stages, and (iii) the matter involves facts that ACE believes are distinguishable from the facts of the “take-home” cause of action recognized by the New Jersey courts. A trial date has been set for May 20, 2013.

Environmental Matters

PHI, through its subsidiaries, is subject to regulation by various federal, regional, state and local authorities with respect to the environmental effects of its operations, including air and water quality control, solid and hazardous waste disposal and limitations on land use. Although penalties assessed for violations of environmental laws and regulations are not recoverable from customers of PHI’s utility subsidiaries, environmental clean-up costs incurred by Pepco, DPL and ACE generally are included by each company in its respective cost of service for ratemaking purposes. The total accrued liabilities for the environmental contingencies described below of PHI and its subsidiaries at September 30, 2012 are summarized as follows:

 

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

Beginning balance as of January 1

   $ 15       $ 8      $ 10       $ 2      $ 35  

Accruals

     —           —          —           —           —     

Payments

     —           (1     —           —           (1
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

 

Ending balance as of September 30

     15        7       10        2         34   

Less amounts in Other current liabilities

     2        2       —           2         6   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

 

Amounts in Other deferred credits

   $ 13       $ 5      $ 10      $ —         $ 28   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

 

 

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Conectiv Energy Wholesale Power Generation Sites

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

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

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

Franklin Slag Pile Site

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

 

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

Peck Iron and Metal Site

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

Ward Transformer Site

In April 2009, a group of PRPs with respect to the Ward Transformer site in Raleigh, North Carolina, filed a complaint in the U.S. District Court for the Eastern District of North Carolina, alleging cost recovery and/or contribution claims against a number of entities, including ACE, DPL and Pepco with respect to past and future response costs incurred by the PRP group in performing a removal action at the site. In a March 2010 order, the court denied the defendants’ motion to dismiss. The litigation is moving forward with certain “test case” defendants (not including ACE, DPL and Pepco) filing summary judgment motions regarding liability. The case has been stayed as to the remaining defendants pending rulings upon the test cases. Although PHI cannot at this time estimate an amount or range of reasonably possible losses to which it may be exposed, PHI does not believe that any of its three utility subsidiaries had extensive business transactions, if any, with the Ward Transformer site and therefore, costs incurred to resolve this matter are not expected to be material.

Benning Road Site

In September 2010, PHI received a letter from EPA stating that EPA and the District of Columbia Department of the Environment (DDOE) have identified the Benning Road location, consisting of a generation facility operated by Pepco Energy Services until the facility was deactivated in June 2012, and a transmission and distribution facility operated by Pepco, as one of six land-based sites potentially contributing to contamination of the lower Anacostia River. The letter stated that the principal contaminants of concern are polychlorinated biphenyls and polycyclic aromatic hydrocarbons. In December 2011, the U.S. District Court for the District of Columbia approved a consent decree entered into by Pepco and Pepco Energy Services with DDOE, which requires Pepco and Pepco Energy Services to conduct a RI/FS for the Benning Road site and an approximately 10-15 acre portion of the adjacent Anacostia River. The RI/FS will form the basis for DDOE’s

 

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selection of a remedial action for the Benning Road site and for the Anacostia River sediment associated with the site. The consent decree does not obligate Pepco or Pepco Energy Services to pay for or perform any remediation work, but it is anticipated that DDOE will look to the companies to assume responsibility for cleanup of any conditions in the river that are determined to be attributable to past activities at the Benning Road site. The court order entering the consent decree requires the parties to submit a written status report to the court on May 24, 2013 regarding the implementation of the requirements of the consent decree and any related plans for remediation. In addition, if the RI/FS has not been completed by May 24, 2013, the status report must provide an explanation and a showing of good cause for why the work has not been completed.

Pepco and Pepco Energy Services submitted a proposed RI/FS work plan in July 2012, and anticipate that the work plan will be approved by DDOE during the fourth quarter of 2012, following which the RI/FS field work will commence.

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

Indian River Oil Release

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

Potomac River Mineral Oil Release

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

The release falls within the regulatory jurisdiction of multiple federal and state agencies. Beginning in March 2011, DDOE issued a series of compliance directives requiring Pepco to prepare an incident report, provide certain records, and prepare and implement plans for sampling surface water and river sediments and assessing ecological risks and natural resources damages. Pepco completed field sampling during the fourth quarter of 2011 and submitted sampling results to DDOE during the second quarter of 2012. Initial discussions with DDOE indicate that additional monitoring of shoreline sediments may be required.

In June 2012, Pepco commenced discussions with DDOE regarding a possible consent decree that would resolve DDOE’s threatened claims for civil penalties for alleged violation of the District’s Water Pollution Control Law, as well as for damages to natural resources. Based on the discussions to date, PHI and Pepco do not believe that the resolution of these claims will have a material adverse effect on their respective financial conditions, results of operations or cash flows.

In March 2011, the Virginia Department of Environmental Quality (VADEQ) requested documentation regarding the release and the preparation of an emergency response report, which Pepco submitted to the agency in April 2011. In March 2011, Pepco received a notice of violation from VADEQ and in December 2011, entered into a consent decree with VADEQ, pursuant to which Pepco paid a civil penalty of approximately $40,000. The U.S. Coast Guard assessed a $5,000 penalty against Pepco for the release of oil into the waters of the United States, which Pepco has paid.

During March 2011, EPA conducted an inspection of the Potomac River substation to review compliance with federal regulations regarding Spill Prevention, Control, and Countermeasure (SPCC) plans for facilities using oil-containing equipment in proximity to surface waters. EPA identified several potential violations of the SPCC regulations relating to SPCC plan content, recordkeeping, and secondary containment. As a result

 

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of the oil release, Pepco submitted a revised SPCC plan to EPA in August 2011 and implemented certain interim operational changes to the secondary containment systems at the facility which involve pumping accumulated storm water to an aboveground holding tank for off-site disposal. In December 2011, Pepco completed the installation of a treatment system designed to allow automatic discharge of accumulated storm water from the secondary containment system. Pepco currently is seeking DDOE’s and EPA’s approval to commence operation of the new system and, after receiving such approval, will submit a further revised SPCC plan to EPA. In the meantime, Pepco is continuing to use the aboveground holding tank to manage storm water from the secondary containment system. On April 19, 2012, EPA advised Pepco that it is not seeking civil penalties at this time for alleged non-compliance with SPCC regulations.

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

PHI’s Cross-Border Energy Lease Investments

PCI has cross-border energy lease investments involving public utility assets (primarily consisting of hydroelectric generation and coal-fired electric generation facilities and natural gas distribution networks) located outside of the United States. Each of these investments is comprised of multiple leases and each investment is structured as a sale and leaseback transaction commonly referred to by the IRS as a sale-in, lease-out, or SILO transaction. PHI current annual tax benefits from these lease investments are approximately $43 million. As of September 30, 2012, the book value of PHI’s investment in its cross-border energy lease investments was approximately $1.2 billion. After taking into consideration the $74 million paid with the 2001-2002 audit (as discussed below), the net federal and state tax benefits received for the remaining leases from January 1, 2001, the earliest year that remains open to audit, to September 30, 2012, has been approximately $479 million. As more fully discussed in Note (8), “Leasing Activities,” in the third quarter of 2012 and in the second quarter of 2011, PHI entered into early termination agreements with lessees with respect to a number of leases in the cross-border energy lease portfolio.

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

In the event that the IRS were to be successful in disallowing 100% of the tax benefits associated with these lease investments and recharacterizing these lease investments as loans, PHI estimates that, as of September 30, 2012, it would be obligated to pay approximately $622 million in additional federal and state taxes and $138 million of interest on the remaining leases. The $760 million in additional federal and state taxes and interest is net of the $74 million tax payment made in January 2011. In addition, the IRS could require PHI to pay a penalty of up to 20% on the amount of additional taxes due.

PHI anticipates that any additional taxes that it would be required to pay as a result of the disallowance of prior deductions or a re-characterization of the leases as loans would be recoverable in the form of lower taxes

 

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PEPCO HOLDINGS

 

over the remaining terms of the affected leases. Moreover, the entire amount of any additional federal and state tax would not be due immediately, but rather, the federal and state taxes would be payable when the open audit years are closed and PHI amends subsequent tax returns not then under audit. To mitigate the taxes due in the event of a total disallowance of tax benefits, PHI could elect to liquidate all or a portion of its remaining cross-border energy lease investments, which PHI estimates could be accomplished over a period of six months to one year. Based on current market values, PHI estimates that liquidation of the remaining portfolio would generate sufficient cash proceeds to cover the estimated $760 million in federal and state taxes and interest due as of September 30, 2012, in the event of a total disallowance of tax benefits and a recharacterization of the leases as loans. If payments of additional taxes and interest preceded the receipt of liquidation proceeds, the payments would be funded by currently available sources of liquidity.

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

District of Columbia Tax Legislation

On September 14, 2012, the District of Columbia Office of Tax and Revenue adopted regulations to implement the mandatory unitary combined reporting method for tax years beginning in 2011. PHI has analyzed these regulations and determined that the regulations did not impact PHI’s results of operations for the three and nine months ended September 30, 2012.

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

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

As of September 30, 2012, PHI and its subsidiaries were parties to a variety of agreements pursuant to which they were guarantors for standby letters of credit, energy procurement obligations, and other commitments and obligations. The commitments and obligations, in millions of dollars, were as follows:

 

     Guarantor         
     PHI      Pepco      DPL      ACE      Total  

Energy procurement obligations of Pepco Energy Services (a)

   $ 101      $ —         $ —         $ —         $ 101  

Guarantees associated with disposal of Conectiv Energy assets (b)

     13        —           —           —           13  

Guaranteed lease residual values (c)

     2        4        6        4        16  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 116       $ 4      $ 6