10-K 1 d440828d10k.htm FORM 10-K Form 10-K
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

 

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

THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2012

 

 

 

Commission

File Number

  

Exact Name of Registrant as Specified in its Charter,

State or Other Jurisdiction of Incorporation,
Address of Principal Executive Offices, Zip Code
and Telephone Number (Including Area Code)

   I.R.S. Employer
Identification Number

001-31403

  

PEPCO HOLDINGS, INC.

(Pepco Holdings or PHI), a Delaware corporation

701 Ninth Street, N.W.

Washington, D.C. 20068

Telephone: (202)872-2000

   52-2297449

001-01072

  

POTOMAC ELECTRIC POWER COMPANY

(Pepco), a District of Columbia and Virginia corporation

701 Ninth Street, N.W.

Washington, D.C. 20068

Telephone: (202)872-2000

   53-0127880

001-01405

  

DELMARVA POWER & LIGHT COMPANY

(DPL), a Delaware and Virginia corporation

500 North Wakefield Drive, 2nd Floor

Newark, DE 19702

Telephone: (202)872-2000

   51-0084283

001-03559

  

ATLANTIC CITY ELECTRIC COMPANY

(ACE), a New Jersey corporation

500 North Wakefield Drive, 2nd Floor

Newark, DE 19702

Telephone: (202)872-2000

   21-0398280

 

 

Securities registered pursuant to Section 12(b) of the Act:

 

Registrant

 

Title of Each Class

 

Name of Each Exchange

on Which Registered

Pepco Holdings   Common Stock, $.01 par value   New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act:

 

Registrant

 

Title of Each Class

Pepco   Common Stock, $.01 par value
DPL   Common Stock, $2.25 par value
ACE   Common Stock, $3.00 par value

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

 

Pepco Holdings   Yes  x       No  ¨      Pepco   Yes  ¨       No  x
DPL   Yes  ¨       No  x      ACE   Yes  ¨       No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

 

Pepco Holdings   Yes  ¨       No  x      Pepco   Yes  ¨       No  x
DPL   Yes  ¨       No  x      ACE   Yes  ¨       No  x

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K (applicable to Pepco Holdings only).  x

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 I(1)(a) and (b) of Form 10-K and are therefore filing this Form 10-K with the reduced disclosure format specified in General Instruction I(2) of Form 10-K.

 

Registrant

 

Aggregate Market Value of Voting and

Non-Voting Common Equity Held by

Non-Affiliates of the Registrant at

June 29, 2012

 

Number of Shares of Common

Stock of the Registrant

Outstanding at February 15, 2013

Pepco Holdings   $4,464,800,000(a)   230,073,469
($.01 par value)
Pepco   None (b)   100
($.01 par value)
DPL   None (c)   1,000
($2.25 par value)
ACE   None (c)   8,546,017
($3.00 par value)

 

(a) Solely for purposes of calculating this aggregate market value, PHI has defined its affiliates to include (i) those persons who were, as of June 29, 2012, its executive officers, directors and beneficial owners of more than 10% of its common stock, and (ii) such other persons who were, as of June 29, 2012, controlled by, or under common control with, the persons described in clause (i) above.
(b) All voting and non-voting common equity is owned by Pepco Holdings.
(c) All voting and non-voting common equity is owned by Conectiv, LLC, a wholly owned subsidiary of Pepco Holdings.

THIS COMBINED FORM 10-K 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.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Pepco Holdings, Inc. definitive proxy statement for the 2013 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission within 120 days after December 31, 2012 are incorporated by reference into Part III of this report.

 

 

 


Table of Contents

TABLE OF CONTENTS

 

                   Page  
Glossary of Terms                i   
Forward-Looking Statements                1   
PART I             

Item 1.

     -      Business      3   

Item 1A.

     -      Risk Factors      24   

Item 1B.

     -      Unresolved Staff Comments      37   

Item 2.

     -      Properties      38   

Item 3.

     -      Legal Proceedings      39   

Item 4.

     -      Mine Safety Disclosures      39   
PART II             

Item 5.

     -      Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities      40   

Item 6.

     -      Selected Financial Data      42   

Item 7.

     -      Management’s Discussion and Analysis of Financial Condition and Results of Operations      43   

Item 7A.

     -      Quantitative and Qualitative Disclosures About Market Risk      124   

Item 8.

     -      Financial Statements and Supplementary Data      127   

Item 9.

     -      Changes in and Disagreements With Accountants on Accounting and Financial Disclosure      326   

Item 9A.

     -      Controls and Procedures      327   

Item 9B.

     -      Other Information      328   
PART III             

Item 10.

     -      Directors, Executive Officers and Corporate Governance      329   

Item 11.

     -      Executive Compensation      330   

Item 12.

     -      Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters      331   

Item 13.

     -      Certain Relationships and Related Transactions, and Director Independence      331   

Item 14.

     -      Principal Accountant Fees and Services      331   
PART IV             

Item 15.

     -      Exhibits and Financial Statement Schedules      332   

Schedule I

     -      Condensed Financial Information of Parent Company      334   

Schedule II

     -      Valuation and Qualifying Accounts      339   

Exhibit 12

     -      Statements Re: Computation of Ratios      358   

Exhibit 21

     -      Subsidiaries of the Registrant      362   

Exhibit 23

     -      Consents of Independent Registered Public Accounting Firm      364   

Exhibits 31.1 - 31.8

     -      Rule 13a-14a/15d-14(a) Certifications      368   

Exhibits 32.1 - 32.4

     -      Section 1350 Certifications      376   

Signatures

          380   


Table of Contents

GLOSSARY OF TERMS

The following is a glossary of terms, abbreviations and acronyms that are used in the Reporting Companies’ SEC reports. The terms, abbreviations and acronyms used have the meanings set forth below, unless the context requires otherwise.

 

Term

  

Definition

2012 LTIP    Pepco Holdings, Inc. 2012 Long-Term Incentive Plan
ACE    Atlantic City Electric Company
ACE Funding    Atlantic City Electric Transition Funding LLC
AFUDC    Allowance for funds used during construction
AOCL    Accumulated Other Comprehensive Loss
AMI    Advanced metering infrastructure, a system that collects, measures and analyzes energy usage data from advanced digital electric and gas meters known as smart meters
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)
BGS-CIEP    BGS-Commercial and Industrial Energy Price
BGS-FP    BGS-Fixed Price
Bondable Transition Property    Principal and interest payments on the Transition Bonds and related taxes, expenses and fees
BSA    Bill Stabilization Adjustment
Budget Support Act    The Fiscal Year 2012 Budge Support Act of 2011, approved by the Council of the District of Columbia on June 14, 2011
CAA    Federal Clean Air Act
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
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
DPL    Delmarva Power & Light Company
DEDA    Delaware Economic Development Authority
DOE    U.S. Department of Energy
DPSC    Delaware Public Service Commission
DRP    Shareholder Dividend Reinvestment Plan
EBITDA    Earnings before interest, taxes, depreciation, and amortization
EDC    Electricity Distribution Company
EmPower Maryland    A Maryland demand-side management program for Pepco and DPL
EPA    U.S. Environmental Protection Agency
Exchange Act    Securities Exchange Act of 1934, as amended
FASB    Financial Accounting Standards Board
FERC    Federal Energy Regulatory Commission
FPA    Federal Power Act
GAAP    Accounting principles generally accepted in the United States of America
GCR    Gas Cost Rate
GWh    Gigawatt hour
HPS    Hourly Priced Service
IIP    ACE’s Infrastructure Investment Program

 

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Term

  

Definition

IRS    Internal Revenue Service
ISDA    International Swaps and Derivatives Association Master Agreement
ISRA    Industrial Site Recovery Act
LIBOR    London Interbank Offered Rate
Line Losses    Estimates of electricity and gas expected to be lost in the process of its transmission and distribution to customers
LTIP    The Pepco Holdings, Inc. Long-Term Incentive Plan
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
Mcf    Thousand Cubic Feet
MDC    MDC Industries, Inc.
Medicare Act    Medicare Prescription Drug Improvement and Modernization Act of 2003
Medicare Part D    A prescription drug benefit under the Medicare Act
MFVRD    Modified fixed variable rate design
Mirant    Mirant Corporation
MMBtu    One Million British Thermal Units
MPSC    Maryland Public Service Commission
MW    Megawatt
MWh    Megawatt hour
NAV    Net Asset Value
NERC    North American Electric Reliability Corporation
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
New Jersey Societal Benefit Charge    A surcharge related to the New Jersey Societal Benefit Program

New Jersey Societal Benefit Program

   A New Jersey public interest program for low income customers
NJBPU    New Jersey Board of Public Utilities
NPCC    Northeast Power Coordinating Council
NPDES    National Pollutant Discharge Elimination System
NUGs    Non-utility generators
NYMEX    New York Mercantile Exchange
OPEB    Other postretirement benefit
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 OPEB Plan    The Pepco Holdings, Inc. Welfare Plan for Retirees
PJM    PJM Interconnection, LLC
PJM RTO    PJM regional transmission organization
Power Delivery    The transmission, distribution and default supply of electricity and, to a lesser extent, the distribution and supply of natural gas, conducted through Pepco, DPL and ACE, PHI’s regulated public utility subsidiaries.
PPA    Power purchase agreement
PRP    Potentially responsible party
PUHCA 2005    Public Utility Holding Company Act of 2005
RECs    Renewable energy credits

 

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Term

  

Definition

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
Regulatory Asset Recovery Charge    Costs associated with deferred, NJBPU-approved expenses incurred as part of ACE’s obligation to serve the public
Reporting Company    PHI, Pepco, DPL or ACE
Revenue Decoupling Adjustment    An adjustment equal to the amount by which revenue from distribution sales differs from the revenue that Pepco and DPL are entitled to earn based on the approved distribution charge per customer
RFC    ReliabilityFirst Corporation
RI/FS    Remedial investigation and feasibility study
RIM    Reliability investment recovery mechanism
ROE    Return on equity
RPS    Renewable Energy Portfolio Standards
Sarbanes-Oxley Act    Sarbanes-Oxley Act of 2002
SEC    Securities and Exchange Commission
SO2    Sulfur dioxide
SOCA    Standard Offer Capacity Agreement 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
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
SRECs    Solar renewable energy credits
T&D    Transmission and distribution
TEFA    Transitional Energy Facility Assessment, a New Jersey tax surcharge providing a gradual transition from the previous franchise and gross receipts tax eliminated in 1997, to its new total liability under the corporation business tax and the sales-and-use tax (this surcharge will be eliminated in 2013)
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
VRDBs    Variable Rate Demand Bonds
WACC    Weighted average cost of capital

 

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FORWARD-LOOKING STATEMENTS

Some of the statements contained in this Annual Report on Form 10-K 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 under 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 outcome of PHI’s litigation with the Internal Revenue Service (IRS) regarding its cross-border energy leases or the amount of Federal and state income taxes, including interest and the likelihood of penalties, that may be due as a result of the disallowance of prior deductions or a recharacterization of the leases as loans, and PHI’s method of funding such tax payments as well as the ability of PHI to timely liquidate the lease portfolio, if it determines to do so, and the impact of such liquidation on future earnings;

 

   

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 or their subsidiaries 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;

 

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

 

   

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

 

   

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

 

   

Changes in tax rates or policies;

 

   

Changes in rates of inflation;

 

   

Changes in accounting standards or practices;

 

   

Unanticipated changes in operating expenses and capital expenditures;

 

   

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 and other 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 this Annual Report on Form 10-K, and investors should refer to such risk factors and other statements in evaluating the forward-looking statements contained in this Annual Report on Form 10-K.

Any forward-looking statements speak only as to the date this Annual Report on Form 10-K for each Reporting Company 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. Furthermore, it may not be possible to assess the impact of any such factor on such Reporting Company’s or its subsidiaries’ business (viewed independently or together with the business or businesses of some or all of the other Reporting Companies or their subsidiaries), or the extent to which any factor, or combination of factors, may cause results to differ materially from those contained in any forward-looking statement. The foregoing factors should not be construed as exhaustive.

 

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Part I

 

Item 1. BUSINESS

Overview

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

 

   

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

 

   

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

 

   

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

Through Pepco Energy Services, Inc. and its subsidiaries (collectively, Pepco Energy Services), PHI provides energy savings performance contracting services primarily to government customers, high voltage underground transmission cabling for industrial customers, construction and operations of combined heat and power and central energy plants for government and commercial customers, and is in the process of winding down its competitive electricity and natural gas retail supply business.

In addition, through Potomac Capital Investment Corporation (PCI), PHI holds six cross-border energy lease investments as described below under the heading “Other Business Operations.”

The following chart shows, in simplified form, the corporate structure of PHI and its principal subsidiaries:

 

LOGO

 

 

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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 methods set forth in the service agreement.

Pepco Holdings’ management has identified its operating segments at December 31, 2012 as (i) Power Delivery, consisting of the operations of Pepco, DPL and ACE, engaged primarily in the transmission, distribution and default supply of electricity and the distribution and supply of natural gas, (ii) Pepco Energy Services and (iii) Other Non-Regulated, consisting primarily of the operations of PCI. For financial information relating to PHI’s segments, see Note (5), “Segment Information,” to the consolidated financial statements of PHI.

Business Strategy

PHI’s business strategy is to be a top-performing, regulated power delivery company focused on:

 

   

investing in transmission and distribution infrastructure to provide safe and reliable electric and natural gas service;

 

   

building a smarter grid to automate certain functions on the electric system, restore power more efficiently and provide customers detailed energy information to help them control their energy costs;

 

   

enhancing the customer experience and PHI’s communications with its customers through the development and use of the smart grid and other technology; and

 

   

providing comprehensive energy management solutions and developing, installing and operating renewable energy solutions.

The elements of PHI’s business strategy support PHI’s core values of safety, diversity and environmental stewardship. PHI’s success in achieving this business strategy is dependent on its ability to earn reasonable rates of return on, and timely cost recovery of, its investments through its regulatory proceedings.

To further its business strategy, Pepco Holdings may consider transactions involving its existing businesses, including joint ventures, and dispositions and acquisitions of businesses. Pepco Holdings also may refine components of its business strategy as it deems necessary or appropriate in response to business factors and conditions, including regulatory requirements.

Description of Business

Power Delivery

PHI’s primary business is Power Delivery. Power Delivery in 2012, 2011 and 2010, produced 86%, 78% and 73%, respectively, of PHI’s consolidated operating revenues and 79%, 78% and 81%, respectively, of PHI’s consolidated operating income.

Each utility comprising Power Delivery is regulated in the jurisdictions that encompass its electricity distribution service territory and is regulated by the Federal Energy Regulatory Commission (FERC) for its electricity transmission facilities. DPL also is a regulated natural gas utility serving portions of Delaware. In the aggregate, Power Delivery distributes electricity to more than 1.8 million customers in the mid-Atlantic region and delivers natural gas to approximately 125,000 customers in Delaware. PHI no longer owns any electric generation facilities except for 17,400 kilowatts of generating capacity owned and operated by Pepco Energy Services.

 

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The Pepco, DPL and ACE service territories are located within a corridor extending from the District of Columbia to southern New Jersey. These service territories are economically diverse and include key industries that contribute to the regional economic base:

 

   

Commercial activities in the region include banking and other professional services, government, insurance, real estate, shopping malls, casinos, stand alone construction and tourism.

 

   

Industrial activities in the region include chemical, glass, pharmaceutical, steel manufacturing, food processing and oil refining.

Distribution and Default Supply of Electricity

Pepco, DPL and ACE each owns and operates a network of wires, substations and other equipment that are classified as transmission facilities, distribution facilities or common facilities (which are used for both transmission and distribution). Transmission facilities carry wholesale electricity into, out of and across, the utilties’ service territories. Distribution facilities carry electricity from the transmission facilities to the end-use customers located in the utilities’ service territories.

Each utility is responsible for the distribution of electricity 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 retail supplier. The regulatory term for this default supply service is Standard Offer Service (SOS) in Delaware, the District of Columbia and Maryland, and Basic Generation Service (BGS) in New Jersey. In this Annual Report on Form 10-K, these supply services are referred to generally as Default Electricity Supply.

Transmission of Electricity and Relationship with PJM

The transmission facilities owned by Pepco, DPL and ACE are interconnected with the transmission facilities of contiguous utilities and are part of an interstate power transmission grid over which electricity is transmitted throughout the mid-Atlantic portion of the United States and parts of the Midwest. Pepco, DPL and ACE each is a member of the PJM Regional Transmission Organization (PJM RTO), the regional transmission organization designated by FERC to coordinate the movement of wholesale electricity within a region consisting of all or parts of Delaware, Illinois, Indiana, Kentucky, Maryland, Michigan, New Jersey, North Carolina, Ohio, Pennsylvania, Tennessee, Virginia, West Virginia and the District of Columbia.

PJM, the FERC-approved independent grid operator, manages the transmission grid and the wholesale electricity market in the PJM RTO region. Any entity that wishes to have wholesale electricity delivered at any point within the PJM RTO region must obtain transmission services from PJM. In accordance with FERC-approved rules, Pepco, DPL, ACE and the other transmission-owning utilities in the region make their transmission facilities available to the PJM RTO, and PJM directs and controls the operation of these transmission facilities. For transmission services, transmission owners are paid rates proposed by the transmission owner and approved by FERC. PJM provides billing and settlement services, collects transmission service revenue from transmission service customers and distributes the revenue to the transmission owners. PJM also directs the regional transmission planning process within the PJM RTO region. The PJM Board of Managers reviews and approves each PJM regional transmission expansion plan, including whether to include new construction of transmission facilities proposed by PJM RTO members in the plan and, if so, the target in-service date for those facilities.

 

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Reliability Enhancement

Since 2010, PHI has implemented comprehensive reliability enhancement plans which include various initiatives to improve electrical system reliability, including:

 

   

the identification and upgrading of under-performing feeder lines;

 

   

the addition of new facilities to support load;

 

   

the installation of distribution automation systems on both the overhead and underground network system;

 

   

the rejuvenation and replacement of underground residential cables;

 

   

selective undergrounding of portions of existing above-ground primary feeder lines, where appropriate to improve reliability;

 

   

improvements to substation supply lines; and

 

   

enhanced vegetation management.

PHI’s capital expenditures for continuing reliability enhancement efforts are included in the table of projected capital expenditures within “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Capital Resources and Liquidity – Capital Requirements.”

Smart Grid

A key initiative for PHI in 2012 was the continued transformation of the electric grid owned and operated by Pepco Holdings’ utility subsidiaries into a “smart grid,” a sophisticated network of automated digital devices capable of communicating vast amounts of real-time information. The smart grid is designed to meet the challenges of rising energy costs, respond to concerns about the environment, improve reliability, provide timely and accurate customer information and address government energy reduction goals. During 2012, Power Delivery continued its development of the smart grid by replacing existing meters with smart meters, continuing construction of a wireless network and related information technology infrastructure to collect, manage and provide customers with the data made available by the smart meters and installing equipment to automate certain functions on the electric grid.

A central component of the smart grid is advanced metering infrastructure (AMI) which is a system that collects, measures and analyzes energy usage data from advanced digital electric and gas meters known as smart meters. In total, Power Delivery is deploying 1.3 million smart meters across the Pepco and DPL service territories. Also critical to the operation of the smart grid is distribution automation technology, which is comprised of automated devices that have internal intelligence and can be controlled remotely to better manage power flow and restore service quickly and more safely. Both AMI and distribution automation are enabled by advanced technology that is able to communicate with devices on the electric and gas delivery system and carry energy usage data to the host utility. The smart grid system will provide customers access to detailed energy information to help them better manage energy usage and costs, improve the customer experience during power restoration and enhance the ability of PHI’s utilities to manage and operate their electrical and natural gas distribution systems. The implementation of the AMI system and distribution automation involves an integration of technologies provided by multiple vendors.

The installation of smart meters is subject to the approval of applicable state regulators. Electric meter installation and activation are substantially complete for DPL electric customers in Delaware; installation of smart meters for natural gas delivery customers in Delaware is ongoing. Meter installation is substantially complete for Pepco customers in the District of Columbia, with activation expected to be completed in the first quarter of 2013. For Pepco customers in Maryland, installation and activation are expected to be completed in the third quarter of 2013. In 2012, the Maryland Public Service Commission (MPSC) approved the deployment of AMI for electric customers in DPL’s Maryland service territory, and installation is scheduled to begin in the first quarter of 2013.

The respective public service commissions have approved the creation of regulatory assets to defer AMI costs between rate cases, as well as the accrual of returns on the deferred costs. Thus, these costs will be recovered in the future through base rates. Approval of AMI has been deferred by the New Jersey Board of Public Utilities (NJBPU) for ACE in New Jersey.

 

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PHI’s implementation of dynamic pricing rate structures helps ensure that customers experience additional benefits from the smart grid. Dynamic pricing provides bill credits to reward eligible customers for lowering their energy use during those times when energy demand and, consequently, the cost of supplying electricity, are higher. In 2011, the Delaware Public Service Commission (DPSC) approved DPL’s request to implement dynamic pricing for Delaware customers. In Delaware, approximately 6,700 SOS customers participated in the phase-in stage of the program in 2012; the remaining residential SOS customers will be eligible to participate in 2013.

Dynamic pricing has been approved for all Pepco customers in Maryland, and the phase-in for approximately 5,000 residential customers has been completed; the remaining Maryland residential customers will be eligible to participate in 2013. Pepco intends to re-file the dynamic pricing proposal in its District of Columbia jurisdiction in 2013. Dynamic pricing has been approved in concept pending AMI deployment for DPL’s Maryland SOS customers, and has been deferred by the NJBPU for ACE’s customers in New Jersey.

In April 2010, PHI signed agreements to formalize $168 million in awards from the U.S. Department of Energy to support the rollout of smart grid initiatives. In the Pepco service area, $149 million was awarded for AMI, direct load control, distribution automation and communications infrastructure, while in the Atlantic City Electric service area, $19 million was awarded for direct load control, distribution automation and communications infrastructure. The grants effectively reduce the project costs of these initiatives. The cumulative award payments received by Pepco and ACE as of December 31, 2012, were $115 million and $13 million, respectively.

For projected 2013 through 2017 capital expenditures associated with the smart grid, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Capital Resources and Liquidity – Capital Requirements.”

Regulated Utility Subsidiaries

The following is a more detailed description of the business of each of PHI’s three regulated utility subsidiaries:

Pepco

Pepco is engaged in the transmission, distribution and default supply of electricity in the District of Columbia and major portions of Prince George’s County and Montgomery County in Maryland. Pepco’s service territory covers approximately 640 square miles and has a population of approximately 2.2 million. As of December 31, 2012, Pepco distributed electricity to 793,000 customers (of which 260,000 were located in the District of Columbia and 533,000 were located in Maryland), as compared to 788,000 customers as of December 31, 2011 (of which 257,000 were located in the District of Columbia and 531,000 were located in Maryland). As of December 31, 2010, Pepco distributed electricity to 787,000 customers (of which 256,000 were located in the District of Columbia and 531,000 were located in Maryland).

In 2012, Pepco distributed a total of 26,006,000 megawatt hours of electricity, of which 57% was distributed within its Maryland territory and 43% within the District of Columbia. Of this amount, 30% of the total megawatt hours were delivered to residential customers, 50% to commercial customers, and 20% to United States and District of Columbia government customers. In 2011, Pepco distributed a total of 26,895,000 megawatt hours of electricity, of which 57% was distributed within its Maryland territory and 43% within the District of Columbia. Of this amount, 30% of the total megawatt hours were distributed to residential customers, 50% to commercial customers, and 20% to United States and District of Columbia government customers. In 2010, Pepco distributed a total of 27,665,000 megawatt hours of electricity, of which 57% was distributed within its Maryland territory and 43% within the District of Columbia. Of this amount, 30% of the total megawatt hours were distributed to residential customers, 49% to commercial customers, and 21% to United States and District of Columbia government customers.

 

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Pepco has been providing SOS in Maryland since July 2004. Pursuant to orders issued by the MPSC, Pepco is obligated to provide SOS (i) to residential and small commercial customers until further action of the Maryland General Assembly and (ii) to medium-sized commercial customers through November 2013. Pepco purchases the electricity required to satisfy these SOS obligations from wholesale suppliers under contracts entered into in accordance with competitive bid procedures approved and supervised by the MPSC. Pepco also is obligated to provide Standard Offer Service, known as Hourly Priced Service (HPS), for large Maryland customers. Power to supply HPS customers is acquired in next-day and other short-term PJM RTO markets. Pepco is entitled to recover from its SOS customers the cost of acquiring the SOS supply, plus an administrative charge that is intended to allow Pepco to recover the administrative costs incurred to provide the SOS and a modest margin. Because the margin varies by customer class, the actual average margin over any given time period depends on the number of Maryland SOS customers in each customer class and the electricity used by such customers. Pepco is paid tariff rates for the distribution of electricity over its transmission and distribution facilities to all electricity customers in its Maryland service territory regardless of whether the customer receives SOS or purchases electricity from another supplier.

Pepco has been providing SOS in the District of Columbia since February 2005. Pursuant to orders issued by the District of Columbia Public Service Commission (DCPSC), Pepco is obligated to provide SOS to residential and small, medium-sized and large commercial customers indefinitely. Pepco purchases the electricity required to satisfy its SOS obligations from wholesale suppliers under contracts entered into in accordance with a competitive bid procedure approved and supervised by the DCPSC. Pepco is entitled to recover from its SOS customers the costs of acquiring the SOS supply, plus an administrative charge that is intended to allow Pepco to recover the administrative costs incurred to provide the SOS and a modest margin. Because the margin varies by customer class, the actual average margin over any given time period depends on the number of District of Columbia SOS customers in each customer class and the amount of electricity used by such customers. Pepco is paid tariff rates for the distribution of electricity over its transmission and distribution facilities to all electricity customers in its District of Columbia service territory regardless of whether the customer receives SOS or purchases electricity from another supplier.

For the year ended December 31, 2012, 40% of Pepco’s Maryland distribution sales (measured by megawatt hours) were to SOS customers, as compared to 43% and 46% in 2011 and 2010, respectively, and 25% of its District of Columbia distribution sales (measured by megawatt hours) were to SOS customers in 2012, as compared to 27% and 29% in 2011 and 2010, respectively.

DPL

DPL is engaged in the transmission, distribution and default supply of electricity in Delaware and portions of Maryland. In northern Delaware, DPL also supplies and delivers natural gas to retail customers and provides transportation-only services to retail customers that purchase natural gas from another supplier.

Distribution and Supply of Electricity

DPL’s electricity distribution service territory consists of the state of Delaware, and Caroline, Cecil, Dorchester, Harford, Kent, Queen Anne’s, Somerset, Talbot, Wicomico and Worcester counties in Maryland. This territory covers approximately 5,000 square miles and has a population of approximately 1.4 million. As of December 31, 2012, DPL delivered electricity to 503,000 customers (of which 303,000 were located in Delaware and 200,000 were located in Maryland), as compared to 501,000 customers as of December 31, 2011 (of which 301,000 were located in Delaware and 200,000 were located in Maryland). As of December 31, 2010, DPL delivered electricity to 500,000 customers (of which 301,000 were located in Delaware and 199,000 were located in Maryland).

 

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In 2012, DPL distributed a total of 12,641,000 megawatt hours of electricity to its customers, of which 67% was distributed within its Delaware territory and 33% within its Maryland territory. Of this amount, 40% of the total megawatt hours were distributed to residential customers, 41% to commercial customers and 19% to industrial customers. In 2011, DPL distributed a total of 12,688,000 megawatt hours of electricity, of which 66% was distributed within its Delaware territory and 34% within its Maryland territory. Of this amount, 41% of the total megawatt hours were distributed to residential customers, 42% to commercial customers and 17% to industrial customers. In 2010, DPL distributed a total of 12,853,000 megawatt hours of electricity, of which 66% was distributed within its Delaware territory and 34% within its Maryland territory. Of this amount, 42% of the total megawatt hours were distributed to residential customers, 41% to commercial customers and 17% to industrial customers.

DPL has been providing SOS in Delaware since May 2006. Pursuant to orders issued by the DPSC, DPL is obligated to provide SOS to residential, small commercial and industrial customers through May 2015, and to medium, large and general service commercial customers through May 2013. DPL purchases the electricity required to satisfy these SOS obligations from wholesale suppliers under contracts entered into in accordance with competitive bid procedures approved and supervised by the DPSC. DPL also has an obligation to provide SOS, known as HPS, for the largest Delaware customers. Power to supply the HPS customers is acquired in next-day and other short-term PJM RTO markets. DPL’s rates for supplying SOS and HPS reflect the associated capacity, energy (including satisfaction of renewable energy requirements), transmission and ancillary services costs and an amount referred to as a Reasonable Allowance for Retail Margin. Components of the Reasonable Allowance for Retail Margin include a fixed annual margin of approximately $2.75 million, plus estimated incremental expenses and a cash working capital allowance. DPL is paid tariff rates for the distribution of electricity over its transmission and distribution facilities to all electricity customers in its Delaware service territory regardless of whether the customer receives SOS or purchases electricity from another supplier.

DPL has been providing SOS in Maryland since June 2004. Pursuant to orders issued by the MPSC, DPL is obligated to provide SOS to residential and small commercial customers until further action of the Maryland General Assembly, and to medium-sized commercial customers through November 2013. DPL purchases the electricity required to satisfy these SOS obligations from wholesale suppliers under contracts entered into in accordance with a competitive bid procedure approved and supervised by the MPSC. DPL also is obligated to provide HPS for large Maryland customers. Power to supply the HPS customers is acquired in next-day and other short-term PJM RTO markets. DPL is entitled to recover from its SOS customers the costs of acquiring the SOS supply, plus an administrative charge that is intended to allow DPL to recover the administrative costs incurred to provide the SOS and a modest margin. Because the margin varies by customer class, the actual average margin over any given time period depends on the number of Maryland SOS customers in each customer class and the electricity used by such customers. DPL is paid tariff rates for the distribution of electricity over its transmission and distribution facilities to all electricity customers in its Maryland service territory regardless of whether the customer receives SOS or purchases electricity from another supplier.

For the year ended December 31, 2012, 47% of DPL’s Delaware distribution sales (measured by megawatt hours) were to SOS customers, as compared to 51% and 53% in 2011 and 2010, respectively, and 53% of its Maryland distribution sales (measured by megawatt hours) were to SOS customers in 2012, as compared to 58% in 2011 and 63% in 2010.

 

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Supply and Distribution of Natural Gas

DPL provides regulated natural gas supply and distribution service to customers in a service territory consisting of a major portion of New Castle County in Delaware. This service territory covers approximately 275 square miles and has a population of approximately 500,000. Large volume commercial, institutional, and industrial natural gas customers may purchase natural gas either from DPL or from other suppliers. DPL uses its natural gas distribution facilities to deliver natural gas to customers that choose to purchase natural gas from another supplier. Intrastate transportation customers pay DPL distribution service rates approved by the DPSC. DPL purchases natural gas supplies for resale to its retail service customers from marketers and producers through a combination of long-term agreements and next-day distribution arrangements. For the year ended December 31, 2012, DPL supplied 60% of the natural gas that it delivered, compared to 64% in 2011 and 65% in 2010.

As of December 31, 2012, DPL delivered natural gas to 125,000 customers as compared to 124,000 customers in 2011 and 123,000 customers in 2010. In 2012, DPL delivered 16,815,000 Mcf (thousand cubic feet) of natural gas to customers in its Delaware service territory, of which 38% were sales to residential customers, 22% to commercial customers, less than 1% to industrial customers and 40% to customers receiving a transportation-only service. In 2011, DPL delivered 18,754,000 Mcf of natural gas, of which 40% were sales to residential customers, 23% were sales to commercial customers, 1% were sales to industrial customers and 36% were sales to customers receiving a transportation-only service. In 2010, DPL delivered 19,336,000 Mcf of natural gas, of which 41% were sales to residential customers, 23% were sales to commercial customers, 1% were sales to industrial customers and 35% were sales to customers receiving a transportation-only service.

ACE

ACE is primarily engaged in the transmission, distribution and default supply of electricity in a service territory consisting of Gloucester, Camden, Burlington, Ocean, Atlantic, Cape May, Cumberland and Salem counties in southern New Jersey. ACE’s service territory covers approximately 2,700 square miles and has a population of approximately 1.1 million. As of December 31, 2012, ACE distributed electricity to 545,000 customers in its service territory, as compared to 547,000 and 548,000 customers as of December 31, 2011 and 2010, respectively.

In 2012, ACE distributed a total of 9,495,000 megawatt hours of electricity to its customers, of which 46% of the total was distributed to residential customers, 45% to commercial customers and 9% to industrial customers. In 2011, ACE distributed a total of 9,683,000 megawatt hours of electricity to its customers, of which 46% of the total was distributed to residential customers, 45% to commercial customers, and 9% to industrial customers. In 2010, ACE distributed a total of 10,185,000 megawatt hours of electricity to its customers, of which 46% was distributed to residential customers, 44% to commercial customers, and 10% to industrial customers.

Electric customers in New Jersey who do not choose another supplier receive BGS from their electric distribution company. New Jersey’s electric distribution companies, including ACE, jointly obtain the electricity to meet their BGS obligations from competitive suppliers selected through auctions authorized by the NJBPU for the supply of New Jersey’s total BGS requirements. Each winning bidder is required to supply its committed portion of the BGS customer load with full requirements service, consisting of power supply and transmission service.

ACE provides two types of BGS:

 

   

BGS-Fixed Price (BGS-FP), which is supplied to smaller commercial and residential customers at seasonally-adjusted fixed prices. BGS-FP rates change annually on June 1 and are based on the average BGS price obtained at auction in the current year and the two prior years. As of December 31, 2012, ACE’s BGS-FP peak load was approximately 1,320 megawatts, which represents approximately 96% of ACE’s total BGS load.

 

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BGS-Commercial and Industrial Energy Price (BGS-CIEP), which is supplied to large customers at hourly PJM RTO real-time market prices for a term of 12 months. As of December 31, 2012, ACE’s peak BGS-CIEP load was approximately 54 megawatts, which represents approximately 4% of ACE’s BGS load.

ACE is paid tariff supply rates established by the NJBPU that compensate it for the cost of obtaining the BGS supply. These rates are set such that ACE does not make any profit or incur any loss on the supply component of the BGS it supplies to customers. ACE is paid tariff rates for the distribution of electricity over its transmission and distribution facilities to all electricity customers in its service territory regardless of whether the customer receives BGS or purchases electricity from another supplier.

For the year ended December 31, 2012, 51% of ACE’s total distribution sales (measured by megawatt hours) were to BGS customers, as compared to 56% and 65% in 2011 and 2010, respectively.

ACE has contracts with three unaffiliated non-utility generators (NUGs) under which ACE is obligated to purchase capacity and the entire generation output of the facilities. One of the contracts expires in 2016 and the other two expire in 2024. In 2012, ACE purchased 1.7 million megawatt hours of power from the NUGs. ACE sells this electricity into the wholesale market administered by PJM.

In 2001, ACE established Atlantic City Electric Transitional Funding LLC (ACE Funding) 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 were transferred to ACE in exchange for the transfer by ACE to ACE Funding of the right to collect a non-bypassable transition bond charge (Transition Bond charge) from ACE customers pursuant to bondable stranded costs rate orders issued by the 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). The assets of ACE Funding, including the Bondable Transition Property, and the Transition Bond Charges (representing revenue ACE receives, and pays to ACE Funding, to fund the principal and interest payments on Transition Bonds and related taxes, expenses and fees) collected from ACE’s customers, are not available to creditors of ACE. The holders of Transition Bonds have recourse only to the assets of ACE Funding.

Seasonality

The operating results of Power Delivery historically have been directly related to the volume of electricity delivered to its customers, producing higher revenues and net income during periods when customers consumed higher amounts of electricity (usually during periods of extreme temperatures) and lower revenues and net income during periods when customers consumed lower amounts of electricity (usually during periods of mild temperatures). This has been due in part to the long standing practice by which the applicable public service commissions set distribution rates based on a fixed charge per kilowatt-hour of electricity used by the customer. Because most of the costs associated with the distribution of electricity do not vary with the volume of electricity delivered, this pricing mechanism also contributed to seasonal variations in net income. As a result of the implementation of a bill stabilization adjustment (BSA) for retail customers of Pepco and DPL in Maryland and for customers of Pepco in the District of Columbia, distribution revenues have been decoupled from the amount of electricity delivered. Under the BSA, utility customers pay an approved distribution charge for their electric service which does not vary by electricity usage. This change has had the effect of aligning annual distribution revenues more closely with annual distribution costs. In addition, the change has had the effect of eliminating changes in customer electricity usage, whether due to weather conditions or for any other reason, as a factor having an impact on annual distribution revenue and net income in those jurisdictions. The BSA also eliminates what otherwise might be a disincentive for the utility to aggressively develop and promote efficiency programs. A comparable revenue decoupling mechanism for DPL electricity and natural gas customers in Delaware is under consideration by the DPSC. Distribution revenues are not decoupled for the distribution of electricity by ACE in New Jersey, and thus are subject to variability due to changes in customer consumption.

 

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In contrast to electricity distribution costs, the cost of the electricity supplied, which is the largest component of a customer’s bill, does vary directly in relation to the volume of electricity used by a customer. Accordingly, whether or not a BSA is in effect for the jurisdiction, the revenues of Pepco, DPL and ACE from the supply of electricity and natural gas vary based on consumption and on this basis are seasonal. Because the revenues received by each of the utility subsidiaries for the default supply of electricity and natural gas closely approximate the supply costs, the impact on net income is immaterial, and therefore is not seasonal.

MAPP Project

On August 24, 2012, the board of PJM terminated the Mid-Atlantic Power Pathway (MAPP) project and removed it from PJM’s regional transmission expansion plan. PHI had been directed to construct a 152-mile high-voltage interstate transmission line, to address the reliability needs of the region’s transmission system.

In a 2008 FERC order approving incentives for the MAPP project, FERC authorized the recovery of prudently incurred abandoned costs in connection with the MAPP project. Consistent with this order, on December 21, 2012, PHI submitted a filing to FERC seeking recovery over a period of five years of approximately $88 million of abandoned MAPP capital expenditures. The FERC filing addressed, among other things, the prudence of the recoverable costs incurred, the proposed period over which the abandoned costs are to be amortized and the rate of return on these costs during the recovery period (see Note (7), “Regulatory Matters – MAPP Project” to the consolidated financial statements of PHI for additional information).

Pepco Energy Services

Pepco Energy Services is engaged in the following businesses:

 

   

providing energy savings performance contracting 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. area, and

 

   

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

Since 2010, Pepco Energy Services has been focused on growing its energy savings performance contracting services business in the federal, state and local government markets. Activity in the state and local government markets, which are Pepco Energy Services’ largest markets, has slowed significantly in 2012, due to, among other factors, lower energy prices that have lessened the economic benefits of energy savings projects and the reluctance of state and local governments to incur new debt associated with these projects. As a result of this slowdown, Pepco Energy Services believes that new business in these markets will remain challenged for the foreseeable future. Consequently, during 2012, Pepco Energy Services reduced resources and personnel and limited geographic expansion in the energy savings services business, and has refocused its existing resources on developing business in the federal government market while continuing to pursue combined heat and power projects.

Most of Pepco Energy Services’ contracts with federal, state and local governments, as well as independent agencies such as housing and water authorities, contain provisions authorizing the governmental authority or independent agency to terminate the contract at any time. Those provisions include explicit mechanisms that, if exercised, would require the other party to pay Pepco Energy

 

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Services for work performed through the date of termination and for additional costs incurred as a result of the termination. In addition, Pepco Energy Services provides energy services guarantees in connection with its energy services performance contracts.

PHI guarantees the obligations of Pepco Energy Services under certain of its energy savings, combined heat and power and construction contracts. At December 31, 2012, PHI’s guarantees of Pepco Energy Services’ obligations under these contracts totaled $198 million.

Pepco Energy Services also has historically been engaged in the business of providing retail energy supply services, consisting of the sale of electricity, including electricity from renewable resources, primarily to commercial, industrial and government customers located in the mid-Atlantic and northeastern regions of the United States, as well as Texas and Illinois, and the sale of natural gas to customers located primarily in the mid-Atlantic region. In December 2009, PHI announced that it will wind down the retail energy supply component of the Pepco Energy Services business.

Pepco Energy Services’ retail natural gas sales volumes and revenues are seasonally dependent. Colder weather from November through March of each year generally translates into increased sales volumes, which, when coupled with higher natural gas prices during these months, allows Pepco Energy Services to recognize generally higher revenues as compared to other months of the year. Retail electricity sales volumes are also seasonally dependent, with sales in the summer and winter months being generally higher than other months of the year, which, when coupled with higher electricity prices during these periods, allows Pepco Energy Services to recognize generally higher revenues as compared to other periods during the year. The impact of this seasonality on Pepco Energy Services’ results is diminishing with the wind-down of the business. The energy services business is not seasonal.

To effectuate the wind-down of the retail energy supply business, Pepco Energy Services is continuing to fulfill all of its commercial and regulatory obligations and perform its customer service functions to ensure that it meets the needs of its existing customers, but is not entering into any new retail energy supply contracts.

Substantially all of Pepco Energy Services’ retail customer obligations will be fully performed by June 1, 2014. PHI is reviewing strategic alternatives that could accelerate into 2013 the completion of the wind-down of its remaining portfolio of retail energy contracts.

Pepco Energy Services’ remaining businesses will not be affected by the wind-down of the retail energy supply business.

During 2012, Pepco Energy Services deactivated its Buzzard Point and Benning Road oil-fired generation facilities. Pepco Energy Services has placed the facilities into an idle condition termed a “cold closure.” A cold closure requires that the utility service be disconnected so that the facilities are no longer operable and that the facilities require only essential maintenance until they are completely decommissioned.

Competition

Pepco Energy Services’ energy services business is highly competitive. Pepco Energy Services competes with other energy services companies primarily with respect to contracts with federal, state and local governments and independent agencies. Many of these energy services companies are subsidiaries of larger building controls and equipment providers or utility holding companies (as is the case with Pepco Energy Services). Among the factors as to which the energy services business competes are the amount and duration of the guarantees provided in energy savings performance contracts and the quality and value of service provided to customers. The energy services business is impacted by new entrants into the market, financial strength of customers, energy prices, and general economic conditions.

 

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Other Business Operations

Between 1994 and 2002, PCI, a subsidiary of PHI, entered into eight 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 structured as a sale and leaseback transaction commonly referred to as a sale-in, lease-out, or SILO, transaction. During the second quarter of 2011 and the third quarter of 2012, PHI entered into early termination agreements with several lessees involving all of the leases comprising two of the eight lease investments and a small portion of the leases comprising a third lease investment. As of December 31, 2012, PHI’s net investment in its six remaining cross-border energy lease investments was approximately $1.2 billion.

The net investment value of the cross-border energy lease investments and the pattern of recognizing the related cross-border energy lease income are based on the estimated timing and amount of all cash flows related to the investments, including the income tax-related cash flows. The Treasury Department and the Internal Revenue Service (IRS) have identified SILO transactions, such as PCI’s cross-border energy lease investments, as tax avoidance transactions and the IRS disallowed a substantial portion of the tax benefits claimed by PHI related to its cross-border energy lease investments beginning with PHI’s 2001 income tax return. IRS challenges related to SILO and lease-in, lease-out, or LILO, transactions also have been the subject of litigation, including litigation commenced by PHI in the U.S. Court of Federal Claims in January 2012 related to certain tax benefits claimed by PHI on its federal income tax returns for 2001 and 2002. PHI is required to assess on a periodic basis the likely outcome of tax positions relating to its cross-border energy lease investments and, if there is a change or a projected change in the timing of the estimated tax benefits generated by the transactions, PHI is required to recalculate the value of its net investment. In 2008, after evaluating court rulings that had been recently decided in favor of the IRS on certain SILO and LILO transactions, PHI significantly revised the projected timing of the tax benefits generated by the transactions and reduced the carrying value of its net investment by recording a non-cash charge of $86 million after tax.

On January 9, 2013, the U.S. Court of Appeals for the Federal Circuit issued an opinion in Consolidated Edison Company of New York, Inc. & Subsidiaries v. United States (to which PHI is not a party) that disallowed tax benefits associated with Consolidated Edison’s LILO transaction. PHI had viewed the initial trial court ruling on this matter, in which the U.S. Court of Federal Claims issued a decision in favor of the taxpayer in October 2009, as a favorable development in PHI’s dispute with the IRS. After analyzing the U.S. Court of Appeals ruling in this case, PHI has determined that its tax position with respect to the tax benefits associated with the cross-border energy lease investments no longer meets the more likely than not standard of recognition for accounting purposes. Accordingly, PHI expects to record a non-cash charge of between $355 million and $380 million (after-tax) in the first quarter of 2013, consisting of a charge to reduce the carrying value of the cross-border energy lease investments and a charge to reflect the anticipated additional interest expense related to changes in its estimated federal and state income tax obligations for the period over which the tax benefits may be disallowed. While the IRS could require PHI to pay a penalty of up to 20 percent of the amount of additional taxes due, PHI believes that it is more likely than not that no such penalty will be incurred, and therefore no amount for any potential penalty will be included in the charge expected to be recorded in the first quarter of 2013. PHI also is evaluating the liquidation of all or a portion of its remaining cross-border energy lease investments. The aggregate financial impact of a partial or complete liquidation of the cross-border leases is not determinable at this time, but could result in material gains or losses. PHI continues to weigh its options with respect to its litigation with the IRS.

For additional information concerning these cross-border energy lease investments, see Note (8), “Leasing Activities,” Note (16), “Commitments and Contingencies – PHI’s Cross-Border Energy Lease Investments,” and Note (20), “Subsequent Event,” to the consolidated financial statements of PHI.

 

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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 Conectiv Energy’s remaining assets and businesses not included in the Calpine sale, including its load service supply contracts, energy hedging portfolio and certain tolling agreements, has been completed. The former operations of Conectiv Energy, which previously comprised a separate segment for financial reporting purposes, have been classified as a discontinued operation in PHI’s consolidated financial statements, and the business is no longer treated as a separate segment for financial reporting purposes. For further information on the former Conectiv Energy segment, see Note (19), “Discontinued Operations,” to the consolidated financial statements of PHI.

Regulation

The operations of PHI’s utility subsidiaries, including the rates and tariffs they are permitted to charge customers for the distribution and transmission of electricity and, in the case of DPL, the distribution and transportation of natural gas, are subject to regulation by governmental agencies in the jurisdictions in which the subsidiaries provide utility service as follows:

 

   

Pepco’s electricity distribution operations are regulated in Maryland by the MPSC and in the District of Columbia by the DCPSC.

 

   

DPL’s electricity distribution operations are regulated in Maryland by the MPSC and in Delaware by the DPSC.

 

   

DPL’s natural gas distribution and intrastate transportation operations in Delaware are regulated by the DPSC.

 

   

ACE’s electricity distribution operations are regulated by the NJBPU.

 

   

Each utility subsidiary’s transmission facilities are regulated by FERC.

 

   

DPL’s interstate transportation and wholesale sale of natural gas are regulated by FERC.

 

   

Each utility subsidiary’s bulk power system is subject to reliability standards established by NERC.

Rates and tariffs are established by these regulatory commissions. PHI’s utility subsidiaries have filed or plan to file rate cases in each of its jurisdictions as further described in Note (7), “Regulatory Matters – Rate Proceedings,” to the consolidated financial statements of PHI.

Regulatory Lag

An important factor in the ability of each of Pepco, DPL and ACE to earn its authorized rate of return is the willingness of applicable public service commissions to adequately recognize forward-looking costs in the utility’s rate structure in order to address the shortfall in revenues due to the delay in time or “lag” between when costs are incurred and when they are reflected in rates. This delay is commonly known as “regulatory lag.” Each of Pepco, DPL and ACE is currently experiencing significant regulatory lag because its investment in the rate base and its operating expenses are outpacing revenue growth.

Each of PHI’s utility subsidiaries will continue to seek cost recovery from applicable public service commissions to reduce the effects of regulatory lag. There can be no assurance that any attempts by PHI’s utility subsidiaries to mitigate regulatory lag will be approved, or that even if approved, the cost recovery mechanisms will fully mitigate the effects of regulatory lag. Until such time as any cost recovery mechanisms are approved, PHI’s utility subsidiaries plan to file rate cases at least annually in an effort to align more closely the revenue and cash flow levels of PHI’s utility subsidiaries with other operation and maintenance spending and capital investments. For additional discussion on this matter, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations – General Overview – Power Delivery Initiatives and Activities – Regulatory Lag.”

 

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Reliability Task Forces

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 (see Note (7), “Regulatory Matters – Reliability Task Forces” to the consolidated financial statements of PHI). The resulting Grid Resiliency Task Force issued its report in September 2012, in which it 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’s electric distribution base rate case filed with the MPSC on November 30, 2012, addresses the Grid Resiliency Task Force recommendations. See Note (7), “Regulatory Matters — Rate Proceedings — Pepco Electric Distribution Bases Rates,” to the consolidated financial statements of PHI. DPL will consider the Grid Resiliency Task Force recommendations in its next electric distribution base rate case expected to be filed with the MPSC in the first quarter of 2013.

In August 2012, the District of Columbia mayor issued an Executive Order establishing the Mayor’s Power Line Undergrounding Task Force. The purpose of the Power Line Undergrounding Task Force is to pool the collective resources available in the District of Columbia to produce an analysis of the technical feasibility, infrastructure options and reliability implications of undergrounding new or existing overhead distribution facilities in the District of Columbia. These resources include legislative bodies, regulators, utility personnel, experts and other parties who could contribute in a meaningful way to the Power Line Undergrounding Task Force. The options that are available for financing these efforts are also to be evaluated to identify required legislative or regulatory actions to implement these recommendations. The results of this analysis are intended to help determine the path forward for these types of infrastructure improvements and additions. A written report from the Power Line Undergrounding Task Force setting forth the findings and recommendations was originally due on January 31, 2013 but has been extended to early March 2013.

MPSC New Generation Contract Requirement

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

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 megawatts (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.

In April 2012, a group of generating companies operating in the PJM region filed a complaint in the U.S. District Court for the 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. In May 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 have

 

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been stayed pending the issuance of a final order from the MPSC approving the form of contract, including the payment obligations of the utilities in the event the utilities do not recover the costs for such payments from their 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 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.

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, as more fully described in Note (2), “Significant Accounting Policies – Consolidation of Variable Interest Entities – ACE Standard Offer Capacity Agreements” and Note (14), “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. The dispute is pending before the NJBPU and has been referred to an Administrative Law Judge for further consideration.

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. In September 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 and trial is tentatively scheduled to begin in March 2013.

Delaware Renewable Energy Portfolio Standards

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. In July 2011, the Governor of the State of Delaware signed legislation that expands DPL’s RPS obligations beginning in 2012. Before this legislation, DPL was required to obtain RECs for energy delivered only to SOS customers in Delaware; the legislation expands that requirement to energy delivered to all of DPL’s distribution customers in Delaware. DPL’s costs associated with obtaining RECs to fulfill its RPS obligations are recoverable from its distribution customers by law.

The legislation also establishes that the energy output from fuel cells manufactured in Delaware capable of running on renewable fuels is an eligible resource for RECs under the Renewable Portfolio Standards Act. The legislation requires that the DPSC adopt a tariff under which DPL would be an agent that collects payments from its customers and disburses the amounts collected to a qualified fuel cell provider that deploys Delaware-manufactured fuel cells as part of a 30-megawatt generation facility. The legislation also provides for a reduction in DPL’s REC and solar REC requirements based upon the actual energy output of the 30-megawatt generation facility. In October 2011, the DPSC approved the tariff submitted by DPL in response to the legislation. For more information on the tariff, see Note (2), “Significant Accounting Policies – Consolidation of Variable Interest Entities – DPL Renewable Energy Transactions,” to the consolidated financial statements of PHI.

 

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NERC Reliability Standards

NERC has established, and FERC has approved, reliability standards with regard to the bulk power system that impose certain operating, planning and cyber security requirements on Pepco, DPL, ACE and Pepco Energy Services. There are eight NERC regional oversight entities, including ReliabilityFirst Corporation (RFC), of which Pepco, DPL, ACE and Pepco Energy Services are members, and Northeast Power Coordinating Council (NPCC), of which Pepco Energy Services is a member. These oversight entities are charged with the day-to-day implementation and enforcement of NERC’s reliability standards, which impose certain operating, planning and cyber security requirements on the bulk power systems of Pepco, DPL, ACE and Pepco Energy Services. RFC and NPCC perform compliance audits on entities registered with NERC based on reliability standards and criteria established by NERC. NERC, RFC and NPCC also conduct compliance investigations in response to a system disturbance, complaint, or possible violation of a reliability standard identified by other means. Each of PHI’s utility subsidiaries and Pepco Energy Services are subject to routine audits and monitoring for compliance with applicable NERC reliability standards, including standards requested by FERC to increase the number of assets designated as “critical assets” (including cyber security assets) subject to NERC’s cyber security standards. NERC is empowered to impose financial penalties, fines and other sanctions for non-compliance with certain rules and regulations.

Employees

At December 31, 2012, PHI had the following number of employees:

 

            In Collective Bargaining Agreements         
     Non-union      International
Brotherhood
of Electrical
Workers
     International
Union of
Operating
Engineers
     Other      Total  

Pepco

     354         1,086         —           —           1,440  

DPL

     235         684         —           —           919  

ACE

     191         384         —           —           575  

Pepco Energy Services

     208         162         40        27         437  

PHI Service Company and Other

     1,333         336         —           —           1,669  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total PHI Employees

     2,321         2,652         40        27         5,040  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

PHI’s subsidiaries are parties to five collective bargaining agreements with four local unions. All five collective bargaining agreements will expire within the next four years, including two agreements, covering approximately 977 employees in total, that expire in 2013. Collective bargaining agreements are generally renegotiated every three to five years.

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, greenhouse gas emissions, and limitations on land use. In addition, federal and state statutes authorize governmental agencies to compel responsible parties to clean up certain abandoned or unremediated hazardous waste sites. PHI’s subsidiaries may incur costs to clean up currently or formerly owned facilities or sites found to be contaminated, as well as other facilities or sites that may have been contaminated due to past disposal practices. PHI’s subsidiaries may also be responsible for ongoing environmental remediation costs associated with facilities or operations that have been sold to third parties as further described in Note (16), “Commitments and Contingencies – Environmental Matters – Conectiv Energy Wholesale Power Generation Sites,” to the consolidated financial statements of PHI.

 

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PHI’s subsidiaries’ currently projected capital expenditures for the replacement of existing or installation of new environmental control facilities that are necessary for compliance with environmental laws, rules or agency orders are approximately $12 million in 2013, $7 million in each of 2014 and 2015, and $2 million in each of 2016 and 2017. Because of a comprehensive review of environmental control facilities undertaken in 2012, during which a substantially greater number of replacements of control facilities were identified, the estimated spending for each of these years is significantly higher than the estimates reported last year. The projections for these capital expenditures could change depending on the outcome of the matters addressed below or as a result of the imposition of additional environmental requirements or new or different interpretations of existing environmental laws, rules and agency orders. In view of the sale of the Conectiv Energy wholesale power generation business in 2010 and the deactivation in 2012 of two generating facilities located in the District of Columbia owned by Pepco Energy Services, PHI is no longer significantly affected by environmental regulations prospectively applicable to electricity generating facilities.

Air Quality Regulation

The generating facilities owned by Pepco Energy Services were subject to federal, state and local laws and regulations, including the Federal Clean Air Act (CAA), which limit emissions of air pollutants, require permits for operation of facilities and impose recordkeeping and reporting requirements. Following the deactivation of the Pepco Energy Services generating facilities, both of which are considered major sources under the CAA, in June 2012, Pepco Energy Services requested exclusion for these major sources from the CAA Title V operating permits. For the remaining minor sources (e.g., Pepco-operated emergency generators) currently covered by a CAA Title V operating permit, Pepco intends to secure minor source permits.

Sulfur Dioxide and Nitrogen Oxide Emissions

The acid rain provisions of the Clean Air Act regulate total sulfur dioxide (SO2) emissions from affected generating units and allocate “allowances” to each affected unit that permit the unit to emit a specified amount of SO2. Until their deactivation in 2012, the generating facilities of Pepco Energy Services that required allowances used allocated allowances or allowances acquired, as necessary, in the open market to satisfy the applicable regulatory requirements.

Federal Regional Haze Rule

The federal Regional Haze Rule was adopted by the U.S. Environmental Protection Agency (EPA) to address a type of visibility impairment known as regional haze created by the emission of specified pollutants by certain types of large stationary sources. The regulation requires installation of best available retrofit technology to boilers that (i) emit 250 tons or more per year of a visibility-impairing air pollutant, (ii) were placed in service between 1962 and 1977, and (iii) may reasonably be anticipated to cause or contribute to visibility impairment in any federally protected park or wilderness area. Pepco Energy Services’ Benning Road generating units were subject to this regulation for particulate matter less than ten microns in diameter and for SO2 and nitrogen oxide to the extent not addressed by other regulations. Under Pepco Energy Services’ current operating permit issued by the District of Columbia Department of the Environment (DDOE), the Benning Road generating units are not required to implement any remedial actions because the facilities were deactivated in 2012.

Pepco Energy Services’ other generating units are not subject to the Regional Haze Rule.

 

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Hazardous Air Pollutant Emissions

In December 2011, EPA finalized a rule to reduce the emission of toxic air pollutants from generating facilities. The Mercury and Air Toxics Standards will reduce emissions of heavy metals, including mercury, arsenic, chromium and nickel, as well as emissions of acid gases, including hydrochloric and hydrofluoric acid. Because existing generating sources generally have up to four years from the Standards’ effective date to comply with the Mercury and Air Toxics Standards, this rule will not impact the Benning Road or Buzzard Point generating facilities, which were retired in June 2012.

Greenhouse Gas Emissions Reporting

In October 2009, EPA adopted regulations requiring sources that emit designated greenhouse gases – specifically, carbon dioxide, methane, nitrous oxide, hydrofluorocarbons, perfluorocarbons, and other fluorinated gases (e.g., nitrogen trifluoride and hydrofluorinated ethers) – in excess of specified thresholds to file annual reports with EPA disclosing the amount of such emissions. Under these regulations:

 

   

For the operating period ending with the generating units’ deactivation in June 2012, Pepco Energy Services reported CO2, methane and nitrous oxide for its Benning Road units.

 

   

DPL currently reports with respect to its gas distribution operations CO2 emissions that would result assuming the complete combustion or oxidation of the annual volume of natural gas it distributes to its customers. Beginning in September 2012, DPL is required to report fugitive CO2 and methane emissions for its gas distribution operations for the previous calendar year (hence, the 2012 report contained data from calendar year 2011). DPL’s liquefied natural gas storage facility does not meet the reporting threshold (25,000 metric tons) for fugitive emissions.

 

   

Beginning in September 2012, Pepco, DPL and ACE are required to report sulfur hexafluoride emissions from electrical equipment for the previous calendar year.

Water Quality Regulation

Clean Water Act

Provisions of the federal Water Pollution Control Act, also known as the Clean Water Act, establish the basic legal structure for regulating the discharge of pollutants from point sources to surface waters of the United States. Among other things, the Clean Water Act requires that any person wishing to discharge pollutants from a point source (generally a confined, discrete conveyance such as a pipe) obtain a National Pollutant Discharge Elimination System (NPDES) permit issued by EPA or by a state agency under a federally authorized state program.

Pepco holds a NPDES permit issued by EPA in July 2009, which authorizes discharges from the Benning Road facility, including the now deactivated generating station. The permit imposes compliance monitoring and storm water best management practices to satisfy the District of Columbia’s Total Maximum Daily Load (TMDL) standards for polychlorinated biphenyls, oil and grease, metals and other substances. As required by the permit, Pepco has initiated studies to identify the source of the regulated substances to determine appropriate best management practices for minimizing the presence of the substances in storm water. The initial study reports were completed in May 2012. Pepco has completed the implementation of the first two phases of the best management practices recommended in the study reports (consisting principally of installing screens and booms to capture contaminants from storm water flows, removing stored equipment and materials from areas exposed to the weather, covering and painting exposed metal pipes, and covering and cleaning dumpsters). Pepco will be evaluating the effectiveness of these initial best management practices and will consult with EPA regarding the need for additional measures. The capital expenditures, if any, that may be needed to implement additional best management practices to satisfy TMDL requirements will not be known until Pepco and EPA have completed the assessment of the initial best management practices.

 

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EPA Oil Pollution Prevention Regulations

Facilities that, because of their location, store or use oil and could reasonably be expected to discharge oil into water bodies or adjacent shorelines in quantities that may be harmful to the environment are subject to EPA’s oil pollution prevention regulations. These regulations require entities to prepare and implement Spill Prevention, Control, and Countermeasure (SPCC) plans and specify site-specific measures to prevent and respond to an oil discharge. The SPCC regulations generally require the use of containment and/or diversionary structures to prevent the discharge of oil in the event of a leak or release of oil at the facility. As an alternative to the containment/diversionary structure requirement, owners of certain oil-filled operational equipment, such as electric system transformers, may comply with EPA’s regulations by implementing an inspection and monitoring program, developing an oil spill contingency plan, and providing a written commitment of resources to control and remove any discharge of oil. Pepco, DPL and ACE are complying with the SPCC regulations by employing containment/diversionary structures and by means of inspection and monitoring measures, in each case where such measures have been determined to be appropriate. Total costs of complying with these regulations in 2012 for Pepco, DPL and ACE collectively were approximately $8 million, as of December 31, 2012. In addition to the costs to comply with EPA’s oil pollution prevention regulations, PHI companies project expenditures of approximately $9 million over the next four years, which amount is included in the capital expenditure projection set forth in “Environmental Matters” above, to install additional containment facilities and to replace certain oil-filled breakers with gas-filled breakers to eliminate the possibility of an oil release from such equipment. Compliance costs for Pepco Energy Services have not been material, and PHI does not expect that they will become material in the foreseeable future.

Hazardous Substance Regulation

The Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA) of 1980 authorizes EPA, and comparable state laws authorize state environmental authorities, to issue orders and bring enforcement actions to compel responsible parties to investigate and take remedial actions at any site that is determined to present an actual or potential threat to human health or the environment because of an actual or threatened release of one or more hazardous substances. Parties that generated or transported hazardous substances to such sites, as well as the owners and operators of such sites, may be deemed liable under CERCLA or comparable state laws. Pepco, DPL and ACE each has been named by EPA or a state environmental agency as a potentially responsible party in pending proceedings involving certain contaminated sites. See Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Capital Resources and Liquidity – Capital Requirements – Environmental Remediation Obligations,” and Note (16), “Commitments and Contingencies – Environmental Matters,” to the consolidated financial statements of PHI.

 

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Executive Officers of PHI

The names of the executive officers of PHI, their ages and the positions they held as of February 27, 2013, are set forth in the following table. The business experience of each executive officer during the past five years is set forth adjacent to his or her name under the heading “Office and Length of Service” in the following table and in the applicable footnote.

 

Name

   Age     

Office and
Length of Service

Joseph M. Rigby

     56       Chairman of the Board 5/09 - Present, President 3/08 - Present, and Chief Executive Officer 3/09 - Present (1)

David M. Velazquez

     53      

Executive Vice President

3/09 - Present (2)

Kevin C. Fitzgerald

     50      

Executive Vice President and General Counsel

9/12 - Present (3)

Frederick J. Boyle

     55      

Senior Vice President and Chief Financial Officer

4/12 - Present (4)

Kenneth J. Parker

     50      

Senior Vice President, Government Affairs and Corporate Citizenship

9/12 - Present (5)

Kirk J. Emge

     63      

Senior Vice President and Special Counsel to CEO

9/12 - Present (6)

Beverly L. Perry

     65      

Senior Vice President and Special Advisor to CEO

9/12 Present (7)

Ronald K. Clark

     57      

Vice President and Controller

8/05 - Present

Ernest L. Jenkins

     58      

Vice President

5/05 – Present

Laura L. Monica

     56      

Vice President

8/11 – Present (8)

Hallie M. Reese

     49      

Vice President, PHI Service Company

5/05 - Present

John U. Huffman

     53      

President 6/06 - Present, and Chief Executive Officer,

Pepco Energy Services, Inc. 3/09 - Present (9)

 

(1) Mr. Rigby was Chief Operating Officer of PHI from September 2007 until February 28, 2009 and Executive Vice President of PHI from September 2007 until March 2008, Senior Vice President of PHI from August 2002 until September 2007 and Chief Financial Officer of PHI from May 2004 until September 2007. Mr. Rigby was President and Chief Executive Officer of Pepco, DPL and ACE from September 1, 2007 to February 28, 2009. Mr. Rigby has been Chairman of Pepco, DPL and ACE since March 1, 2009.
(2) Mr. Velazquez served as President of Conectiv Energy Holding Company, formerly an affiliate of PHI, from June 2006 to February 28, 2009, Chief Executive Officer of Conectiv Energy Holding Company from January 2007 to February 28, 2009 and Chief Operating Officer of Conectiv Energy Holding Company from June 2006 to December 2006.
(3) Mr. Fitzgerald joined PHI in September 2012 as Executive Vice President and General Counsel. Prior to such time, he was a partner with the law firm of Troutman Sanders, LLP in Washington, D.C. since 1997. Mr. Fitzgerald was Managing Partner of that firm’s Washington, D.C. office from 1999 until 2010 and Executive Partner for Client Development Strategic Planning from 2010 to September 2012.

 

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(4) Mr. Boyle joined PHI in April 2012 as Senior Vice President and Chief Financial Officer. Prior to such time, he served as Senior Vice President and Chief Financial Officer of DPL Inc. and its wholly owned utility subsidiary, The Dayton Power and Light Company, from December 2010 until its acquisition in 2011. He served as Senior Vice President, Chief Financial Officer and Treasurer of DPL Inc. and The Dayton Power and Light Company from May 2009 to December 2010, Senior Vice President, Chief Financial Officer, Treasurer and Controller of both companies from December 2008 to May 2009, Vice President, Finance, Chief Accounting Officer and Controller of both companies from June 2008 to November 2008, Vice President, Chief Accounting Officer and Controller of both companies from July 2007 to June 2008, and Vice President and Chief Accounting Officer of both companies from June 2006 to July 2007.
(5) Mr. Parker became Senior Vice President, Government Affairs and Corporate Citizenship effective September 1, 2012. Prior to such time, he was Vice President of Public Policy from 2009 to 2012 and President, ACE from 2005 to 2009.
(6) Mr. Emge was Senior Vice President and General Counsel from March 2008 through September 2012. Prior to such time, Mr. Emge was Vice President, Legal Services of PHI from August 2002 until March 2008. Mr. Emge has served as General Counsel of ACE, DPL and Pepco from August 2002 to September 2012 and as Senior Vice President of Pepco and DPL from March 2009 to September 2012. Mr. Emge has announced that he will retire from PHI effective April 1, 2013.
(7) Ms. Perry was Senior Vice President Regulatory Affairs and Corporate Citizenship from October 2002 through August 2012. Ms. Perry has announced that she will retire from PHI effective June 1, 2013.
(8) From October 2006 to October 2010, Ms. Monica was Senior Vice President, Corporate Communications at American Water Works Company (NYSE: AWK), and from September 1991 to October 2006, Ms. Monica was President of High Point Communications, a strategic communications firm. Ms. Monica rejoined High Point Communications as President from October 2010 to August 2011.
(9) Mr. Huffman has been employed by Pepco Energy Services since June 2003. He was Chief Operating Officer from April 2006 to February 28, 2009, Senior Vice President from February 2005 to March 2006 and Vice President from June 2003 to February 2005.

Each PHI executive officer is elected annually and serves until his or her respective successor has been elected and qualified or his or her earlier resignation or removal.

Investor Information

Each Reporting Company maintains an Internet web site, at the Internet address listed below:

 

Reporting Company

 

Internet Address

PHI

  http://www.pepcoholdings.com

Pepco

  http://www.pepco.com

DPL

  http://www.delmarva.com

ACE

  http://www.atlanticcityelectric.com

 

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Each Reporting Company files reports with the SEC under the Exchange Act. Copies of the Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to those reports, of each Reporting Company are routinely made available free of charge on PHI’s Internet Web site (http://www.pepcoholdings.com/investors) as soon as reasonably practicable after such documents are electronically filed with or furnished to the SEC. 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. The information contained on the web sites listed above shall not be deemed incorporated into, or to be part of, this Annual Report on Form 10-K, and any web site references included herein are not intended to be made through active hyperlinks.

INFORMATION FOR THIS ITEM IS NOT REQUIRED FOR PEPCO, DPL, AND ACE AS THEY MEET THE CONDITIONS SET FORTH IN GENERAL INSTRUCTIONS I(1)(a) AND (b) OF FORM 10-K AND THEREFORE ARE FILING THIS FORM WITH THE REDUCED FILING FORMAT.

 

Item 1A. RISK FACTORS

The businesses of each Reporting Company are subject to numerous risks and uncertainties, including the events or conditions identified below. The occurrence of one or more of these events or conditions could have an adverse effect on the business of any one or more of the Reporting Companies, including, depending on the circumstances, its financial condition, results of operations and cash flow. Unless otherwise noted, each risk factor set forth below applies to each Reporting Company.

PHI’s utility subsidiaries are subject to comprehensive regulation which may significantly affect their operations. PHI’s utility subsidiaries may be subject to fines, penalties and other sanctions for the inability to meet these requirements.

The regulated utilities that comprise Power Delivery are subject to extensive regulation by various federal, state and local regulatory agencies. Each of Pepco, DPL and ACE is regulated by the state agencies for each service territory in which it operates, with respect to, among other things, the manner in which utility service is provided to customers, as well as rates it can charge customers for the distribution and supply of electricity (and, additionally for DPL, the distribution and supply of natural gas). NERC has also established, and FERC has approved, reliability standards with regard to the bulk power system that impose certain operating, planning and cyber security requirements on Pepco, DPL, ACE and Pepco Energy Services. Further, FERC regulates the electricity transmission facilities of Pepco, DPL and ACE.

Approval of these regulators is required in connection with changes in rates and other aspects of the utilities’ operations. These regulatory authorities, and NERC with respect to electric reliability, are empowered to impose financial penalties, fines and other sanctions against the utilities for non-compliance with certain rules and regulations. In this regard, in December 2011, the MPSC sanctioned Pepco related to its reliability in connection with major storm events that occurred in July and August 2010. These sanctions included imposing a fine on Pepco and requiring Pepco to file a work plan detailing, among other things, its reliability improvement objectives and progress in meeting those objectives, while raising the possibility of additional fines or cost recovery disallowances for failing to meet those objectives. The MPSC also stated that it would consider in Pepco’s latest Maryland retail base rate case the potential disallowance of the recovery of costs which may be determined to have been imprudently incurred. In this base rate case, the MPSC set rates at a level that was not adequate to recover costs that Pepco will incur during the period the rates are in effect.

NERC’s eight regional oversight entities, including RFC, of which Pepco, DPL, ACE and Pepco Energy Services are members, and NPCC, of which Pepco Energy Services is a member, are charged with the day-to-day implementation and enforcement of NERC’s standards. RFC and NPCC perform compliance audits on entities registered with NERC based on reliability standards and criteria established by NERC. NERC, RFC and NPCC also conduct compliance investigations in response to a system disturbance, complaint, or possible violation of a reliability standard identified by other means. Pepco, DPL, ACE and

 

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Pepco Energy Services are subject to routine audits and monitoring with respect to compliance with applicable NERC reliability standards, including standards requested by FERC to increase the number of assets (including cyber security assets) subject to NERC cyber security standards that are designated as “critical assets.” From time to time, Pepco, DPL and ACE have entered into settlement agreements with RFC resolving alleged violations and resulting in fines. There can be no assurance that additional settlements resolving issues related to RFC or NPCC requirements will not occur in the future. The imposition of additional sanctions and civil fines by these enforcement entities could have a material adverse effect on a Reporting Company’s results of operations, cash flow and financial condition.

PHI’s utility subsidiaries, as well as Pepco Energy Services, are also required to have numerous permits, approvals and certificates from governmental agencies that regulate their businesses. Although PHI believes that each of its subsidiaries has, and each of Pepco, DPL and ACE believes it has, obtained or sought renewal of the material permits, approvals and certificates necessary for its existing operations and that its business is conducted in accordance with applicable laws, PHI is unable to predict the impact that future regulatory activities may have on its business. Changes in or reinterpretations of existing laws or regulations, or the imposition of new laws or regulations, may require any one or more of PHI’s subsidiaries to incur additional expenses or significant capital expenditures or to change the way it conducts its operations.

PHI’s profitability is largely dependent on its ability to recover costs of providing utility services to its customers and to earn an adequate return on its capital investments. The failure of PHI to obtain timely recognition of costs in its rates may have a negative effect on PHI’s results of operations and financial condition.

The public service commissions which regulate PHI’s utility subsidiaries establish utility rates and tariffs intended to provide the utility the opportunity to obtain revenues sufficient to recover its prudently incurred costs, together with a reasonable return on investor supplied capital. These regulatory authorities also determine how Pepco, ACE and DPL recover from their customers purchased power and natural gas and other operating costs, including transmission and other costs. The utilities cannot change their rates without approval by the applicable regulatory authority. There can be no assurance that the regulatory authorities will consider all costs to have been prudently incurred, nor can there be any assurance that the regulatory process by which rates are determined will always result in rates that achieve full and timely recovery of costs or a just and reasonable rate of return on investments. In addition, if the costs incurred by any of the utilities in operating its business exceed the amounts on which its approved rates are based, the financial results of that utility, and correspondingly PHI, may be adversely affected.

PHI’s utility subsidiaries are also exposed to “regulatory lag,” which refers to a shortfall in revenues due to the delay in time or “lag” between when costs are incurred and when they are reflected in rates. All of PHI’s utilities are currently experiencing significant regulatory lag because their investment in the rate base and their operating expenses are outpacing revenue growth. PHI anticipates that this trend will continue for the foreseeable future. The failure to timely recognize costs in rates could have a material adverse effect on PHI’s and each utility subsidiary’s business, results of operations, cash flow and financial condition.

In recent rate cases, Pepco (in the District of Columbia and Maryland), DPL (in Maryland and Delaware) and ACE (in New Jersey) have proposed mechanisms that would track reliability and other expenses and permit each utility to make adjustments in its approved rates to account for prudent investments as made, thereby seeking to reduce the magnitude of regulatory lag. However, the MPSC and the DCPSC did not approve in substantial part requests by Pepco (in Maryland and the District of Columbia) and DPL (in Maryland) to implement regulatory lag mitigation mechanisms. In Delaware, a settlement agreement approved by the DPSC in DPL’s electric distribution base rate case did not include these mechanisms, but it did provide that the parties will meet and discuss alternate regulatory methodologies for the mitigation of regulatory lag. In New Jersey, the NJBPU has previously approved a similar mechanism; however, ACE agreed as part of the settlement of its electric distribution base rate case to withdraw without

 

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prejudice its filing with the NJBPU to extend and expand that previously approved mechanism. There can be no assurance that any of the outstanding proposals or any other attempts by Pepco, DPL and ACE to mitigate regulatory lag will be approved, or that even if approved, the rate recovery mechanisms will fully mitigate the effects of regulatory lag. If necessary to address in whole or in part the problem of regulatory lag, each utility can file (and each utility presently intends to file) base rate cases annually (or even more frequently) to seek to align its revenue and related cash flow levels allowed by the applicable public service commissions with operation and maintenance spending and capital investments. The inability of PHI’s utility subsidiaries to obtain relief from the impact of regulatory lag through base rate cases or otherwise may have an adverse effect on the business, results of operations, cash flow and financial condition of PHI and each utility subsidiary.

The operating results of Power Delivery and the retail energy supply business of Pepco Energy Services fluctuate on a seasonal basis and can be adversely affected by changes in weather.

The Power Delivery business historically has been seasonal and, as a result, weather has had a material impact on its operating performance. Demand for electricity is generally higher in the summer months associated with cooling and demand for electricity and natural gas is generally higher in the winter months associated with heating as compared to other times of the year. Accordingly, each of PHI, Pepco, DPL and ACE historically has generated less revenue and income when temperatures are warmer in the winter and cooler in the summer. In addition, severe weather conditions can produce storms that cause extensive damage to the transmission and distribution systems, as well as related facilities, that can require the utilities to incur additional operation and maintenance expense, as well as capital expenditures. These additional costs can be significant and the rates charged to customers may not always be timely or adequately adjusted to reflect these higher costs.

In the District of Columbia and Maryland, Pepco and DPL are subject to a bill stabilization adjustment mechanism applicable to retail customers, which decouples distribution revenue for a given reporting period from the amount of power delivered during the period. The bill stabilization mechanism has the effect in those jurisdictions of reducing the impact of changes in the use of electricity by retail customers due to weather conditions or for other reasons on reported distribution revenue and income. A comparable revenue decoupling mechanism for DPL electricity and natural gas customers in Delaware is under consideration by the DPSC. In those jurisdictions that have not adopted a bill stabilization adjustment or similar mechanism, operating results continue to be affected by weather conditions.

The retail energy supply business of Pepco Energy Services, the wind-down of which is expected to be completed at the latest in 2014, generally produces higher gross margins when temperatures are colder than normal in winter or warmer than normal in summer, and less gross margin when weather conditions are milder than normal in the winter and cooler than normal in the summer. The energy services business of Pepco Energy Services, which includes providing energy savings performance contracting services principally to federal, state and local government customers, and designing, constructing and operating combined heat and power energy plants for customers, is not seasonal.

Facilities may not operate as planned or may require significant capital or operation and maintenance expenditures, which could decrease revenues or increase expenses.

Operation of the Pepco, DPL and ACE transmission and distribution facilities involves many risks, including the breakdown or failure of equipment, accidents, labor disputes, theft of copper wire or pipe, scams, failure of software or hardware, and performance below expected levels. Older facilities and equipment, even if maintained in accordance with sound engineering practices, may require significant capital expenditures for additions or upgrades to provide reliable operations or to comply with changing environmental requirements. Thefts of copper wire or pipe, which seek to capitalize on the current high market price of copper, increase the likelihood of poor system voltage control, electricity and streetlight outages, damage to equipment and property, and injury or death, as well as increasing the likelihood of damage to fuel lines, which can create an unsafe and potentially explosive condition. Natural disasters and weather,

 

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including tornadoes, hurricanes and snow and ice storms, also can disrupt transmission and distribution systems. Disruption of the operation of transmission or distribution facilities can reduce revenues and result in the incurrence of additional expenses that may not be recoverable from customers or through insurance.

PHI is replacing customers’ existing electric and gas meters with an AMI system. In addition to the replacement of existing meters, the AMI system involves the construction of a wireless network across the service territories of PHI’s utility subsidiaries and the implementation and integration of new and existing information technology systems to collect and manage data made available by the advanced meters. The implementation of the AMI system involves a combination of technologies provided by multiple vendors. If the AMI system results in lower than projected performance, PHI’s utility subsidiaries could experience higher than anticipated maintenance expenditures.

Energy companies are subject to adverse publicity and reputational risks, which make them vulnerable to negative customer perception and could lead to increased regulatory oversight or other sanctions.

Utility companies, including PHI’s utility subsidiaries, have a large consumer customer base and as a result have been the subject of public criticism focused on the reliability of their distribution services and the speed with which they are able to respond to outages caused by storm damage or other unanticipated events. Adverse publicity of this nature may render legislatures, public service commissions and other regulatory authorities and government officials less likely to view energy companies such as PHI and its subsidiaries in a favorable light, and may cause PHI and its subsidiaries to be susceptible to less favorable legislative and regulatory outcomes or increased regulatory oversight. Unfavorable regulatory outcomes can include more stringent laws and regulations governing PHI’s operations, such as reliability and customer service quality standards or vegetation management requirements, as well as fines, penalties or other sanctions or requirements. The imposition of any of the foregoing could have a material negative impact on PHI’s and each utility subsidiary’s business, results of operations, cash flow and financial condition.

Unfavorable regulatory developments and compliance with new or enhanced regulatory requirements will subject PHI’s utility subsidiaries to higher operating costs.

PHI’s utility subsidiaries are subject to and will continue to be subject to changing regulatory requirements, including those related to reliability and customer service, in the various jurisdictions in which they operate. For example, the MPSC has adopted new rules (which became effective in May 2012), establishing reliability and customer service regulations. Furthermore, in its most recent electric distribution base rate case filing, Pepco has proposed (subject to MPSC review and approval) a reliability performance-based mechanism that would allow Pepco to earn up to $1 million as an incentive for meeting enhanced reliability goals in 2015, but provides a credit to customers of up to $1 million in total if Pepco does not meet at least the minimum targets.

In addition, in July 2011, the DCPSC adopted regulations that establish specific maximum outage frequency and outage duration levels beginning in 2013 and continuing through 2020 and thereafter and are intended to require Pepco to achieve a reliability level in the first quartile of all utilities in the nation by 2020. Pepco believes that the DCPSC’s standards are achievable in the short term, but believes that the standards may not be realistically achievable at an acceptable cost over the longer term. The reliability standards permit Pepco to petition the DCPSC to reevaluate these standards for the period from 2016 to 2020 to address feasibility and cost issues.

Each of Pepco and DPL expect that it will have to incur significant operating and maintenance and capital expenses to comply with these requirements. Furthermore, each of Pepco and DPL would be subject to civil penalties or other sanctions if it does not meet the required performance or reliability standards. Other jurisdictions in which PHI’s utility subsidiaries have operations have reliability and customer service

 

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quality standards, the violation of which could also result in the imposition of penalties, fines and other sanctions. Compliance, and any failure to comply, with current, proposed or future regulatory requirements may have a material adverse effect on PHI and each utility subsidiary’s business, results of operations, cash flow and financial condition.

A recent case law decision involving lease transactions could impact our ongoing litigation against the IRS involving certain cross-border energy lease investments, could cause us to seek to unwind those lease investments, which may have a material negative impact on our results of operations and financial condition. (PHI only)

PCI maintains a portfolio of cross-border energy lease investments involving public utility assets located outside of the United States, which as of December 31, 2012, had a net investment value of approximately $1.2 billion and from which PHI currently derives approximately $43 million per year in tax benefits in the form of interest and depreciation deductions in excess of rental income. PHI’s cross-border energy lease investments, each of which is with a tax-indifferent party, have been under examination by the IRS as part of normal PHI federal income tax audits. In connection with the audits of PHI’s federal income tax returns from 2001 to 2008, the IRS disallowed the depreciation and interest deductions in excess of rental income claimed by PHI with respect to its cross-border energy lease investments. In addition, the IRS has sought to recharacterize the leases as loan transactions. PHI commenced litigation in the U.S. Court of Federal Claims in January 2012 to review certain tax benefits claimed by PHI on its federal tax returns for 2001 and 2002.

On January 9, 2013, the U.S. Court of Appeals for the Federal Circuit issued an opinion in Consolidated Edison Company of New York, Inc. & Subsidiaries v. United States (to which PHI is not a party) that disallowed tax benefits associated with a lease-in, lease-out transaction. Under applicable accounting standards, the financial statement recognition of the tax benefits of PHI’s uncertain tax position associated with the cross-border energy lease investments is permitted only if it is more likely than not that the position will be sustained. Further, the carrying value of the cross-border energy lease investments must be recalculated if there is a change or a projected change in the timing of the estimated tax benefits generated from these investments.

After analyzing the Consolidated Edison ruling, PHI has determined that its tax position with respect to the tax benefits associated with the cross-border energy leases no longer meets the more-likely-than-not standard of recognition for accounting purposes. Accordingly, PHI expects to record a non-cash charge of between $355 million and $380 million (after-tax) in the first quarter of 2013, consisting of a charge to reduce the carrying value of the cross-border energy lease investments and a charge to reflect the anticipated additional interest expense related to changes in its estimated federal and state income tax obligations for the period over which the tax benefits may be disallowed.

After accounting for certain tax benefits arising from matters unrelated to these lease investments, PHI estimates that it would be obligated to pay between $170 million and $200 million in additional federal and state taxes and between $50 million and $60 million of interest on the additional federal and state taxes as of March 31, 2013. While PHI presently believes that it is more likely than not that no penalty will be incurred, the IRS could require PHI to pay a penalty of up to 20% of the amount of additional taxes due. PHI continues to weigh its options with respect to its litigation with the IRS.

PHI is also evaluating the liquidation of all or a portion of its remaining cross-border energy lease investments. While PHI estimates that a complete liquidation could be accomplished within one year, the liquidation of any of the lease investments would generally require the consent of the counterparty to that lease investment, and negotiations with the respective lessee or a purchaser of the lease investment may take longer than anticipated. PHI is unable to presently estimate the amount of proceeds that would be realized upon the liquidation of the lease portfolio in whole or in part. Furthermore, even if PHI is able to successfully liquidate a lease investment, it may incur losses and additional earnings charges if the net proceeds from such liquidation were less than the then carrying value of the liquidated lease investment. As a result of these and other uncertainties, the aggregate financial impact of a partial or complete liquidation of the lease investments by PHI cannot be presently determined at this time, but PHI believes that any such impact on PHI’s consolidated results of operations and financial condition may be material.

 

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The transmission facilities of Power Delivery are interconnected with the facilities of other transmission facility owners. Failures of neighboring transmission systems could have a negative impact on Power Delivery’s operations.

The electricity transmission facilities of Pepco, DPL and ACE are interconnected with the transmission facilities of neighboring utilities and are part of the interstate power transmission grid. Pepco, DPL and ACE are members of the PJM RTO, a regional transmission organization that operates the portion of the interstate transmission grid that includes the PHI transmission facilities. Although PJM’s systems and operations are designed to ensure the reliable operation of the transmission grid and prevent the operations of one utility from having an adverse impact on the operations of the other utilities, there can be no assurance that service interruptions originating at other utilities will not cause interruptions in the Pepco, DPL or ACE service territories. Thus, due to the interconnected nature of the grid, an outage in a neighboring utility could trigger a system outage in either Pepco, DPL or ACE. If Pepco, DPL or ACE were to suffer such a service interruption, it could have a negative impact on its and PHI’s business, results of operations, cash flow and financial condition.

Changes in technology and conservation measures may adversely affect Power Delivery.

Increased conservation and end-user generation made possible through advances in technology could reduce demand for the transmission and distribution facilities of Power Delivery and adversely affect PHI and one or more of its utility subsidiaries. Alternative technologies to produce electricity, the development of which has expanded due to climate change and other environmental concerns, could ultimately provide alternative sources of electricity. As these new technologies are developed and become available, the quantity and pattern of electricity usage by customers could decline, which could have a negative impact on the business, results of operations, cash flow and financial condition of PHI or its utility subsidiaries.

The cost of compliance with environmental laws is significant and implementation of new and existing environmental laws may increase operating costs.

The operations of PHI’s subsidiaries are subject to extensive federal, state and local environmental laws and regulations relating to air quality, water quality, spill prevention, waste management, natural resource protection, site remediation and health and safety. These laws and regulations may require significant capital and other expenditures to, among other things, meet emissions and effluent standards, conduct site remediation, complete environmental studies and perform environmental monitoring. If a company fails to comply with applicable environmental laws and regulations, even if caused by factors beyond its control, such failure could result in the assessment of civil or criminal penalties and liabilities and the need to expend significant sums to achieve compliance.

In addition, PHI’s subsidiaries are required to obtain and comply with a variety of environmental permits, licenses, inspections and other approvals. If there is a delay in obtaining any required environmental regulatory approval, or if there is a failure to obtain, maintain or comply with any such approval, operations at affected facilities could be halted or subjected to additional costs.

Failure to retain and attract key skilled and properly motivated professional and technical employees could have an adverse effect on operations.

PHI and its subsidiaries operate in a highly regulated industry that requires the continued operation of sophisticated systems and technology. One of the challenges they face in implementing their business strategy is to attract, motivate and retain a skilled, efficient and cost-effective workforce while recruiting new talent to replace losses in knowledge and skills due to retirements. Over the course of the next three years, PHI estimates that approximately one-third of this skilled workforce will reach retirement age. Competition for skilled employees in some areas is high and the inability to attract and retain these employees, especially as existing skilled workers retire in the near future, could adversely affect the business, operations and financial condition of PHI or the affected company.

 

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PHI’s subsidiaries are subject to collective bargaining agreements that could impact their business and operations.

As of December 31, 2012, 54% of employees of PHI and its subsidiaries, collectively, were represented by various labor unions. PHI’s subsidiaries are parties to five collective bargaining agreements with four local unions that represent these employees. Collective bargaining agreements are generally renegotiated every three to five years, and the risk exists that there could be a work stoppage after expiration of an agreement until a new collective bargaining agreement has been reached. Labor negotiations typically involve bargaining over wages, benefits and working conditions, including management rights. PHI’s last work stoppage, a two-week strike by DPL’s employees, occurred in 2010. During that strike, DPL used management and contractor employees to maintain essential operations.

One of the collective bargaining agreements to which PHI’s subsidiaries are a party was set to expire on February 1, 2013 and a second agreement will expire on June 25, 2013. The parties amended the agreement that was to expire in February to extend its expiration date, which is now currently March 1, 2013. Further extensions of this expiration date may be possible. Though PHI believes that a protracted work stoppage is unlikely, such an event could result in a disruption of the operations of the affected utility, which could, in turn, have a material adverse effect upon the business, results of operations, cash flow and financial condition of the affected utility and PHI.

The energy services business of Pepco Energy Services is highly competitive and is exposed to customer concentration. (PHI only)

Unlike PHI’s regulated business, Pepco Energy Services’ business is highly competitive and is not assured a rate of return on capital investments through a predetermined rate structure. This competition puts downward pressure on margins and increases costs. The energy services business is impacted by new entrants into the market, energy prices, and general economic conditions. These factors may negatively impact Pepco Energy Services’ ability to market its services to new customers, or renew existing contracts, as well as the prices Pepco Energy Services may charge.

Among the factors on which the energy services business competes are the amount and duration of the guarantees provided in energy savings performance contracts. In connection with many of its energy savings performance installation projects, Pepco Energy Services guarantees a minimum level of annual energy cost savings over a period typically up to 15 years. Currently, Pepco Energy Services does not insure against this risk, and accordingly could suffer financial losses if a project does not achieve the guaranteed level of performance.

Under the Budget Control Act of 2011, mandatory federal spending cuts, or “sequestration,” becomes effective for years 2013 through 2021 unless Congress agrees to a deficit reduction plan. In January 2013, Congress passed, and the President signed, the American Taxpayer Relief Act of 2012 that addressed rising federal income tax rates that would have taken effect on January 1, 2013. The American Taxpayer Relief Act of 2012 does not address spending issues or sequestration issues that Congress intends to address later in 2013. Substantial Federal spending cuts could make it more difficult for Pepco Energy Services to enter into new energy services performance contracts with Federal, state and local government agencies and thus could have a material adverse effect on the energy savings performance services business of Pepco Energy Services.

In addition, revenues associated with Pepco Energy Services’ combined heat and power generating plant in Atlantic City, New Jersey are concentrated with a few major customers in the hotel and casino industry. Pepco Energy Services has long-term contracts with these customers, and for the largest customer, the contracts expire in 2017. Pepco Energy Services is exposed to the risk that it is not able to renew these contracts or that the contract counterparties fail to perform, and in either case, Pepco Energy Services’ results of operations and financial condition could be adversely affected.

 

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Under its energy savings performance contracts, Pepco Energy Services is responsible for maintaining, repairing and replacing energy equipment, which obligations may require Pepco Energy Services to incur significant costs many years after an installation of a project is completed. (PHI only)

Pepco Energy Services owns energy equipment and is also responsible for operating and maintaining additional energy equipment that it does not own. In addition, it is generally Pepco Energy Services’ responsibility to repair or replace this energy equipment in the event of a failure. These equipment maintenance, repair and replacement obligations could adversely affect PHI’s results of operations, cash flow and financial condition.

The inability of Pepco Energy Services to perform its obligations in connection with its energy services construction projects may have a material adverse effect on PHI. (PHI only)

Projects undertaken by Pepco Energy Services include design, construction, startup and testing activities related to combined heat and power and other energy facilities, pursuant to guaranteed maximum price or fixed-price contracts. Pepco Energy Services will generally secure commitments from subcontractors and vendors to perform within contract pricing commitments, equipment-performance standards, jobsite safety requirements, and other key parameters. Ultimately, however, Pepco Energy Services will bear responsibility in the event of unexcused failures by these subcontractors and vendors, as well as other third parties, to perform in accordance with the terms of these contracts or otherwise pursuant to the expectations of the parties. When such events occur, Pepco Energy Services may experience reputational harm and claims for money damages and other relief, which could, depending upon the cause and severity of the failure of performance, adversely affect PHI’s business, results of operations, cash flow and financial condition.

If PHI is not successful in mitigating the risks inherent in its business, its operations could be adversely affected.

PHI and its subsidiaries are faced with a number of different types of risk. PHI confronts legislative, regulatory policy, compliance and other risks, including:

 

   

our inability to timely recover capital and operating costs, which may result in a shortfall in revenues;

 

   

resource planning and other long-term planning risks, including resource acquisition risks, which may hinder our ability to maintain adequate resources;

 

   

financial risks, including credit, interest rate and capital market risks, which could increase the cost of capital or make raising capital more difficult; and

 

   

macroeconomic risks, including risks related to economic conditions and changes in demand for electricity and natural gas in the service territories of PHI’s utility subsidiaries, as well as with respect to Pepco Energy Services’ business, which could negatively impact the operations of the affected business.

PHI management seeks to mitigate the risks inherent in the implementation of PHI’s business strategy through its established risk mitigation process, which includes adherence to PHI’s business policies and other compliance policies, operation of formal risk management structures and groups, and overall business management. PHI management is responsible for identifying, assessing and managing risks, and developing risk-management strategies, while the Board of Directors and its various committees oversee the assessment, management and mitigation of risk. However, there can be no assurance these risk mitigation efforts will adequately address all such risks or that such efforts will be successful.

PHI and its subsidiaries are exposed to contractual and credit risks associated with certain of their operations.

PHI and its subsidiaries are subject to a number of contractual and credit risks associated with certain of their operations. For example, Pepco Energy Services has entered into commercial transactions for the purchase and sale of electricity and natural gas, as well as derivative and other transactions to manage the risk of commodity price fluctuations. Under these arrangements, Pepco Energy Services is exposed to the

 

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risk that the counterparty may fail to perform its obligation to make or take delivery under the contract, fail to make a required payment or fail to return collateral posted by Pepco Energy Services when the counterparty is required to do so. In addition, PHI’s PCI subsidiary has entered into several cross-border energy lease investments located outside the United States. Under these leases, PCI is exposed to the risk that the counterparty may fail to make lease payments on time or at all.

Many of these contracts provide for PHI or a subsidiary to receive collateral or other types of performance assurance from the counterparty, which may be in the form of cash, letters of credit or parent guarantees, to protect against performance and credit risk. Even where collateral is provided, capital market disruptions can prevent the counterparty from meeting its collateral obligations or degrade the value of letters of credit and guarantees as a result of the lowered rating or insolvency of the issuer or guarantor. In the event of a bankruptcy of a counterparty to any contract to which PHI or any of its subsidiaries is a party, bankruptcy law, in some circumstances, could require the surrender of collateral held or payments received. In the case of PCI, the fact that the counterparties are located outside the United States could make it more difficult for PCI to seek redress or obtain a judgment or compensation against a foreign counterparty for any breach of the lease agreement by that counterparty.

Business operations could be adversely affected by terrorism and cyber attacks.

The threat of, or actual acts of, terrorism may affect the operations of PHI and its subsidiaries in unpredictable ways and may cause changes in the insurance markets, force an increase in security measures and cause electrical disruptions or disruptions of fuel supplies and markets, including natural gas. Utility industry operations require the continued deployment and utilization of sophisticated information technology systems and network infrastructure. While PHI has implemented protective measures designed to mitigate its vulnerability to physical and cyber threats and attacks, such protective measures, and technology systems generally, are vulnerable to disability or failure due to cyber attack, acts of war or terrorism, and other causes. As a result, there can be no assurance that such protective measures will be completely effective in protecting PHI’s infrastructure or assets from a physical or cyber attack or the effects thereof. If any of Pepco’s, DPL’s or ACE’s infrastructure facilities, including their transmission or distribution facilities, were to be a direct target, or an indirect casualty, of an act of terrorism, the operations of PHI, Pepco, DPL or ACE could be adversely affected. Furthermore, any threats or actions that negatively impact the physical security of PHI’s and its subsidiaries’ facilities, or the integrity or security of their computer networks and systems (and any programs or data stored thereon or therein), could adversely affect PHI’s and its subsidiaries’ ability to manage these facilities, networks, systems, programs and data efficiently or effectively, which in turn could have a material adverse effect on PHI’s or its subsidiaries’ results of operations and financial condition. Corresponding instability in the financial markets as a result of threats or acts of terrorism or threatened or actual cyber attacks also could adversely affect the ability of PHI or its subsidiaries to raise needed capital.

Mark-to-market accounting treatment for instruments Pepco Energy Services uses to hedge the cost of supply used to satisfy retail customer load obligations could cause earnings volatility. (PHI only)

Pepco Energy Services purchases 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 natural gas and electricity for delivery to customers. Certain commodity contracts that do not qualify as cash flow hedges of forecasted transactions or do not meet the requirements for normal purchase and normal sale accounting are marked to market through current earnings. Any change in the fair value of the transactions used to hedge price risk that do not qualify for hedge accounting and receive mark-to-market accounting treatment will be reflected in PHI’s current earnings without any offsetting change in the fair value of its retail load obligations until the settlement date of these contracts in future periods. Pepco Energy Services has discontinued hedge accounting, so PHI’s earnings could be more volatile due to the mark-to-market accounting treatment associated with these commodity contracts. As of December 31, 2012, the commodity contracts that currently qualify for normal purchase and normal sale accounting and an exception from mark-to-market accounting are in a significant net loss position on a

 

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fair value basis. If PHI could no longer sustain the normal purchase and normal sale designation for these contracts, it would be required to recognize these net losses and future changes in the fair value in earnings, which could result in greater earnings volatility. It is anticipated that the notional value and the fair value of the supply contracts will decrease considerably during 2013 with the wind-down of the retail energy business.

New accounting standards or changes to existing accounting standards could materially impact how a Reporting Company reports its results of operations, cash flow and financial condition.

Each Reporting Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The SEC, the Public Company Accounting Oversight Board, the FASB or other authoritative bodies or governmental entities may issue new pronouncements or new interpretations of existing accounting standards that may require the Reporting Companies to change their accounting policies. These changes are beyond the control of the Reporting Companies, can be difficult to predict and could materially impact how they report their results of operations, cash flow and financial condition. Each Reporting Company could be required to apply a new or revised standard retroactively, which could adversely affect its results of operations, cash flow and financial condition.

Undetected errors in internal controls and information reporting could result in the disallowance of cost recovery and noncompliant disclosure.

Each Reporting Company’s internal controls, accounting policies and practices and internal information systems are designed to enable the Reporting Company to capture and process transactions and information in a timely and accurate manner in compliance with GAAP, laws and regulations, taxation requirements and federal securities laws and regulations applicable to it. Such compliance permits each Reporting Company to, among other things, disclose and report financial and other information in connection with the recovery of its costs and with the reporting requirements for each Reporting Company under federal securities, tax and other laws and regulations.

Each Reporting Company has implemented corporate governance, internal control and accounting policies and procedures in connection with the Sarbanes-Oxley Act of 2002 (the Sarbanes-Oxley Act) and relevant SEC rules, as well as other applicable regulations. Such internal controls and policies have been and continue to be closely monitored by each Reporting Company’s management and PHI’s Board of Directors to ensure continued compliance with these laws, rules and regulations. Management is also responsible for establishing and maintaining internal control over financial reporting and is required to assess annually the effectiveness of these controls. While PHI believes these controls, policies, practices and systems are adequate to verify data integrity, unanticipated and unauthorized actions of employees or temporary lapses in internal controls due to shortfalls in oversight or resource constraints could lead to undetected errors that could result in the disallowance of cost recovery and noncompliant disclosure and reporting. The consequences of these events could have a negative impact on the results of operations and financial condition of the affected Reporting Company. The inability of management to certify as to the effectiveness of these controls due to the identification of one or more material weaknesses in these controls could also increase financing costs or could also adversely affect the ability of a Reporting Company to access the capital markets.

Insurance coverage may not be sufficient to cover all casualty or property losses that the companies might incur.

PHI and its subsidiaries, including Pepco, DPL and ACE, currently have insurance coverage for their facilities and operations in amounts and with deductibles that they consider appropriate. However, there is no assurance that such insurance coverage will be available in the future on commercially reasonable terms or at all. In addition, some risks, such as weather related casualties, may not be insurable. In the case of loss or damage to property, plant or equipment, there is no assurance that the insurance proceeds received, if any, will be sufficient to cover the entire cost of replacement or repair.

 

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PHI and its subsidiaries are dependent on obtaining access to capital markets and bank financing to satisfy their capital and liquidity requirements. The inability to obtain required financing would have an adverse effect on their respective businesses.

PHI, Pepco, DPL and ACE each have significant capital requirements, including the funding of construction expenditures and the refinancing of maturing debt. These companies rely primarily on cash flow from operations and access to the capital markets to meet these financing needs. The operating activities of PHI and its subsidiaries also require access to short-term money markets and bank financing as sources of liquidity that are not met by cash flow from their operations. Adverse business developments or market disruptions could increase the cost of financing or prevent PHI or any of its subsidiaries from accessing one or more financial markets. Events that could cause or contribute to a disruption of the financial markets include, but are not limited to:

 

   

a recession or an economic slowdown;

 

   

the bankruptcy of one or more energy companies or financial institutions;

 

   

a significant change in energy prices;

 

   

a terrorist or cyber attack or threatened attacks;

 

   

the outbreak of a pandemic or other similar event; or

 

   

a significant electricity or natural gas transmission disruption.

Any reductions in or other actions with respect to the credit ratings of PHI or any of its subsidiaries could increase its financing costs and the cost of maintaining certain contractual relationships.

Nationally recognized rating agencies currently rate PHI, Pepco, DPL and ACE, and debt securities issued by Pepco, DPL and ACE. Ratings are not recommendations to buy or sell securities. PHI or its subsidiaries may, in the future, incur new indebtedness with interest rates that may be affected by changes in or other actions associated with these credit ratings. Each of the rating agencies reviews its ratings periodically, and previous ratings may not be maintained in the future. Rating agencies may also place PHI, Pepco, DPL or ACE under review for potential downgrade in certain circumstances or if any of them seek to take certain actions. A downgrade of these debt ratings or other negative action, such as a review for a potential downgrade, could affect the market price of existing indebtedness and the ability to raise additional debt without incurring increases in the cost of capital. In addition, a downgrade of these ratings, or other negative action, could make it more difficult to raise capital to refinance any maturing debt obligations, to support business growth and to maintain or improve the current financial strength of PHI’s business and operations.

The collateral requirements of Pepco Energy Services’ retail energy supply business also are determined in part by the unsecured debt rating of PHI. Negative ratings actions by one or more of the credit rating agencies resulting from a change in PHI’s or the utility’s operating results or prospects would increase funding costs. Any increases in collateral requirements could make such contractual obligations more expensive and make financing more difficult to obtain.

The agreements that govern PHI’s primary credit facility and its term loan agreement contain a consolidated indebtedness covenant that may limit discretion of each borrower to incur indebtedness or reduce its equity.

Under the terms of PHI’s primary credit facility, of which each Reporting Company is a borrower, and of PHI’s term loan agreement entered into in April 2012, the consolidated indebtedness of a borrower cannot exceed 65% of its consolidated capitalization. If a borrower’s equity were to decline or its debt were to increase to a level that caused its debt to exceed this limit, lenders under the credit facility would be entitled to refuse any further extension of credit and to declare all of the outstanding debt under the credit facility immediately due and payable. To avoid such a default, a waiver or renegotiation of this covenant would be required, which would likely increase funding costs and could result in additional covenants that would restrict the affected Reporting Company’s operational and financing flexibility.

 

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Each borrower’s ability to comply with this covenant is subject to various risks and uncertainties, including events beyond the borrower’s control. For example, events that could cause a reduction in PHI’s equity include, without limitation, a further write-down of PHI’s cross-border energy lease investments or a significant write-down of PHI’s goodwill. Even if each borrower is able to comply with this covenant, the restrictions on its ability to operate its business in its sole discretion could harm its and PHI’s business by, among other things, limiting the borrower’s ability to incur indebtedness or reduce equity in connection with financings or other corporate opportunities that it may believe would be in its best interests or the interests of PHI’s stockholders to complete.

PHI’s cash flow, ability to pay dividends and ability to satisfy debt obligations depend on the performance of its regulated and competitive operating subsidiaries, access to capital markets and other sources of liquidity. PHI’s unsecured obligations are effectively subordinated to the liabilities of its subsidiaries. (PHI only)

PHI is a holding company that conducts its operations entirely through its regulated and competitive subsidiaries, and all of PHI’s consolidated operating assets are held by its subsidiaries. Accordingly, PHI’s cash flow, its ability to satisfy its obligations to creditors and its ability to pay dividends on its common stock are dependent upon the earnings of its subsidiaries, each Reporting Company’s access to capital markets and all sources of cash flow and liquidity that may be available to PHI. PHI’s subsidiaries are separate legal entities and have no obligation to pay any amounts due on any debt or equity securities issued by PHI or to make any funds available for such payment. The ability of PHI’s subsidiaries to pay dividends and make other payments to PHI may be restricted by, among other things, applicable corporate, tax and other laws and regulations and agreements made by PHI and its subsidiaries, including under the terms of indebtedness, and PHI’s financial objective of maintaining a common equity ratio at its utility subsidiaries of between 49% and 50%. Because the claims of the creditors of PHI’s subsidiaries are superior to PHI’s entitlement to dividends, the unsecured debt and obligations of PHI are effectively subordinated to all existing and future liabilities of its subsidiaries, including trade creditors. In addition, claims of creditors, including trade creditors, of PHI’s subsidiaries will generally have priority with respect to the assets and earnings of such subsidiaries over the claims of PHI’s creditors.

PHI has a significant goodwill balance related to its Power Delivery business. A determination that goodwill is impaired could result in a significant non-cash charge to earnings.

PHI had a goodwill balance at December 31, 2012, of approximately $1.4 billion, primarily attributable to Pepco’s acquisition of Conectiv in 2002. An impairment charge must be recorded under GAAP to the extent that the implied fair value of goodwill is less than the carrying value of goodwill, as shown on the consolidated balance sheet. PHI is required to test goodwill for impairment at least annually and whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors that may result in an interim impairment test include a decline in PHI’s stock price causing market capitalization to fall below book value, an adverse change in business conditions or an adverse regulatory action. If PHI were to determine that its goodwill is impaired, PHI would be required to reduce its goodwill balance by the amount of the impairment and record a corresponding non-cash charge to earnings. Depending on the amount of the impairment, an impairment determination could have a material adverse effect on PHI’s financial condition and results of operations, but would not have an impact on cash flow.

 

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The funding of future defined benefit pension plan and post-retirement benefit plan obligations is based on assumptions regarding the valuation of future benefit obligations and the performance of plan assets. If market performance decreases plan assets or changes in assumptions regarding the valuation of benefit obligations increase plan liabilities, any of the Reporting Companies may be required to make significant cash contributions to fund these plans.

PHI holds assets in trust to meet its obligations under PHI’s defined benefit pension plan and its post-retirement benefit plan. The amounts that PHI is required to contribute (including the amounts for which Pepco, DPL and ACE are responsible) to fund the trusts are determined based on assumptions made as to the valuation of future benefit obligations, and the investment performance of the plan assets. Accordingly, the performance of the capital markets will affect the value of plan assets. A decline in the market value of plan assets may increase the plan funding requirements to meet the future benefit obligations. In addition, changes in interest rates affect the valuation of the liabilities of the plans. As interest rates decrease, the liabilities increase, potentially requiring additional funding. Demographic changes, such as a change in the expected timing of retirements or changes in life expectancy assumptions, also may increase the funding requirements of the plans. A need for significant additional funding of the plans could have a material adverse effect on the cash flows of any of the Reporting Companies. Future increases in pension plan and other post-retirement benefit plan costs, to the extent they are not recoverable in the base rates of PHI’s utility subsidiaries, could have a material adverse effect on the results of operations, cash flow and financial condition of any of the Reporting Companies.

Provisions of the Delaware General Corporation Law and in PHI’s constituent documents may discourage an acquisition of PHI. (PHI only)

PHI is governed by the provisions of Section 203 of the Delaware General Corporation Law, which prohibit a public Delaware corporation from engaging in a business combination with an interested stockholder (as defined in Section 203) for a period commencing three years from the date in which the person became an interested stockholder, unless:

 

   

the board of directors approved the transaction which resulted in the stockholder becoming an interested stockholder;

 

   

upon consummation of the transaction which resulted in the stockholder becoming an interested stockholder, the interested stockholder owned at least 85% of the voting stock of the corporation (excluding shares owned by officers, directors, or certain employee stock purchase plans); or

 

   

at or subsequent to the time the transaction is approved by the board of directors, there is an affirmative vote of at least 66 2/3% of the outstanding voting stock not owned by the interested stockholder approving the transaction.

Section 203 could prohibit or delay mergers or other takeover attempts against PHI, and accordingly, may discourage or prevent attempts to acquire or control PHI through a tender offer, proxy contest or otherwise.

In addition, PHI’s restated certificate of incorporation and amended and restated bylaws contain provisions that may discourage, delay or prevent a third party from acquiring PHI, even if doing so would be beneficial to its stockholders. Under PHI’s restated certificate of incorporation, only its board of directors may call special meetings of stockholders. Further, stockholder actions may only be taken at a duly called annual or special meeting of stockholders and not by written consent. Moreover, directors of PHI may be removed by stockholders only for cause and only by the effective vote of at least a majority of the outstanding shares of capital stock of PHI entitled to vote generally in the election of directors (voting together as a single class) at a meeting of stockholders called for that purpose. In addition, under PHI’s amended and restated bylaws, stockholders must comply with advance notice requirements for nominating candidates for election to PHI’s board of directors or for proposing matters that can be acted upon by stockholders at stockholder meetings, and this provision may be amended or repealed by stockholders only upon the affirmative vote of the holders of two-thirds of the outstanding shares of PHI capital stock entitled to vote generally in the election of directors, voting together as a single class.

 

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Issuances of additional series of PHI preferred stock could adversely affect holders of PHI’s common stock. (PHI only)

PHI’s board of directors is authorized to issue shares of PHI preferred stock in series without any action on the part of PHI stockholders. PHI’s board of directors also has the power, without stockholder approval, to set the terms of any such series of preferred stock, including with respect to dividend rights, redemption rights and sinking fund provisions, conversion rights, voting rights, and other preferential rights, limitations and restrictions. If PHI issues preferred stock in the future that has a preference over PHI’s common stock with respect to the payment of dividends or upon its liquidation, dissolution or winding up, or if preferred stock is issued with voting rights that dilute the voting power of the common stock, the rights of holders of PHI’s common stock or the market price of such common stock could be adversely affected. Furthermore, issuances of preferred stock can be used to discourage, delay or prevent a third party from acquiring PHI where the acquisition might be perceived as being beneficial to stockholders.

Because Pepco, DPL and ACE are direct or indirect wholly owned subsidiaries of PHI and have directors and executive officers who are also officers of PHI, PHI can effectively exercise control over their dividend policies and significant business and financial transactions. (Pepco, DPL and ACE only)

All of the members of each of Pepco’s, DPL’s and ACE’s board of directors, as well as many of their respective executive officers, are officers of PHI, and Pepco, DPL and ACE are direct or indirect wholly owned subsidiaries of PHI. Among other decisions, each of Pepco’s, DPL’s and ACE’s board of directors is responsible for decisions regarding payment of dividends, financing and capital raising activities and acquisition and disposition of assets. Within the limitations of applicable law, and subject to the financial covenants under each company’s respective outstanding debt instruments, each of Pepco’s, DPL’s and ACE’s board of directors will base its decisions concerning the amount and timing of dividends, and other business decisions, on its capital structure, which is based in part on earnings and cash flow, and also may take into account the business plans and financial requirements of PHI and its other subsidiaries.

 

Item 1B. UNRESOLVED STAFF COMMENTS

Pepco Holdings

None.

Pepco

None.

DPL

None.

ACE

None.

 

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Item 2. PROPERTIES

Generating Facilities

The following table identifies the electric generating facilities owned by PHI’s subsidiaries at December 31, 2012.

 

Electric Generating Facilities

  

Location

  

Owner

   Generating
Capacity
(kilowatts)
 

Landfill Gas-Fired Units

        

Fauquier Landfill Project

   Fauquier County, VA    Pepco Energy Services      2,000   

Eastern Landfill Project

   Baltimore County, MD    Pepco Energy Services      3,000   

Bethlehem Landfill Project

   Northampton, PA    Pepco Energy Services      5,000   
        

 

 

 
           10,000   
        

 

 

 

Solar Photovoltaic

        

Atlantic City Convention Center

   Atlantic City, NJ    Pepco Energy Services      2,000   
        

 

 

 

Combined Heat and Power Generating

        

Mid Town Plant

   Atlantic City, NJ    Pepco Energy Services      5,400   
        

 

 

 

Total Electric Generating Capacity

           17,400   
        

 

 

 

The preceding table sets forth the net summer electric generating capacity of each electric generating facility owned. Although the generating capacity may be higher during the winter months, the facilities are used to meet summer peak loads that are generally higher than winter peak loads. Accordingly, the summer generating capacity more accurately reflects the operational capability of the facilities.

Transmission and Distribution Systems

On a combined basis, the electric transmission and distribution systems owned by Pepco, DPL and ACE at December 31, 2012, consisted of approximately 4,000 transmission circuit miles of overhead lines, 600 transmission circuit miles of underground cables, 18,200 distribution circuit miles of overhead lines, and 15,900 distribution circuit miles of underground cables, primarily in their respective service territories. DPL and ACE own and operate distribution system control centers in New Castle, Delaware and Mays Landing, New Jersey, respectively. Pepco also operates a distribution system control center in Bethesda, Maryland. The computer equipment and systems contained in Pepco’s control center are financed through a sale and leaseback transaction.

DPL owns a liquefied natural gas facility located in Wilmington, Delaware, with a storage capacity of approximately 3 million gallons and an emergency sendout capability of 25,000 Mcf per day. DPL owns 10 natural gas city gate stations at various locations in New Castle County, Delaware. These stations have a total primary delivery point contractual entitlement of 202,075 Mcf per day. DPL also owns approximately 110 pipeline miles of natural gas transmission mains, 1,927 pipeline miles of natural gas distribution mains, and 1,313 pipeline miles of natural gas service lines. In addition, DPL has a 10% undivided interest in approximately 7 miles of natural gas transmission mains, which are used by DPL for its natural gas operations and by the 90% owner for distribution of natural gas to its electric generating facilities.

Substantially all of the transmission and distribution property, plant and equipment owned by each of Pepco, DPL and ACE is subject to the liens of the respective mortgages under which the companies issue First Mortgage Bonds. See Note (11), “Debt” to the consolidated financial statements of PHI.

 

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Item 3. LEGAL PROCEEDINGS

Pepco Holdings

Other than litigation incidental to PHI and its subsidiaries’ business, PHI is not a party to, and PHI and its subsidiaries’ property is not subject to, any material pending legal proceedings except as described in Note (16), “Commitments and Contingencies,” to the consolidated financial statements of PHI.

Pepco

Other than litigation incidental to its business, Pepco is not a party to, and its property is not subject to, any material pending legal proceedings except as described in Note (13), “Commitments and Contingencies,” to the financial statements of Pepco.

DPL

Other than litigation incidental to its business, DPL is not a party to, and its property is not subject to, any material pending legal proceedings except as described in Note (15), “Commitments and Contingencies,” to the financial statements of DPL.

ACE

Other than litigation incidental to its business, ACE is not a party to, and its property is not subject to, any material pending legal proceedings except as described in Note (14), “Commitments and Contingencies,” to the consolidated financial statements of ACE.

 

Item 4. MINE SAFETY DISCLOSURES

Not applicable

 

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Part II

 

Item 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

The New York Stock Exchange is the principal market on which Pepco Holdings common stock is traded. The following table presents the dividends declared per share on the Pepco Holdings common stock and the high and low sales prices for the common stock based on composite trading as reported by the New York Stock Exchange during each quarter in the last two years.

 

     Dividends      Price Range  

Period

   Per Share      High      Low  

2012:

        

First Quarter

   $ .27      $ 20.48       $ 18.63   

Second Quarter

     .27        19.63         18.14   

Third Quarter

     .27        20.30         18.67   

Fourth Quarter

     .27        20.06         18.80   
  

 

 

       
   $ 1.08        
  

 

 

       

2011:

        

First Quarter

   $ .27      $ 19.14       $ 17.83   

Second Quarter

     .27        20.36         18.10   

Third Quarter

     .27        20.04         16.57   

Fourth Quarter

     .27        20.64         17.77   
  

 

 

       
   $ 1.08        
  

 

 

       

At February 15, 2013, there were 49,824 holders of record of Pepco Holdings common stock.

Dividends

On January 24, 2013, the PHI Board of Directors declared a dividend on common stock of 27 cents per share payable March 28, 2013, to shareholders of record on March 11, 2013.

See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Capital Resources and Liquidity – Capital Requirements – Dividends,” and Note (13), “Stock-Based Compensation, Dividend Restrictions, and Calculations of Earnings Per Share of Common Stock – Dividend Restrictions,” of the consolidated financial statements of PHI for information regarding restrictions on the ability of PHI and its subsidiaries to pay dividends.

PHI Subsidiaries

One of PHI’s financial objectives is to maintain an equity ratio of 49%-50% in each of its operating utilities. Each quarter, PHI may contribute equity into its utility subsidiaries or the utility subsidiaries may make a dividend payment to PHI in order to maintain an equity ratio of 49%-50% in each of the utility subsidiaries. During 2012, PHI made capital contributions of $50 million and $60 million to Pepco and DPL, respectively, and in 2011, PHI made a capital contribution to ACE of $60 million.

All of Pepco’s common stock is held by Pepco Holdings, and all of DPL’s and ACE’s common stock is held by Conectiv, LLC (Conectiv), which in turn is wholly owned by Pepco Holdings. The table below presents the aggregate amount of common stock dividends paid by Pepco to PHI, and by DPL and ACE to PHI (through Conectiv), during each quarter in the last two years. Dividends received by PHI in 2012 and 2011 were used to support the payment of its common stock dividend. Dividends paid by ACE in 2012 were used by Conectiv to pay down its short-term debt owed to PHI and in 2011 were passed through to PHI to support the payment of its common stock dividend.

 

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Period

   Pepco      DPL      ACE  

2012:

        

First Quarter

   $ —         $ —         $ —     

Second Quarter

     —           —           15,000,000   

Third Quarter

     35,000,000         —           20,000,000   

Fourth Quarter

     —           —           —     
  

 

 

    

 

 

    

 

 

 
   $ 35,000,000       $ —         $ 35,000,000   
  

 

 

    

 

 

    

 

 

 

2011:

        

First Quarter

   $ —         $ —         $ —     

Second Quarter

     —           —           —     

Third Quarter

     —           50,000,000         —     

Fourth Quarter

     25,000,000         10,000,000         —     
  

 

 

    

 

 

    

 

 

 
   $ 25,000,000       $ 60,000,000       $ —     
  

 

 

    

 

 

    

 

 

 

Recent Sales of Unregistered Equity Securities

Pepco Holdings

None.

Pepco

None.

DPL

None.

ACE

None.

Purchases of Equity Securities by the Issuer and Affiliated Purchasers

Pepco Holdings

None.

Pepco

None.

DPL

None.

ACE

None.

 

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Item 6. SELECTED FINANCIAL DATA

The following table sets forth selected historical consolidated data for PHI as of and for the years ended December 31, 2012, 2011, 2010, 2009, and 2008, derived from PHI’s audited financial statements.

PEPCO HOLDINGS CONSOLIDATED FINANCIAL HIGHLIGHTS

 

     2012     2011     2010     2009     2008  
     (in millions, except per share data)  

Consolidated Operating Results

        

Total Operating Revenue

   $ 5,081     $ 5,951     $ 7,040     $ 7,402     $  8,059 (k) 

Total Operating Expenses

     4,411 (a)(b)      5,314 (d)      6,416 (f)      6,754 (i)      7,510  

Operating Income

     670       637       624       648       549  

Other Expenses

     229       228       474 (g)      321       276  

Income from Continuing Operations Before Income

    Tax Expense

     441       409       150       327       273  

Income Tax Expense Related to Continuing

    Operations

     156 (c)      149 (e)      11 (h)      104 (j)      90 (k)(l) 

Net Income from Continuing Operations

     285       260       139       223       183  

(Loss) Income from Discontinued Operations, net

    of Income Taxes

     —         (3 )     (107 )     12       117  

Net Income

     285       257       32       235       300  

Earnings Available for Common Stock

     285       257       32       235       300  

Common Stock Information

          

Basic Earnings Per Share of Common Stock from Continuing Operations

   $ 1.25     $ 1.15     $ 0.62     $ 1.01     $ 0.90  

Basic (Loss) Earnings Per Share of Common Stock from Discontinued Operations

     —         (0.01 )     (0.48 )     0.05       0.57  

Basic Earnings Per Share of Common Stock

     1.25       1.14       0.14       1.06       1.47  

Diluted Earnings Per Share of Common Stock from

    Continuing Operations

     1.24       1.15       0.62       1.01       0.90  

Diluted (Loss) Earnings Per Share of Common

    Stock from Discontinued Operations

     —         (0.01 )     (0.48 )     0.05       0.57  

Diluted Earnings Per Share of Common Stock

     1.24       1.14       0.14       1.06       1.47  

Cash Dividends Per Share of Common Stock

     1.08       1.08       1.08       1.08       1.08  

Year-End Stock Price

     19.61       20.30       18.25       16.85       17.76  

Net Book Value Per Common Share

     19.32       19.05       18.79       19.15       19.14  

Weighted Average Shares Outstanding–Basic

     229       226       224       221       204  

Weighted Average Shares Outstanding–Diluted

     230       226       224       221       204  

Other Information

          

Investment in Property, Plant and Equipment

   $ 13,625     $ 12,855     $ 12,120     $ 11,431     $ 10,860  

Net Investment in Property, Plant and Equipment

     8,846       8,220       7,673       7,241       6,874  

Total Assets

     15,776       14,910       14,480       15,779       16,133  

Capitalization

          

Short-term Debt

   $ 965     $ 732     $ 534     $ 530     $ 465  

Long-term Debt

     3,648       3,794       3,629       4,470       4,859  

Current Portion of Long-Term Debt and Project Funding

     569       112       75       536       85  

Transition Bonds issued by ACE Funding

     256       295       332       368       401  

Capital Lease Obligations due within one year

     8        8       8       7       6  

Capital Lease Obligations

     70        78       86       92       99  

Long-Term Project Funding

     12       13       15       17       19  

Non-controlling Interest

     —         —         6       6       6  

Common Shareholders’ Equity

     4,446       4,336       4,230       4,256       4,190  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total Capitalization

   $ 9,974     $ 9,368     $ 8,915     $ 10,282     $ 10,130  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(a) Includes impairment losses of $12 million pre-tax ($7 million after-tax) at Pepco Energy Services associated primarily with investments in landfill gas-fired electric generation facilities, and the combustion turbines at Buzzard Point.
(b) Includes $39 million pre-tax ($9 million after-tax) gain from the early termination of finance leases held in trust.
(c) Includes a $16 million charge related to the recognition of the tax consequences associated with the early termination of finance leases held in trust.
(d) Includes $39 million pre-tax ($3 million after-tax) gain from the early termination of certain cross-border energy leases held in trust.
(e) Includes tax benefits of $14 million primarily associated with an interest benefit related to federal tax liabilities and a $22 million charge related to the recognition of the tax consequences associated with the early termination of cross-border energy leases held in trust.
(f) Includes $30 million ($18 million after-tax) related to a restructuring charge and an $11 million ($6 million after-tax) charge related to the effects of Pepco divestiture-related claims.
(g) Includes a loss on extinguishment of debt of $189 million ($113 million after-tax).
(h) Includes $12 million of net Federal and state income tax benefits primarily related to adjustments of accrued interest on uncertain and effectively settled tax positions, $14 million of state tax benefits resulting from the restructuring of certain PHI subsidiaries and $17 million of state income tax benefits associated with the loss on extinguishment of debt.
(i) Includes $40 million ($24 million after-tax) gain related to the effects of Pepco divestiture-related claims.
(j) Includes a $13 million state income tax benefit (after Federal tax) related to a change in the state income tax reporting for the disposition of certain assets in prior years and a benefit of $6 million related to additional analysis of current and deferred tax balances completed in 2009.
(k) Includes a pre-tax charge of $124 million ($86 million after-tax) related to the adjustment to the equity value of cross-border energy lease investments, and included in Income Taxes is a $7 million after-tax charge for the additional interest accrued on the related tax obligation.
(l) Includes $18 million of after-tax net interest income on uncertain and effectively settled tax positions (primarily associated with the reversal of previously accrued interest payable resulting from the tentative settlement with the IRS on the mixed service cost issue and a claim made with the IRS related to the tax reporting for fuel over- and under-recoveries) and a benefit of $8 million (including a $3 million correction of prior period errors) related to additional analysis of deferred tax balances completed in 2008.

 

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INFORMATION FOR THIS ITEM IS NOT REQUIRED FOR PEPCO, DPL, AND ACE AS THEY MEET THE CONDITIONS SET FORTH IN GENERAL INSTRUCTIONS I(1)(a) AND (b) OF FORM 10-K AND THEREFORE ARE FILING THIS FORM WITH THE REDUCED FILING FORMAT.

 

Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The information required by this item is contained herein, as follows:

 

Registrants

   Page No.  

Pepco Holdings

     44   

Pepco

     94   

DPL

     104  

ACE

     115  

 

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PEPCO HOLDINGS

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Pepco Holdings, Inc.

General Overview

PHI, a Delaware corporation incorporated in 2001, is a holding company that, through its regulated public utility subsidiaries, is engaged primarily in the transmission, distribution and default supply of electricity and the distribution and supply of natural gas (Power Delivery). Through Pepco Energy Services, PHI provides energy savings performance contracting services, high voltage underground transmission cabling, construction and operations of combined heat and power and central energy plants and is in the process of winding down its competitive electricity and natural gas retail supply business.

Each of Power Delivery and Pepco Energy Services constitutes a separate segment for financial reporting purposes. A third segment, Other Non-Regulated, consists of a portfolio of cross-border energy lease investments.

The following table sets forth the percentage contributions to consolidated operating revenue and operating income from continuing operations attributable to PHI segments:

 

     December 31,  
     2012     2011     2010  

Percentage of Consolidated Operating Revenue

      

Power Delivery

     86     78     73

Pepco Energy Services

     13     21     27

Other (a)

     1     1     —  

Percentage of Consolidated Operating Income

      

Power Delivery

     79     78     81

Pepco Energy Services

     4     5     11

Other (a)(b)

     17     17     8

Percentage of Power Delivery Operating Revenue

      

Power Delivery Electric

     96     95     95

Power Delivery Gas

     4     5     5

 

(a) For presentation purposes, this category includes Other Non-Regulated and Corporate and Other.
(b) Includes gains on early termination of finance leases held in trust that represent 6% of the consolidated operating income in 2012 and 2011.

Power Delivery

Power Delivery Electric consists primarily of the transmission, distribution and default supply of electricity, and Power Delivery Gas consists of the delivery and supply of natural gas. Power Delivery represents a single operating segment for financial reporting purposes.

Each utility comprising Power Delivery is a regulated public utility in the jurisdictions that comprise its 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 commission in each jurisdiction. 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 SOS in Delaware, the District of Columbia and Maryland, and BGS in New Jersey. In this report, these supply service obligations are referred to generally as Default Electricity Supply.

 

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PEPCO HOLDINGS

 

Each of Pepco, DPL and ACE is responsible for the transmission of wholesale electricity into and across its service territory. The rates each utility is permitted to charge for the wholesale transmission of electricity are regulated by FERC. Transmission rates are updated annually based on a FERC-approved formula methodology.

The profitability of Power Delivery depends on its ability to recover costs and earn a reasonable return on its capital investments through the rates it is permitted to charge. Operating results also can be affected by economic conditions, energy prices, the impact of energy efficiency measures on customer usage of electricity and weather.

Power Delivery’s results historically have been seasonal, generally producing higher revenue and income in the warmest and coldest periods of the year. For retail customers of Pepco and DPL in Maryland and of Pepco in the District of Columbia, revenue is not affected by unseasonably warmer or colder weather because a BSA for retail customers was implemented that provides for a fixed distribution charge per customer rather than a charge based upon energy usage. The BSA has the effect of decoupling the distribution revenue recognized in a reporting period from the amount of power delivered during the period. As a result, the only factors that will cause distribution revenue from retail customers in Maryland and the District of Columbia to fluctuate from period to period are changes in the number of customers and changes in the approved distribution charge per customer. A comparable revenue decoupling mechanism for DPL electricity and natural gas customers in Delaware is under consideration by the DPSC.

In accounting for the BSA in Maryland and the District of Columbia, a Revenue Decoupling Adjustment (an adjustment equal to the amount by which revenue from distribution sales differs from the revenue that Pepco and DPL are entitled to earn based on the approved distribution charge per customer) is recorded representing either (i) a positive adjustment equal to the amount by which revenue from retail distribution sales falls short of the revenue that Pepco and DPL are entitled to earn based on the approved distribution charge per customer or (ii) a negative adjustment equal to the amount by which revenue from such distribution sales exceeds the revenue that Pepco and DPL are entitled to earn based on the approved distribution charge per customer.

Since 2010, PHI has implemented comprehensive reliability enhancement plans which include various initiatives to improve electrical system reliability, including:

 

   

the identification and upgrading of under-performing feeder lines;

 

   

the addition of new facilities to support load;

 

   

the installation of distribution automation systems on both the overhead and underground network systems;

 

   

the rejuvenation and replacement of underground residential cables;

 

   

selective undergrounding of portions of existing above-ground primary feeder lines, where appropriate to improve reliability;

 

   

improvements to substation supply lines; and

 

   

enhanced vegetation management.

PHI’s capital expenditures for continuing reliability enhancement efforts are included in the table of projected capital expenditures within “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Capital Resources and Liquidity – Capital Requirements – Capital Expenditures.”

 

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Power Delivery Initiatives and Activities

Smart Grid

PHI is building a “smart grid” which is designed to meet the challenges of rising energy costs, concerns about the environment, reliability improvement, providing timely and accurate customer information and meeting government energy reduction goals. The installation of smart meters is subject to the approval of applicable state regulators. The DCPSC, MPSC and DPSC have approved the creation of regulatory assets to defer AMI costs between rate cases, as well as the accrual of returns on the deferred costs. Thus, these costs will be recovered in the future through base rates. Approval of AMI has been deferred by the New Jersey Board of Public Utilities (NJBPU) for ACE in New Jersey.

In April 2010, PHI signed agreements to formalize $168 million in awards from the U.S. Department of Energy to support the rollout of smart grid initiatives. In the Pepco service area, $149 million was awarded for AMI, direct load control, distribution automation and communications infrastructure, while in the Atlantic City Electric service area, $19 million was awarded for direct load control, distribution automation and communications infrastructure. The grants effectively reduce the project costs of these initiatives. The cumulative award payments received by Pepco and ACE as of December 31, 2012, were $115 million and $13 million, respectively.

For projected 2013 through 2017 capital expenditures associated with the smart grid, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Capital Resources and Liquidity – Capital Requirements.”

Regulatory Lag

An important factor in the ability of each of Pepco, DPL and ACE to earn its authorized rate of return is the willingness of applicable public service commissions to adequately recognize forward-looking costs in the utility’s rate structure in order to address the shortfall in revenues due to the delay in time or “lag” between when costs are incurred and when they are reflected in rates. This delay is commonly known as “regulatory lag.” Each of Pepco, DPL and ACE is currently experiencing significant regulatory lag because its investment in the rate base and its operating expenses are outpacing revenue growth.

In an effort to minimize the effects of regulatory lag, Pepco’s and DPL’s Delaware, District of Columbia and Maryland base rate case filings in 2011 each included a request for approval from the applicable state regulatory commissions of (i) a reliability investment recovery mechanism (RIM) to recover reliability-related capital expenditures incurred between base rate cases and (ii) the use by the applicable utility of fully forecasted test years in future base rate cases. See Note (7), “Regulatory Matters – Rate Proceedings,” to the consolidated financial statements of PHI for a discussion of each of these mechanisms. In both the Pepco and DPL base rate case orders in Maryland, the MPSC did not approve Pepco’s and DPL’s requests to implement the RIM and did not endorse the use by Pepco and DPL of fully forecasted test years in future rate cases. However, the MPSC did permit an adjustment to the rate base of Pepco and DPL to reflect the actual cost of reliability plant additions outside the test year. In the District of Columbia, 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 Delaware, a settlement agreement approved by the DPSC in DPL’s electric distribution base rate case did not include approval of a RIM or the use of fully forecasted test years in future DPL rate cases, but it did provide that the parties will meet and discuss alternate regulatory methodologies for the mitigation of regulatory lag.

Each of PHI’s utility subsidiaries will continue to seek cost recovery from applicable public service commissions to reduce the effects of regulatory lag. There can be no assurance that any attempts by PHI’s utility subsidiaries to mitigate regulatory lag will be approved, or that even if approved, the cost recovery mechanisms will fully mitigate the effects of regulatory lag. Until such time as any cost recovery mechanisms are approved, PHI’s utility subsidiaries plan to file rate cases at least annually in an effort to align more closely the revenue and cash flow levels of PHI’s utility subsidiaries with other operation and maintenance spending and capital investments. In addition to the electric distribution base rate cases filed by Pepco and to be filed by DPL in the first quarter of 2013 in Maryland, DPL filed a natural gas distribution case on December 7, 2012 and ACE filed an electric distribution base rate case on December 11, 2012. Additionally, Pepco intends to file its next electric distribution base rate case with the DCPSC, and DPL with the DPSC, in the first quarter of 2013.

MAPP Project

On August 24, 2012, the board of PJM terminated the MAPP project and removed it from PJM’s regional transmission expansion plan. PHI had been directed to construct the MAPP project, a 152-mile high-voltage interstate transmission line, to address the reliability needs of the region’s transmission system.

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. See “Capital Resources and Liquidity – Capital Requirements – Capital Expenditures” for a discussion of PHI’s projected capital expenditures. As of December 31, 2012, PHI’s total capital expenditures related to the MAPP project were approximately $102 million. In a 2008 FERC order approving incentives for the MAPP project, FERC authorized the recovery of prudently incurred abandoned costs in connection with the MAPP project. Consistent with this order, on December 21, 2012, PHI submitted a filing to FERC seeking recovery over a period of five years of approximately $88 million of abandoned MAPP capital expenditures. The FERC filing addressed, among other things, the prudence of the recoverable costs incurred, the proposed period over which the abandoned costs are to be amortized and the rate of return on these costs during the recovery period (see Note (7), “Regulatory Matters – MAPP Project” to the consolidated financial statements of PHI for additional information).

As of December 31, 2012, PHI had placed in service approximately $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, transferred approximately $3 million of materials to inventories for use on other projects and reclassified the remaining $88 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.

 

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Pepco Energy Services

Since 2010, Pepco Energy Services has been focused on growing its energy savings performance contracting services business in the federal, state and local government markets. Activity in the state and local government markets, which are Pepco Energy Services’ largest markets, slowed significantly in 2012, due to, among other factors, lower energy prices that have lessened the economic benefits of energy savings projects and the reluctance of state and local governments to incur new debt associated with these projects. As a result of the slowdown, Pepco Energy Services believes that new business in these markets will remain challenged for the foreseeable future. Consequently, Pepco Energy Services reduced resources and personnel and limited geographic expansion in the energy savings services business, and has refocused its existing resources on developing business in the federal government market and continuing to pursue combined heat and power projects.

PHI guarantees the obligations of Pepco Energy Services under certain of its energy savings performance, combined heat and power and construction contracts. At December 31, 2012, PHI’s guarantees of Pepco Energy Services’ obligations under these contracts totaled $198 million.

Pepco Energy Services also has historically been engaged in the business of providing retail energy supply services, consisting of the sale of electricity, including electricity from renewable resources, primarily to commercial, industrial and government customers located in the mid-Atlantic and northeastern regions of the United States, as well as Texas and Illinois, and the sale of natural gas to customers located primarily in the mid-Atlantic region. In December 2009, PHI announced that it will wind down the retail energy supply component of the Pepco Energy Services business.

To effectuate the wind-down of the retail energy supply business, Pepco Energy Services is continuing to fulfill all of its commercial and regulatory obligations and perform its customer service functions to ensure that it meets the needs of its existing customers, but is not entering into any new retail energy supply contracts. Operating revenues related to the retail energy supply business for the years ended December 31, 2012, 2011 and 2010 were $418 million, $962 million and $1,609 million, respectively, and operating income for the same periods was $46 million, $11 million and $59 million, respectively.

PHI expects the operating results of the retail energy supply business, excluding the effects of unrealized mark-to-market gains or losses on derivatives contracts, to have immaterial losses in 2013 and 2014. Substantially all of Pepco Energy Services’ retail customer obligations will be fully performed by June 1, 2014. PHI is reviewing strategic alternatives to accelerate into 2013 the completion of the wind-down of its remaining portfolio of retail energy contracts.

In connection with the operation of the retail energy supply business, as of December 31, 2012 and 2011, Pepco Energy Services had net collateral pledged to counterparties, primarily in connection with the instruments it uses to hedge commodity price risk, of approximately $26 million and $113 million, respectively. The collateral pledged as of December 31, 2012 included less than $1 million in the form of letters of credit and $25 million posted in cash. Pepco Energy Services does not expect to have any such collateral obligations beyond June 1, 2014.

Pepco Energy Services’ remaining businesses will not be affected by the wind-down of the retail energy supply business.

During 2012, Pepco Energy Services deactivated its Buzzard Point and Benning Road oil-fired generation facilities. Pepco Energy Services has placed the facilities into an idle condition termed a “cold closure.” A cold closure requires that the utility service be disconnected so that the facilities are no longer operable and that the facilities require only essential maintenance until they are completely decommissioned.

 

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Other Non-Regulated

Through its subsidiary Potomac Capital Investment Corporation and its subsidiaries, PHI maintains a portfolio of cross-border energy lease investments with a net investment value at December 31, 2012 of approximately $1.2 billion. This activity comprises the “Other Non-Regulated” segment. PHI expects to record a non-cash charge of between $355 million and $380 million (after-tax) in the first quarter of 2013, consisting of a charge to reduce the carrying value of the cross-border energy lease investments and a charge to reflect the anticipated additional interest expense related to changes in PHI’s estimated federal and state income tax obligations resulting from the disallowance of certain tax benefits associated with the cross-border energy lease investments. PHI also is evaluating the liquidation of all or a portion of its remaining cross-border energy lease investments. The aggregate financial impact of a partial or complete liquidation of the cross-border leases is not determinable at this time, but could result in material gains or losses. Further, the earnings from the cross-border energy leases represent a substantial portion of the “Other Non-Regulated” segment’s earnings and a partial or complete liquidation of the leases would reduce significantly the earnings of the segment. For additional information concerning these cross-border energy lease investments, see Note (8), “Leasing Activities – Investment in Finance Leases Held in Trust,” Note (16), “Commitments and Contingencies – PHI’s Cross-Border Energy Lease Investments,” and Note (20), “Subsequent Event” 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 Conectiv Energy. On July 1, 2010, PHI completed the sale of Conectiv Energy’s wholesale power generation business to Calpine for $1.64 billion. The disposition of Conectiv Energy’s remaining assets and businesses not included in the Calpine sale, including its load service supply contracts, energy hedging portfolio and certain tolling agreements, has been completed. The former operations of Conectiv Energy, which previously comprised a separate segment for financial reporting purposes, have been classified as a discontinued operation in PHI’s consolidated financial statements, and the business is no longer treated as a separate segment for financial reporting purposes. Accordingly, in this Management’s Discussion and Analysis of Financial Condition and Results of Operations, all references to continuing operations exclude the operations of the former Conectiv Energy segment.

Earnings Overview

Year Ended December 31, 2012 Compared to Year Ended December 31, 2011

 

     2012     2011     Change  

Power Delivery

   $ 235      $ 210     $ 25   

Pepco Energy Services

     18        24       (6

Other Non-Regulated

     40        35       5   

Corporate and Other

     (8     (9 )     1   
  

 

 

   

 

 

   

 

 

 

Net Income from Continuing Operations

     285        260       25   

Discontinued Operations

     —          (3 )     3   
  

 

 

   

 

 

   

 

 

 

Total PHI Net Income

   $ 285      $ 257     $ 28   
  

 

 

   

 

 

   

 

 

 

Net income from continuing operations for the year ended December 31, 2012 was $285 million, or $1.25 per share ($1.24 per share on a diluted basis), compared to $260 million, or $1.15 per share ($1.15 per share on a diluted basis), for the year ended December 31, 2011.

Net loss from discontinued operations for the year ended December 31, 2011 was $3 million, or $0.01 per share.

 

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Discussion of Operating Segment Net Income Variances:

Power Delivery’s $25 million increase in earnings was primarily due to the following:

 

   

An increase of $27 million from electric distribution base rate increases (Pepco in the District of Columbia and Maryland, DPL in Maryland and Delaware and ACE in New Jersey) and the DPL gas distribution rate increase in Delaware.

 

   

An increase of $15 million from higher transmission revenue, primarily attributable to higher rates effective June 1, 2012 and June 1, 2011, related to increases in transmission plant investment.

 

   

An increase of $5 million primarily due to the net effect of income tax benefits resulting from changes in estimates and interest related to uncertain and effectively settled income tax positions.

 

   

A decrease of $7 million due to higher interest expense resulting from an increase in outstanding debt.

 

   

A decrease of $7 million associated with Default Electricity Supply margins for Pepco and DPL, primarily due to regulatory approvals by the respective public service commissions in the District of Columbia, Maryland and Delaware in 2011 of adjustments providing for recovery of higher cash working capital, administrative costs and miscellaneous taxes, partially offset by favorable Default Electricity Supply margin adjustments in 2012 related to the under-recognition of allowed revenues on procurement and transmission taxes in Delaware.

 

   

A decrease of $7 million due to higher operation and maintenance expenses, primarily associated with higher customer support service and system support costs and higher employee-related costs in 2012, and a reduction in self-insurance reserves in 2011, partially offset by regulatory approval in 2012 for the establishment of regulatory assets for recovery of 2011 storm restoration costs and regulatory expenses.

Pepco Energy Services’ $6 million decrease in earnings was primarily due to lower energy services construction activity, the closure of its oil-fired generation facilities and asset impairment charges in 2012, partially offset by higher gross margins in the retail energy supply business attributable to mark-to-market accounting.

Other Non-Regulated’s $5 million increase in earnings was primarily due to an increase of $6 million in gains from early terminations of certain cross-border energy leases ($9 million in 2012, as compared to $3 million in 2011), partially offset by favorable income tax adjustments related to uncertain and effectively settled income tax positions in 2011.

Corporate and Other’s $1 million decrease in net loss was primarily due to the write-off of an equity investment in 2011, partially offset by higher interest expense in 2012.

 

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The following results of operations discussion is for the year ended December 31, 2012, compared to the year ended December 31, 2011. All amounts in the tables (except sales and customers) are in millions of dollars.

Continuing Operations

Operating Revenue

A detail of the components of PHI’s consolidated operating revenue is as follows:

 

     2012     2011     Change  

Power Delivery

   $ 4,378     $ 4,650     $ (272 )

Pepco Energy Services

     662       1,269       (607 )

Other Non-Regulated

     52       48       4  

Corporate and Other

     (11 )     (16 )     5  
  

 

 

   

 

 

   

 

 

 

Total Operating Revenue

   $ 5,081      $ 5,951      $ (870 )
  

 

 

   

 

 

   

 

 

 

Power Delivery Business

The following table categorizes Power Delivery’s operating revenue by type of revenue.

 

     2012      2011      Change  

Regulated T&D Electric Revenue

   $ 2,006      $ 1,891      $ 115  

Default Electricity Supply Revenue

     2,124        2,462        (338 )

Other Electric Revenue

     65        67        (2 )
  

 

 

    

 

 

    

 

 

 

Total Electric Operating Revenue

     4,195        4,420        (225 )
  

 

 

    

 

 

    

 

 

 

Regulated Gas Revenue

     151        183        (32 )

Other Gas Revenue

     32        47        (15 )
  

 

 

    

 

 

    

 

 

 

Total Gas Operating Revenue

     183        230        (47 )
  

 

 

    

 

 

    

 

 

 

Total Power Delivery Operating Revenue

   $ 4,378      $ 4,650      $ (272 )
  

 

 

    

 

 

    

 

 

 

Regulated T&D Electric Revenue includes revenue from the distribution of electricity, including the distribution of Default Electricity Supply, by PHI’s utility subsidiaries to customers within their service territories at regulated rates. Regulated T&D Electric Revenue also includes transmission service revenue that PHI’s utility subsidiaries receive as transmission owners from PJM at rates regulated by FERC. Transmission rates are updated annually based on a FERC-approved formula methodology.

Default Electricity Supply Revenue is the revenue received from the supply of electricity by PHI’s utility subsidiaries at regulated rates to retail customers who do not elect to purchase electricity from a competitive energy supplier. The costs related to Default Electricity Supply are included in Fuel and Purchased Energy. Default Electricity Supply Revenue also includes revenue from Transition Bond Charges that ACE receives, and pays to ACE Funding, to fund the principal and interest payments on Transition Bonds issued by ACE Funding, and revenue in the form of transmission enhancement credits that PHI utility subsidiaries receive as transmission owners from PJM for approved regional transmission expansion plan costs.

Other Electric Revenue includes work and services performed on behalf of customers, including other utilities, which is generally not subject to price regulation. Work and services include mutual assistance to other utilities, highway relocation, rentals of pole attachments, late payment fees and collection fees.

Regulated Gas Revenue includes the revenue DPL receives from on-system natural gas delivered sales and the transportation of natural gas for customers within its service territory at regulated rates.

 

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Other Gas Revenue consists of DPL’s off-system natural gas sales and the short-term release of interstate pipeline transportation and storage capacity not needed to serve customers. Off-system sales are made possible when low demand for natural gas by regulated customers creates excess pipeline capacity.

Regulated T&D Electric

 

     2012      2011      Change  

Regulated T&D Electric Revenue

        

Residential

   $ 722      $ 683      $ 39  

Commercial and industrial

     923        884        39  

Transmission and other

     361        324        37  
  

 

 

    

 

 

    

 

 

 

Total Regulated T&D Electric Revenue

   $ 2,006      $ 1,891      $ 115  
  

 

 

    

 

 

    

 

 

 
     2012      2011      Change  

Regulated T&D Electric Sales (Gigawatt hour (GWh)

        

Residential

     17,150         17,728         (578

Commercial and industrial

     30,734         31,282         (548 )

Transmission and other

     258         256         2  
  

 

 

    

 

 

    

 

 

 

Total Regulated T&D Electric Sales

     48,142        49,266        (1,124 )
  

 

 

    

 

 

    

 

 

 
     2012      2011      Change  

Regulated T&D Electric Customers (in thousands)

        

Residential

     1,641        1,636        5  

Commercial and industrial

     198        198        —    

Transmission and other

     2        2        —    
  

 

 

    

 

 

    

 

 

 

Total Regulated T&D Electric Customers

     1,841        1,836        5  
  

 

 

    

 

 

    

 

 

 

The Pepco, DPL and ACE service territories are located within a corridor extending from the District of Columbia to southern New Jersey. These service territories are economically diverse and include key industries that contribute to the regional economic base:

 

   

Commercial activities in the region include banking and other professional services, government, insurance, real estate, shopping malls, casinos, stand alone construction and tourism.

 

   

Industrial activities in the region include chemical, glass, pharmaceutical, steel manufacturing, food processing and oil refining.

Regulated T&D Electric Revenue increased by $115 million primarily due to:

 

   

An increase of $46 million due to distribution rate increases in all jurisdictions (Pepco in the District of Columbia effective October 2012, and in Maryland effective July 2012; DPL in Maryland effective July 2012 and July 2011, and in Delaware effective July 2012; ACE effective November 2012).

 

   

An increase of $35 million in transmission revenue primarily attributable to higher Pepco and DPL rates effective June 1, 2012 and June 1, 2011 related to increases in transmission plant investment and operating expenses.

 

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An increase of $17 million due to EmPower Maryland (a demand-side management program) rate increases in February 2012 (which is substantially offset by a corresponding increase in Depreciation and Amortization).

 

   

An increase of $15 million primarily due to a Renewable Portfolio Surcharge in Delaware effective June 2012 (which is substantially offset by a corresponding increase in Fuel and Purchased Energy and Depreciation and Amortization).

 

   

An increase of $15 million primarily due to a rate increase in the New Jersey Societal Benefit Charge (related to the New Jersey Societal Benefit Program, a public interest program for low income customers) effective July 2012 (which is offset in Deferred Electric Service Costs).

 

   

An increase of $7 million due to Pepco customer growth in 2012, primarily in the residential class.

The aggregate amount of these increases was partially offset by:

 

   

A decrease of $13 million due to lower pass-through revenue (which is substantially offset by a corresponding decrease in Other Taxes) primarily the result of a decrease in Montgomery County, Maryland utility taxes that are collected by Pepco on behalf of the jurisdiction.

 

   

A decrease of $6 million in Transitional Energy Facility Assessment (TEFA) rate revenue in New Jersey due to a rate decrease effective January 2012 (which is primarily offset by a corresponding decrease in Other Taxes).

Default Electricity Supply

 

     2012      2011      Change  

Default Electricity Supply Revenue

        

Residential

   $ 1,467       $ 1,668       $ (201 )

Commercial and industrial

     542         642         (100 )

Other

     115        152        (37 )
  

 

 

    

 

 

    

 

 

 

Total Default Electricity Supply Revenue

   $ 2,124       $ 2,462       $ (338 )
  

 

 

    

 

 

    

 

 

 

Other Default Electricity Supply Revenue consists primarily of (i) revenue from the resale by ACE in the PJM RTO market of energy and capacity purchased under contracts with unaffiliated NUGs, and (ii) revenue from transmission enhancement credits.

 

     2012      2011      Change  

Default Electricity Supply Sales (GWh)

        

Residential

     14,245         15,545        (1,300

Commercial and industrial

     5,508         6,168        (660

Other

     55        73        (18 )
  

 

 

    

 

 

    

 

 

 

Total Default Electricity Supply Sales

     19,808         21,786         (1,978
  

 

 

    

 

 

    

 

 

 
     2012      2011      Change  

Default Electricity Supply Customers (in thousands)

        

Residential

     1,366        1,432        (66 )

Commercial and industrial

     128        137        (9 )

Other

     1        —          1  
  

 

 

    

 

 

    

 

 

 

Total Default Electricity Supply Customers

     1,495        1,569        (74 )
  

 

 

    

 

 

    

 

 

 

 

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Default Electricity Supply Revenue decreased by $338 million primarily due to:

 

   

A decrease of $140 million due to lower sales, primarily as a result of customer migration to competitive suppliers.

 

   

A net decrease of $100 million as a result of lower Pepco and DPL Default Electricity Supply rates, partially offset by higher ACE rates.

 

   

A decrease of $38 million in wholesale energy and capacity resale revenues primarily due to lower market prices for the resale of electricity and capacity purchased from NUGs.

 

   

A decrease of $35 million due to lower sales as a result of milder weather during the 2012 winter and spring months, as compared to 2011.

 

   

A net decrease of $26 million due to lower Pepco and ACE non-weather related average residential customer usage, partially offset by higher DPL residential customer usage.

The aggregate amount of these decreases was partially offset by an increase of $5 million due to higher Pepco revenue from transmission enhancement credits.

Regulated Gas

 

     2012      2011      Change  

Regulated Gas Revenue

        

Residential

   $ 94      $ 113      $ (19 )

Commercial and industrial

     47        61        (14 )

Transportation and other

     10        9        1  
  

 

 

    

 

 

    

 

 

 

Total Regulated Gas Revenue

   $ 151      $ 183      $ (32 )
  

 

 

    

 

 

    

 

 

 
     2012      2011      Change  

Regulated Gas Sales (million cubic feet)

        

Residential

     6,428        7,346        (918 )

Commercial and industrial

     3,636        4,442        (806 )

Transportation and other

     6,751        6,966        (215 )
  

 

 

    

 

 

    

 

 

 

Total Regulated Gas Sales

     16,815        18,754        (1,939 )
  

 

 

    

 

 

    

 

 

 
     2012      2011      Change  

Regulated Gas Customers (in thousands)

        

Residential

     115        115        —    

Commercial and industrial

     10        9        1  

Transportation and other

     —          —          —    
  

 

 

    

 

 

    

 

 

 

Total Regulated Gas Customers

     125        124        1  
  

 

 

    

 

 

    

 

 

 

DPL’s natural gas service territory is located in New Castle County, Delaware. Several key industries contribute to the economic base as well as to growth as follows:

 

   

Commercial activities in the region include banking and other professional services, government, insurance, real estate, shopping malls and stand alone construction.

 

   

Industrial activities in the region include chemical and pharmaceutical.

 

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Regulated Gas Revenue decreased by $32 million primarily due to:

 

   

A decrease of $14 million due to lower sales primarily as a result of milder weather during the winter months of 2012 as compared to 2011.

 

   

A decrease of $9 million due to Gas Cost Rate (GCR) decreases effective November 2011 and November 2012.

 

   

A decrease of $5 million due to lower non-weather related average customer usage.

 

   

A decrease of $4 million due to a revenue adjustment recorded in June 2012 for a reduction in the estimate of gas sold but not yet billed to customers (which is offset by a decrease in Fuel and Purchased Energy).

The aggregate amount of these decreases was partially offset by an increase of $1 million due to a distribution rate increase effective July 2011.

Other Gas Revenue

Other Gas Revenue decreased by $15 million primarily due to lower average prices and lower volumes for off-system sales to electric generators and gas marketers.

Pepco Energy Services

Pepco Energy Services’ operating revenue decreased by $607 million primarily due to:

 

   

A decrease of $534 million due to lower retail supply sales volume primarily attributable to the ongoing wind-down of the retail energy supply business.

 

   

A decrease of $55 million due to lower generation and capacity revenues attributable to the retirement of the remaining generation facilities in the second quarter of 2012.

 

   

A decrease of $18 million due to decreased energy services construction activities.

Operating Expenses

Fuel and Purchased Energy and Other Services Cost of Sales

A detail of PHI’s consolidated Fuel and Purchased Energy and Other Services Cost of Sales is as follows:

 

     2012     2011     Change  

Power Delivery

   $ 2,109     $ 2,490     $ (381 )

Pepco Energy Services

     539       1,137       (598 )

Corporate and Other

     (2 )     (2 )     —    
  

 

 

   

 

 

   

 

 

 

Total

   $ 2,646     $ 3,625     $ (979 )
  

 

 

   

 

 

   

 

 

 

Power Delivery Business

Power Delivery’s Fuel and Purchased Energy consists of the cost of electricity and natural gas purchased by its utility subsidiaries to fulfill their respective Default Electricity Supply and Regulated Gas obligations and, as such, is recoverable from customers in accordance with the terms of public service commission orders. It also includes the cost of natural gas purchased for off-system sales. Fuel and Purchased Energy expense decreased by $381 million primarily due to:

 

   

A decrease of $158 million due to lower average electricity costs under Default Electricity Supply contracts.

 

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A decrease of $142 million primarily due to customer migration to competitive suppliers.

 

   

A decrease of $29 million due to lower electricity sales primarily as a result of milder weather during the winter and spring months of 2012, as compared to the corresponding periods in 2011.

 

   

A decrease of $21 million in the cost of gas purchases for on-system sales as a result of lower average gas prices and lower volumes purchased.

 

   

A decrease of $18 million in deferred electricity expense primarily due to lower Pepco and DPL Default Electricity Supply revenue rates, which resulted in a lower rate of recovery of Default Electricity Supply costs.

 

   

A decrease of $12 million in the cost of gas purchases for off-system sales as a result of lower average gas prices and lower volumes purchased.

 

   

A decrease of $11 million from the settlement of financial hedges entered into as part of DPL’s hedge program for the purchase of regulated natural gas.

 

   

A decrease of $4 million in the cost of gas purchases for on-system sales as a result of an adjustment recorded in June 2012 for a reduction in the estimate of gas sold but not yet billed to customers (which is offset by a decrease in Regulated Gas Revenue).

The aggregate amount of these decreases was partially offset by:

 

   

An increase of $6 million in deferred gas expense as a result of higher rate of recovery of natural gas supply costs due to lower average gas prices.

 

   

An increase of $6 million in costs to purchase Renewable Energy Credits in Delaware (which is offset by corresponding increase in Regulated T&D Electric Revenue).

Pepco Energy Services

Pepco Energy Services’ Fuel and Purchased Energy and Other Services Cost of Sales decreased by $598 million primarily due to:

 

   

A decrease of $379 million due to lower volumes of electricity purchased to serve decreased retail electricity sales volumes as a result of the ongoing wind-down of the retail energy supply business.

 

   

A decrease of $189 million due to lower volumes of gas purchased to serve decreased retail gas sales volumes as a result of the ongoing wind-down of the retail energy supply business.

 

   

A decrease of $29 million due to lower purchases of capacity and lower fuel usage, both attributable to the retirement of the remaining generation facilities in the second quarter of 2012.

 

   

A decrease of $2 million due to lower energy services construction activity partially offset by costs associated with increased high voltage construction activity and existing energy services contracts.

 

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Other Operation and Maintenance

A detail of PHI’s Other Operation and Maintenance expense is as follows:

 

        2012             2011         Change  

Power Delivery

  $ 901     $ 884     $ 17  

Pepco Energy Services

    68       81       (13 )

Other Non-Regulated

    2       6       (4 )

Corporate and Other

    (60 )     (57 )     (3 )
 

 

 

   

 

 

   

 

 

 

Total

  $ 911     $ 914       (3 )
 

 

 

   

 

 

   

 

 

 

Power Delivery

Other Operation and Maintenance expense for Power Delivery increased by $17 million primarily due to:

 

   

An increase of $16 million in employee-related costs, primarily pension and other employee benefits.

 

   

An increase of $10 million resulting from a decrease in deferred cost adjustments associated with DPL Default Electricity Supply. The deferred costs adjustments were primarily due to the under-recognition of allowed returns on working capital and administrative costs in 2011, partially offset by favorable adjustments in 2012 related to allowed returns on net uncollectible expense and recovery of regulatory taxes.

 

   

An increase of $8 million in customer support service and system support costs.

 

   

An increase of $5 million in New Jersey Societal Benefit Program costs that are deferred and recoverable.

 

   

An increase of $4 million in expenses related to regulatory filings.

 

   

An increase of $4 million in self-insurance reserves for general and auto liability claims.

The aggregate amount of these increases was partially offset by:

 

   

A decrease of $15 million primarily due to a decrease in total incremental storm restoration costs for major storm events as described in the following table:

 

         2012             2011         Change  

Costs associated with severe winter storm (January 2011)

   $ —       $ 10      $ (10 )

Regulatory asset established for future recovery of January 2011 winter storm costs

     (9 )     —         (9 )

Costs associated with derecho storm (June 2012)

     38       —         38   

Regulatory asset established for future recovery of derecho storm costs

     (34 )     —         (34 )

Costs associated with Hurricane Sandy (October 2012)

     28        —         28   

Regulatory asset established for future recovery of Hurricane Sandy costs

     (22 )     —         (22 )

Costs associated with Hurricane Irene (August 2011)

     —         28       (28 )

Regulatory asset established for future recovery of Hurricane Irene costs

     —         (22 )     22   
  

 

 

   

 

 

   

 

 

 

Total incremental major storm restoration costs

   $ 1      $ 16     $ (15 )
  

 

 

   

 

 

   

 

 

 

 

   

In January 2011, Pepco incurred incremental storm restoration costs of $10 million associated with a severe winter storm, all of which were expensed in 2011. In July 2012, the MPSC issued an order allowing for the deferral and recovery of $9 million of such costs over a five-year period.

 

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During 2012, Pepco, DPL and ACE incurred incremental storm restoration costs of $38 million associated with the June 2012 derecho which resulted in widespread damage to the electric distribution system in each of their service territories. PHI’s utility subsidiaries deferred $34 million of these costs as regulatory assets to reflect the probable recovery of these storm restoration costs in Maryland and New Jersey, and will be pursuing recovery of these incremental storm restoration costs in their respective jurisdictions in their electric distribution base rate cases. The remaining costs of $4 million primarily relate to repair work completed in Delaware and the District of Columbia which are not currently deferrable in those jurisdictions.

 

   

In the fourth quarter of 2012, Pepco, DPL and ACE incurred incremental storm restoration costs of $28 million associated with Hurricane Sandy which resulted in widespread damage to the electric distribution system in each of their service territories. PHI’s utility subsidiaries deferred $22 million of these costs as regulatory assets to reflect the probable recovery of these storm restoration costs in Maryland and New Jersey, and will be pursuing recovery of these incremental storm restoration costs in their respective jurisdictions in their electric distribution base rate cases. The remaining costs of $6 million primarily relate to repair work completed in Delaware and the District of Columbia which are not currently deferrable in those jurisdictions.

 

   

During 2011, Pepco, DPL and ACE incurred incremental storm restoration costs of $28 million associated with Hurricane Irene which resulted in widespread damage to the electric distribution system in each of their service territories. PHI’s utility subsidiaries deferred $22 million of these costs as regulatory assets to reflect the probable recovery of these storm restoration costs in Maryland and New Jersey. The MPSC approved the recovery of these costs in Maryland for both Pepco and DPL in its July 2012 rate orders over a five-year period. ACE’s stipulation of settlement approved by the NJBPU in October 2012 provides for recovery of these costs in New Jersey over a three-year period. The remaining costs of $6 million relate to repair work completed in Delaware and the District of Columbia which are not currently deferrable in those jurisdictions.

 

   

A decrease of $8 million in bad debt expenses.

 

   

A decrease of $4 million associated with lower preventative maintenance and tree trimming costs due to accelerated efforts made in 2011 to improve reliability.

 

   

A decrease of $3 million due to the deferral of distribution rate case costs previously charged to Other Operation and Maintenance expense. These deferrals were recorded in accordance with the MPSC rate order issued in July 2012 and the DCPSC rate order issued in September 2012, each allowing for the recovery of these costs.

Pepco Energy Services

Other Operation and Maintenance expense for Pepco Energy Services decreased by $13 million primarily due to the closing of the oil-fired generation facilities in the second quarter of 2012 and the wind-down of the retail energy supply business.

Depreciation and Amortization

Depreciation and Amortization expense increased by $28 million to $454 million in 2012 from $426 million in 2011 primarily due to:

 

   

An increase of $22 million in amortization of regulatory assets primarily due to EmPower Maryland surcharge rate increases effective February 2012 and expanding Demand Side Management Programs (which are substantially offset by corresponding increases in Regulated T&D Electric Revenue).

 

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An increase of $11 million in amortization of AMI projects.

 

   

An increase of $5 million due to utility plant additions, partially offset by lower depreciation rates.

 

   

An increase of $4 million in the Delaware Renewable Energy Portfolio Standards deferral associated with the over-recovery of renewable energy procurement costs (which is offset by a corresponding increase in Regulated T&D Electric Revenue).

The aggregate amount of these increases was partially offset by:

 

   

A decrease of $12 million in amortization of stranded costs primarily as the result of lower revenue due to rate decreases effective October 2011 for the ACE Transition Bond Charge and Market Transition Charge Tax (revenue ACE receives and pays to ACE Funding to recover income taxes associated with Transition Bond Charge revenue) (partially offset in Default Electricity Supply Revenue).

 

   

A decrease of $ 4 million primarily due to the deactivation of Pepco Energy Services generating facilities in May 2012.

The MPSC reduced the depreciation rates for Pepco and DPL in their most recent electric distribution base rate cases, which is expected to lower annual Depreciation and Amortization expense for PHI by approximately $31 million effective July 20, 2012.

Other Taxes

Other Taxes decreased by $19 million to $432 million in 2012 from $451 million in 2011. The decrease was primarily due to:

 

   

A decrease of $10 million, primarily due to a decrease in utility taxes that are collected and passed through by Power Delivery (substantially offset by a corresponding decrease in Regulated T&D Electric Revenue).

 

   

A decrease of $5 million in TEFA tax collections due to a rate decrease effective January 2012 (partially offset by a corresponding decrease in Regulated T&D Electric Revenue).

Gains on Early Terminations of Finance Leases Held in Trust

PHI’s operating expenses include a $39 million pre-tax gain for each of the years ended December 31, 2012 and 2011, associated with the early termination of several leases included in its cross-border energy lease portfolio. The after-tax gains were $9 million and $3 million for the years ended December 31, 2012 and 2011, respectively.

Deferred Electric Service Costs

Deferred Electric Service Costs, which relate only to ACE, represent (i) the over or under recovery of electricity costs incurred by ACE to fulfill its Default Electricity Supply obligation and (ii) the over or under recovery of New Jersey Societal Benefit Program costs incurred by ACE. The cost of electricity purchased is reported under Fuel and Purchased Energy and the corresponding revenue is reported under Default Electricity Supply Revenue. The cost of New Jersey Societal Benefit Programs is reported under Other Operation and Maintenance and the corresponding revenue is reported under Regulated T&D Electric Revenue.

Deferred Electric Service Costs increased by $58 million, to an expense reduction of $5 million in 2012 as compared to an expense reduction of $63 million in 2011, primarily due to an increase in deferred electricity expense as a result of higher Default Electricity Supply revenue rates, partially offset by higher electricity supply costs.

 

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Impairment Losses

PHI’s operating expenses for the year ended December 31, 2012, included impairment losses of $12 million ($7 million after-tax) at Pepco Energy Services associated with the combustion turbines at Buzzard Point and certain landfill gas-fired electric generation facilities.

Other Income (Expenses)

Other Expenses (which are net of Other Income) increased by $1 million to a net expense of $229 million in 2012 from a net expense of $228 million in 2011. The increase reflects an $11 million increase in interest expense primarily associated with higher long-term debt and lower capitalized interest. The increase was mostly offset by an increase of $10 million in other income primarily from losses and impairments on equity investments in 2011 that did not occur in 2012.

Income Tax Expense

PHI’s income tax expense increased by $7 million to $156 million in 2012 from $149 million in 2011.

PHI’s consolidated effective income tax rates for the years ended December 31, 2012 and 2011 were 35.4% and 36.4%, respectively.

The effective income tax rate for the year ended December 31, 2012 reflects charges related to the recognition of the tax consequences associated with the early termination of cross-border energy leases in the third quarter of 2012 of $16 million as discussed in Note (8), “Leasing Activities,” to the consolidated financial statements of PHI.

In addition, the effective income tax rate for the year ended December 31, 2012 includes income tax benefits of $10 million related to uncertain and effectively settled tax positions, primarily due to the effective settlement with the 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 year ended December 31, 2011, PHI recorded tax benefits of $17 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 year ended December 31, 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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Consolidated Results of Operations

The following results of operations discussion compares the year ended December 31, 2011, to the year ended December 31, 2010. All amounts in the tables (except sales and customers) are in millions of dollars.

Continuing Operations

Operating Revenue

A detail of the components of PHI’s consolidated operating revenue is as follows:

 

     2011     2010     Change  

Power Delivery

   $ 4,650     $ 5,114     $ (464 )

Pepco Energy Services

     1,269       1,884       (615 )

Other Non-Regulated

     48       54       (6 )

Corporate and Other

     (16 )     (12 )     (4 )
  

 

 

   

 

 

   

 

 

 

Total Operating Revenue

   $ 5,951     $ 7,040     $ (1,089
  

 

 

   

 

 

   

 

 

 

Power Delivery Business

The following table categorizes Power Delivery’s operating revenue by type of revenue.

 

     2011      2010      Change  

Regulated T&D Electric Revenue

   $ 1,891      $ 1,858      $ 33  

Default Electricity Supply Revenue

     2,462        2,951        (489 )

Other Electric Revenue

     67        68        (1 )
  

 

 

    

 

 

    

 

 

 

Total Electric Operating Revenue

     4,420        4,877        (457 )
  

 

 

    

 

 

    

 

 

 

Regulated Gas Revenue

     183        191        (8 )

Other Gas Revenue

     47        46        1  
  

 

 

    

 

 

    

 

 

 

Total Gas Operating Revenue

     230        237        (7 )
  

 

 

    

 

 

    

 

 

 

Total Power Delivery Operating Revenue

   $ 4,650      $ 5,114      $ (464 )
  

 

 

    

 

 

    

 

 

 

Regulated T&D Electric Revenue includes revenue from the distribution of electricity, including the distribution of Default Electricity Supply, by PHI’s utility subsidiaries to customers within their service territories at regulated rates. Regulated T&D Electric Revenue also includes transmission service revenue that PHI’s utility subsidiaries receive as transmission owners from PJM at rates regulated by FERC. Transmission rates are updated annually based on a FERC-approved formula methodology.

Default Electricity Supply Revenue is the revenue received from the supply of electricity by PHI’s utility subsidiaries at regulated rates to retail customers who do not elect to purchase electricity from a competitive energy supplier. The costs related to Default Electricity Supply are included in Fuel and Purchased Energy. Default Electricity Supply Revenue also includes revenue from Transition Bond Charges that ACE receives, and pays to ACE Funding, to fund the principal and interest payments on Transition Bonds issued by ACE Funding, and revenue in the form of transmission enhancement credits that PHI utility subsidiaries receive as transmission owners from PJM for approved regional transmission expansion plan costs.

Other Electric Revenue includes work and services performed on behalf of customers, including other utilities, which is generally not subject to price regulation. Work and services include mutual assistance to other utilities, highway relocation, rentals of pole attachments, late payment fees and collection fees.

 

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Regulated Gas Revenue includes the revenue DPL receives from on-system natural gas delivered sales and the transportation of natural gas for customers within its service territory at regulated rates.

Other Gas Revenue consists of DPL’s off-system natural gas sales and the short-term release of interstate pipeline transportation and storage capacity not needed to serve customers. Off-system sales are made possible when low demand for natural gas by regulated customers creates excess pipeline capacity.

Regulated T&D Electric

 

     2011      2010      Change  

Regulated T&D Electric Revenue

        

Residential

   $ 683      $ 683      $  —    

Commercial and industrial

     884        883        1  

Transmission and other

     324        292        32  
  

 

 

    

 

 

    

 

 

 

Total Regulated T&D Electric Revenue

   $ 1,891      $ 1,858      $ 33  
  

 

 

    

 

 

    

 

 

 
     2011      2010      Change  

Regulated T&D Electric Sales (GWh)

        

Residential

     17,728         18,398         (670

Commercial and industrial

     31,282         32,045         (763 )

Transmission and other

     256         260         (4 )
  

 

 

    

 

 

    

 

 

 

Total Regulated T&D Electric Sales

     49,266        50,703        (1,437 )
  

 

 

    

 

 

    

 

 

 
     2011      2010      Change  

Regulated T&D Electric Customers (in thousands)

        

Residential

     1,636        1,635        1  

Commercial and industrial

     198        198        —    

Transmission and other

     2        2        —    
  

 

 

    

 

 

    

 

 

 

Total Regulated T&D Electric Customers

     1,836        1,835        1  
  

 

 

    

 

 

    

 

 

 

The Pepco, DPL and ACE service territories are located within a corridor extending from the District of Columbia to southern New Jersey. These service territories are economically diverse and include key industries that contribute to the regional economic base.

 

   

Commercial activity in the region includes banking and other professional services, government, insurance, real estate, shopping malls, casinos, stand alone construction and tourism.

 

   

Industrial activity in the region includes chemical, glass, pharmaceutical, steel manufacturing, food processing and oil refining.

Regulated T&D Electric Revenue increased by $33 million primarily due to:

 

   

An increase of $32 million due to distribution rate increases (Pepco in the District of Columbia effective March 2010 and July 2010, and in Maryland effective July 2010; DPL in Maryland effective July 2011, and in Delaware effective February 2011; and ACE in New Jersey effective June 2010).

 

   

An increase of $32 million in transmission revenue primarily attributable to higher rates effective June 1, 2010 and June 1, 2011 related to increases in transmission plant investment.

 

 

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An increase of $11 million due to higher pass-through revenue (which is substantially offset by a corresponding increase in Other Taxes) primarily the result of rate increases in Montgomery County, Maryland utility taxes that are collected by Pepco on behalf of the county.

 

   

An increase of $7 million primarily due to Pepco customer growth in 2011, primarily in the residential class.

 

   

An increase of $2 million due to the implementation of the EmPower Maryland surcharge in March 2010 (which is substantially offset by a corresponding increase in Depreciation and Amortization).

The aggregate amount of these increases was partially offset by:

 

   

A decrease of $30 million due to an ACE New Jersey Societal Benefit Charge rate decrease that became effective in January 2011 (which is offset in Deferred Electric Service Costs).

 

   

A decrease of $11 million due to lower sales as a result of cooler weather during the spring and summer months of 2011, and warmer weather during the fall months of 2011, as compared to the corresponding periods in 2010.

 

   

A decrease of $10 million due to lower non-weather related average customer usage.

Default Electricity Supply

 

     2011      2010      Change  

Default Electricity Supply Revenue

        

Residential

   $  1,668       $ 2,022       $  (354 )

Commercial and industrial

     642        733        (91 )

Other

     152        196        (44 )
  

 

 

    

 

 

    

 

 

 

Total Default Electricity Supply Revenue

   $ 2,462       $ 2,951       $ (489
  

 

 

    

 

 

    

 

 

 

Other Default Electricity Supply Revenue consists primarily of (i) revenue from the resale by ACE in the PJM RTO market of energy and capacity purchased under contracts with unaffiliated NUGs, and (ii) revenue from transmission enhancement credits.

 

     2011      2010      Change  

Default Electricity Supply Sales (GWh)

        

Residential

     15,545        17,385        (1,840 )

Commercial and industrial

     6,168        7,034        (866 )

Other

     73        93        (20 )
  

 

 

    

 

 

    

 

 

 

Total Default Electricity Supply Sales

     21,786        24,512         (2,726 )
  

 

 

    

 

 

    

 

 

 
     2011      2010      Change  

Default Electricity Supply Customers (in thousands)

        

Residential

     1,432        1,525        (93 )

Commercial and industrial

     137        148        (11 )

Other

     —          1        (1 )
  

 

 

    

 

 

    

 

 

 

Total Default Electricity Supply Customers

     1,569        1,674        (105 )
  

 

 

    

 

 

    

 

 

 

 

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Default Electricity Supply Revenue decreased by $489 million primarily due to:

 

   

A decrease of $200 million due to lower sales, primarily as a result of customer migration to competitive suppliers.

 

   

A net decrease of $153 million as a result of lower Pepco and DPL Default Electricity Supply rates, partially offset by higher ACE rates.

 

   

A decrease of $94 million due to lower sales as a result of cooler weather during the spring and summer months of 2011, and warmer weather during the fall months of 2011, as compared to the corresponding periods in 2010.

 

   

A decrease of $40 million in wholesale energy and capacity resale revenues primarily due to the sale of lower volumes of electricity and capacity purchased from NUGs.

 

   

A decrease of $3 million due to a decrease in revenue from Transmission Enhancement Credits.

The aggregate amount of these decreases was partially offset by:

 

   

An increase of $3 million resulting from an approval by the DCPSC of an increase in Pepco’s cost recovery rate for providing Default Electricity Supply in the District of Columbia to provide for recovery of higher cash working capital costs incurred in prior periods. The higher cash working capital costs were incurred when the billing cycle for providers of Default Electricity Supply was shortened from a monthly to a weekly period, effective in June 2009.

Total Default Electricity Supply Revenue for the 2011 period includes a decrease of $8 million in unbilled revenue attributable to ACE’s BGS ($5 million decrease in net income), primarily due to lower customer usage and lower Default Electricity Supply rates during the unbilled revenue period at the end of 2011 as compared to the corresponding period in 2010. Under the BGS terms approved by the NJBPU, ACE’s BGS unbilled revenue is not included in the deferral calculation until it is billed to customers, and therefore has an impact on the results of operations in the period during which it is accrued.

Regulated Gas

 

     2011      2010      Change  

Regulated Gas Revenue

        

Residential

   $ 113      $ 118      $ (5 )

Commercial and industrial

     61        65        (4 )

Transportation and other

     9        8        1  
  

 

 

    

 

 

    

 

 

 

Total Regulated Gas Revenue

   $ 183      $ 191      $ (8 )
  

 

 

    

 

 

    

 

 

 
     2011      2010      Change  

Regulated Gas Sales (million cubic feet)

        

Residential

     7,268        7,879        (611 )

Commercial and industrial

     4,397        4,770        (373 )

Transportation and other

     6,966        6,687        279  
  

 

 

    

 

 

    

 

 

 

Total Regulated Gas Sales

     18,631        19,336        (705 )
  

 

 

    

 

 

    

 

 

 
     2011      2010      Change  

Regulated Gas Customers (in thousands)

        

Residential

     115        114        1  

Commercial and industrial

     9        9        —    

Transportation and other

     —          —          —    
  

 

 

    

 

 

    

 

 

 

Total Regulated Gas Customers

     124        123        1  
  

 

 

    

 

 

    

 

 

 

 

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DPL’s natural gas service territory is located in New Castle County, Delaware. Several key industries contribute to the economic base as well as to growth as follows:

 

   

Commercial activities in the region include banking and other professional services, government, insurance, real estate, shopping malls, stand alone construction and tourism.

 

   

Industrial activities in the region include chemical and pharmaceutical.

Regulated Gas Revenue decreased by $8 million primarily due to:

 

   

A decrease of $17 million due to lower non-weather related average customer usage.

The decrease was partially offset by:

 

   

An increase of $6 million due to higher sales primarily as a result of colder weather during the winter of 2011 as compared to the winter of 2010.

 

   

An increase of $2 million due to a distribution rate increase effective February 2011.

 

   

An increase of $2 million due to customer growth in 2011.

Pepco Energy Services

Pepco Energy Services’ operating revenue decreased $615 million primarily due to:

 

   

A decrease of $642 million due to lower retail supply sales volume primarily attributable to the ongoing wind-down of the retail energy supply business.

 

   

A decrease of $33 million due to lower generation and capacity revenues at the generating facilities.

The aggregate amount of these decreases was partially offset by:

 

   

An increase of $61 million due to increased energy services activities.

Operating Expenses

Fuel and Purchased Energy and Other Services Cost of Sales

A detail of PHI’s consolidated Fuel and Purchased Energy and Other Services Cost of Sales is as follows:

 

     2011     2010     Change  

Power Delivery

   $ 2,490     $ 3,086     $ (596 )

Pepco Energy Services

     1,137       1,692       (555 )

Corporate and Other

     (2 )     (6 )     4  
  

 

 

   

 

 

   

 

 

 

Total

   $ 3,625     $ 4,772     $ (1,147 )
  

 

 

   

 

 

   

 

 

 

Power Delivery Business

Power Delivery’s Fuel and Purchased Energy consists of the cost of electricity and natural gas purchased by its utility subsidiaries to fulfill their respective Default Electricity Supply and Regulated Gas obligations and, as such, is recoverable from customers in accordance with the terms of public service commission orders. It also includes the cost of natural gas purchased for off-system sales. Fuel and Purchased Energy expense decreased by $596 million primarily due to:

 

   

A decrease of $300 million due to lower average electricity costs under Default Electricity Supply contracts.

 

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A decrease of $221 million primarily due to customer migration to competitive suppliers.

 

   

A decrease of $83 million due to lower electricity sales primarily as a result of cooler weather during the spring and summer months of 2011, and warmer weather during the fall months of 2011, as compared to the corresponding periods in 2010.

 

   

A decrease of $16 million in the cost of gas purchases for on-system sales as a result of lower average gas prices, lower volumes purchased and lower withdrawals from storage.

 

   

A decrease of $11 million from the settlement of financial hedges entered into as part of DPL’s hedge program for the purchase of regulated natural gas.

The aggregate amount of these decreases was partially offset by:

 

   

An increase of $18 million in deferred electricity expense primarily due to lower Default Electricity Supply rates, which resulted in a higher rate of recovery of Default Electricity Supply costs.

 

   

An increase of $18 million in deferred natural gas expense as a result of a higher rate of recovery of natural gas supply costs.

Pepco Energy Services

Pepco Energy Services’ Fuel and Purchased Energy and Other Services Cost of Sales decreased $555 million primarily due to:

 

   

A decrease of $591 million due to lower volumes of electricity and gas purchased to serve decreased retail supply sales volume as a result of the ongoing wind-down of the retail energy supply business.

 

   

A decrease of $10 million due to lower fuel usage associated with the generating facilities.

The aggregate amount of these decreases was partially offset by:

 

   

An increase of $46 million due to increased energy services activities.

Other Operation and Maintenance

A detail of PHI’s Other Operation and Maintenance expense is as follows:

 

     2011     2010     Change  

Power Delivery

   $ 884     $ 809     $ 75  

Pepco Energy Services

     81       95       (14 )

Other Non-Regulated

     6       4       2  

Corporate and Other

     (57 )     (24 )     (33 )
  

 

 

   

 

 

   

 

 

 

Total

   $ 914     $ 884     $ 30  
  

 

 

   

 

 

   

 

 

 

 

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Other Operation and Maintenance expense for Power Delivery increased by $75 million primarily due to:

 

   

An increase of $38 million associated with higher tree trimming and preventative maintenance costs.

 

   

An increase of $9 million in employee-related costs, primarily benefit expenses.

 

   

An increase of $8 million primarily due to an increase in total incremental storm restoration costs for major storm events as described in the following table:

 

     2011     2010     Change  

Costs associated with Hurricane Irene (August 2011)

     28        —         28   

Regulatory asset established for future recovery of Hurricane Irene costs

     (22 )     —         (22

Costs associated with severe winter storm (January 2011)

     10        —         10   

Costs associated with severe winter storm (February 2010)

            13       (13

Regulatory asset established for future recovery of 2010 severe winter storm costs

           (5     5   
  

 

 

   

 

 

   

 

 

 

Total incremental major storm restoration costs

   $ 16      $ 8     $ 8   
  

 

 

   

 

 

   

 

 

 

 

   

During 2011, Pepco, DPL and ACE incurred incremental storm restoration costs of $28 million associated with Hurricane Irene which also resulted in widespread damage to the electric distribution system in each of their service territories. PHI’s utility subsidiaries deferred $22 million of these costs as regulatory assets to reflect the probable recovery of these storm restoration costs in Maryland and New Jersey. The MPSC approved the recovery of these costs in Maryland for both Pepco and DPL in its July 2012 rate orders. ACE’s stipulation of settlement approved by the NJBPU in October 2012 provides for recovery of these costs in New Jersey. The remaining costs of $6 million relate to repair work completed in Delaware and the District of Columbia which are not currently deferrable in those jurisdictions.

 

   

In January 2011, Pepco incurred incremental storm restoration costs of $10 million associated with a severe winter storm, all of which were expensed in 2011. In July 2012, the MPSC issued an order allowing for the deferral and recovery of $9 million of such costs.

 

   

In February 2010, Pepco, DPL and ACE incurred incremental storm restoration costs of $13 million associated with a severe winter storm, all of which were expensed in 2010. In August 2010, the MPSC issued an order allowing for the deferral and recovery of $5 million of such costs for Pepco.

 

   

An increase of $8 million primarily due to higher 2011 DCPSC rate case costs and reliability audit expenses and due to 2010 Pepco adjustments for the deferral of distribution rate case costs of $4 million that previously were charged to other operation and maintenance expense. The adjustments were recorded in accordance with a MPSC rate order issued in August 2010 and a DCPSC rate order issued in February 2010, allowing for the recovery of the costs.

 

   

An increase of $8 million primarily due to Pepco’s emergency restoration improvement project and reliability improvement costs.

 

   

An increase of $8 million in customer support service and system support costs.

 

   

An increase of $6 million in communication costs.

 

   

An increase of $5 million in corporate cost allocations, primarily due to higher contractor and outside legal counsel fees.

 

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An increase of $5 million related to New Jersey Societal Benefit Program costs that are deferred and recoverable.

 

   

An increase of $3 million in costs related to customer requested and mutual assistance work (primarily offset in other Electric T&D Revenue).

The aggregate amount of these increases was partially offset by:

 

   

A decrease of $17 million resulting from adjustments recorded by PHI in 2011 associated with the accounting for DPL and Pepco Default Electricity Supply. These adjustments were primarily due to the under-recognition of allowed returns on working capital, uncollectible accounts, late fees and administrative costs.

 

   

A decrease of $15 million in environmental remediation costs.

Restructuring Charge

As a result of PHI’s organizational review in the second quarter of 2010, PHI’s operating expenses include a pre-tax restructuring charge of $30 million for the year ended December 31, 2010, related to severance and health and welfare benefits to be provided to terminated employees.

Depreciation and Amortization

Depreciation and Amortization expense increased by $33 million to $426 million in 2011 from $393 million in 2010 primarily due to:

 

   

An increase of $16 million in amortization of stranded costs as the result of higher revenue due to rate increases effective October 2010 for the ACE Transition Bond Charge and Market Transition Charge Tax (partially offset in Default Electricity Supply Revenue).

 

   

An increase of $14 million due to utility plant additions.

 

   

An increase of $4 million in amortization of regulatory assets primarily associated with the EmPower Maryland surcharge that became effective in March 2010 (which is substantially offset by a corresponding increase in Regulated T&D Electric Revenue).

 

   

An increase of $1 million in amortization of software upgrades to Pepco’s Energy Management System.

The aggregate amount of these increases was partially offset by:

 

   

A decrease of $3 million primarily due to the higher 2010 recognition of asset retirement obligations associated with Pepco Energy Services generating facilities scheduled for deactivation in May 2012.

Other Taxes

Other Taxes increased by $17 million to $451 million in 2011 from $434 million in 2010. The increase was primarily due to:

 

   

An increase of $16 million primarily due to rate increases in the Montgomery County, Maryland utility taxes that are collected and passed through by Pepco (substantially offset by a corresponding increase in Regulated T&D Electric Revenue).

 

   

An increase of $5 million due to an adjustment in the third quarter of 2010 to correct certain errors related to other taxes.

 

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The aggregate amount of these increases was partially offset by:

 

   

A decrease of $5 million in the Energy Assistance Trust Fund surcharge primarily due to rate decreases effective October 2010 (substantially offset by a corresponding decrease in Regulated T&D Electric Revenue).

Gains on Early Terminations of Finance Leases Held in Trust

PHI’s operating expenses include a $39 million pre-tax gain for the year ended December 31, 2011 associated with the early termination of several lease investments included in its cross-border energy lease portfolio.

Deferred Electric Service Costs

Deferred Electric Service Costs, which relate only to ACE, represent (i) the over or under recovery of electricity costs incurred by ACE to fulfill its Default Electricity Supply obligation and (ii) the over or under recovery of New Jersey Societal Benefit Program costs incurred by ACE. The cost of electricity purchased is reported under Fuel and Purchased Energy and the corresponding revenue is reported under Default Electricity Supply Revenue. The cost of New Jersey Societal Benefit Programs is reported under Other Operation and Maintenance and the corresponding revenue is reported under Regulated T&D Electric Revenue.

Deferred Electric Service Costs increased by $45 million, to an expense reduction of $63 million in 2011 as compared to an expense reduction of $108 million in 2010, primarily due to higher Default Electricity Supply Revenue rates and lower electricity supply costs.

Effects of Pepco Divestiture-Related Claims

The DCPSC on May 18, 2010 issued an order addressing all of the outstanding issues relating to Pepco’s obligation to share with its District of Columbia customers the net proceeds realized by Pepco from the sale of its generation-related assets in 2000. This order disallowed certain items that Pepco had included in the costs it deducted in calculating the net proceeds of the sale. The disallowance of these costs, together with interest, increased the aggregate amount Pepco is required to distribute to customers by approximately $11 million. PHI recognized a pre-tax expense of $11 million for the year ended December 31, 2010.

Other Income (Expenses)

Other Expenses (which are net of Other Income) decreased by $246 million primarily due to the loss on extinguishment of debt that was recorded in 2010 and lower interest expense in 2011 resulting from the reduction in outstanding long-term debt in 2010 with the proceeds from the Conectiv Energy sale.

Loss on Extinguishment of Debt

In 2010, PHI purchased or redeemed senior notes in the aggregate principal amount of $1,194 million. In connection with these transactions, PHI recorded a pre-tax loss on extinguishment of debt of $189 million in 2010, $174 million of which was attributable to the retirement of the debt and $15 million of which related to the acceleration of losses on treasury rate lock transactions associated with the retired debt. For a further discussion of these transactions, see Note (11), “Debt,” to the consolidated financial statements of PHI.

 

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Income Tax Expense

PHI’s consolidated effective tax rates from continuing operations for the years ended December 31, 2011 and 2010 were 36.4% and 7.3%, respectively. The increase in the effective tax rate was primarily due to the recognition of certain tax benefits in 2010 that did not recur in 2011 and PHI’s early termination of its interest in certain cross-border energy leases in 2011.

In 2010, certain PHI subsidiaries were restructured which subjected PHI to state income taxes in new jurisdictions and resulted in current state tax benefits that were recorded in 2010 and did not recur in 2011. Specifically, on April 1, 2010, as part of an ongoing effort to simplify PHI’s organizational structure, certain of PHI’s subsidiaries were converted from corporations to single member limited liability companies. In addition to increased organizational flexibility and reduced administrative costs, converting these entities to limited liability companies allows PHI to include income or losses in the former corporations in a single state income tax return, thus increasing the utilization of state income tax attributes. As a result of inclusions of income or losses in a single state return as discussed above, PHI recorded an $8 million benefit by reversing a valuation allowance on certain state net operating losses and an additional benefit of $6 million resulting from changes to certain state deferred tax benefits.

In addition, in November 2010, PHI reached final settlement with the IRS with respect to its federal tax returns for the years 1996 to 2002 for all issues except its cross-border energy lease investments. In connection with the settlement, PHI reallocated certain amounts on deposit with the IRS since 2006 among liabilities in the settlement years and subsequent years. In light of the settlement and reallocations, PHI has recalculated the estimated interest due for the tax years 1996 to 2002. The revised estimate resulted in the reversal of $15 million (after-tax) of estimated interest due to the IRS which was recorded as an income tax benefit in the fourth quarter of 2010.

In 2011, a $17 million (after-tax) income tax benefit was recorded in the first quarter when PHI reached a settlement with the IRS related to the calculation of interest due as a result of the November 2010 audit settlement. This benefit was more than offset during the second quarter of 2011, when PHI terminated early its interest in certain cross-border energy leases prior to the end of their stated term. As a result, PHI recognized a $22 million charge related to the tax consequences associated with the early terminations.

Discontinued Operations

For the year ended December 31, 2011, the $3 million loss from discontinued operations, net of income taxes, consists of an after-tax loss from operations of $1 million and after-tax net loss of $2 million from dispositions of assets and businesses.

Capital Resources and Liquidity

This section discusses PHI’s working capital, cash flow activity, capital requirements and other uses and sources of capital.

Working Capital

At December 31, 2012, PHI’s current assets on a consolidated basis totaled $1.2 billion and its consolidated current liabilities totaled $2.5 billion, resulting in a working capital deficit of $1.3 billion. PHI expects the working capital deficit at December 31, 2012 to be funded during 2013 in part through cash flows from operations, from the February 2013 settlement of the equity forward transaction discussed below and from the issuance of long-term debt. At December 31, 2011, PHI’s current assets on a consolidated basis totaled $1.4 billion and its current liabilities totaled $1.9 billion, for a working capital deficit of $422 million. The increase of $856 million in the working capital deficit from December 31, 2011 to December 31, 2012 was primarily due to an increase in long-term debt that will mature within one year and an increase in short-term debt for PHI, Pepco and ACE to temporarily support higher spending by the utilities on infrastructure investments and reliability initiatives.

 

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At December 31, 2012, PHI’s consolidated cash and cash equivalents totaled $25 million, which consisted of cash and uncollected funds but excludes current Restricted Cash Equivalents (cash that is available to be used only for designated purposes) that totaled $10 million. At December 31, 2011, PHI’s consolidated cash and cash equivalents totaled $109 million, of which $87 million was invested in money market funds, and the balance was held as cash and uncollected funds. At December 31, 2011, PHI’s current Restricted Cash Equivalents totaled $11 million.

A detail of PHI’s short-term debt balance and current portion of long-term debt and project funding balance was as follows:

 

     As of December 31, 2012
 
     (millions of dollars)  

Type

   PHI
Parent
     Pepco      DPL      ACE      ACE
Funding
     Pepco Energy
Services
     PHI
Consolidated
 

Variable Rate Demand Bonds

   $  —        $  —        $ 105      $ 23      $  —        $  —        $ 128  

Commercial Paper

     264        231        32        110        —          —          637  

Term Loan Agreement

     200        —          —          —          —          —          200  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total Short-Term Debt

   $ 464      $ 231      $ 137      $ 133      $  —        $  —        $ 965  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Current Portion of Long-Term Debt and Project Funding

   $  —        $ 200      $ 250      $ 69      $ 39      $ 11      $ 569  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
     As of December 31, 2011
 
     (millions of dollars)  

Type

   PHI
Parent
     Pepco      DPL      ACE      ACE
Funding
     Pepco Energy
Services
     PHI
Consolidated
 

Variable Rate Demand Bonds

   $  —        $  —        $ 105       $ 23      $  —        $ 18      $ 146  

Commercial Paper

     465        74         47         —          —          —          586  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total Short-Term Debt

   $ 465      $ 74       $ 152       $ 23      $  —        $ 18      $ 732  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Current Portion of Long-Term Debt and Project Funding

   $  —        $  —        $ 66      $  —        $ 37      $ 9       $ 112  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Commercial Paper

PHI, Pepco, DPL and ACE maintain commercial paper programs to address short-term liquidity needs. As of December 31, 2012, the maximum capacity available under these programs was $875 million, $500 million, $500 million and $250 million, respectively, subject to available borrowing capacity under the credit facility.

The weighted average interest rate for commercial paper issued by PHI, Pepco, DPL and ACE during 2012 was 0.87%, 0.43%, 0.43% and 0.41%, respectively. The weighted average maturity of all commercial paper issued by PHI, Pepco, DPL and ACE during 2012 was ten, five, four and three days, respectively.

 

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Equity Forward Transaction

During 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.

The equity forward transaction had no initial fair value since it was entered into at the then market price of the common stock. PHI did not receive any proceeds from the sale of common stock until the equity forward transaction was settled, and at that time PHI recorded the proceeds 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.

As allowed by the terms of the transaction, PHI physically settled the equity forward transaction on February 27, 2013 by issuing 17,922,077 shares of common stock at $17.39 per share to the forward counterparty. The net proceeds of approximately $312 million were used to pay down outstanding commercial paper, a portion of which was issued in order to make capital contributions to the utilities, and for general corporate purposes.

During 2012, the equity forward transaction was 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. For the year ended December 31, 2012, the equity forward transaction had a dilutive effect of $0.01 on PHI’s earnings per share.

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 credit sublimit at December 31, 2012 was $650 million for PHI, $350 million for Pepco and $250 million for each of 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

 

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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 or 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.

For additional discussion of the Credit Facility, see Note (11), “Debt,” to the consolidated financial statements of PHI.

Term Loan Agreement

During 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 the London Interbank Offered Rate with respect to the relevant interest period, all as defined in the loan agreement, plus a margin of 0.875%. As of December 31, 2012, outstanding borrowings under the loan agreement bore interest at an annual rate of 1.095%.

PHI used the net proceeds of the borrowings under the term loan agreement to repay outstanding commercial paper obligations and for general corporate purposes. For additional discussion of the Term Loan Agreement, see Note (11), “Debt,” to the consolidated financial statements of PHI.

Cash and Credit Facility Available as of December 31, 2012

 

     Consolidated
PHI
     PHI Parent      Utility
Subsidiaries
 
     (millions of dollars)  

Credit Facility (Total Capacity)

   $ 1,500      $ 650      $ 850  

Term Loan Agreement

     200        200        —    
  

 

 

    

 

 

    

 

 

 

Subtotal

     1,700        850        850  

Less: Credit Facility/Term Loan Agreement Borrowings

     200        200        —    

Letters of Credit issued

     2        2        —    

Commercial Paper outstanding

     637        264        373  
  

 

 

    

 

 

    

 

 

 

Remaining Credit Facility Available

     861        384        477  

Cash Invested in Money Market Funds (a)

     —          —          —    
  

 

 

    

 

 

    

 

 

 

Total Cash and Credit Facility Available

   $ 861      $ 384      $ 477  
  

 

 

    

 

 

    

 

 

 
(a) Cash and cash equivalents reported on the PHI consolidated balance sheet total $25 million which was held in cash and uncollected funds.

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 December 31, 2012, Pepco Energy Services had posted net cash collateral of $25 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 December 31, 2012 and 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 $384 million and $283 million, respectively.

 

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PHI’s Cross-Border Energy Lease Investments

PHI has an ongoing dispute with the IRS regarding the appropriateness of certain significant income tax benefits claimed by PHI related to its cross-border energy lease investments beginning with its 2001 federal income tax return. PHI currently estimates that, in the event the IRS were to be fully successful in its challenge to PHI’s tax position on the cross-border energy leases, PHI would be obligated to pay between $170 million and $200 million in additional federal and state taxes and between $50 million and $60 million of interest on the additional federal and state taxes as of March 31, 2013. The estimate of additional federal and state taxes due takes into account PHI’s estimate of the expected resolution of other uncertain and effectively settled tax positions unrelated to the leases, the carrying back or carrying forward of any existing net operating losses, and the application of certain amounts on deposit with the IRS.

PHI anticipates that it will make a deposit with the IRS for the additional taxes and related interest of approximately $220 million to $260 million in the first quarter of 2013 in order to mitigate PHI’s ongoing interest costs associated with the dispute. This deposit is expected to be funded from currently available sources of liquidity and short-term borrowings. PHI is evaluating the liquidation of all or a portion of its remaining cross-border energy lease investments, which had a net carrying value of approximately $1.2 billion as of December 31, 2012. Any liquidation proceeds could be used to repay any borrowings utilized to fund the deposit discussed above. PHI estimates that a partial or complete liquidation could be accomplished within one year.

Pension and Other Postretirement Benefit Plans

Based on the results of the 2012 actuarial valuation, PHI’s net periodic pension and other postretirement benefit (OPEB) costs were approximately $110 million in 2012 versus $94 million in 2011. The current estimate of benefit cost for 2013 is $99 million. The utility subsidiaries are responsible for substantially all of the total PHI net periodic pension and OPEB costs. Approximately 30% of net periodic pension and OPEB costs are capitalized. PHI estimates that its net periodic pension and OPEB expense will be approximately $69 million in 2013, as compared to $77 million in 2012 and $66 million in 2011.

PHI provides certain postretirement health care and life insurance benefits for eligible retired employees. Most employees hired on January 1, 2005 or later will not have company subsidized retiree medical coverage; however, they will be able to purchase coverage at full cost through PHI.

In 2012 and 2011, Pepco contributed $5 million and $7 million, respectively, DPL contributed $7 million and $6 million, respectively, and ACE contributed $7 million and $7 million, respectively, to the other postretirement benefit plan. In 2012 and 2011, contributions of $13 million were made by other PHI subsidiaries.

Pension benefits are provided under PHI’s non-contributory retirement plan (PHI Retirement Plan), a defined benefit pension plan that covers substantially all employees of Pepco, DPL and ACE and certain employees of other PHI subsidiaries. PHI’s funding policy with regard to 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.

Under the Pension Protection Act, if a plan incurs a funding shortfall in the preceding plan year, there can be required minimum quarterly contributions in the current and following plan years. On January 9, 2013, PHI, DPL and ACE made discretionary tax-deductible contributions to the PHI Retirement Plan in the amounts of $20 million, $10 million and $30 million, respectively, which is expected to bring the PHI Retirement Plan assets to the funding target level for 2013 under the Pension Protection Act. During 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. During 2011, Pepco, DPL and ACE made discretionary tax-deductible contributions to the PHI Retirement Plan in the amounts of $40

 

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million, $40 million and $30 million, respectively. PHI satisfied the minimum required contribution rules under the Pension Protection Act in 2012, 2011 and 2010. For additional discussion of PHI’s Pension and Other Postretirement Benefits, see Note (10), “Pension and Other Postretirement Benefits,” to the consolidated financial statements of PHI.

Cash Flow Activity

PHI’s cash flows during 2012, 2011 and 2010 are summarized below:

 

     Cash Source (Use)  
     2012