10-K 1 d828307d10k.htm 10-K 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, 2014

 

 

 

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).    ¨

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 30, 2014

  

Number of Shares of Common

Stock of the Registrant

Outstanding at February 13, 2015

Pepco Holdings    $6,893.8 million (a)   

252,815,448

($.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 30, 2014, its executive officers, directors and beneficial owners of more than 10% of its common stock, and (ii) such other persons who were deemed, as of June 30, 2014, to be controlled by, or under common control with, PHI or any of 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

Information required by Items 10, 11, 12 and 13 of Part III of this report will be incorporated by reference to Pepco Holdings’ definitive proxy statement with respect to its 2015 Annual Meeting of Stockholders, if such definitive proxy statement is filed with the Securities and Exchange Commission on or before April 30, 2015.

 

 

 


Table of Contents

TABLE OF CONTENTS

 

              Page

Glossary of Terms

        i

Forward-Looking Statements

        1

PART I

       

Item 1.

  -    Business    4

Item 1A.

  -    Risk Factors    28

Item 1B.

  -    Unresolved Staff Comments    43

Item 2.

  -    Properties    43

Item 3.

  -    Legal Proceedings    44

Item 4.

  -    Mine Safety Disclosures    44

PART II

       

Item 5.

  -   

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

   45

Item 6.

  -    Selected Financial Data    48

Item 7.

  -    Management’s Discussion and Analysis of Financial Condition and Results of Operations    49

Item 7A.

  -    Quantitative and Qualitative Disclosures About Market Risk    134

Item 8.

  -    Financial Statements and Supplementary Data    136

Item 9.

  -    Changes in and Disagreements With Accountants on Accounting and Financial Disclosure    345

Item 9A.

  -    Controls and Procedures    346

Item 9B.

  -    Other Information    347

PART III

       

Item 10.

  -    Directors, Executive Officers and Corporate Governance    348

Item 11.

  -    Executive Compensation    348

Item 12.

  -   

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

   348

Item 13.

  -    Certain Relationships and Related Transactions, and Director Independence    349

Item 14.

  -    Principal Accountant Fees and Services    349

PART IV

       

Item 15.

  -    Exhibits and Financial Statement Schedules    350

Schedule I

  -    Condensed Financial Information of Parent Company    352

Schedule II

  -    Valuation and Qualifying Accounts    357

Signatures

   377

Index to Exhibits Filed Herewith

   380

Index to Exhibits Furnished Herewith

   381

Exhibit 12

  -    Statements Re: Computation of Ratios   

Exhibit 21

  -    Subsidiaries of the Registrant   

Exhibit 23

  -    Consents of Independent Registered Public Accounting Firm   

Exhibits 31.1 - 31.8

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

Exhibits 32.1 - 32.4

  -    Section 1350 Certifications   


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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

AMI

   Advanced metering infrastructure, a system that collects, measures and analyzes energy usuage data from advanced digital electric and gas meters known as smart meters

AOCL

   Accumulated Other Comprehensive Loss

ASC

   Accounting Standards Codification

BGE

   Baltimore Gas and Electric Company

BGS

   Basic Generation Service (the supply of electricity by ACE to retail customers in New Jersey who have not elected to purchase electricity from a competitive supplier)

Bondable Transition Property

   Principal and interest payments on the Transition Bonds and related taxes, expenses and fees

BSA

   Bill Stabilization Adjustment

CAA

   Federal Clean Air Act

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

   PHI’s former competitive wholesale power generation, marketing and supply business, the disposition of which was completed in 2010

Consent

   An amendment of and consent entered into by PHI, Pepco, DPL and ACE with respect to the credit agreement, which, among other things, permits the consummation of the Merger

Contract EDCs

   Pepco, DPL and BGE, the Maryland utilities required by the MPSC to enter into a contract for new generation

CRMC

   PHI’s Corporate Risk Management Committee

CTA

   Consolidated tax adjustment

DCPSC

   District of Columbia Public Service Commission

DC PLUG

   District of Columbia Power Line Undergrounding

DDOE

   District of Columbia Department of the Environment

Default Electricity Supply

   The supply of electricity by PHI’s electric utility subsidiaries at regulated rates to retail customers who do not elect to purchase electricity from a competitive supplier, and which, depending on the jurisdiction, is also known as Standard Offer Service or BGS

Default Electricity Supply Revenue

   Revenue primarily from Default Electricity Supply

DEDA

   Delaware Economic Development Authority

DEMEC

   Delaware Municipal Electric Corporation, Inc.

DOE

   U.S. Department of Energy

DOJ

   U.S. Department of Justice

DPL

   Delmarva Power & Light Company

DPSC

   Delaware Public Service Commission

DRC

   New Jersey Division of Rate Counsel

DRP

   Direct Stock Purchase and Dividend Reinvestment Plan

DSEU

   Delaware Sustainable Energy Utility

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

 

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Term

  

Definition

FERC    Federal Energy Regulatory Commission
FLRP    Forward Looking Rate Plan
FPA    Federal Power Act
FTC    U.S. Federal Trade Commission
GAAP    Accounting principles generally accepted in the United States of America
GCR    Gas Cost Rate
GWh    Gigawatt hour
HPS    Hourly Priced Service
HSR Act    The Hart-Scott-Rodino Antitrust Improvements Act of 1976
Improvement Financing Act    The Electric Company Infrastructure Improvement Financing Act of 2014 enacted by the Council of the District of Columbia on May 3, 2014
IMU    Interface management unit
IRS    Internal Revenue Service
ISRA    Industrial Site Recovery Act
LIBOR    London Interbank Offered Rate
LTIP    Pepco Holdings, Inc. Long-Term Incentive Plan
MAPP    Mid-Atlantic Power Pathway
Mcf    Thousand Cubic Feet
MDC    MDC Industries, Inc.
Merger    Merger of Merger Sub with and into PHI, with PHI surviving as a wholly owned subsidiary of Exelon
Merger Agreement    Agreement and Plan of Merger, dated April 29, 2014 among Exelon, Merger Sub and PHI, as amended and restated on July 18, 2014
MFVRD    Modified fixed variable rate design
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 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
NJ SOCA Law    The New Jersey law under which the SOCAs were established
NJBPU    New Jersey Board of Public Utilities
NOLC    Net operating loss carryforward
NOV    Notice of violation
NPCC    Northeast Power Coordinating Council
NPDES    National Pollutant Discharge Elimination System
NRG    NRG Energy, Inc. (successor to GenOn MD Ash Management, LLC)
NUGs    Non-utility generators
NYMEX    New York Mercantile Exchange
OPC    Office of People’s Counsel
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    Pepco Holdings, Inc. Welfare Plan for Retirees

 

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Term

  

Definition

PHI Retirement Plan    PHI’s non-contributory, defined benefit pension plan
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
Preferred Stock    Originally issued shares of PHI non-voting, non-convertible and non-transferable Series A preferred stock, par value $0.01 per share
PRP    Potentially responsible party
PUHCA 2005    Public Utility Holding Company Act of 2005
RECs    Renewable energy credits
Regulated T&D Electric Revenue    Revenue from the transmission and the distribution of electricity to PHI’s customers within its service territories at regulated rates
Regulatory Asset Recovery Charge    Costs associated with deferred, NJBPU-approved expenses incurred as part of ACE’s obligation to serve the public
Regulatory Termination    Termination of the Merger Agreement under certain circumstances due to, generally speaking, the failure to obtain regulatory approvals with respect to the Merger or the breach by Exelon of its obligations in respect of obtaining such regulatory approvals
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
RF    ReliabilityFirst
RI/FS    Remedial investigation and feasibility study
ROE    Return on equity
RPS    Renewable Energy Portfolio Standards
Sarbanes-Oxley Act    Sarbanes-Oxley Act of 2002
SEC    Securities and Exchange Commission
SEP    Supplemental Environmental Project
SOCAs    Standard Offer Capacity Agreements required to be entered into by ACE pursuant to a New Jersey law enacted to promote the construction of qualified electric generation facilities in New Jersey
SOS    Standard Offer Service, how Default Electricity Supply is referred to in Delaware, the District of Columbia and Maryland
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 was eliminated in 2013)
TMDL    Total Maxium Daily Load
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

 

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Term

  

Definition

Triennial Plan    A three-year plan related to the construction in the District of Columbia of selected underground feeders as part of the DC PLUG initiative and the recovery of Pepco’s investment through a volumetric surcharge
VDEQ    Virginia Department of Environmental Quality
VIE    Variable interest entity
VRDBs    Variable Rate Demand Bonds
VSCC    Virginia State Corporation Commission
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:

 

    Certain risks and uncertainties associated with the proposed merger (the Merger) of an indirect, wholly owned subsidiary of Exelon Corporation, a Pennsylvania corporation (Exelon) with and into Pepco Holdings, including, without limitation:

 

    The inability of Pepco Holdings or Exelon to obtain regulatory approvals required for the Merger;

 

    Delays caused by required regulatory approvals, which may delay the Merger or cause the companies to abandon the Merger;

 

    The inability of Pepco Holdings or Exelon to satisfy conditions to the closing of the Merger;

 

    Unexpected costs, liabilities or delays that may arise from the Merger, including as a result of stockholder litigation;

 

    Negative impacts on the businesses of Pepco Holdings and its utility subsidiaries as a result of uncertainty surrounding the Merger; and

 

    Future regulatory or legislative actions impacting the industries in which Pepco Holdings and its subsidiaries operate, which actions could adversely affect Pepco Holdings and its utility subsidiaries.

 

    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 (i) challenges to the base return on equity (ROE) and the application of the formula rate process previously established by the Federal Energy Regulatory Commission (FERC) for transmission services provided by Pepco, DPL and ACE; (ii) challenges to DPL’s 2012, 2013 and 2014 annual FERC formula rate updates; and (iii) other possible disallowances related to recovery of costs (including capital costs and advanced metering infrastructure (AMI) costs) and expenses or delays in the recovery of such costs;

 

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    The resolution of outstanding tax matters with the Internal Revenue Service (IRS), and the funding of any additional taxes, interest or penalties that may be due;

 

    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 negative customer perception and could lead to increased regulatory oversight or other sanctions;

 

    Weather conditions affecting usage and emergency restoration costs;

 

    Population growth rates and changes in demographic patterns;

 

    Changes in customer energy demand due to, among other things, conservation measures and the use of renewable energy and other energy-efficient products, as well as the impact of net metering and other issues associated with the deployment of distributed generation and other new technologies;

 

    General economic conditions, including the impact on energy use caused by an economic downturn or recession, or by changes in the level of commercial activity in a particular region or service territory, or affecting a particular business or industry located therein;

 

    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 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.

 

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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 Securities and Exchange Commission (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 is a holding company that was incorporated in Delaware in 2001. Through its regulated public utility subsidiaries, PHI is engaged primarily in the transmission, distribution and default supply of electricity, and, to a lesser extent, the distribution and supply of natural gas. The principal executive offices of PHI are located at 701 Ninth Street, N.W., Washington, D.C. 20068.

PHI’s public utility subsidiaries are:

 

Name of Utility

  

State and

Year of Incorporation

  

Business

  

Service

Territories

  

Address of Principal
Executive Offices

Potomac Electric Power

Company

 

  

District of Columbia (1896)

 

Virginia (1949)

  

Transmission, distribution and

default supply of electricity

  

District of Columbia

 

Major portions of Montgomery and Prince George’s Counties, Maryland

 

  

701 Ninth Street, N.W.,

Washington, D.C. 20068

 

  

 

  

 

  

 

  

 

Delmarva Power & Light

Company

 

Delaware (1909)

 

Virginia (1979)

 

Transmission, distribution and

default supply of electricity

 

Distribution and

supply of natural gas

Portions of

Delaware and

Maryland

(electricity)

 

Portions of New Castle County, Delaware (natural gas)

 

500 North Wakefield Drive,

Newark, Delaware 19702

 

  

 

  

 

  

 

  

 

Atlantic City Electric
Company

 

New Jersey (1924)

Transmission, distribution and

default supply of electricity

 

Portions of Southern New Jersey

500 North Wakefield Drive,

Newark, Delaware 19702

 

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The service territories of each of Pepco Holdings’ utilities are depicted in the map below:

 

 

LOGO

PHI’s three utility subsidiaries comprise a single operating segment for accounting purposes, which is referred to herein as “Power Delivery.”

In addition to its regulated utility operations, Pepco Holdings, through Pepco Energy Services, Inc. and its subsidiaries (collectively, Pepco Energy Services), is engaged in an energy savings performance contracting business, an underground transmission and distribution construction business and a thermal business.

The operations of Pepco Energy Services collectively comprise a separate, second operating segment for accounting purposes. During 2013, Pepco Energy Services completed the wind-down of its retail electricity and natural gas supply businesses, and, as a result, these businesses have been accounted for as discontinued operations, as described below under “Discontinued Operations.”

Through its wholly owned subsidiary, Potomac Capital Investment Corporation (PCI), PHI previously held a portfolio of cross-border energy lease investments. During 2013, Pepco Holdings completed the termination of its interests in its cross-border energy lease investments, and as a result, these investments have been accounted for as discontinued operations, as described below under “Discontinued Operations.”

 

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The following table shows PHI’s consolidated operating revenue and net income from continuing operations derived from the Power Delivery and Pepco Energy Services segments over the three preceding fiscal years.

 

     2014      2013      2012  
     (millions of dollars)  

Operating Revenue

        

Power Delivery

   $ 4,607       $ 4,472       $ 4,378   

Pepco Energy Services

     278         203         256   

Net Income (Loss) from Continuing Operations

        

Power Delivery

   $ 320       $ 289      $ 235   

Pepco Energy Services

     (39      3         (8

For additional financial information with respect to PHI’s segments, see Note (5), “Segment Information,” to the consolidated financial statements of PHI.

PHI Service Company, a wholly owned subsidiary 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 service agreements among PHI, PHI Service Company and the participating operating subsidiaries. The expenses of PHI Service Company are charged to PHI and the participating operating subsidiaries in accordance with cost allocation methodologies set forth in the service agreements.

Agreement and Plan of Merger with Exelon Corporation

PHI entered into an Agreement and Plan of Merger, dated April 29, 2014, as amended and restated July 18, 2014 (the Merger Agreement), with Exelon and Purple Acquisition Corp., a Delaware corporation and an indirect, wholly owned subsidiary of Exelon (Merger Sub), providing for the Merger, with PHI surviving the Merger as an indirect, wholly owned subsidiary of Exelon. Pursuant to the Merger Agreement, at the effective time of the Merger, each outstanding share of common stock, par value $0.01 per share, of PHI (other than (i) shares owned by Exelon, Merger Sub or any other direct or indirect wholly owned subsidiary of Exelon and shares owned by PHI or any direct or indirect wholly owned subsidiary of PHI, and in each case not held on behalf of third parties (but not including shares held by PHI in any rabbi trust or similar arrangement in respect of any compensation plan or arrangement) and (ii) shares that are owned by stockholders who have perfected and not withdrawn a demand for appraisal rights pursuant to Delaware law), will be canceled and converted into the right to receive $27.25 in cash, without interest.

In connection with entering into the Merger Agreement, PHI entered into a Subscription Agreement, dated April 29, 2014 (the Subscription Agreement), with Exelon, pursuant to which on April 30, 2014, PHI issued to Exelon 9,000 originally issued shares of non-voting, non-convertible and non-transferable Series A preferred stock, par value $0.01 per share (the Preferred Stock), for a purchase price of $90 million. Exelon also committed pursuant to the Subscription Agreement to purchase 1,800 originally issued shares of Preferred Stock for a purchase price of $18 million at the end of each 90-day period following the date of the Subscription Agreement until the Merger closes or is terminated, up to a maximum of 18,000 shares of Preferred Stock for a maximum aggregate consideration of $180 million. In accordance with the Subscription Agreement, on each of July 29, 2014, October 27, 2014 and January 26, 2015, an additional 1,800 shares of Preferred Stock were issued by PHI to Exelon for a purchase price of $18 million. The holders of the Preferred Stock will be entitled to receive a cumulative, non-participating cash dividend of 0.1% per annum, payable quarterly, when, as and if declared by PHI’s board of directors. The proceeds from the issuance of the Preferred Stock are not subject to restrictions and are intended to serve as a prepayment of any applicable reverse termination fee payable from Exelon to PHI. The Preferred Stock will be redeemable on the terms and in the circumstances set forth in the Merger Agreement and the Subscription Agreement.

 

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Consummation of the Merger is subject to the satisfaction or waiver of specified closing conditions, including (i) the approval of the Merger by the holders of a majority of the outstanding shares of common stock of PHI; (ii) the receipt of regulatory approvals required to consummate the Merger, including approvals from FERC, the Federal Communications Commission (FCC), the Delaware Public Service Commission (DPSC), the District of Columbia Public Service Commission (DCPSC), the Maryland Public Service Commission (MPSC), the New Jersey Board of Public Utilities (NJBPU) and the Virginia State Corporation Commission (VSCC); (iii) the expiration or termination of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 (the HSR Act); and (iv) other customary closing conditions, including (a) the accuracy of each party’s representations and warranties (subject to customary materiality qualifiers) and (b) each party’s compliance with its obligations and covenants contained in the Merger Agreement (including covenants that may limit, restrict or prohibit PHI and its subsidiaries from taking specified actions during the period between the date of the Merger Agreement and the closing of the Merger or the termination of the Merger Agreement). In addition, the obligations of Exelon and Merger Sub to consummate the Merger are subject to the required regulatory approvals not imposing terms, conditions, obligations or commitments, individually or in the aggregate, that constitute a burdensome condition (as defined in the Merger Agreement).

On September 23, 2014, the stockholders of PHI approved the Merger, on October 7, 2014, the VSCC approved the Merger, and on November 20, 2014, FERC approved the Merger. On December 22, 2014, the applicable waiting period under the HSR Act expired, and the HSR Act no longer precludes completion of the Merger. Although the Department of Justice (DOJ) allowed the waiting period under the HSR Act to expire without taking any action with respect to the Merger, the DOJ has not advised PHI that it has concluded its investigation. In addition, the transfer of control of certain communications licenses held by certain of PHI’s subsidiaries has been approved by the FCC. The NJBPU approved the Merger on February 11, 2015. On February 13, 2015, Pepco Holdings, DPL, Exelon, certain of Exelon’s affiliates, the Staff of the DPSC and certain other parties, filed a settlement agreement with the DPSC with respect to the Merger. This settlement agreement is subject to approval by the DPSC.

The Merger Agreement may be terminated by each of PHI and Exelon under certain circumstances, including if the Merger is not consummated by July 29, 2015 (subject to extension by PHI or Exelon to October 29, 2015, if all of the conditions to closing, other than the conditions related to obtaining regulatory approvals, have been satisfied). The Merger Agreement also provides for certain termination rights for both PHI and Exelon, and further provides that, upon termination of the Merger Agreement under certain specified circumstances, PHI will be required to pay Exelon a termination fee of $259 million or reimburse Exelon for its expenses up to $40 million (which reimbursement of expenses shall reduce on a dollar for dollar basis any termination fee subsequently payable by PHI), provided, however, that if the Merger Agreement is terminated in connection with an acquisition proposal made under certain circumstances by a person who made an acquisition proposal between April 1, 2014 and the date of the Merger Agreement, the termination fee will be $293 million plus reimbursement of Exelon for its expenses up to $40 million (not subject to offset). In addition, if the Merger Agreement is terminated under certain circumstances due to the failure to obtain regulatory approvals with respect to the Merger or the breach by Exelon of its obligations in respect of obtaining such regulatory approvals (a Regulatory Termination), PHI will be able to redeem any issued and outstanding Preferred Stock at par value. If the Merger Agreement is terminated, other than for a Regulatory Termination, PHI will be required to redeem the Preferred Stock at the purchase price of $10,000 per share, plus any unpaid accrued and accumulated dividends thereupon.

 

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Business Strategy

PHI’s business objective is to be a top-performing, regulated power delivery company that delivers safe and reliable electric and natural gas service to its customers and through its regulatory proceedings, earns a just and reasonable rate of return on, and receives timely recovery of, its utility investments.

In seeking to achieve this objective, Pepco Holdings’ business strategy is guided by its core values of safety, integrity, and diversity and its mission of environmental stewardship, and is focused on the following initiatives:

 

    investing in its utilities’ transmission and distribution infrastructure;

 

    building a smarter grid and implementing other technological enhancements designed to:

 

    automate power delivery system functions and improve the reliability of the power distribution system;

 

    enable its utilities to restore power more quickly and efficiently;

 

    offer customers detailed information about, and options to help customers better manage, their energy usage;

 

    enhance the customer experience and PHI’s communications with customers; and

 

    through Pepco Energy Services, providing comprehensive energy management solutions and developing, installing and operating renewable energy solutions.

In furtherance of its business strategy, PHI entered into the Merger Agreement with Exelon Corporation. For a discussion of the Merger Agreement, see “– Agreement and Plan of Merger with Exelon Corporation.” Further, PHI may dispose of existing businesses consistent with the terms of the Merger Agreement. PHI also may from time to time refine components of its business strategy as it deems necessary or appropriate in response to business factors and other conditions consistent with the terms of the Merger Agreement and subject to regulatory requirements.

Overview of the Power Delivery Business

Distribution and Default Supply of Electricity

Each of PHI’s utility subsidiaries 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 utilities’ service territories. Distribution facilities carry electricity from the transmission facilities to the customers located in the utilities’ service territories.

Each utility subsidiary is responsible for the distribution of electricity to customers within its service territory or territories and for which it is paid tariff rates established by the applicable public service commissions. While the transmission and distribution of electricity is regulated, the law of each of these service territories allows for competition in the supply of electricity, which enables distribution customers to contract to purchase their electricity from a supplier approved by the applicable public service commission. PHI’s utility subsidiaries supply electricity at regulated rates to customers who do not elect to purchase their electricity from a competitive supplier. These “default” supply services are referred to generally in this Form 10-K as Default Electricity Supply. The regulatory term for Default Electricity Supply is Standard Offer Service (SOS) in Delaware, the District of Columbia and Maryland, and Basic Generation Service (BGS) in New Jersey. The results of operations of PHI’s utility subsidiaries are only minimally impacted when customers choose to obtain their electricity through competitive suppliers because the utilities earn their approved rates of return by providing distribution service, and not by supplying the electricity.

 

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Transmission of Electricity and Relationship With PJM

Each of PHI’s utility subsidiaries provides transmission services within the jurisdictions that encompass its electricity distribution service territory. In the aggregate, PHI owns approximately 4,600 circuit miles of interconnected transmission lines with voltages ranging from 115 kilovolts (kV) to 500 kV. Under the Open Access Transmission Tariff adopted by FERC, each owner of transmission services is required to provide transmission customers with non-discriminatory access to its transmission facilities at tariff rates approved by FERC.

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 a region encompassing the mid-Atlantic portion of the United States and parts of the Midwest. PJM is the FERC-approved independent operator of this transmission grid and manages the wholesale electricity market within its region. Pepco, DPL and ACE each are members of the PJM Regional Transmission Organization (PJM RTO), the regional transmission organization designated by FERC to coordinate the movement of wholesale electricity in PJM’s region.

In accordance with FERC-approved rules, Pepco, DPL, ACE and the other transmission-owning utilities in the PJM region make their transmission facilities available to PJM, and PJM directs and controls the operation of these transmission facilities. Each transmission owner is compensated at transmission rates approved by FERC for the use of its transmission facilities. 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 its region. The Board of Managers of PJM reviews and approves all transmission expansion plans within the PJM region, including the construction of new transmission facilities by PJM members. Changes in the current policies for building new transmission lines ordered by FERC and implemented by PJM could result in additional competition to build transmission lines in the PJM region, including in the service territories of PHI’s utility subsidiaries, and could allow PHI’s utility subsidiaries the opportunity to construct transmission facilities in other service territories.

For a discussion of the regulation of transmission rates, see Part II, Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Regulatory and Other Matters – Rate Proceedings – Transmission” and for a discussion of recently completed and pending FERC transmission rate proceedings, see Note (7), “Regulatory Matters – Rate Proceedings – Federal Energy Regulatory Commission,” to the consolidated financial statements of PHI.

Distribution and Supply of Natural Gas

DPL owns pipelines and other equipment for the distribution and supply of natural gas. DPL uses its natural gas distribution facilities to deliver natural gas to retail customers in its service territory and provides transportation-only services to customers that purchase natural gas from another supplier. Intrastate transportation customers pay DPL distribution service rates approved by the DPSC. Rates for the interstate transportation and sale of wholesale natural gas are regulated by FERC. 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.

 

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PHI’s Utility Subsidiaries

Potomac Electric Power Company

Pepco’s electric distribution service territory consists of the District of Columbia and major portions of Prince George’s County and Montgomery County in Maryland. The service territory covers approximately 640 square miles and, as of December 31, 2014, had a population of approximately 2.3 million. This region includes the following key industries that contribute to the regional economic base:

 

    Federal and municipal government services;

 

    Professional, scientific, educational and technical services;

 

    Leisure, hospitality and transportation services; and

 

    Healthcare and social services.

The following table shows the number of Pepco distribution customers in each of its service territories as of the end of each of the preceding three years.

 

     2014      2013      2012  
     (in thousands)  

District of Columbia

     271         264         260   

Maryland

     544         537         533   
  

 

 

    

 

 

    

 

 

 

Total

  815      801      793   
  

 

 

    

 

 

    

 

 

 

Pepco distributed a total of 25,751,000, 25,801,000 and 26,006,000 megawatt (MW) hours (MWh) of electricity in 2014, 2013 and 2012, respectively. The following table shows the allocation by percentage among customer types of the total MWh of electricity delivered by Pepco in each of its service territories during each of the preceding three fiscal years:

 

     2014     2013     2012  

District of Columbia:

      

Residential

     8     8     8

Commercial, industrial and other

     35     35     35
  

 

 

   

 

 

   

 

 

 

Total

  43   43   43
  

 

 

   

 

 

   

 

 

 

Maryland:

Residential

  22   22   22

Commercial, industrial and other

  35   35   35
  

 

 

   

 

 

   

 

 

 

Total

  57   57   57
  

 

 

   

 

 

   

 

 

 

Pepco has been designated as the default electricity supplier in its District of Columbia and Maryland service territories by the DCPSC and the MPSC, respectively. Pepco purchases the electricity required to satisfy its SOS obligations from wholesale suppliers primarily under contracts entered into in accordance with competitive bid procedures approved and supervised by each of the DCPSC and the MPSC. For commercial customers in the District of Columbia and large commercial customers in Maryland that do not purchase their electricity from a competitive supplier, Pepco is obligated to provide Hourly Priced Service (HPS), a form of SOS service for which Pepco purchases the electricity in the next-day and other short-term PJM RTO markets.

Under orders issued by the DCPSC, Pepco is obligated to provide SOS to residential and small, medium-sized and large commercial customers in the District of Columbia indefinitely. Under orders issued by the MPSC, Pepco is obligated to provide SOS to residential and small commercial customers and to medium-sized commercial customers in Maryland through November 2015. As contracts expire, they are rebid

 

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annually by Pepco through the MPSC-approved request for proposal process. Pepco is paid tariff rates for the transmission and distribution of electricity over its transmission and distribution facilities to all electricity customers in its service territory, whether the customer receives SOS or HPS, or purchases electricity from a competitive supplier, and is entitled to recover from its SOS and HPS customers the costs of acquiring the electricity, plus an administrative charge that is intended to allow it to recover its administrative costs, plus a modest margin, which varies depending on the customer class.

The following table shows for Pepco customers in the District of Columbia and Maryland the percentage of distribution sales (measured by MWh) over the past three fiscal years to SOS customers.

 

     2014     2013     2012  

District of Columbia

     27     25     25

Maryland

     41     41     40

In the District of Columbia, under various acts of Congress, pursuant to Pepco’s corporate charter, and subject to the supervision of the DCPSC, Pepco has the non-exclusive authority to install and maintain overhead and underground transmission and distribution lines and other related facilities for the furnishing of electricity. Pepco’s right to occupy public space for utility purposes is by permit from the District of Columbia and the federal government. Pepco is the only public utility that distributes electricity for sale to the public in the District of Columbia.

In Maryland, Pepco operates pursuant to state-wide franchises granted by Maryland’s General Assembly that are unlimited in duration. These franchises were granted to Pepco or to predecessor companies acquired by Pepco, and confer, among other things, the ability to construct electric transmission and distribution lines. Pursuant to statute, public service companies in Maryland may exercise a franchise to the extent authorized by the MPSC. The service territories for Pepco, as well as for other electric utilities in the state, were precisely delineated in 1966 by the MPSC and have been modified in minor ways over the years.

Delmarva Power & Light Company

DPL is engaged in the transmission, distribution and default supply of electricity in portions of Delaware and 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.

In Maryland, DPL operates pursuant to state-wide franchises that are substantially similar in nature to those described above with respect to Pepco’s Maryland operations. DPL’s exclusive and continuing authority to distribute electricity and natural gas in its non-municipal service territories in Delaware is derived from legislation, through which the DPSC has established exclusive service territories. With respect to municipalities that it serves, DPL provides service under various franchises granted to DPL and predecessor companies, which franchises are generally either unlimited as to time or renew automatically.

 

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Distribution and Supply of Electricity

DPL’s electric distribution service territory consists of portions 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, as of December 31, 2014, had a population of approximately 1.4 million. This region is economically diverse and includes the following key industries that contribute to the regional economic base:

 

    Commercial activities in the region include banking, government, educational and health services, transportation and tourism.

 

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

The following table shows the number of DPL electricity distribution customers in each of its service territories as of the end of each of the preceding three fiscal years.

 

     2014      2013      2012  
     (in thousands)  

Delaware

     308         305         303   

Maryland

     202         201         200   
  

 

 

    

 

 

    

 

 

 

Total

  510      506      503   
  

 

 

    

 

 

    

 

 

 

DPL distributed a total of 12,413,000, 12,465,000 and 12,641,000 MWh of electricity in 2014, 2013 and 2012, respectively. The following table shows the allocation by percentage among customer types of the total MWh of electricity delivered by DPL in each of its service territories during each of the preceding three fiscal years:

 

     2014     2013     2012  

Delaware:

      

Residential

     24     24     24

Commercial and industrial

     41     42     43
  

 

 

   

 

 

   

 

 

 

Total

  65   66   67
  

 

 

   

 

 

   

 

 

 

Maryland:

Residential

  18   17   16

Commercial and industrial

  17   17   17
  

 

 

   

 

 

   

 

 

 

Total

  35   34   33
  

 

 

   

 

 

   

 

 

 

DPL has been designated as the default electricity supplier in its Delaware and Maryland service territories by the DPSC and the MPSC, respectively. DPL purchases the electricity required to satisfy its SOS obligations from wholesale suppliers primarily under contracts entered into in accordance with competitive bid procedures approved and supervised by each of the DPSC and the MPSC. DPL also has an obligation to provide HPS for its largest customers in Delaware and its large customers in Maryland. DPL acquires power to supply its HPS customers in the next-day and other short-term PJM RTO markets.

Under orders issued by the DPSC, DPL is obligated to provide SOS to residential, small commercial and industrial customers in Delaware through May 2018, and to medium, large and general service commercial customers in Delaware through May 2016. Under orders issued by the MPSC, DPL is obligated to provide SOS to residential and small commercial customers in Maryland until further action of the Maryland General Assembly, and to medium-sized commercial customers in Maryland through November 2015. As contracts expire, they are rebid annually by DPL through the MPSC-approved request for proposal process. In Delaware and Maryland, DPL is paid tariff rates for the transmission and distribution of electricity over its transmission and distribution facilities to all electricity customers in its

 

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service territories, whether the customer receives SOS or HPS, or purchases electricity from a competitive supplier. In Delaware, DPL is also entitled to recover from its SOS and HPS customers the associated costs of acquiring the electricity (including transmission, capacity and ancillary services costs and costs to satisfy renewable energy requirements), plus an amount referred to as a Reasonable Allowance for Retail Margin. In Maryland, DPL is entitled to recover from its SOS and HPS customers the costs of acquiring the electricity, plus an administrative charge that is intended to allow it to recover its administrative costs, plus a modest margin, which varies depending on the customer class.

The following table shows for DPL customers in Delaware and Maryland the percentage of distribution sales (measured in MWh) over the past three fiscal years to SOS customers.

 

     2014     2013     2012  

Delaware

     44     44     47

Maryland

     51     51     53

Distribution and Supply 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, as of December 31, 2014, had a population of approximately 500,000.

Large volume commercial, institutional, and industrial natural gas customers may purchase natural gas from DPL. Alternatively, a customer receiving a “transportation-only” service from DPL will purchase natural gas from a competitive supplier and have the natural gas delivered through DPL’s distribution facilities. The following table provides certain information regarding DPL’s natural gas distribution business for each of the last three fiscal years.

 

     2014     2013     2012  
     (in thousands, except percentages)  

Number of natural gas customers

     128        126        125   

Thousand cubic feet (Mcf) of natural gas delivered

     21,031        19,796        16,815   

Percentage of natural gas supplied and delivered by DPL

     69 %     64     60

The following table shows on a percentage basis the allocation among customer types of the Mcf of natural gas delivered by DPL in Delaware in each of the preceding three fiscal years.

 

     2014     2013     2012  

Residential

     41     40     38

Commercial and industrial

     29     25     22

Transportation and other

     30     35     40

 

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Atlantic City Electric Company

Electricity Distribution and Supply

ACE’s electric distribution service territory consists of Gloucester, Camden, Burlington, Ocean, Atlantic, Cape May, Cumberland and Salem counties in southern New Jersey. The service territory covers approximately 2,700 square miles and had, as of December 31, 2014, a population of approximately 1.1 million. This region is economically diverse and includes the following key industries that contribute to the regional economic base:

 

    Commercial activities in the region include professional services, government, educational and health services, casinos and tourism.

 

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

The following table provides certain information regarding ACE’s electric distribution business for each of the last three fiscal years.

 

     2014      2013      2012  
     (in thousands)  

Number of electric distribution customers

     546         545         545   

MWh of electricity delivered

     9,051         9,231         9,495   

The following table shows the allocation by percentage among customer types of the total MWh of electricity delivered by ACE during each of the preceding three fiscal years.

 

     2014     2013     2012  

Residential

     45     46     46

Commercial and industrial

     55     54     54

ACE has been designated as the default electricity supplier in its service territory by the NJBPU. In New Jersey, each of the state’s electric distribution companies, including ACE, jointly obtains the electricity to meet such companies’ collective 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:

 

    fixed price BGS, which is provided to smaller commercial and residential customers at seasonally-adjusted fixed prices (which as of December 31, 2014, had a peak load of approximately 1,511 MW and represented approximately 97% of ACE’s total BGS load); and

 

    commercial and industrial energy price BGS, which is provided to large customers at hourly PJM RTO real-time market prices for a term of 12 months (which as of December 31, 2014, had a peak load of approximately 54 MW and represented approximately 3% of ACE’s total 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 with respect to the supply component of its BGS obligations. ACE is also paid tariff rates for the transmission and distribution of electricity over its transmission and distribution facilities to all electricity customers in its service territory, whether the customer receives BGS or purchases electricity from a competitive supplier.

 

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For the year ended December 31, 2014, 49% of ACE’s total distribution sales (measured in MWh) were to BGS customers, as compared to 48% and 51% in 2013 and 2012, respectively.

ACE operates under non-exclusive franchises that have been granted by the NJBPU and under certain non-exclusive consents from municipalities in which ACE provides service. While most of the municipal consents were granted in perpetuity, two of the municipal consents require renewal on a periodic basis in accordance with their terms, and are subject to the ultimate review and approval of the NJBPU. All of the franchises and consents are currently in full force and effect.

Atlantic City Electric Transition Funding LLC

In 2001, ACE established Atlantic City Electric Transition 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.

Smart Grid Initiatives

PHI’s utility subsidiaries are engaged in transforming the power grid that they own and operate into a “smart grid,” a network of automated digital devices capable of collecting and communicating large amounts of real-time data. PHI believes that the smart grid benefits its customers by:

 

    improving service reliability of the energy distribution system;

 

    automating specific distribution system functions;

 

    enabling its utilities to restore energy to customers more quickly and efficiently;

 

    facilitating more efficient use of energy to meet the challenges of rising energy costs and governmental energy reduction goals;

 

    permitting its utilities to obtain and communicate to their customers timely and accurate information regarding energy usage and outages; and

 

    enhancing communications with its customers and the overall customer experience.

A central component of the smart grid is AMI, a system that collects, measures and analyzes energy usage data from advanced digital meters, known as “smart meters.” 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 the AMI system and distribution automation are enabled by advanced technology that communicates with devices installed on the energy delivery system and transmits energy usage data to the host utility. The implementation of the AMI system and distribution automation involves an integration of technologies provided by multiple vendors.

 

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Both Pepco and DPL have completed the installation and activation of AMI smart meters and related technologies in each of their jurisdictions. ACE has yet to receive approval from the NJBPU to proceed with the installation of AMI smart meters.

The DCPSC, the MPSC and the DPSC have approved the creation by Pepco and DPL of regulatory assets to defer certain costs associated with the implementation of the AMI system between rate cases and to defer carrying costs associated with the deferred costs. Thus, these costs will be recovered in the future through base rates; however, for AMI-related costs incurred by Pepco in Maryland with respect to test years after 2011, pursuant to an MPSC order, the recovery of such costs will be allowed when Pepco demonstrates that the AMI system is cost-effective. The MPSC’s July 2013 order in Pepco’s November 2012 electric distribution base rate application excluded the cost of AMI smart meters from Pepco’s rate base until such time as Pepco demonstrates the cost effectiveness of the AMI system. As a result, costs for AMI smart meters incurred with respect to the 2012 test year and beyond will be treated as other incremental AMI-related costs incurred in conjunction with the deployment of the AMI system that are deferred and on which carrying costs are deferred, but only until such cost effectiveness has been demonstrated and such costs are included in rates.

In 2010, two of PHI’s utility subsidiaries were granted cash awards in the aggregate amount of $168 million by the U.S. Department of Energy to support their smart grid initiatives.

 

    Pepco was awarded $149 million for AMI, direct load control, distribution automation and communications infrastructure, of which $148 million has been received through December 31, 2014.

 

    ACE was awarded $19 million for direct load control, distribution automation and communications infrastructure, all of which has been received through December 31, 2014.

Substantially all of the awards received have been recorded as reductions in AMI-related costs (including those costs capitalized as property, plant and equipment and those costs deferred as regulatory assets).

Utility Capital Expenditures

PHI’s utility subsidiaries allocate a substantial portion of their total capital expenditures to improving the reliability of their electrical transmission and distribution systems and replacing aging infrastructure throughout their service territories. These activities include:

 

    identifying and upgrading under-performing feeder lines;

 

    adding new facilities to support load;

 

    installing distribution automation systems on both the overhead and underground network systems; and

 

    rejuvenating and replacing underground residential cables.

In addition, PHI’s utility subsidiaries allocate capital expenditures to increasing transmission and distribution system capacity, providing resiliency against major storm events, providing operating and system flexibility and installing and upgrading facilities for new and existing customers. For a discussion of PHI’s consolidated capital expenditure plan for 2015 through 2019, see Part II, Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Capital Resources and Liquidity – Capital Requirements – Capital Expenditures.”

District of Columbia Power Line Undergrounding Initiative

On May 3, 2014, the Council of the District of Columbia enacted the Electric Company Infrastructure Improvement Financing Act of 2014 (the Improvement Financing Act), which provides enabling legislation for the District of Columbia Power Line Undergrounding (DC PLUG) initiative. This $1 billion initiative seeks to selectively place underground some of the District of Columbia’s most outage-prone

 

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power lines, which lines and surrounding conduit would be owned and maintained by Pepco. A more detailed discussion of the Improvement Financing Act is provided in Note (7), “Regulatory Matters – District of Columbia Power Line Undergrounding Initiative,” to the consolidated financial statements of PHI.

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 and ACE. There are eight NERC regional oversight entities, including ReliabilityFirst (RF), of which Pepco, DPL, ACE and Pepco Energy Services are members. These oversight entities are charged with the day-to-day implementation and enforcement of NERC’s reliability standards, which impose certain operating, planning and cybersecurity requirements on the bulk power systems of each utility. RF performs compliance audits on entities registered with NERC based on reliability standards and criteria established by NERC. NERC and RF 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 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 cybersecurity assets) subject to NERC’s cybersecurity standards. NERC is empowered to impose financial penalties, fines and other sanctions for non-compliance with certain rules and regulations.

Energy Efficiency Initiatives

Dynamic Pricing

Dynamic pricing provides customers with incentives to reward them for decreasing their energy use during peak energy demand periods, when energy demand and consequently, the cost of supplying electricity, are higher. PHI’s dynamic pricing rate structures, implemented in tandem with PHI’s smart grid, provide customers with billing credits when they reduce their power usage in response to their utility’s request. Dynamic pricing programs include variable peak pricing and critical peak rebate programs.

Dynamic pricing has been approved by the respective public service commissions and is in place for Pepco customers in Maryland and DPL customers in Maryland and Delaware. As of December 31, 2014, approximately 468,000 Pepco customers in Maryland, 5,000 DPL customers in Maryland and 252,000 DPL customers in Delaware have participated in dynamic pricing programs.

In February 2014, the DCPSC rejected Pepco’s proposal for dynamic pricing in the District of Columbia, but expressed interest in exploring dynamic pricing rate structures in future proceedings. Dynamic pricing has not been approved by the NJBPU for ACE’s customers in New Jersey.

Utility Energy Efficiency Programs

Each of Pepco, DPL and ACE has implemented the Energy Wise Rewards™ program, which allows participating customers to reduce energy usage and costs by authorizing the utility to cycle their air conditioner compressors off and on during high energy demand periods. Customers participating in this program are eligible to receive a credit on their bill. Pepco and DPL have also implemented a portfolio of energy efficiency programs designed to reduce energy consumption in Maryland, including appliance rebate and recycling, home energy check-ups, rebates on the purchase of energy efficiency equipment and services and discounts on energy efficient light bulbs and lighting fixtures. The MPSC has approved a customer surcharge through 2015 to recover Pepco’s and DPL’s costs associated with these energy efficiency programs.

 

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Pepco Energy Services

Pepco Energy Services is engaged in the following:

 

    Energy savings performance contracting business: designing, constructing and operating energy efficiency projects and distributed generation equipment, including combined heat and power plants, principally for federal, state and local government customers;

 

    Underground transmission and distribution business: providing underground transmission and distribution construction and maintenance services for electric utilities in North America; and

 

    Thermal business: providing steam and chilled water under long-term contracts through systems owned and operated by Pepco Energy Services, primarily to hotel casinos in Atlantic City, New Jersey.

The energy savings performance contracting business is highly competitive, and 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. Competitive offerings include a wide range of electrical and thermal system upgrades, improved controls, and generation equipment such as combined heat and power units. Among the factors as to which companies in this business compete are the amount and duration of the guarantees provided in energy savings performance contracts and the quality and value of service provided to customers. In connection with many of Pepco Energy Services’ energy savings performance contracts, Pepco Energy Services provides performance guarantees, including guarantees of a certain level of energy savings. This business is affected by new entrants into the market, the financial strength of customers, governmental directives regarding energy efficiency, energy prices, and general economic conditions. Pepco Energy Services’ backlog of construction contracts in this business decreased to $41 million at December 31, 2014 from $91 million at December 31, 2013. Pepco Energy Services estimates that it will complete the construction contracts in its 2014 backlog during 2015.

Most of Pepco Energy Services’ energy savings performance contracts with federal, state and local governments, as well as those with 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 which, if exercised, would require the other party to pay Pepco Energy Services for work performed through the date of termination and for additional costs incurred as a result of the termination.

Through its wholly owned subsidiary, W.A. Chester, L.L.C., and its subsidiaries, Pepco Energy Services constructs and maintains underground transmission and distribution projects for electric utilities in North America. W.A. Chester is one of the two largest North American contractors that specializes in the installation and maintenance of pipe-type cable systems, a technology that W.A. Chester believes currently accounts for the majority of existing underground transmission circuit miles in North America. W.A. Chester’s primary competitor in the pipe-type cable system market is UTEC Constructors Corporation, and there are several other contractors that do not specialize in this cable system but rather undertake installation projects on a more limited basis. W.A. Chester also competes in the market for the installation and maintenance of solid dielectric cable, which is a relatively newer technology compared to pipe-type cable systems. The solid dielectric cable installation and maintenance market is highly competitive and composed of numerous different competitors, and the barriers to entry in this market are relatively low. The principal factors for competition in both of these markets are price, experience, customer service and ability to handle a wide range of utility applications. W.A. Chester believes its competitive strengths in both of these markets are the breadth of its experience in working with both technologies in various utility applications (including new installations, modifications, upgrades and maintenance of existing systems), its in-depth knowledge of the U.S. and Canadian utility industries and utility customers’ needs, and its ability to manage successfully all phases of these projects for the

 

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customer. W.A. Chester’s backlog of construction contracts increased to $104 million at December 31, 2014 from $84 million at December 31, 2013. W.A. Chester estimates that it will complete $67 million of the construction contracts in its backlog in 2015 and $37 million in 2016.

Revenues associated with Pepco Energy Services’ combined heat and power thermal generating facilities and operations in Atlantic City are derived from long-term contracts with a few major customers in the Atlantic City hotel and casino industry. The carrying amount of Pepco Energy Services’ long-lived assets in Atlantic City at December 31, 2014 totaled $2 million, after impairment losses aggregating $81 million that were recorded during the third and fourth quarters of 2014. In September 2014, two significant customers of these thermal operations declared Chapter 11 bankruptcy. One of the customers closed operations in September 2014 and is seeking a buyer for its facility. The second customer announced that it would remain open in 2015 but that it could close operations later this year if it is unable to lower its operating costs. At September 30, 2014, PHI performed impairment tests on asset groups comprising substantially all of the long-lived assets associated with its thermal operations in Atlantic City and recorded an impairment loss of $53 million ($32 million after-tax) with respect to the most significant asset group (with a carrying amount, before the impairment loss, of $70 million at September 30, 2014). In light of recent developments regarding future business prospects with the two significant customers that declared bankruptcy in September 2014 (including their rejection of Pepco Energy Services’ long-term thermal contracts during February 2015, as part of these customers’ bankruptcy proceedings) and the fact that two other significant customers of the thermal operations declared Chapter 11 bankruptcy in January 2015, Pepco Energy Services again performed impairment tests on asset groups comprising substantially all of the long-lived assets associated with its thermal operations in Atlantic City at December 31, 2014. As a result, Pepco Energy Services recorded an additional impairment charge of $28 million ($16 million after-tax) in the fourth quarter of 2014 that was associated with the most significant asset group and another asset group. Future developments with respect to these and other customers in Atlantic City may require Pepco Energy Services to perform additional impairment analyses of the thermal operations and certain related assets. If these assets are determined to be further impaired, Pepco Energy Services would reduce the carrying value of these assets by the amount of the impairment and record a corresponding non-cash charge to earnings. Moreover, the contract rejections referred to above are expected to reduce Pepco Energy Services’ future earnings and cash flow associated with its thermal operations in Atlantic City.

PHI guarantees the obligations of Pepco Energy Services under certain contracts in its energy savings performance contracting business and underground transmission and distribution construction business. At December 31, 2014, PHI’s guarantees of Pepco Energy Services’ obligations under these contracts totaled $336 million. PHI also guarantees the obligations of Pepco Energy Services under surety bonds obtained by Pepco Energy Services for construction projects. These guarantees totaled $185 million at December 31, 2014.

During 2012, Pepco Energy Services deactivated its Buzzard Point and Benning Road oil-fired generation facilities. Pepco Energy Services is demolishing the Benning Road generation facility and realizing the scrap metal salvage value of the facility. The demolition of the facility commenced in the fourth quarter of 2013 and is expected to be completed in the first quarter of 2015. Pepco Energy Services is recognizing the salvage proceeds associated with the scrap metals at the facility as realized. At December 31, 2014, Pepco Energy Services owned five renewable energy generating facilities, with an aggregate generating capacity of 17,400 KW. See Part I, Item 2. “Properties – Generating Facilities” for more information about these facilities.

Discontinued Operations

Through its wholly owned subsidiary PCI, PHI maintained a portfolio of cross-border energy lease investments. During the third quarter of 2013, PHI completed the termination of its interests in its cross-border energy lease investments. These activities, which previously comprised substantially all of the operations of the Other Non-Regulated segment, have been accounted for as discontinued operations. The remaining operations of the Other Non-Regulated segment, which no longer meet the definition of a separate segment for financial reporting purposes, are included in Corporate and Other. Substantially all of the information in the notes to the consolidated financial statements of PHI with respect to the cross-border energy lease investments has been consolidated in Note (20), “Discontinued Operations – Cross-Border Energy Lease Investments.”

 

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In 2013, Pepco Energy Services completed a previously announced wind-down of its retail electric and retail natural gas supply businesses. These operations are being accounted for as discontinued operations and are no longer a part of the Pepco Energy Services segment for financial reporting purposes. Substantially all of the information in the notes to the consolidated financial statements of PHI with respect to Pepco Energy Services’ retail electric and retail natural gas supply businesses has been consolidated in Note (20), “Discontinued Operations – Retail Electric and Natural Gas Supply Businesses of Pepco Energy Services.”

Seasonality

Power Delivery

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 longstanding practice of tying the distribution charges paid by customers to kilowatt-hours of electricity used. 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 from utility customers in these jurisdictions 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 proposed for DPL electricity and natural gas customers in Delaware is under consideration by the DPSC although there was little activity in this matter in 2014. 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.

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.

Pepco Energy Services

The energy services business of Pepco Energy Services is not seasonal, except with respect to its thermal operations. The thermal operations of Pepco Energy Services provide steam and chilled water to customers year-round. Steam usage peaks during months with colder temperatures and chilled water usage peaks during months with warmer temperatures. The rates charged customers adjust quarterly for the cost of natural gas used to produce steam and electricity used to produce chilled water. Pepco Energy Services’ revenues and gross profit from its thermal operations will fluctuate based on the volumes of steam and chilled water delivered to customers.

 

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Regulation

The operations of PHI’s utility subsidiaries, including the rates and tariffs they are permitted to charge customers for the transmission and distribution 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 described above in “– PHI’s Utility Subsidiaries.” Rates and tariffs are established by these regulatory commissions.

As further described in Note (1), “Organization,” to the consolidated financial statements of PHI, on April 29, 2014, PHI entered into the Merger Agreement with Exelon and Merger Sub. Subject to certain exceptions, prior to the Merger or the termination of the Merger Agreement, PHI and its subsidiaries may not, without the consent of Exelon, initiate, file or pursue any rate cases, other than pursuing the conclusion of certain proceedings, as described in Note (7), “Regulatory Matters – Rate Proceedings,” to the consolidated financial statements of PHI.

In addition to the other regulatory matters described elsewhere in this section and in Note (7), “Regulatory Matters,” to the consolidated financial statements of PHI, provided below are summary descriptions of certain regulatory matters involving PHI’s utility subsidiaries.

Mitigation of Regulatory Lag

An important factor in the ability of PHI’s utility subsidiaries to earn their authorized ROE is the willingness of applicable public service commissions to adequately address the shortfall in revenues in a utility’s rate structure 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.” Pepco, DPL and ACE are currently experiencing significant regulatory lag because investments in rate base and operating expenses are increasing more rapidly than their revenue growth.

In an effort to minimize the effects of regulatory lag, prior to the initial execution of the Merger Agreement in April 2014, PHI’s utility subsidiaries had been filing electric distribution base rate cases every nine to twelve months in each of their jurisdictions, pursuing alternative ratemaking mechanisms, evaluating potential reductions in planned capital expenditures, and discussing with the regulatory community and other stakeholders the changing regulatory model economics that are causing regulatory lag.

As further described in Part II, Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations – General Overview – Agreement and Plan of Merger with Exelon Corporation,” PHI has entered into the Merger Agreement with Exelon and Merger Sub. Subject to certain exceptions, prior to the Merger or the termination of the Merger Agreement, PHI and its subsidiaries may not, without the consent of Exelon, initiate, file or pursue any rate cases, other than concluding pending filings. Accordingly, with the exception of ongoing rate cases (see Note (7), “Regulatory Matters – Rate Proceedings,” to the consolidated financial statements of PHI), PHI’s efforts to mitigate regulatory lag have been delayed pending the closing of the Merger or the termination of the Merger Agreement.

MAPP Settlement Agreement

For information about the Mid-Atlantic Power Pathway (MAPP) settlement agreement, please refer to Note (7), “Regulatory Matters – MAPP Settlement Agreement,” to the consolidated financial statements of PHI.

 

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MPSC New Generation Contract Requirement

For information about the MPSC new generation contract requirement, please refer to Note (7), “Regulatory Matters – MPSC New Generation Contract Requirement,” to the consolidated financial statements of PHI.

ACE Standard Offer Capacity Agreements

For information about the ACE Standard Offer Capacity Agreements, please refer to Note (7), “Regulatory Matters – ACE Standard Offer Capacity Agreements,” to the consolidated financial statements of PHI.

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.

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 $13.0 million in 2015, $9.3 million in 2016, $4.3 million in 2017 and $2.4 million in 2018. 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 PHI’s competitive 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 air quality and other environmental regulations 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 June 2012 deactivation of Pepco Energy Services’ Buzzard Point and Benning Road oil-fired generating facilities, both of which were considered major sources under the CAA, Pepco Energy Services received authorization in 2013 from the District Department of the Environment (DDOE) to exclude these major sources from the CAA Title V operating permits. DDOE also agreed to transfer the CAA Title V operating permit covering the remaining minor sources (e.g., Pepco-operated emergency generators) to Pepco. Pepco has filed minor source permit applications with DDOE for these minor sources.

Greenhouse Gas Emissions Reporting

In October 2009, the U.S. Environmental Protection Agency (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

 

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hydrofluorinated ethers) – in excess of specified thresholds to file annual reports with EPA disclosing the amount of such emissions. Under these regulations:

 

    By April 1 of each year, DPL is required to report 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 distributed to its customers during the previous calendar year. In addition, DPL is required to report fugitive CO2 and methane emissions for its gas distribution operations for the previous calendar year. DPL’s liquefied natural gas storage facility does not meet the reporting threshold (25,000 metric tons) for fugitive emissions.

 

    By April 1 of each year, 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 (generally confined, discrete conveyances such as pipes) 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 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 with a June 19, 2009 effective date, which authorizes discharges from the Benning Road facility, including the now deactivated Pepco Energy Services generating facility located at that site. The 2009 permit imposed 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 part of the implementation of the TMDL requirements, the permit also imposed numerical limits on certain substances in storm water discharges to the Anacostia River. Quarterly monitoring results since the issuance of the permit have shown consistent exceedances of the limits for copper and zinc, as well as occasional exceedances for iron and lead. As required by the permit, Pepco initiated a study to identify the potential sources of these regulated substances at the site and to determine appropriate best management practices for minimizing the presence of the substances in storm water discharges from the facility. The initial study report was completed in May 2012. Pepco has completed the implementation of the first two phases of the best management practices recommended in the study report (consisting principally of installing metal absorbing filters to capture contaminants from storm water flows, removing stored equipment from areas exposed to the weather, covering and painting exposed metal pipes, and covering and cleaning dumpsters). These measures have been effective in reducing metal concentrations in stormwater discharges; however, additional measures will be required to be implemented by Pepco to reduce the concentrations to levels required by the permit.

The NPDES permit was due to expire on June 19, 2014. Pepco submitted a permit renewal application on December 17, 2013. In November 2014, EPA advised Pepco that it will not renew the permit until the Benning Road facility has come into compliance with the existing permit limits. The current permit remains in effect pending EPA’s action on the renewal application. Pepco has prepared a plan to implement the third phase of the best management practices recommended in the study report with the objective of achieving full compliance with the permit limits by the end of 2015. The plan was submitted to EPA on December 30, 2014, and Pepco has begun implementing those best practices in accordance with the plan. Pepco anticipates that EPA may request that Pepco enter into an administrative compliance agreement with respect to the implementation of these additional control measures, and may seek administrative penalties for past noncompliance with the permit limits for metals in storm water. Whether such penalties will be imposed and, if so, the amount of any such penalties, is not known or estimable at this time. At present, Pepco expects that compliance with the permit limits can be achieved through a

 

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combination of enhanced storm drain inlet controls (filters and metal absorbing booms), enhanced site housekeeping, and enhanced inspection and maintenance of storm water controls. If these measures are not adequate to achieve compliance with the permit limits, however, it is possible that a capital project to install a storm water treatment system may be required. The need for any such capital expenditures will not be known until Pepco has implemented the third phase of the best management practices.

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 2014 for Pepco, DPL and ACE collectively were approximately $7.4 million. PHI projects total expenditures of approximately $29.0 million over the next five years for its subsidiaries to comply with these regulations, as shown in the capital expenditure projection set forth in “Environmental Matters” above, all of which are 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.

EPA Coal Combustion Residuals Regulations

In December 2014, EPA issued new regulations regarding coal combustion residuals, commonly known as coal ash, from coal-fired power plants. These regulations govern risks associated with coal ash disposal and establish recordkeeping and reporting requirements. The regulations also support the responsible recycling of coal ash by distinguishing safe and beneficial uses from disposal.

The regulations do not apply to inactive ash landfills that cease receiving coal ash prior to the effective date of the regulations, which will be six months after they are published in the Federal Register. Accordingly, the new regulations will not apply to PHI’s Edge Moor landfill, which was retained in the sale of the Conectiv Energy wholesale power generation business to Calpine Corporation in 2010. PHI also does not expect that these regulations will necessitate any changes to Pepco’s technical closure plan for the right-of-way that traverses the Brandywine fly ash disposal site in Brandywine, Prince George’s County, Maryland, because the technical closure plan is designed to comply with the more stringent Maryland landfill closure requirements.

Hazardous Substance Regulation

The Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CERCLA) 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. Each of Pepco, DPL and ACE has been named

 

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by EPA or a state environmental agency as a potentially responsible party in pending proceedings involving certain contaminated sites. For additional information on these matters, see Part II, 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.

Employees

At December 31, 2014, PHI had the following employees:

 

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

Pepco

     385         1,116         —           —           1,501   

DPL

     233         650         —           —           883   

ACE

     184         361         —           —           545   

Pepco Energy Services

     140         209         37         31         417   

PHI Service Company and Other

     1,432         347         —           —           1,779   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total PHI Employees

  2,374     2,683     37      31      5,125   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

PHI’s utility subsidiaries are parties to five collective bargaining agreements with four local unions. Collective bargaining agreements are generally renegotiated every three to five years. All of these collective bargaining agreements were renegotiated in 2014 and were extended through various dates ranging from October 2018 through June 2020.

 

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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 26, 2015, are set forth in the following table. The business experience of each executive officer during at least 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

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

David M. Velazquez

   55   

Executive Vice President

3/09 - Present (2)

Kevin C. Fitzgerald

   52   

Executive Vice President and General Counsel

9/12 - Present (3)

Frederick J. Boyle

   57   

Senior Vice President and Chief Financial Officer

4/12 - Present (4)

Kenneth J. Parker

   52   

Senior Vice President, Government Affairs and Corporate Citizenship

9/12 - Present (5)

Thomas H. Graham

   54   

Vice President

8/13 - Present (6)

Ronald K. Clark

   59   

Vice President and Controller

8/05 - Present

Laura L. Monica

   58   

Vice President

8/11 - Present (7)

Hallie M. Reese

   51   

Vice President, PHI Service Company

5/05 - Present

John U. Huffman

   55    President 6/06 - Present, and Chief Executive Officer, Pepco Energy Services, Inc.
3/09 - Present (8)

 

(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. Since October 10, 2014, Mr. Rigby has served as a director of Dominion Midstream GP, LLC, the general partner of Dominion Midstream Partners, LP (NYSE: DM), a publicly-traded limited partnership. On April 29, 2014, PHI entered into that certain Employment Extension Agreement with Mr. Rigby, which extended the term of his employment as PHI’s President and Chief Executive Officer for a period beginning on January 1, 2015 and ending on the first to occur of (1) April 29, 2016, (2) the closing date of the Merger or (3) the date that is six months after the Merger Agreement is terminated.
(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. From 1997 to 2012, he was a partner with the law firm of Troutman Sanders, LLP in Washington, D.C. 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 both companies 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 in September 2012. From June 2009 to September 2012, he served as Vice President of Public Policy of PHI. From March 2005 to June 2009, he served as the ACE Region President.
(6) Mr. Graham became Vice President, People Strategy and Human Resources, in August 2013. From March 2005 to August 2013, he served as the Pepco Region President.
(7) Ms. Monica joined PHI in August 2011 as Vice President, Corporate Communications. From October 2006 to October 2010, Ms. Monica was Senior Vice President, Corporate Communications at American Water Works Company, Inc. (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.
(8) 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

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.

 

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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 significantly affects 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 including setting rates at a level that may be inadequate to permit recovery of costs 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.

NERC’s eight regional oversight entities, including RF, of which Pepco, DPL, ACE and Pepco Energy Services are members, and the Northeast Power Coordinating Council (NPCC), of which Pepco Energy Services is a member, are charged with the day-to-day implementation and enforcement of NERC’s standards. RF and NPCC perform compliance audits on entities registered with NERC based on reliability standards and criteria established by NERC. NERC, RF 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 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 RF resolving alleged violations and resulting in fines. There can be no assurance that additional settlements resolving issues related to RF 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.

 

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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’s utility subsidiaries to obtain timely recognition of costs in rates may have a negative effect on PHI’s results of operations and financial condition.

The regulatory authorities that regulate PHI’s utility subsidiaries establish utility rates and tariffs intended to provide each 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, DPL and ACE 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.

For example, PHI’s utility subsidiaries are exposed to “regulatory lag,” which refers to a shortfall in revenues in a utility’s rate structure 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 investments in rate base and operating expenses are increasing more rapidly than their revenue growth. PHI anticipates that this trend will continue for the foreseeable future.

Prior to PHI’s initial execution of the Merger Agreement in April 2014, in an effort to minimize the effects of regulatory lag, PHI’s utility subsidiaries had been filing electric distribution base rate cases every nine to twelve months in each of their jurisdictions, pursuing alternative ratemaking mechanisms, evaluating potential reductions in planned capital expenditures, and discussing with the regulatory community and other stakeholders the changing regulatory model economics that are causing regulatory lag. Subject to certain exceptions, prior to the Merger or the termination of the Merger Agreement, PHI and its subsidiaries may not, without the consent of Exelon, initiate, file or pursue any rate cases, other than concluding pending filings. Any inability of PHI’s utility subsidiaries to mitigate regulatory lag could have a material adverse effect on PHI’s and each utility subsidiary’s business, results of operations, cash flow and financial condition.

The operating results of Power Delivery 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.

 

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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.

Facilities and related systems 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 and related systems involves many risks, including: the breakdown or failure of equipment; accidents; labor disputes; theft of copper wire or pipe; failure of computer systems, software or hardware; and performance below expected levels. Older facilities, systems 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, including tornadoes, hurricanes and snow and ice storms, also can disrupt transmission and distribution systems. Disruption of the operation of transmission or distribution facilities and related systems can reduce revenues and result in the incurrence of additional expenses that may not be recoverable from customers or through insurance.

Upgrades and improvements to computer systems and networks may require substantial amounts of management’s time and financial resources to complete, and may also result in system or network defects or operational errors due to employees’ inexperience of using a new or upgraded system. In January 2015, PHI’s utility subsidiaries implemented an integrated customer billing and information management system to replace separate existing legacy customer billing and information systems. There can be no assurance that this new system will not cause disruptions to the utility subsidiaries’ operations, which disruptions, if not anticipated and appropriately mitigated, could harm their business (individually or collectively) and have a material adverse effect on their results of operations, financial condition and cash flows.

In connection with the replacement of certain customers’ existing electric and natural gas meters with smart meters as part of the AMI system, Pepco and DPL were required to construct a wireless network across certain of their service territories and to implement and integrate new and existing information technology systems to collect and manage data made available by the smart meters and the AMI system. 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 and other governing bodies, 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

 

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be susceptible to less favorable legislative and regulatory outcomes, as well as increased regulatory oversight and more stringent regulatory requirements. Unfavorable regulatory outcomes can include the enactment of 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 more rigorous regulatory requirements may 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, in 2012, the MPSC adopted rules establishing reliability and customer service requirements. In April 2014, DPL filed a corrective action plan with the MPSC to address noncompliance in 2013 with certain of these reliability requirements. DPL expects to file an annual report in April 2015 indicating that it has not complied with certain of these requirements for 2014. 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. 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 may 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 already adopted or may in the future adopt reliability and customer service 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.

The resolution of tax matters involving PHI’s former cross-border energy lease investments may have a material negative impact on PHI’s results of operations and financial condition. (PHI only).

Prior to July 2013, a wholly owned subsidiary of PHI had maintained a portfolio of cross-border energy lease investments involving public utility assets located outside of the United States, which investments were terminated during the third quarter of 2013 prior to the expiration date of the leases. The aggregate financial impact to PHI of the completion of these early terminations resulted in a pre-tax loss, including transaction costs, of approximately $3 million ($2 million after-tax) for the year ended December 31, 2013.

These cross-border energy lease investments, each of which was 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. In January 2012, PHI commenced litigation in the U.S. Court of Federal Claims regarding the disallowance of certain tax benefits claimed by PHI on its federal tax returns for 2001 and 2002.

 

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In January 2013, the U.S. Court of Appeals for the Federal Circuit issued an opinion in an unrelated case that disallowed tax benefits associated with a lease-in, lease-out transaction. After analyzing this ruling, in the first quarter of 2013, PHI determined that its tax position with respect to the tax benefits associated with its cross-border energy leases no longer met the more-likely-than-not standard of recognition for accounting purposes. Accordingly, PHI recorded non-cash charges of $383 million (after-tax) in the first half of 2013, consisting of a non-cash charge to reduce the carrying value of the cross-border energy lease investments and a non-cash charge to reflect the anticipated additional interest expense related to changes in estimated federal and state income tax obligations for the period over which the tax benefits may be disallowed.

After consideration of certain tax benefits arising from matters unrelated to these lease investments, PHI estimated that, as of March 31, 2013, it would have been obligated to pay approximately $192 million in additional federal and state taxes and approximately $50 million of interest on the additional federal and state taxes. In order to mitigate PHI’s ongoing interest costs associated with the $242 million estimate of additional taxes and interest, PHI made an advanced payment to the IRS of $242 million in the first quarter of 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. In order to mitigate the cost of continued litigation related to the cross-border energy lease investments, PHI and its subsidiaries have entered into discussions with the IRS with the intention of seeking a settlement of all tax issues for open tax years 2001 through 2011, including the cross-border energy lease issue. PHI currently believes that it is possible that a settlement with the IRS may be reached in 2015. If a settlement of all tax issues or a standalone settlement on the cross-border energy leases is not reached, PHI may move forward with its litigation with the IRS. Further discovery in the case is stayed until March 19, 2015, pursuant to an order issued by the court on December 2, 2014.

Given the uncertainties associated with PHI’s litigation with the IRS, as well as with other efforts by PHI to address and resolve tax matters associated with its former cross-border energy leases in tax years not subject to this litigation, the aggregate financial impact, and timing of the resolution, of all of these matters cannot be determined presently; however, PHI presently believes that any such impact on PHI’s consolidated results of operations and financial condition could be material.

Power Delivery’s transmission facilities 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 interstate power transmission 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, distributed generation and conservation measures may adversely affect Power Delivery.

Increased conservation and end-user generation made possible through current or future advances in technology, such as through fuel and solar (photovoltaic) cells, wind power and microturbines, could reduce demand for the transmission and distribution facilities of Power Delivery and adversely affect the results of operations of PHI and one or more of its utility subsidiaries. Alternative technologies that

 

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produce electricity, the development of which has expanded due to climate change and other environmental concerns, could ultimately provide alternative sources of electricity and permit current customers to adopt distributed generation systems which would allow them to generate electricity for their own use. As these and other technologies are created, developed and improved, the quantity and frequency 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, greenhouse gas emissions 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.

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

As of December 31, 2014, 54% of employees of PHI and its subsidiaries, collectively, were represented by various labor unions. PHI’s utility 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. All of these collective bargaining agreements were renegotiated in 2014. Labor negotiations typically involve bargaining over wages, benefits and working conditions, including management rights. Although PHI believes that protracted work stoppages are 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.

 

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Pepco Energy Services’ thermal business in Atlantic City, New Jersey is exposed to customer concentration, and the loss of one or more of its significant customers would have a material adverse effect on Pepco Energy Services’ results of operations and cash flow. (PHI only)

Revenues associated with Pepco Energy Services’ combined heat and power thermal generating facilities and operations in Atlantic City are derived from long-term contracts with a few major customers in the Atlantic City hotel and casino industry, some of which are experiencing significant financial difficulties and have closed or have contemplated closing operations. During 2014, PHI performed impairment tests on the most significant asset groups comprising these facilities and operations and recorded impairment losses of $81 million ($48 million after-tax) with respect to the two most significant asset groups. Two significant thermal business customers declared Chapter 11 bankruptcy in September 2014, and in February 2015, rejected Pepco Energy Services’ long-term thermal contracts as part of these customers’ bankruptcy proceedings. These contract rejections are expected to reduce Pepco Energy Services’ future earnings and cash flow associated with its thermal operations in Atlantic City and further reductions in future earnings and cash flows may occur if Pepco Energy Services’ thermal customers continue to experience financial difficulties.

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 be material and could adversely affect PHI’s results of operations, cash flow and financial condition.

Pepco Energy Services’ obligations in connection with its combined heat and power construction projects, energy savings construction projects and energy savings performance contracts may have a material adverse effect on PHI. (PHI only)

Pepco Energy Services has undertaken projects which include design, construction, startup and testing activities related to combined heat and power and energy savings construction projects, 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. Under a number of these projects, the customer of Pepco Energy Services has required Pepco Energy Services to obtain surety bonds securing the performance of Pepco Energy Services, or its subcontractors or vendors. PHI has been required to guarantee the performance of Pepco Energy Services under the surety bonds and certain of these construction contracts. PHI also guarantees the obligations of Pepco Energy Services under certain of its energy savings performance contracts. At December 31, 2014, PHI’s guarantees of Pepco Energy Services’ obligations under its energy savings performance, combined heat and power, and construction contracts totaled $336 million, and PHI’s guarantees of Pepco Energy Services’ obligations under surety bonds for construction projects totaled $185 million.

 

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As a result, PHI may bear responsibility in the event of unexcused failures by Pepco Energy Services or its subcontractors or vendors to perform in accordance with the terms of these contracts, or if the customer does not realize the energy savings provided for in a performance contract. When such events occur, Pepco Energy Services and PHI may experience reputational harm and claims for money damages and other relief that may be sought in connection with such contracts, guarantees and surety bonds, which could, depending upon the nature of the claim and the amount of damages or other relief sought, have a material adverse effect upon Pepco Energy Services’ and 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:

 

    PHI’s 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 PHI’s 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, and risks related to economic conditions and changes in demand for electricity and natural gas in the service territories of PHI’s utility subsidiaries (including changes due to or in connection with the loss of one or more commercial customers of a utility subsidiary), 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, and a failure to successfully identify, assess, manage or mitigate such risks may have a material adverse effect on the business, results of operations, cash flow or financial condition of one or more of the Reporting Companies.

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. To mitigate contractual or credit risk, PHI or a subsidiary may give to or receive from the counterparty collateral or other types of performance assurance, 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, the lowered rating or insolvency of the issuer or guarantor, changes in the power supply other market prices and other events may prevent a party from being able to meet its obligations or may degrade the value of collateral, letters of credit and guarantees, and the collateral, guarantee or other performance assurance provided may prove insufficient to protect against all losses that a party may ultimately suffer. 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 or other guarantees held or payments received.

 

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

The threat of, or actual acts of, terrorism or cyber attacks 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 or a cyber attack, the operations of PHI, Pepco, DPL or ACE could be adversely affected. Furthermore, any threats or actions that negatively impact the physical security of the facilities of PHI or its subsidiaries, or the integrity or security of their computer networks and systems (and any programs or data stored thereon or therein), could adversely affect the ability of PHI or its subsidiaries 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. In addition, any theft, loss or fraudulent use of customer, stockholder, employee or proprietary data as a result of a cyber attack or otherwise could subject PHI or its subsidiaries to significant litigation, liability and costs, as well as adversely impact PHI’s or its utility subsidiaries’ reputation with customers, stockholders and regulators, among others. 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.

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 Financial Accounting Standards Board (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, taxation requirements, federal securities laws and regulations and other laws and regulations (including pursuant to federal and state administrative grant programs) 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

 

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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, property or other losses that PHI and its subsidiaries might incur.

PHI and its subsidiaries, including Pepco, DPL and ACE, as well as Pepco Energy Services, 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 and losses, such as weather related casualties, may not be insurable, and, where a risk has been insured, a risk or loss may be deemed to be excluded from coverage or coverage may otherwise be denied in whole or in part. PHI has also obtained insurance to provide coverage for a portion of the losses and damages that may result from a security breach of its or its utility subsidiaries’ information technology systems. In the case of loss or damage to property, plant, equipment, data or other assets, there is no assurance that the insurance proceeds received, if any, will be sufficient to cover the entire loss, including costs of replacement or repair.

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

PHI and its subsidiaries, including Pepco, DPL and ACE, have significant capital requirements, including the funding of construction expenditures and the refinancing of maturing debt. Each of the Reporting Companies relies primarily on cash flow from operations, access to the capital markets and medium- and long-term bank financing, to meet these long-term financing needs. The operating activities of PHI and its subsidiaries also require continued access to short-term sources of liquidity, including issuances by a Reporting Company of commercial paper and access to money markets and short-term bank financing, to provide for short-term liquidity needs that are not met by cash flows 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 these sources of short-term and long-term capital. 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.

 

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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 each Reporting Company 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 a Reporting Company under review for potential downgrade in certain circumstances or if any of them seek to take certain actions that it believes would otherwise be in its best interests. 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 agreements that govern PHI’s primary credit facility 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, 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 each Reporting Company’s operational and financing flexibility.

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, potential IRS taxes, interest and penalties associated with PHI’s former 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 limitations on its operational and financial flexibility 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 the 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 the 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

 

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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, 2014, 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, but are not limited to: an adverse change in business conditions; a protracted decline in stock price causing market capitalization to fall significantly below book value; an adverse regulatory action; impairment of long-lived assets in the reporting unit; or a change in identified reporting units. 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, results of operations and cash flow.

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 projected 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 projected 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 as well as a decline in the rate of return on 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 present value of 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;

 

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    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. Section 203 does not apply to the Merger.

In addition, and notwithstanding the proposed Merger with Exelon, 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. For example, 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.

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. As of January 26, 2015, there were 14,400 shares of PHI Preferred Stock issued and outstanding. See Part II, Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations – General Overview – Agreement and Plan of Merger with Exelon Corporation,” for information regarding the outstanding Preferred Stock.

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

 

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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.

PHI and Exelon may be unable to obtain the required governmental, regulatory and other approvals required to complete the Merger, or such approvals may require the combined company to comply with material restrictions or conditions.

Consummation of the Merger is subject to the satisfaction or waiver of specified closing conditions, including, as of February 26, 2015, the receipt of regulatory approvals required to consummate the Merger from the DCPSC, the MPSC and the DPSC, and other customary closing conditions. The regulatory and other approvals required to consummate the Merger may not be obtained at all, may not be obtained on the proposed terms and schedules as contemplated by the parties, and/or may impose terms, conditions, obligations or commitments that constitute a “burdensome condition” (as defined in the Merger Agreement). In the event that the regulatory approvals include any such burdensome conditions, or if any of the conditions to closing are not satisfied prior to the termination date specified in the Merger Agreement, Exelon will not be obligated to consummate the Merger.

In the event that the Merger Agreement is terminated prior to the completion of the Merger, PHI could incur significant transaction costs that could materially impact its financial performance and results.

PHI will incur significant transaction costs, including legal, accounting, financial advisory, filing, printing and other costs, relating to the Merger. If (i) the Merger Agreement is terminated under certain specified circumstances, PHI will be required to pay Exelon a termination fee of $259 million or reimburse Exelon for its expenses up to $40 million (which reimbursement shall reduce on a dollar for dollar basis any termination fee subsequently payable by PHI), or (ii) if the Merger Agreement is terminated in connection with an acquisition proposal made under certain circumstances by a person who made an acquisition proposal between April 1, 2014 and the date of the Merger Agreement, PHI will be required to pay Exelon a termination fee of $293 million plus reimbursement of Exelon for its expenses up to $40 million (not subject to offset). The occurrence of either of these events could have a material adverse effect on PHI’s financial results.

PHI and its subsidiaries will be subject to business uncertainties and contractual restrictions while the Merger is pending that could adversely affect PHI’s financial results.

Uncertainty about the effect of the Merger on employees or vendors and others may have an adverse effect on PHI. Although PHI intends to take steps designed to reduce any adverse effects, these uncertainties may impair PHI’s and its subsidiaries’ ability to attract, retain and motivate key personnel until the Merger is completed, and could cause vendors and others that deal with PHI to seek to change existing business relationships. Employee retention and recruitment may be particularly challenging prior to the completion of the Merger, as current employees and prospective employees may experience uncertainty about their future roles with the combined company. If, despite PHI’s retention and recruiting efforts, key employees depart or fail to accept employment with PHI or its subsidiaries due to the uncertainty and difficulty of integration or a desire not to remain with the combined company, PHI’s business operations and financial results could be adversely affected.

PHI expects that matters relating to the Merger and integration-related issues will place a significant burden on management, employees and internal resources, which could otherwise have been devoted to other business opportunities. The diversion of management time on Merger-related issues could affect PHI’s financial results. In addition, the Merger Agreement restricts PHI and its subsidiaries, without Exelon’s consent, from taking specified actions until the Merger occurs or the Merger Agreement is terminated, including, without limitation: (i) making certain acquisitions and dispositions of assets or

 

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property; (ii) exceeding certain capital spending limits; (iii) incurring indebtedness; (iv) issuing equity or equity equivalents; and (v) increasing the dividend rates on its stock. These restrictions may prevent PHI from pursuing otherwise attractive business opportunities and making other changes to its business prior to consummation of the Merger or termination of the Merger Agreement.

Pending or potential future litigation against PHI and its directors challenging the proposed Merger may prevent the Merger from being completed within the anticipated timeframe.

PHI and its directors have been named as defendants in a purported consolidated state class action lawsuit and a substantially similar purported federal class action lawsuit filed on behalf of public stockholders challenging the proposed Merger and seeking, among other things, to enjoin the defendants from consummating the Merger on the agreed-upon terms. If a plaintiff in these lawsuits or any other litigation that may be filed in the future is successful in obtaining an injunction prohibiting the parties from completing the Merger on the terms contemplated by the Merger Agreement, the injunction may prevent the completion of the Merger in the expected timeframe or altogether.

While PHI believes that these lawsuits are without merit, to avoid the risk of litigation delaying or adversely affecting the Merger and to minimize the expense of defending such litigation, on September 12, 2014, PHI entered into a memorandum of understanding with the plaintiffs to document the agreement in principle for the settlement of the state court lawsuit. There can be no assurance that the parties will ultimately enter into a stipulation of settlement or that the state court will approve the settlement even if the parties were to enter into such stipulation. In such event, the proposed settlement as contemplated by the memorandum of understanding may be terminated, which would create additional uncertainty relating to the consummation of the Merger.

Failure to complete the Merger could negatively impact the market price of PHI’s common stock.

Failure to complete the Merger may negatively impact the future trading price of PHI’s common stock. If the Merger is not completed, the market price of PHI’s common stock may decline to the extent that the current market price of PHI’s stock reflects a market assumption that the Merger will be completed.

Additionally, if the Merger is not completed, PHI will have incurred significant costs, as well as the diversion of the time and attention of management. A failure to complete the Merger may also result in negative publicity, litigation against PHI or its directors and officers, and a negative impression of PHI in the investment community. The occurrence of any of these events individually or in combination could have a material adverse effect on PHI’s financial condition, results of operations and its stock price.

 

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Item 1B. UNRESOLVED STAFF COMMENTS

Pepco Holdings

None.

Pepco

None.

DPL

None.

ACE

None.

 

Item 2. PROPERTIES

Transmission and Distribution Systems

On a combined basis, the electric transmission and distribution systems owned by Pepco, DPL and ACE at December 31, 2014, 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 224,744 Mcf per day. DPL also owns approximately 104 pipeline miles of natural gas transmission mains, 1,874 pipeline miles of natural gas distribution mains, and 1,322 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 (10), “Debt” to the consolidated financial statements of PHI.

 

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Generating Facilities

The following table identifies the electric generating facilities owned by PHI’s subsidiaries at December 31, 2014.

 

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.

 

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 (12), “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 (14), “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 (13), “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
Per Share
     Price Range  
        High      Low  

2014:

        

First Quarter

   $ 0.27      $ 20.93       $ 18.53   

Second Quarter

     0.27        27.90         20.09   

Third Quarter

     0.27        27.92         26.76   

Fourth Quarter

     0.27        27.65        26.35  
  

 

 

       
$ 1.08  
  

 

 

       

2013:

First Quarter

$ 0.27   $ 21.43    $ 18.82   

Second Quarter

  0.27     22.72      19.35   

Third Quarter

  0.27     20.90      18.04   

Fourth Quarter

  0.27     19.62      18.19   
  

 

 

       
$ 1.08  
  

 

 

       

At February 13, 2015, there were 43,769 holders of record of Pepco Holdings common stock.

Dividends

On January 22, 2015, the PHI Board of Directors declared a dividend on common stock of 27 cents per share payable March 31, 2015, to shareholders of record on March 10, 2015.

See Part II, Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Capital Resources and Liquidity – Capital Requirements – Dividends,” and Note (12), “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 to 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 2014, PHI made capital contributions of $80 million and $130 million to Pepco and DPL, respectively, and in 2013, PHI made capital contributions of $175 million and $75 million to Pepco and ACE, respectively.

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 Conectiv, during each quarter in the last two years. Dividends received by PHI in 2014 and 2013 from Pepco were used to support the payment of its common stock dividend. Dividends paid by ACE and DPL in 2014 and 2013 were used by Conectiv to pay down its short-term debt owed to PHI.

 

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     Pepco      DPL      ACE  

2014:

        

First Quarter

   $ —         $ 20,000,000       $ 26,000,000   

Second Quarter

     46,000,000         —           —     

Third Quarter

     —           —           —     

Fourth Quarter

     40,000,000         80,000,000         —     
  

 

 

    

 

 

    

 

 

 
$ 86,000,000    $ 100,000,000    $ 26,000,000   
  

 

 

    

 

 

    

 

 

 

2013:

First Quarter

$ —      $ —      $ —     

Second Quarter

  15,000,000      20,000,000      —     

Third Quarter

  31,000,000      10,000,000      25,000,000   

Fourth Quarter

  —        —        35,000,000   
  

 

 

    

 

 

    

 

 

 
$ 46,000,000    $ 30,000,000    $ 60,000,000   
  

 

 

    

 

 

    

 

 

 

Recent Sales of Unregistered Equity Securities

Pepco Holdings

None.

Pepco

None.

DPL

None.

ACE

None.

 

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Purchases of Equity Securities by the Issuer and Affiliated Purchasers

Pepco Holdings

The following table includes shares of common stock accepted by Pepco Holdings during the quarter ended December 31, 2014 from certain employees in accordance with the provisions of the Pepco Holdings 2012 Long-Term Incentive Plan (2012 LTIP) to satisfy the employees’ minimum statutory tax withholding obligations related to awards of restricted stock under the 2012 LTIP that were granted in December 2014. Pepco Holdings does not currently have any publicly announced plans or programs to repurchase its common stock.

 

Period

   Total
Number of
Shares
Accepted (a)
     Average Price
Per Share
 

October 1 – October 31, 2014

     —           —     

November 1 – November 30, 2014

     —           —     

December 1 – December 31, 2014

     29,065       $ 27.01 (b) 
  

 

 

    

Total

  29,065    $ 27.01   
  

 

 

    

 

(a) Includes shares of Pepco Holdings’ common stock accepted from certain employees under the 2012 LTIP to satisfy the employees’ minimum statutory tax withholding obligations related to awards of restricted stock, which shares of common stock were then held in treasury.
(b) Represents the average of the high and low trading prices of a share of common stock on the New York Stock Exchange (NYSE) on the date of grant of the shares of restricted stock.

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 each of the years ended December 31, 2014, 2013, 2012, 2011 and 2010, derived from PHI’s audited consolidated financial statements.

PEPCO HOLDINGS CONSOLIDATED FINANCIAL HIGHLIGHTS

 

     2014     2013     2012      2011      2010  
     (in millions, except per share data)  

Consolidated Operating Results

            

Total Operating Revenue

   $ 4,878     $ 4,666     $ 4,625       $ 4,964      $ 5,407  

Net Income from Continuing Operations

     242 (a)      110  (b)      218         222        91 (c) 

Net Income (Loss)

     242        (212     285         257        32  

Common Stock Information

            

Basic Earnings Per Share of Common Stock from Continuing Operations

   $ 0.96      $ 0.45     $ 0.95       $ 0.98      $ 0.41  

Basic Earnings (Loss) Per Share of Common Stock

     0.96        (0.86     1.25         1.14        0.14  

Weighted Average Shares Outstanding—Basic

     251       246       229         226        224  

Cash Dividends Per Share of Common Stock

     1.08       1.08       1.08         1.08        1.08  

Year-End Stock Price

     26.93       19.13       19.61         20.30        18.25  

Net Book Value Per Common Share

     17.10       17.23       19.19         18.92        18.65  

Other Information

            

Total Assets

   $ 15,667     $ 14,848     $ 15,794       $ 15,001      $ 14,654  

Capitalization

            

Short-Term Debt

   $ 729     $ 565     $ 965       $ 732      $ 534  

Long-Term Debt

     4,441       4,053       3,648         3,794        3,629  

Current Portion of Long-Term Debt and Project Funding

     431       446       569         112        75  

Transition Bonds issued by ACE Funding

     171       214       256         295        332  

Capital Lease Obligations Due Within One Year

     10       9       8         8        8  

Capital Lease Obligations

     50       60       70         78        86  

Long-Term Project Funding

     8       10       12         13        15  

Series A Preferred Stock

     129       —         —           —          —    

Non-controlling Interest

     —         —         —           —          6  

Common Shareholders’ Equity

     4,322       4,315       4,414         4,304        4,198  
  

 

 

   

 

 

   

 

 

    

 

 

    

 

 

 

Total Capitalization

$ 10,291   $ 9,672   $ 9,942    $ 9,336   $ 8,883  
  

 

 

   

 

 

   

 

 

    

 

 

    

 

 

 

 

(a) Includes impairment losses of $81 million ($48 million after-tax) associated with Pepco Energy Services’ combined heat and power thermal generating facilities and operations in Atlantic City and $25 million ($23 million after-tax) of incremental merger-related transaction costs.
(b) Includes a charge of $101 million to establish valuation allowances related to certain PCI deferred tax assets and a charge of $66 million to reflect the anticipated additional interest expense on estimated federal and state income tax obligations resulting from the change in assessment of the tax benefits associated with the cross-border energy lease investments.
(c) Includes a loss on extinguishment of debt of $189 million ($113 million after-tax).

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.

 

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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

     50   

Pepco

     102  

DPL

     113  

ACE

     124  

 

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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, to a lesser extent, the distribution and supply of natural gas (Power Delivery). Through Pepco Energy Services, PHI provides energy savings performance contracting services, underground transmission and distribution construction and maintenance services and steam and chilled water under long-term contracts. For additional discussion, see “Pepco Energy Services” below.

Each of Power Delivery and Pepco Energy Services constitutes a separate segment for financial reporting purposes. Through its subsidiary PCI, PHI maintained a portfolio of cross-border energy lease investments. PHI completed the termination of its interests in its cross-border energy lease investments during 2013. As a result, the cross-border energy lease investments, which comprised substantially all of the operations of the Other Non-Regulated segment, have been accounted for as discontinued operations. The remaining operations of the Other Non-Regulated segment, which no longer meet the definition of a separate segment for financial reporting purposes, have been included in Corporate and Other.

The following table sets forth the percentage contributions to consolidated operating revenue and operating income from continuing operations attributable to PHI segments for each of the preceding three years:

 

     2014     2013     2012  

Percentage of Consolidated Operating Revenue

      

Power Delivery

     94     96     95

Pepco Energy Services

     6     4     6

Corporate and Other

     —          —          (1 )% 

Percentage of Consolidated Operating Income

      

Power Delivery

     114     97     98

Pepco Energy Services

     (13 )%     —          (3 )% 

Corporate and Other

     (1 )%      3     5

Percentage of Consolidated Operating Revenue—Power Delivery

      

Power Delivery Electric

     96     96     96

Power Delivery Gas

     4     4     4

Agreement and Plan of Merger with Exelon Corporation

PHI entered into the Merger Agreement, with Exelon and Merger Sub, providing for the Merger, with PHI surviving the Merger as an indirect, wholly owned subsidiary of Exelon. Pursuant to the Merger Agreement, at the effective time of the Merger, each outstanding share of common stock of PHI (other than (i) shares owned by Exelon, Merger Sub or any other direct or indirect wholly owned subsidiary of Exelon and shares owned by PHI or any direct or indirect wholly owned subsidiary of PHI, and in each case not held on behalf of third parties (but not including shares held by PHI in any rabbi trust or similar arrangement in respect of any compensation plan or arrangement) and (ii) shares that are owned by stockholders who have perfected and not withdrawn a demand for appraisal rights pursuant to Delaware law), will be canceled and converted into the right to receive $27.25 in cash, without interest.

 

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In connection with entering into the Merger Agreement, PHI entered into the Subscription Agreement with Exelon, pursuant to which on April 30, 2014, PHI issued to Exelon 9,000 originally issued shares of the Preferred Stock, for a purchase price of $90 million. Exelon also committed pursuant to the Subscription Agreement to purchase 1,800 originally issued shares of Preferred Stock for a purchase price of $18 million at the end of each 90-day period following the date of the Subscription Agreement until the Merger closes or is terminated, up to a maximum of 18,000 shares of Preferred Stock for a maximum aggregate consideration of $180 million. In accordance with the Subscription Agreement, on each of July 29, 2014, October 27, 2014 and January 26, 2015, an additional 1,800 shares of Preferred Stock were issued by PHI to Exelon for a purchase price of $18 million. The holders of the Preferred Stock will be entitled to receive a cumulative, non-participating cash dividend of 0.1% per annum, payable quarterly, when, as and if declared by PHI’s board of directors. The proceeds from the issuance of the Preferred Stock are not subject to restrictions and are intended to serve as a prepayment of any applicable reverse termination fee payable from Exelon to PHI. The Preferred Stock will be redeemable on the terms and in the circumstances set forth in the Merger Agreement and the Subscription Agreement.

Consummation of the Merger is subject to the satisfaction or waiver of specified closing conditions, including (i) the approval of the Merger by the holders of a majority of the outstanding shares of common stock of PHI; (ii) the receipt of regulatory approvals required to consummate the Merger, including approvals from FERC, the FCC, the DPSC, the DCPSC, the MPSC, the NJBPU and the VSCC; (iii) the expiration or termination of the applicable waiting period under the HSR Act; and (iv) other customary closing conditions, including (a) the accuracy of each party’s representations and warranties (subject to customary materiality qualifiers) and (b) each party’s compliance with its obligations and covenants contained in the Merger Agreement (including covenants that may limit, restrict or prohibit PHI and its subsidiaries from taking specified actions during the period between the date of the Merger Agreement and the closing of the Merger or the termination of the Merger Agreement). In addition, the obligations of Exelon and Merger Sub to consummate the Merger are subject to the required regulatory approvals not imposing terms, conditions, obligations or commitments, individually or in the aggregate, that constitute a burdensome condition (as defined in the Merger Agreement).

On September 23, 2014, the stockholders of PHI approved the Merger, on October 7, 2014, the VSCC approved the Merger, and on November 20, 2014, FERC approved the Merger. On December 22, 2014, the applicable waiting period under the HSR Act expired, and the HSR Act no longer precludes completion of the Merger. Although the DOJ allowed the waiting period under the HSR Act to expire without taking any action with respect to the Merger, the DOJ has not advised PHI that it has concluded its investigation. In addition, the transfer of control of certain communications licenses held by certain of PHI’s subsidiaries has been approved by the FCC. The NJBPU approved the Merger on February 11, 2015. On February 13, 2015, Pepco Holdings, DPL, Exelon, certain of Exelon’s affiliates, the Staff of the DPSC and certain other parties, filed a settlement agreement with the DPSC with respect to the Merger. This settlement agreement is subject to approval by the DPSC.

The Merger Agreement may be terminated by each of PHI and Exelon under certain circumstances, including if the Merger is not consummated by July 29, 2015 (subject to extension by PHI or Exelon to October 29, 2015, if all of the conditions to closing, other than the conditions related to obtaining regulatory approvals, have been satisfied). The Merger Agreement also provides for certain termination rights for both PHI and Exelon, and further provides that, upon termination of the Merger Agreement under certain specified circumstances, PHI will be required to pay Exelon a termination fee of $259 million or reimburse Exelon for its expenses up to $40 million (which reimbursement of expenses shall reduce on a dollar for dollar basis any termination fee subsequently payable by PHI), provided, however, that if the Merger Agreement is terminated in connection with an acquisition proposal made under certain circumstances by a person who made an acquisition proposal between April 1, 2014 and the date of the Merger Agreement, the termination fee will be $293 million plus reimbursement of Exelon for its expenses up to $40 million (not subject to offset). In addition, in the event of a Regulatory Termination, PHI will be able to redeem any issued and outstanding Preferred Stock at par value. If the Merger Agreement is terminated, other than for a Regulatory Termination, PHI will be required to redeem the Preferred Stock at the purchase price of $10,000 per share, plus any unpaid accrued and accumulated dividends thereupon.

 

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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.

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 federal and municipal government services, professional, scientific and technical services, educational and health services, banking, casinos, tourism and transportation.

 

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

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. These supply service obligations are referred to generally as Default Electricity Supply.

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 generally, the level of commercial activity affecting a region, industry or business sector within a service territory, 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 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.

 

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PHI’s utility subsidiaries allocate a substantial portion of their total capital expenditures to improving the reliability of their electrical transmission and distribution systems and replacing aging infrastructure throughout their service territories. These activities include:

 

    identifying and upgrading under-performing feeder lines;

 

    adding new facilities to support load;

 

    installing distribution automation systems on both the overhead and underground network systems; and

 

    rejuvenating and replacing underground residential cables.

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

Power Delivery Initiatives and Activities

District of Columbia Power Line Undergrounding Initiative

For information about the District of Columbia Power Line Undergrounding Initiative, please refer to Note (7), “Regulatory Matters – District of Columbia Power Line Undergrounding Initiative,” to the consolidated financial statements of PHI.

MPSC New Generation Contract Requirement

For information about the MPSC New Generation Contract Requirement, please refer to Note (7), “Regulatory Matters – MPSC New Generation Contract Requirement,” to the consolidated financial statements of PHI.

Smart Grid Initiatives

PHI’s utility subsidiaries are engaged in transforming the power grid that they own and operate into a “smart grid,” a network of automated digital devices capable of collecting and communicating large amounts of real-time data.

A central component of the smart grid is AMI, a system that collects, measures and analyzes energy usage data from advanced digital meters, known as “smart meters.” 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 the AMI system and distribution automation are enabled by advanced technology that communicates with devices installed on the energy delivery system and transmits energy usage data to the host utility. The implementation of the AMI system and distribution automation involves an integration of technologies provided by multiple vendors.

As of December 31, 2014, Pepco and DPL have completed the installation and activation of smart meters in the District of Columbia, Maryland and Delaware service territories. The DCPSC, the MPSC and the DPSC approved the creation by PHI’s utility subsidiaries of regulatory assets to defer AMI costs between rate cases and to defer carrying charges on the deferred costs. Thus, these costs will be recovered in the future through base rates; however, for AMI costs incurred by Pepco in Maryland with respect to test years after 2011, pursuant to an MPSC order, the recovery of such costs will be allowed when Pepco demonstrates that the AMI system is cost-effective. The MPSC’s July 2013 order in Pepco’s November 2012 electric distribution base rate application excluded the cost of AMI meters from Pepco’s rate base until such time as Pepco demonstrates the cost effectiveness of the AMI system. As a result, costs for AMI meters incurred with respect to the 2012 test year and beyond will be treated as other incremental AMI costs incurred in conjunction with the deployment of the AMI system that are deferred and on which a carrying charge is deferred.

 

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In 2010, two of PHI’s utility subsidiaries were granted cash awards in the aggregate amount of $168 million by the U.S. Department of Energy to support their smart grid initiatives.

 

    Pepco was awarded $149 million for AMI, direct load control, distribution automation and communications infrastructure, of which $148 million has been received through December 31, 2014.

 

    ACE was awarded $19 million for direct load control, distribution automation and communications infrastructure, all of which has been received through December 31, 2014.

Mitigation of Regulatory Lag

An important factor in the ability of PHI’s utility subsidiaries to earn their authorized ROE is the willingness of applicable public service commissions to adequately address the shortfall in revenues in a utility’s rate structure 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.” Pepco, DPL and ACE are currently experiencing significant regulatory lag because investments in rate base and operating expenses are increasing more rapidly than their revenue growth.

In an effort to minimize the effects of regulatory lag, prior to the initial execution of the Merger Agreement in April 2014, PHI’s utility subsidiaries had been filing electric distribution base rate cases every nine to twelve months in each of their jurisdictions, pursuing alternative ratemaking mechanisms, evaluating potential reductions in planned capital expenditures, and discussing with the regulatory community and other stakeholders the changing regulatory model economics that are causing regulatory lag.

As further described in “– Agreement and Plan of Merger with Exelon Corporation,” PHI has entered into the Merger Agreement with Exelon and Merger Sub. Subject to certain exceptions, prior to the Merger or the termination of the Merger Agreement, PHI and its subsidiaries may not, without the consent of Exelon, initiate, file or pursue any rate cases, other than concluding pending filings. Accordingly, with the exception of ongoing rate cases (see Note (7), “Regulatory Matters – Rate Proceedings,” to the consolidated financial statements of PHI), PHI’s efforts to mitigate regulatory lag have been delayed pending the closing of the Merger or the termination of the Merger Agreement.

MAPP Settlement Agreement

For information about the MAPP settlement agreement, please refer to Note (7), “Regulatory Matters – MAPP Settlement Agreement,” to the consolidated financial statements of PHI.

Transmission ROE Challenges

For information about the challenges to the utility subsidiaries’ base ROE and the application of the formula rate process, each associated with the transmission services they provide, please refer to Note (7), “Regulatory Matters – Transmission ROE Challenges,” to the consolidated financial statements of PHI.

 

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Pepco Energy Services

Pepco Energy Services is focused on growing its energy savings business and its underground transmission and distribution construction business while managing its thermal assets in Atlantic City. The energy savings business focuses on developing, building and operating energy savings performance contracting solutions primarily for federal, state and local government customers. After a significant slowdown in 2012, the energy savings market has improved, however the market has not returned to the level of activity prior to 2012. The market is expected to continue to improve as the long-term fundamentals of the energy savings business remain strong. Pepco Energy Services’ underground transmission and distribution construction business focuses on providing construction and maintenance services for electric power utilities in North America.

PHI guarantees the obligations of Pepco Energy Services under certain contracts in its energy savings performance contracting business and underground transmission and distribution construction business. At December 31, 2014, PHI’s guarantees of Pepco Energy Services’ obligations under these contracts totaled $336 million. PHI also guarantees the obligations of Pepco Energy Services under surety bonds obtained by Pepco Energy Services for construction projects. These guarantees totaled $185 million at December 31, 2014.

During 2012, Pepco Energy Services deactivated its Buzzard Point and Benning Road oil-fired generation facilities. Pepco Energy Services is demolishing the Benning Road generation facility and realizing the scrap metal salvage value of the facility. The demolition of the facility commenced in the fourth quarter of 2013 and is expected to be completed in the first quarter of 2015. Pepco Energy Services is recognizing the salvage proceeds associated with the scrap metals at the facility as realized.

Revenues associated with Pepco Energy Services’ combined heat and power thermal generating facilities and operations in Atlantic City are derived from long-term contracts with a few major customers in the Atlantic City hotel and casino industry. The carrying amount of Pepco Energy Services’ long-lived assets in Atlantic City at December 31, 2014 totaled $2 million, after impairment losses aggregating $81 million that were recorded during the third and fourth quarters of 2014. In September 2014, two significant customers of these thermal operations declared Chapter 11 bankruptcy. One of the customers closed operations in September 2014 and is seeking a buyer for its facility. The second customer announced that it would remain open in 2015 but that it could close operations later this year if it is unable to lower its operating costs. At September 30, 2014, PHI performed impairment tests on asset groups comprising substantially all of the long-lived assets associated with its thermal operations in Atlantic City and recorded an impairment loss of $53 million ($32 million after-tax) with respect to the most significant asset group (with a carrying amount, before the impairment loss, of $70 million at September 30, 2014). In light of recent developments regarding future business prospects with the two significant customers that declared bankruptcy in September 2014 (including their rejection of Pepco Energy Services’ long-term thermal contracts during February 2015, as part of these customers’ bankruptcy proceedings) and the fact that two other significant customers of the thermal operations declared Chapter 11 bankruptcy in January 2015, Pepco Energy Services again performed impairment tests on asset groups comprising substantially all of the long-lived assets associated with its thermal operations in Atlantic City at December 31, 2014. As a result, Pepco Energy Services recorded an additional impairment charge of $28 million ($16 million after-tax) in the fourth quarter of 2014 that was associated with the most significant asset group and another asset group. Future developments with respect to these and other customers in Atlantic City may require Pepco Energy Services to perform additional impairment analyses of the thermal operations and certain related assets. If these assets are determined to be further impaired, Pepco Energy Services would reduce the carrying value of these assets by the amount of the impairment and record a corresponding non-cash charge to earnings. Moreover, the contract rejections referred to above are expected to reduce Pepco Energy Services’ future earnings and cash flow associated with its thermal operations in Atlantic City.

Corporate and Other

Corporate and other includes the remaining operations of the former Other Non-Regulated segment, certain parent company transactions (including interest expense on parent company debt and incremental external merger-related costs) and inter-company eliminations.

 

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Between 1990 and 1999, PCI entered into certain transactions involving investments in aircraft and aircraft equipment, railcars and other assets, which comprise substantially all of the remaining operations of the former Other Non-Regulated segment. In connection with these transactions, PCI recorded deferred tax assets in prior years of $101 million in the aggregate. After evaluating events that took place during the first quarter of 2013, PCI established valuation allowances against these deferred tax assets totaling $101 million in the first quarter of 2013. Further, during the fourth quarter of 2013, in light of additional court decisions in favor of the IRS involving other taxpayers, and after consideration of all relevant factors, management determined that it would abandon the further pursuit of these deferred tax assets, and these assets totaling $101 million were charged off against the previously established valuation allowances.

Discontinued Operations

In this Management’s Discussion and Analysis of Financial Condition and Results of Operations, all references to PHI’s segments and continuing operations exclude the following discontinued operations.

Cross-Border Energy Lease Investments

Through its subsidiary PCI, PHI held a portfolio of cross-border energy lease investments. During 2013, PHI completed the termination of its interest in its cross-border energy lease investments and, as a result, these investments are being accounted for as discontinued operations.

As discussed in Note (16), “Commitments and Contingencies – PHI’s Cross-Border Energy Lease Investments,” to the consolidated financial statements of PHI, PHI is involved in ongoing litigation with the IRS concerning certain benefits associated with previously held investments in cross-border energy leases. 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 cross-border lease transaction. As a result of the court’s ruling in this case, PHI determined in the first quarter of 2013 that its tax position with respect to the benefits associated with its cross-border energy leases no longer met the more-likely-than-not standard of recognition for accounting purposes, and PHI recorded non-cash after-tax charges of $323 million (after-tax) in the first quarter of 2013 and $6 million (after-tax) in the second quarter of 2013, consisting of the following components:

 

    A non-cash pre-tax charge of $373 million ($313 million after-tax) to reduce the carrying value of these cross-border energy lease investments under FASB guidance on leases (Accounting Standards Codification (ASC) 840). This pre-tax charge was originally recorded in the consolidated statements of income (loss) as a reduction in operating revenue and is now reflected in loss from discontinued operations, net of income taxes.

 

    A non-cash charge of $16 million after-tax to reflect the anticipated additional net interest expense under FASB guidance for income taxes (ASC 740), related to estimated federal and state income tax obligations for the period over which the tax benefits may be disallowed. This after-tax charge was originally recorded in the consolidated statements of income (loss) as an increase in income tax expense and is now reflected in loss from discontinued operations, net of income taxes. The after-tax interest charge for PHI on a consolidated basis was $70 million and this amount was allocated to each member of PHI’s consolidated group as if each member was a separate taxpayer, resulting in the recognition of a $12 million interest benefit for the Power Delivery segment and interest expense of $16 million for PCI and $66 million for Corporate and Other, respectively.

 

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Retail Electric and Natural Gas Supply Businesses of Pepco Energy Services

In December 2009, PHI announced the wind-down of the retail energy supply component of the Pepco Energy Services business which was comprised of the retail electric and natural gas supply businesses. Pepco Energy Services implemented the wind-down by not entering into any new retail electric or natural gas supply contracts while continuing to perform under its existing retail electric and natural gas supply contracts through their respective expiration dates. On March 21, 2013, Pepco Energy Services entered into an agreement whereby a third party assumed all the rights and obligations of the remaining retail natural gas supply customer contracts, and the associated supply obligations, inventory and derivative contracts. The transaction was completed on April 1, 2013. In addition, Pepco Energy Services completed the wind-down of its retail electric supply business in the second quarter of 2013 by terminating its remaining customer supply and wholesale purchase obligations beyond June 30, 2013.

The operations of Pepco Energy Services’ retail electric and natural gas supply businesses have been classified as discontinued operations and are not a part of the Pepco Energy Services segment for financial reporting purposes.

Earnings Overview

Year Ended December 31, 2014 Compared to Year Ended December 31, 2013

 

     2014      2013      Change  
     (millions of dollars)  

Power Delivery

   $ 320       $ 289      $ 31   

Pepco Energy Services

     (39      3        (42

Corporate and Other

     (39      (182      143   
  

 

 

    

 

 

    

 

 

 

Net Income from Continuing Operations

  242      110     132   

Discontinued Operations

  —        (322   322   
  

 

 

    

 

 

    

 

 

 

Total PHI Net Income (Loss)

$ 242    $ (212 $ 454   
  

 

 

    

 

 

    

 

 

 

Net income from continuing operations for the year ended December 31, 2014 was $242 million, or $0.96 per share, compared to $110 million, or $0.45 per share, for the year ended December 31, 2013.

Net income from continuing operations for the year ended December 31, 2014 included the items set forth below, which are presented net of related federal and state income taxes and are in millions of dollars:

 

Asset impairment losses in Pepco Energy Services ($81 million pre-tax) $  48   

Incremental merger-related transaction costs in Corporate and Other ($25 million pre-tax)

$ 23   

Excluding the items listed above for the year ended December 31, 2014, net income from continuing operations would have been $313 million, or $1.24 per share.

Net income from continuing operations for the year ended December 31, 2013 included the charges set forth below in Corporate and Other, which are presented, where applicable, net of related federal and state income taxes and are in millions of dollars:

 

Charge to establish valuation allowances related to certain PCI deferred tax assets $  101  

Charge to reflect the anticipated additional interest expense on estimated federal and state income tax obligations allocated to Corporate and Other (as if it were a separate taxpayer) resulting from the change in assessment of the tax benefits associated with the cross-border energy lease investments ($102 million pre-tax)

$ 66  

 

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Excluding the items listed above for the year ended December 31, 2013, net income from continuing operations would have been $277 million, or $1.13 per share.

PHI discloses net income from continuing operations and related per share data excluding certain items because management believes that these items are not representative of PHI’s ongoing business operations. Management uses this information, and believes that such information is useful to investors, in evaluating PHI’s period-over-period performance. The inclusion of this disclosure is intended to complement, and should not be considered as an alternative to, PHI’s reported net income from continuing operations and related per share data in accordance with GAAP.

Net loss from discontinued operations was $322 million, or $1.31 per share, for the year ended December 31, 2013.

Discussion of Operating Segment Net Income Variances:

Power Delivery’s $31 million increase in earnings was primarily due to the following:

 

    An increase of $50 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).

 

    An increase of $14 million from other distribution revenue, primarily due to Pepco customer growth.

 

    An increase of $10 million from network service transmission revenues primarily due to increased rates, partially offset by the amortization of MAPP abandonment costs and the establishment of a reserve related to the FERC ROE complaint.

 

    An increase of $5 million related to gains recorded in 2014 associated with condemnation awards for certain Pepco transmission properties.

 

    A decrease of $22 million due to higher depreciation and amortization expense primarily resulting from increases in plant investment and regulatory assets, partially offset by lower depreciation rates.

 

    A decrease of $9 million associated with higher interest benefits recorded in 2013 related to uncertain and effectively settled tax positions.

 

    A decrease of $9 million due to higher other operation and maintenance expense primarily related to higher system maintenance expenses, recovery of energy efficiency and conservation costs in 2013 (in accordance with an MPSC order) and billing system training costs, partially offset by lower pension and other postretirement benefit (OPEB) costs and the allowed recovery in 2014 of certain previously expensed rate case costs in accordance with a District of Columbia rate order.

 

    A decrease of $7 million due to incremental merger-related integration costs.

Pepco Energy Services’ $42 million decrease in earnings was primarily due to asset impairment losses recorded in 2014 associated with its combined heat and power thermal generating facilities and operations in Atlantic City, partially offset by tax benefits received from deductions for energy efficiency construction projects, and higher construction activity.

Corporate and Other’s $143 million decrease in net loss was primarily due to the following:

 

    An after-tax charge of $101 million in 2013 to establish valuation allowances against certain PCI deferred tax assets.

 

    An after-tax charge of $66 million in 2013 to reflect the anticipated additional interest expense allocated to Corporate and Other related to changes in PHI’s consolidated estimated federal and state income tax obligations resulting from the change in assessment regarding the tax benefits related to the cross-border energy lease investments.

 

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    After-tax charges of $23 million in 2014 due to incremental merger-related transaction costs.

Discussion of Discontinued Operations:

There were no discontinued operations for the year ended December 31, 2014. Net loss from discontinued operations for the year ended December 31, 2013 was $322 million, primarily as a result of the following:

 

    An aggregate after-tax charge of $313 million recorded in 2013 to reduce the carrying value of PCI’s cross-border energy lease investments ($373 million pre-tax).

 

    An after-tax charge of $16 million recorded in 2013 to reflect the anticipated additional interest expense on estimated federal and state income tax obligations allocated to PCI (as if it were a separate taxpayer) resulting from the change in assessment of the tax benefits associated with the cross-border energy lease investments ($25 million pre-tax).

 

    A loss of $2 million as a result of the early termination of certain cross-border energy leases in 2013.

 

    Net income of $5 million in 2013 from the discontinued Pepco Energy Services retail electric and natural gas supply businesses.

Consolidated Results of Operations

The following results of operations discussion compares the year ended December 31, 2014 to the year ended December 31, 2013. 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:

 

     2014      2013      Change  

Power Delivery

   $ 4,607       $ 4,472       $ 135   

Pepco Energy Services

     278         203         75   

Corporate and Other

     (7      (9      2   
  

 

 

    

 

 

    

 

 

 

Total Operating Revenue

$ 4,878    $ 4,666    $ 212   
  

 

 

    

 

 

    

 

 

 

Power Delivery

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

 

     2014      2013      Change  

Regulated T&D Electric Revenue

   $ 2,277      $ 2,146      $ 131  

Default Electricity Supply Revenue

     2,076        2,075        1   

Other Electric Revenue

     60        60        —    
  

 

 

    

 

 

    

 

 

 

Total Electric Operating Revenue

  4,413     4,281     132  
  

 

 

    

 

 

    

 

 

 

Regulated Gas Revenue

  176     165     11  

Other Gas Revenue

  18     26     (8 )
  

 

 

    

 

 

    

 

 

 

Total Gas Operating Revenue

  194     191     3  
  

 

 

    

 

 

    

 

 

 

Total Power Delivery Operating Revenue

$ 4,607   $ 4,472   $ 135  
  

 

 

    

 

 

    

 

 

 

 

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Regulated Transmission and Distribution (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 non-bypassable Transition Bond Charges that ACE receives, and pays to ACE Funding, to fund the principal and interest payments on Transition Bonds, and revenue in the form of transmission enhancement credits that PHI utility subsidiaries receive as transmission owners from PJM in consideration for approved regional transmission expansion plan expenditures.

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.

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

 

     2014      2013      Change  

Regulated T&D Electric Revenue

        

Residential

   $ 824      $ 781      $ 43  

Commercial and industrial

     1,013        970        43  

Transmission and other

     440        395        45  
  

 

 

    

 

 

    

 

 

 

Total Regulated T&D Electric Revenue

$ 2,277   $ 2,146   $ 131  
  

 

 

    

 

 

    

 

 

 
     2014      2013      Change  

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

        

Residential

     17,129         17,168         (39

Commercial and industrial

     29,831         30,070         (239 )

Transmission and other

     255         259         (4
  

 

 

    

 

 

    

 

 

 

Total Regulated T&D Electric Sales

  47,215     47,497     (282 )
  

 

 

    

 

 

    

 

 

 
     2014      2013      Change  

Regulated T&D Electric Customers (in thousands)

        

Residential

     1,669        1,650        19   

Commercial and industrial

     200        200        —     

Transmission and other

     2        2        —     
  

 

 

    

 

 

    

 

 

 

Total Regulated T&D Electric Customers

  1,871     1,852     19  
  

 

 

    

 

 

    

 

 

 

 

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Regulated T&D Electric Revenue increased by $131 million primarily due to:

 

    An increase of $81 million due to electric distribution base rate increases (Pepco in the District of Columbia effective March 2014, and in Maryland effective July 2013; DPL in Maryland effective September 2013, and in Delaware effective October 2013; ACE effective July 2013 and September 2014).

 

    An increase of $20 million in transmission revenue resulting from higher rates effective June 1, 2014 and June 1, 2013 related to increases in transmission plant investment and operating expenses, partially offset by the establishment of a reserve related to the FERC ROE complaint.

 

    An increase of $19 million due to an EmPower Maryland (a Maryland demand-side management program for Pepco and DPL) rate increase effective February 2014 (which is substantially offset by a corresponding increase in Depreciation and Amortization).

 

    An increase of $16 million due to customer growth in 2014 primarily in the residential classes.

 

    An increase of $12 million in transmission revenue related to the recovery of MAPP abandonment costs, as approved by FERC (which is substantially offset in Depreciation and Amortization).

 

    An increase of $5 million primarily due to a rate increase in the New Jersey Societal Benefit Charge (a surcharge related to the New Jersey Societal Benefit Program, which is a public interest program for low income customers) effective January 2014 (which is offset in Depreciation and Amortization and Deferred Electric Service Costs).

 

    An increase of $5 million in transmission revenue related to the resale by DPL of renewable energy in Delaware (which is substantially offset in Purchased Energy and Depreciation and Amortization).

 

    An increase of $4 million in capacity revenue as a result of expanding Maryland demand side management programs (which is partially offset in Depreciation and Amortization).

The aggregate amount of these increases was partially offset by:

 

    A decrease of $12 million in distribution revenue due to lower pass-through revenue (which is substantially offset by a corresponding decrease in Other Taxes) primarily the result of a rate decrease effective July 2014 in utility taxes collected by Pepco on behalf of Montgomery County, Maryland.

 

    A decrease of $10 million in distribution revenue due to lower pass-through revenue primarily the result of the expiration of the New Jersey Transitional Energy Facility Assessment (TEFA) tax surcharge effective December 2013 (which is offset in Other Taxes).

 

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

 

    A decrease of $4 million due to lower ACE sales primarily as a result of milder weather during the 2014 spring and summer months.

 

    A decrease of $2 million primarily due to a rate decrease effective May 2013 associated with the Renewable Portfolio Surcharge in Delaware (which is substantially offset in Fuel and Purchased Energy and Depreciation and Amortization).

 

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Default Electricity Supply

 

     2014      2013      Change  

Default Electricity Supply Revenue

        

Residential

   $ 1,312       $ 1,376       $ (64

Commercial and industrial

     553        542        11  

Other

     211        157        54  
  

 

 

    

 

 

    

 

 

 

Total Default Electricity Supply Revenue

$ 2,076    $ 2,075    $ 1  
  

 

 

    

 

 

    

 

 

 

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 non-utility generators (NUGs), and (ii) revenue from transmission enhancement credits.

 

     2014      2013      Change  

Default Electricity Supply Sales (GWh)

        

Residential

     13,851        13,743        108  

Commercial and industrial

     5,420        5,079        341  

Other

     44        55        (11
  

 

 

    

 

 

    

 

 

 

Total Default Electricity Supply Sales

  19,315      18,877      438  
  

 

 

    

 

 

    

 

 

 
     2014      2013      Change  

Default Electricity Supply Customers (in thousands)

        

Residential

     1,397        1,352        45  

Commercial and industrial

     129        125        4   

Other

     —          —          —     
  

 

 

    

 

 

    

 

 

 

Total Default Electricity Supply Customers

  1,526     1,477     49  
  

 

 

    

 

 

    

 

 

 

Default Electricity Supply Revenue increased by $1 million primarily due to:

 

    A net increase of $68 million due to higher sales primarily as a result of customer migration from competitive suppliers in Pepco and ACE, partially offset by lower sales in DPL as a result of customer migration to competitive suppliers.

 

    An increase of $50 million in wholesale energy and capacity resale revenues primarily due to higher market prices for the resale of electricity and capacity purchased from NUGs.

 

    An increase of $5 million in revenue from PJM for transmission enhancement credits as a result of a higher total cost of transmission projects in 2014.

The aggregate amount of these increases was partially offset by:

 

    A decrease of $97 million as a result of lower Default Electricity Supply rates.

 

    A net decrease of $24 million due to lower Pepco and ACE non-weather related average customer usage, partially offset by higher usage at DPL.

The variances described above with respect to Default Electricity Supply Revenue include the effects of an increase of $3 million in ACE’s BGS unbilled revenue resulting primarily from higher rates and customer migration from competitive suppliers in the unbilled revenue period for December 31, 2014 as compared to the corresponding period for December 31, 2013. Such an increase in ACE’s BGS unbilled revenue has the effect of directly increasing the profitability of ACE’s Default Electricity Supply business ($2 million increase in net income) as these unbilled revenues are not included in the deferral calculation until they are billed to customers under the BGS terms approved by the NJBPU.

 

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Regulated Gas

 

     2014      2013      Change  

Regulated Gas Revenue

        

Residential

   $ 106      $ 103      $ 3   

Commercial and industrial

     59        52        7  

Transportation and other

     11        10        1  
  

 

 

    

 

 

    

 

 

 

Total Regulated Gas Revenue

$ 176   $ 165   $ 11   
  

 

 

    

 

 

    

 

 

 
     2014      2013      Change  

Regulated Gas Sales (million cubic feet)

        

Residential

     8,550        7,861        689  

Commercial and industrial

     6,063        4,945        1,118  

Transportation and other

     6,418        6,990        (572 )
  

 

 

    

 

 

    

 

 

 

Total Regulated Gas Sales

  21,031     19,796     1,235  
  

 

 

    

 

 

    

 

 

 
     2014      2013      Change  

Regulated Gas Customers (in thousands)

        

Residential

     118        117        1   

Commercial and industrial

     10        9        1   

Transportation and other

     —          —          —     
  

 

 

    

 

 

    

 

 

 

Total Regulated Gas Customers

  128     126     2  
  

 

 

    

 

 

    

 

 

 

Regulated Gas Revenue increased by $11 million primarily due to:

 

    An increase of $9 million due to higher sales primarily as a result of colder weather during the winter months of 2014, as compared to 2013.

 

    An increase of $6 million due to higher non-weather related average customer usage.

 

    An increase of $4 million due to a distribution rate increase effective July 2013.

 

    An increase of $2 million due to customer growth primarily in the residential customer class.

The aggregate amount of these increases was partially offset by a decrease of $10 million due to a Gas Cost Rate (GCR) decrease effective November 2013.

Other Gas Revenue

Other Gas Revenue decreased by $8 million primarily due to lower volumes for off-system sales to electric generators and gas marketers.

Pepco Energy Services

Pepco Energy Services’ operating revenue increased by $75 million primarily due to:

 

    An increase of $46 million primarily in energy savings construction activities.

 

    An increase of $26 million in underground transmission and distribution construction activities.

 

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    An increase of $3 million associated with the thermal business in Atlantic City primarily due to colder temperatures in the first half of 2014.

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:

 

     2014      2013      Change  

Power Delivery

   $ 2,074      $ 2,070      $ 4  

Pepco Energy Services

     212         148        64   

Corporate and Other

     1         (2 )      3  
  

 

 

    

 

 

    

 

 

 

Total

$ 2,287   $ 2,216   $ 71  
  

 

 

    

 

 

    

 

 

 

Power Delivery

Power Delivery’s Fuel and Purchased Energy expense 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 increased by $4 million primarily due to:

 

    An increase of $33 million primarily due to customer migration from competitive suppliers.

 

    An increase of $20 million in deferred electricity expense primarily due to higher revenue associated with Pepco and DPL Default Electricity Supply sales, which resulted in a higher rate of recovery of Default Electricity Supply costs.

 

    An increase of $16 million in the cost of gas purchases for on-system sales as a result of higher average gas prices.

 

    An increase of $3 million in the costs associated with purchasing Renewable Energy Credits in Delaware (which is offset by a corresponding increase in Regulated T&D Revenue).

 

    An increase of $2 million due to higher electricity sales primarily as a result of colder weather during the 2014 winter months, as compared to 2013.

The aggregate amount of these increases was partially offset by:

 

    A net decrease of $50 million due to lower average electricity costs under Pepco and DPL Default Electricity Supply contracts, and due to lower ACE costs under BGS contracts.

 

    A decrease of $8 million in the cost of gas purchases for off-system sales as a result of lower volumes.

 

    A decrease of $7 million in deferred gas expense as a result of a lower rate of recovery of natural gas supply costs.

 

    A decrease of $6 million from the settlement of financial hedges entered into as part of DPL’s hedge program for the purchase of regulated natural gas.

 

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Pepco Energy Services

Pepco Energy Services’ Fuel and Purchased Energy expense and Other Services Cost of Sales increased by $64 million primarily due to:

 

    An increase of $39 million primarily associated with increased energy savings construction activity.

 

    An increase of $25 million associated with increased underground transmission and distribution construction activities.

Other Operation and Maintenance

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

 

     2014      2013      Change  

Power Delivery

   $ 904      $ 871      $ 33   

Pepco Energy Services

     52         42        10  

Corporate and Other

     (32 )      (62 )      30  
  

 

 

    

 

 

    

 

 

 

Total

$ 924   $ 851   $ 73   
  

 

 

    

 

 

    

 

 

 

Power Delivery

Other Operation and Maintenance expense for Power Delivery increased by $33 million primarily due to:

 

    An increase of $14 million in internal and external merger-related integration costs.

 

    An increase of $8 million primarily due to higher tree trimming and maintenance costs.

 

    An increase of $7 million primarily due to new customer system support costs.

 

    An increase of $6 million in bad debt expense, of which $1 million is deferred and recoverable.

 

    An increase of $5 million in emergency restoration costs.

 

    An increase of $3 million due to the write-off of unrecoverable regulatory assets previously established in connection with the sale of certain ACE generation assets.

The aggregate amount of these increases was partially offset by:

 

    A decrease of $7 million in regulatory expenses.

 

    A decrease of $3 million resulting from the 2013 write-off of disallowed MAPP and associated transmission project costs.

 

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Pepco Energy Services

Other Operation and Maintenance expense for Pepco Energy Services increased by $10 million primarily due to:

 

    An increase of $4 million in bad debt expense for accounts receivable.

 

    An increase of $3 million in employee compensation primarily associated with its energy savings business.

 

    An increase of $2 million in repairs and maintenance costs associated with its thermal business in Atlantic City.

 

    An increase of $1 million associated with the demolition of the Benning Road generation facility.

Corporate and Other

Other Operation and Maintenance expense for Corporate and Other increased by $30 million primarily due to internal and external merger-related transaction costs.

Depreciation and Amortization

Depreciation and Amortization expense increased by $76 million to $549 million in 2014 from $473 million in 2013 primarily due to:

 

    An increase of $20 million due to utility plant additions.

 

    An increase of $13 million in amortization of regulatory assets primarily associated with the EmPower Maryland surcharge rate increase effective February 2014 (which is offset by an increase in Regulated T&D Electric Revenue).

 

    An increase of $12 million in amortization of MAPP abandonment costs (which is offset in Regulated T&D Electric Revenue).

 

    An increase of $12 million in amortization due to the expiration in August 2013 of the excess depreciation reserve regulatory liability of ACE.

 

    An increase of $10 million in amortization of regulatory assets primarily related to recoverable AMI costs, major storm costs and rate case costs.

 

    An increase of $5 million in amortization of solar renewable energy credits (which is offset by an increase in Regulated T&D Electric Revenue).

Other Taxes

Other Taxes decreased by $15 million to $413 million in 2014 from $428 million in 2013. The decrease was primarily due to:

 

    A decrease of $10 million in TEFA tax collections due to the expiration of the assessment effective December 2013 (which is offset by a corresponding decrease in Regulated T&D Electric Revenue).

 

    A decrease of $10 million in the Montgomery County, Maryland utility taxes that are collected and passed through by Pepco (substantially offset by a corresponding decrease in Regulated T&D Electric Revenue).

 

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The aggregate amount of these decreases was partially offset by an increase of $7 million in property taxes in Maryland.

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 the New Jersey Societal Benefit Program is reported under Other Operation and Maintenance and the corresponding revenue is reported under Regulated T&D Electric Revenue.

Deferred Electric Service Costs decreased by $6 million to an expense of $20 million in 2014 as compared to an expense of $26 million in 2013 primarily due to a decrease in deferred electricity expense as a result of lower Default Electricity Supply revenue rates.

Impairment Losses

Impairment losses increased by $77 million to $81 million in 2014 from $4 million in 2013. The increase was primarily due to 2014 impairment losses of $81 million ($48 million after-tax) at Pepco Energy Services associated with its combined heat and power thermal generating facilities and operations in Atlantic City, partially offset by a 2013 impairment loss of $4 million ($3 million after-tax) associated with a landfill gas-fired electric generation facility.

Other Income (Expenses)

Other Expenses (which are net of Other Income) decreased by $15 million to a net expense of $224 million in 2014 from a net expense of $239 million in 2013 primarily due to:

 

    An increase of $9 million in Other Income associated with gains recorded in 2014 associated with condemnation awards for certain Pepco transmission properties.

 

    A decrease of $5 million in interest expense primarily associated with lower short-term debt and lower long-term debt interest expense.

Income Tax Expense

PHI’s income tax expense decreased by $181 million to $138 million in 2014 from $319 million in 2013.

PHI’s consolidated effective income tax rates for the years ended December 31, 2014 and 2013 were 36.3% and 74.4%, respectively. The decrease in the effective tax rate resulted from certain tax benefits associated with Pepco Energy Services recorded in the third quarter of 2014, changes in estimates and interest related to uncertain and effectively settled tax positions and deferred tax valuation allowances established in the first quarter of 2013, partially offset by the effect of certain incremental merger-related costs (as further described in Note (1), “Organization,” to the consolidated financial statements of PHI), incurred in 2014 that are not tax deductible.

During 2014, PHI recorded a tax benefit of $5 million related to certain energy efficiency tax deductions related to Pepco Energy Services’ energy savings performance contracting services.

During 2013, PHI recorded a $56 million charge for a change in estimates and interest related to uncertain and effectively settled tax positions, primarily representing the anticipated additional interest expense on estimated federal and state income tax obligations that was allocated to PHI’s continuing operations resulting from a change in assessment of tax benefits associated with the former cross-border energy lease investments of PCI in the first quarter of 2013.

 

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Also, in the first quarter of 2013, PHI established valuation allowances of $101 million related to deferred tax assets. Between 1990 and 1999, PCI, through various subsidiaries, entered into certain transactions involving investments in aircraft and aircraft equipment, railcars and other assets. In connection with these transactions, PCI recorded deferred tax assets in prior years of $101 million in the aggregate. Following events that took place during the first quarter of 2013, which included (i) court decisions in favor of the IRS with respect to other taxpayers’ cross-border lease and other structured transactions (as discussed in Note (20), “Discontinued Operations – Cross-Border Energy Lease Investments”), (ii) the change in PHI’s tax position with respect to the tax benefits associated with its cross-border energy leases, and (iii) PHI’s decision in March 2013 to begin to pursue the early termination of its remaining cross-border energy lease investments (which represented a substantial portion of the remaining assets within PCI) without the intent to reinvest these proceeds in income-producing assets, management evaluated the likelihood that PCI would be able to realize the $101 million of deferred tax assets in the future. Based on this evaluation, PCI established valuation allowances against these deferred tax assets totaling $101 million in the first quarter of 2013. Further, during the fourth quarter of 2013, in light of additional court decisions in favor of the IRS involving other taxpayers, and after consideration of all relevant factors, management determined that it would abandon the further pursuit of these deferred tax assets, and these assets totaling $101 million were charged off against the previously established valuation allowances.

Discontinued Operations

PHI’s loss from discontinued operations, net of income taxes, is comprised of the following:

 

     2014      2013      Change  

Cross-border energy lease investments

   $  —        $ (327 )    $ 327  

Pepco Energy Services’ retail electric and natural gas supply businesses

     —          5        (5 )
  

 

 

    

 

 

    

 

 

 

Loss from discontinued operations, net of income taxes

$  —      $ (322 ) $ 322  
  

 

 

    

 

 

    

 

 

 

During 2014, there was no activity in PHI’s discontinued operations.

In 2013, the loss from discontinued operations, net of income taxes, for PHI’s cross-border energy lease investments of $327 million was primarily related to a change in assessment regarding the tax benefits related to the cross-border energy lease investments consisting of a $373 million non-cash pre-tax charge ($313 million after-tax) to reduce the carrying value of the investments and a $16 million non-cash after-tax charge to reflect the anticipated additional interest expense related to the change in PCI’s estimated federal and state income tax obligations as if it were a separate taxpayer. In addition, PHI recorded a loss of $3 million ($2 million after-tax) in 2013 for the termination of PHI’s interests in its remaining cross-border energy lease investments, representing the excess of the carrying value of the terminated leases over the net cash proceeds received.

In 2013, the income from discontinued operations, net of income taxes, at Pepco Energy Services of $5 million was due to the completion of the wind-down of the retail electric and natural gas supply businesses in 2013.

 

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The following results of operations discussion compares the year ended December 31, 2013 to the year ended December 31, 2012. 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:

 

     2013      2012      Change  

Power Delivery

   $ 4,472       $ 4,378      $ 94  

Pepco Energy Services

     203         256        (53 )

Corporate and Other

     (9      (9      —    
  

 

 

    

 

 

    

 

 

 

Total Operating Revenue

$ 4,666    $ 4,625    $ 41  
  

 

 

    

 

 

    

 

 

 

Power Delivery

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

 

     2013      2012      Change  

Regulated T&D Electric Revenue

   $ 2,146      $ 2,006      $ 140  

Default Electricity Supply Revenue

     2,075        2,124        (49 )

Other Electric Revenue

     60        65        (5 )
  

 

 

    

 

 

    

 

 

 

Total Electric Operating Revenue

  4,281     4,195     86  
  

 

 

    

 

 

    

 

 

 

Regulated Gas Revenue

  165     151     14  

Other Gas Revenue

  26     32     (6 )
  

 

 

    

 

 

    

 

 

 

Total Gas Operating Revenue

  191     183     8  
  

 

 

    

 

 

    

 

 

 

Total Power Delivery Operating Revenue

$ 4,472   $ 4,378   $ 94  
  

 

 

    

 

 

    

 

 

 

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.

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.

 

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Regulated T&D Electric

 

     2013      2012      Change  

Regulated T&D Electric Revenue

        

Residential

   $ 781      $ 722      $ 59  

Commercial and industrial

     970        923        47  

Transmission and other

     395        361        34  
  

 

 

    

 

 

    

 

 

 

Total Regulated T&D Electric Revenue

$ 2,146   $ 2,006   $ 140  
  

 

 

    

 

 

    

 

 

 
     2013      2012      Change  

Regulated T&D Electric Sales (GWh)

        

Residential

     17,168         17,150         18   

Commercial and industrial

     30,070         30,734         (664 )

Transmission and other

     259         258         1  
  

 

 

    

 

 

    

 

 

 

Total Regulated T&D Electric Sales

  47,497     48,142     (645 )
  

 

 

    

 

 

    

 

 

 
     2013      2012      Change  

Regulated T&D Electric Customers (in thousands)

        

Residential

     1,650        1,641        9  

Commercial and industrial

     200        198        2  

Transmission and other

     2        2        —    
  

 

 

    

 

 

    

 

 

 

Total Regulated T&D Electric Customers

  1,852     1,841     11  
  

 

 

    

 

 

    

 

 

 

Regulated T&D Electric Revenue increased by $140 million primarily due to:

 

    An increase of $107 million due to distribution rate increases (Pepco in the District of Columbia effective October 2012, and in Maryland effective July 2013 and July 2012; DPL in Maryland effective July 2012 and September 2013, and in Delaware effective October 2013 and July 2012; ACE effective November 2012 and July 2013).

 

    An increase of $14 million in transmission revenue related to the recovery of MAPP abandonment costs, as approved by FERC (which is offset in Depreciation and Amortization).

 

    An increase of $14 million in transmission revenue rates effective June 1, 2012 and June 1, 2013 related to increases in transmission plant investment and operating expenses.

 

    An increase of $7 million in transmission revenue related to the resale by DPL of renewable energy in Delaware (which is substantially offset in Purchased Energy and Depreciation and Amortization).

 

    An increase of $6 million primarily due to a rate increase in the New Jersey Societal Benefit Charge effective July 2012 (which is offset in Deferred Electric Service Costs).

 

    An increase of $6 million in transmission revenue primarily attributable to higher capacity as a result of expanding Maryland demand side management programs (which is partially offset in Depreciation and Amortization).

 

    An increase of $5 million primarily due to a Renewable Portfolio Surcharge in Delaware effective June 2012 (which is substantially offset in Fuel and Purchased Energy and Depreciation and Amortization).

 

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    An increase of $3 million due to Pepco and DPL customer growth in 2013, primarily in the residential class.

The aggregate amount of these increases was partially offset by:

 

    A decrease of $13 million due to lower non-weather related average residential and commercial customer usage.

 

    A decrease of $6 million in transmission revenue associated with the change in FERC formula rate true-ups.

 

    A decrease of $4 million in distribution revenue due to lower pass-through revenue (which is substantially offset by a corresponding decrease in Other Taxes) primarily the result of a decrease in utility taxes collected by Pepco on behalf of Montgomery County, Maryland.

 

    A decrease of $1 million in transmission revenue primarily attributable to a peak-load rate decrease effective January 2013.

Default Electricity Supply

 

     2013      2012      Change  

Default Electricity Supply Revenue

        

Residential

   $ 1,376       $ 1,467       $ (91 )

Commercial and industrial

     542        542        —    

Other

     157        115        42  
  

 

 

    

 

 

    

 

 

 

Total Default Electricity Supply Revenue

$ 2,075    $ 2,124    $ (49 )
  

 

 

    

 

 

    

 

 

 

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.

 

     2013      2012      Change  

Default Electricity Supply Sales (GWh)

        

Residential

     13,743        14,245        (502 )

Commercial and industrial

     5,079        5,508        (429 )

Other

     55        55        —    
  

 

 

    

 

 

    

 

 

 

Total Default Electricity Supply Sales

  18,877      19,808      (931 )
  

 

 

    

 

 

    

 

 

 
     2013      2012      Change  

Default Electricity Supply Customers (in thousands)

        

Residential

     1,352        1,366        (14 )

Commercial and industrial

     125        128        (3 )

Other

     —          1        (1 )
  

 

 

    

 

 

    

 

 

 

Total Default Electricity Supply Customers

  1,477     1,495     (18 )
  

 

 

    

 

 

    

 

 

 

Default Electricity Supply Revenue decreased by $49 million primarily due to:

 

    A decrease of $76 million due to lower sales, primarily as a result of customer migration to competitive suppliers.

 

    A decrease of $22 million due to lower ACE and DPL non-weather related average customer usage.

 

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The aggregate amount of these decreases was partially offset by:

 

    An increase of $36 million in wholesale energy and capacity resale revenues primarily due to higher market prices for the resale of electricity and capacity purchased from NUGs.

 

    An increase of $6 million due to higher Pepco and DPL revenue from transmission enhancement credits.

 

    An increase of $4 million due to higher sales primarily as a result of colder weather during the 2013 fall months, as compared to 2012.

 

    A net increase of $2 million as a result of higher Pepco Default Electricity Supply rates, partially offset by lower DPL and ACE rates.

Regulated Gas

 

     2013      2012      Change  

Regulated Gas Revenue

        

Residential

   $ 103      $ 94      $ 9  

Commercial and industrial

     52        47        5  

Transportation and other

     10        10        —    
  

 

 

    

 

 

    

 

 

 

Total Regulated Gas Revenue

$ 165   $ 151   $ 14  
  

 

 

    

 

 

    

 

 

 
     2013      2012      Change  

Regulated Gas Sales (million cubic feet)

        

Residential

     7,861        6,428        1,433  

Commercial and industrial

     4,945        3,636        1,309  

Transportation and other

     6,990        6,751        239  
  

 

 

    

 

 

    

 

 

 

Total Regulated Gas Sales

  19,796     16,815     2,981  
  

 

 

    

 

 

    

 

 

 
     2013      2012      Change  

Regulated Gas Customers (in thousands)

        

Residential

     117        115        2  

Commercial and industrial

     9        10        (1 )

Transportation and other

     —          —          —    
  

 

 

    

 

 

    

 

 

 

Total Regulated Gas Customers

  126     125     1  
  

 

 

    

 

 

    

 

 

 

Regulated Gas Revenue increased by $14 million primarily due to:

 

    An increase of $22 million due to higher sales primarily as a result of colder weather during the winter months of 2013 as compared to 2012.

 

    An increase of $7 million due to higher non-weather related average commercial customer usage.

 

    An increase 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 partially offset by an increase in Purchased Energy).

 

    An increase of $2 million due to a distribution rate increase effective July 2013.

 

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The aggregate amount of these increases was partially offset by a decrease of $22 million due to a GCR decrease effective November 2012.

Other Gas Revenue

Other Gas Revenue decreased by $6 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 $53 million primarily due to:

 

    A decrease of $36 million primarily in energy savings construction activities.

 

    A decrease of $18 million associated with the retirement of the two remaining oil-fired generation facilities in the second quarter of 2012.

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:

 

     2013      2012      Change  

Power Delivery

   $ 2,070      $ 2,109      $ (39 )

Pepco Energy Services

     148        186        (38 )

Corporate and Other

     (2 )      (2 )      —    
  

 

 

    

 

 

    

 

 

 

Total

$ 2,216   $ 2,293   $ (77 )
  

 

 

    

 

 

    

 

 

 

Power Delivery

Power Delivery’s Fuel and Purchased Energy expense 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 $39 million primarily due to:

 

    A decrease of $85 million primarily due to customer migration to competitive suppliers.

 

    A decrease of $20 million in deferred electricity expense primarily due to higher DPL Default Electricity Supply cost of service rates, which resulted in a lower rate of recovery of Default Electricity Supply costs.

 

    A decrease of $13 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 $5 million in the cost of gas purchases for off-system sales as a result of lower volumes.

The aggregate amount of these decreases was partially offset by:

 

    A net increase of $45 million due to higher average electricity costs under Pepco and DPL Default Electricity Supply contracts, partially offset by lower ACE costs.

 

    An increase of $13 million in deferred electricity expense primarily due to a Renewable Portfolio Surcharge in Delaware effective June 2012 (which is substantially offset in Regulated T&D Electric Revenue and Depreciation and Amortization).

 

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    An increase of $11 million in the cost of gas purchases for on-system sales as a result of higher average gas prices.

 

    An increase of $6 million due to higher electricity sales primarily as a result of colder weather during the 2013 fall months, as compared to 2012.

 

    An increase of $4 million in the costs associated with purchasing Renewable Energy Credits in Delaware (which is offset by a corresponding increase in Regulated T&D Electric Revenue).

 

    An increase 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 an increase in Regulated Gas Revenue).

 

    An increase of $2 million in the costs associated with purchases under wind power purchase agreements in Delaware (which is offset by a 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 $38 million primarily due to:

 

    A decrease of $30 million primarily due to lower energy savings construction activity.

 

    A decrease of $7 million due to lower purchases of capacity and lower fuel usage, both attributable to the retirement of the remaining oil-fired generation facilities in the second quarter of 2012.

Other Operation and Maintenance

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

 

     2013      2012      Change  

Power Delivery

   $ 871      $ 901      $ (30 )

Pepco Energy Services

     42        58        (16 )

Corporate and Other

     (62 )      (61 )      (1 )
  

 

 

    

 

 

    

 

 

 

Total

$ 851   $ 898   $ (47 )
  

 

 

    

 

 

    

 

 

 

 

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Power Delivery

Other Operation and Maintenance expense for Power Delivery decreased by $30 million primarily due to:

 

    A decrease of $16 million in storm restoration costs.

 

    A decrease of $15 million associated with lower maintenance costs.

 

    A decrease of $9 million in customer service costs.

 

    A decrease of $1 million primarily due to 2012 total incremental storm restoration costs for major storm events as described in the following table:

 

     2013      2012      Change  

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

   $  —        $ (9 )    $ 9  

Costs associated with derecho storm (June 2012)

     —          38        (38 )

Regulatory assets established for future recovery of derecho storm costs

     —          (34 )      34  

Costs associated with Hurricane Sandy (October 2012)

     —          28        (28 )

Regulatory assets established for future recovery of Hurricane Sandy costs

     —          (22 )      22  
  

 

 

    

 

 

    

 

 

 

Total incremental major storm restoration costs

$ —     $ 1   $ (1 )
  

 

 

    

 

 

    

 

 

 

 

    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.

 

    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. The MPSC approved the recovery of these costs in Maryland for both Pepco and DPL in its July 2013 and August 2013 rate orders, respectively, over a five-year period. ACE’s stipulation of settlement approved by the NJBPU in June 2013 provides for recovery of these costs in New Jersey over a three-year period. The remaining costs of $4 million relate to repair work completed in Delaware and the District of Columbia which are not 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. The MPSC approved the recovery of these costs in Maryland for both Pepco and DPL in its July 2013 and August 2013 rate orders, respectively, over a five-year period. ACE’s stipulation of settlement approved by the NJBPU in June 2013 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 deferrable in those jurisdictions.

 

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The aggregate amount of these decreases was partially offset by:

 

    An increase of $6 million resulting from a 2012 deferred cost adjustment associated with DPL Default Electricity Supply. The deferred cost adjustments were primarily due to the under-recognition of allowed returns on net uncollectible expense and regulatory taxes.

 

    An increase of $3 million associated with the write-off of disallowed MAPP and associated transmission projects costs.

 

    An increase of $3 million in environmental remediation costs.

Pepco Energy Services

Other Operation and Maintenance expense for Pepco Energy Services decreased by $16 million primarily due to:

 

    A decrease of $5 million in personnel costs in its energy savings business primarily due to a reduction in the number of employees in the second half of 2012.

 

    A decrease of $4 million in contractual costs associated with the retirement of the two remaining oil-fired generation facilities in the second quarter of 2012.

 

    A decrease of $3 million in bid and proposal costs in its energy savings business.

 

    A decrease of $1 million associated with an accrual for an energy savings guarantee shortfall in 2012.

 

    A decrease of $1 million in operating, repairs and maintenance expenses at its combined heat and power thermal operations in Atlantic City.

Depreciation and Amortization

Depreciation and Amortization expense increased by $19 million to $473 million in 2013 from $454 million in 2012 primarily due to:

 

    An increase of $14 million in amortization of regulatory assets primarily related to recoverable AMI costs, major storm costs and rate case costs.

 

    An increase of $14 million in amortization of MAPP abandonment costs (which is offset in T&D Electric Revenue).

 

    An increase of $6 million in amortization due to the expiration in August 2013 of the excess depreciation reserve regulatory liability of ACE.

The aggregate amount of these increases was partially offset by:

 

    A decrease of $8 million due to the deactivation of Pepco Energy Services’ oil-fired generating facilities in the second quarter of 2012 and a reduction in the Benning Road asset retirement obligation in 2013 resulting from the decision to pursue the demolition of the Benning Road oil-fired generating facility.

 

    A decrease of $7 million in the Delaware Renewable Energy Portfolio Standards deferral (which is substantially offset by a corresponding increase in Fuel and Purchased Energy).

 

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Power Delivery depreciation reflected no change from 2012 due to an increase from higher plant investment offset by lower depreciation rates in Pepco and DPL, approved by the MPSC effective July 20, 2012.

Other Taxes

Other Taxes decreased by $4 million to $428 million in 2013 from $432 million in 2012. The decrease was primarily due to lower sales that resulted in 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).

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 the New Jersey Societal Benefit Program 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 $31 million to an expense of $26 million in 2013 as compared to an expense reduction of $5 million in 2012 primarily due to an increase in deferred electricity expense as a result of higher Default Electricity Supply and New Jersey Societal Benefit Program revenue rates and lower electricity supply costs.

Impairment Losses

Impairment losses decreased by $8 million to $4 million in 2013 from $12 million in 2012. The decrease was primarily due to 2012 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, partially offset by a 2013 impairment loss of $4 million ($3 million after-tax) associated with a landfill gas-fired electric generation facility.

Other Income (Expenses)

Other Expenses (which are net of Other Income) increased by $19 million to a net expense of $239 million in 2013 from a net expense of $220 million in 2012. The increase reflects a $16 million increase in interest expense primarily associated with higher long-term debt and $3 million associated with lower income related to the allowance for funds used during construction (AFUDC) that is applied to capital projects.

Income Tax Expense

PHI’s income tax expense increased by $216 million to $319 million in 2013 from $103 million in 2012.

PHI’s consolidated effective income tax rates for the years ended December 31, 2013 and 2012 were 74.4% and 32.1%, respectively.

The increase in the effective tax rate for the year ended December 31, 2013 occurred as a result of recording $56 million of changes in estimates and interest related to uncertain and effectively settled tax positions in the first quarter of 2013. In addition, the increase in the effective tax rate resulted from the establishment of valuation allowances of $101 million in the first quarter of 2013 against certain deferred tax assets in PCI, which is now included in Corporate and Other. Between 1990 and 1999, PCI, through various subsidiaries, entered into certain transactions involving investments in aircraft and aircraft equipment, railcars and other assets. In connection with these transactions, PCI recorded deferred tax

 

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assets in prior years of $101 million in the aggregate. Following events that took place during the first quarter of 2013, which included (i) court decisions in favor of the IRS with respect to both Consolidated Edison’s cross-border lease transaction (as discussed in Note (20), “Discontinued Operations – Cross-Border Energy Lease Investments,” to the consolidated financial statements of PHI) and another taxpayer’s structured transactions, (ii) the change in PHI’s tax position with respect to the tax benefits associated with its cross-border energy leases, and (iii) PHI’s decision in March 2013 to begin to pursue the early termination of its remaining cross-border energy lease investments (which represented a substantial portion of the remaining assets within PCI) without the intent to reinvest these proceeds in income-producing assets, management evaluated the likelihood that PCI would be able to realize the $101 million of deferred tax assets in the future. Based on this evaluation, PCI established valuation allowances against these deferred tax assets totaling $101 million in the first quarter of 2013. Further, during the fourth quarter of 2013, in light of additional court decisions in favor of the IRS involving other taxpayers, and after consideration of the relevant factors, management determined that it would abandon the further pursuit of these deferred tax assets, and these assets totaling $101 million were charged off against the previously established valuation allowances.

The effective income tax rate for the year ended December 31, 2012 includes income tax benefits of $8 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.

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.

Discontinued Operations

PHI’s (loss) income from discontinued operations, net of income taxes, is comprised of the following:

 

     2013      2012      Change  

Cross-border energy lease investments

   $ (327 )    $ 41      $ (368 )

Pepco Energy Services’ retail electric and natural gas supply businesses

     5        26        (21 )
  

 

 

    

 

 

    

 

 

 

(Loss) income from discontinued operations, net of income taxes

$ (322 ) $ 67   $ (389 )
  

 

 

    

 

 

    

 

 

 

For the years ended December 31, 2013 and 2012, (loss) income from discontinued operations, net of income taxes, was a loss of $322 million and income of $67 million, respectively. The decrease of $389 million is comprised of a decrease of $368 million related to PHI’s cross-border lease investments and a decrease of $21 million related to the retail electric and natural gas supply businesses at Pepco Energy Services.

The decrease in (loss) income from discontinued operations, net of income taxes, for PHI’s cross-border energy lease investments is primarily due to after-tax non-cash charges of $323 million recorded in the first quarter of 2013 and $6 million in the second quarter of 2013, each related to a change in assessment regarding the tax benefits related to the cross-border energy lease investments and consisting of a $373 million pre-tax non-cash charge ($313 million after-tax) to reduce the carrying value of the investments and a $16 million after-tax non-cash charge to reflect the anticipated additional interest expense related to the change in PCI’s estimated federal and state income tax obligations as if it were a separate taxpayer. The (loss) income from discontinued operations, net of income taxes, was reduced further by lower cross-border energy lease investment earnings as a result of terminating the cross-border lease investments in 2013, the loss recorded on the early termination of the remaining cross-border energy lease investments during 2013, and gains recorded on the early termination of certain leases within the cross-border energy lease portfolio in the third quarter of 2012.

 

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The decrease in (loss) income from discontinued operations, net of income taxes, at Pepco Energy Services is due to a reduction in sales volume associated with the wind-down of the retail electric and natural gas supply businesses, a reduction in mark-to-market gains, and costs incurred to accelerate the wind-down of the retail electric supply business.

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, 2014, PHI’s current assets on a consolidated basis totaled $1.1 billion and its consolidated current liabilities totaled $2.1 billion, resulting in a working capital deficit of $981 million. PHI expects the working capital deficit at December 31, 2014 to be funded during 2015 in part through cash flows from operations, from the issuance of long-term debt and the sale of preferred stock. At December 31, 2013, PHI’s current assets on a consolidated basis totaled $1.4 billion and its consolidated current liabilities totaled $2.3 billion, for a working capital deficit of $915 million. The increase of $66 million in the working capital deficit from December 31, 2013 to December 31, 2014 was primarily due to an increase in short-term debt, an increase in other current liabilities and a decrease in accounts receivable, partially offset by lower net current income tax liabilities associated with the implementation of a new accounting standard, which required certain non-current deferred income tax assets to be netted against current income tax liabilities.

At December 31, 2014, PHI’s consolidated cash and cash equivalents totaled $14 million, which consisted of cash and uncollected funds but excluded current Restricted cash equivalents (cash that is available to be used only for designated purposes) that totaled $25 million. At December 31, 2013, PHI’s consolidated cash and cash equivalents totaled $23 million, which consisted of cash and uncollected funds but excluded current Restricted cash equivalents that totaled $13 million.

Detail of PHI’s short-term debt balance and current portion of long-term debt and project funding balance is as follows:

 

     As of December 31, 2014  

Type

   PHI
Parent
     Pepco      DPL      ACE      ACE
Funding
     Pepco
Energy
Services
     PCI      PHI
Consolidated
 
     (millions of dollars)  

Variable Rate Demand Bonds

   $ —         $ —         $ 105       $ —         $ —         $ —         $ —         $ 105   

Commercial Paper

     287        104        106        127        —          —          —          624  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total Short-Term Debt

$ 287   $ 104   $ 211   $ 127   $ —     $ —     $ —      $ 729  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Current Portion of Long-Term Debt and Project Funding

$ 250   $ 12   $ 100   $ 15   $ 44   $ 10   $ —      $ 431  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

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     As of December 31, 2013  

Type

   PHI
Parent
     Pepco      DPL      ACE      ACE
Funding
     Pepco
Energy
Services
     PCI      PHI
Consolidated
 
     (millions of dollars)  

Variable Rate Demand Bonds

   $ —         $ —         $ 105      $ 18      $ —         $  —         $  —         $ 123  

Commercial Paper

     24         151         147        120        —          —          —          442  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total Short-Term Debt

$  24    $ 151    $ 252   $ 138   $  —     $ —      $ —      $ 565  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Current Portion of Long-Term Debt and Project Funding

$  —      $ 175    $ 100    $ 107    $ 41    $  12    $ 11    $ 446  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Commercial Paper

PHI, Pepco, DPL and ACE maintain commercial paper programs to address short-term liquidity needs. As of December 31, 2014, the maximum capacity available under these programs was $875 million, $500 million, $500 million and $350 million, respectively, subject to available borrowing capacity under the unsecured syndicated credit facility described below.

The weighted average interest rate for commercial paper issued by PHI, Pepco, DPL and ACE during 2014 was 0.57%, 0.28%, 0.26% and 0.27%, respectively. The weighted average maturity of all commercial paper issued by PHI, Pepco, DPL and ACE during 2014 was six, six, five and five days, respectively.

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. The termination date of this credit facility is currently August 1, 2018.

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 is $750 million for PHI and $250 million for each of Pepco, DPL and ACE. The sublimits may be increased or decreased by the individual borrower during the term of the facility, except that (i) the sum of all of the borrower sublimits following any such increase or decrease must equal the total amount of the facility, and (ii) the aggregate amount of credit used at any given time by (a) PHI may not exceed $1.25 billion, and (b) each of Pepco, DPL or ACE may not exceed the lesser of $500 million 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 (10), “Debt,” to the consolidated financial statements of PHI.

 

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Credit Facility Amendment

On May 20, 2014, PHI, Pepco, DPL and ACE entered into an amendment of and consent with respect to the credit agreement (the Consent). PHI was required to obtain the consent of certain of the lenders under the credit facility in order to permit the consummation of the Merger. Pursuant to the Consent, certain of the lenders consented to the consummation of the Merger and the subsequent conversion of PHI from a Delaware corporation to a Delaware limited liability company, provided that the Merger and subsequent conversion are consummated on or before October 29, 2015. In addition, the Consent amends the definition of “Change in Control” in the credit agreement to mean, following consummation of the Merger, an event or series of events by which Exelon no longer owns, directly or indirectly, 100% of the outstanding shares of voting stock of Pepco Holdings.

ACE Term Loan Agreement

On May 10, 2013, ACE entered into a $100 million term loan agreement, pursuant to which ACE borrowed $100 million at a rate of interest equal to the prevailing Eurodollar rate, which was 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 0.75%. On August 21, 2014, ACE repaid the term loan in full.

Sale of Receivables

During 2014, Pepco, as seller, entered into a purchase agreement with a buyer to sell receivables from an energy savings project pursuant to a Task Order entered into under a General Services Administration area-wide agreement. The purchase price received by Pepco was $12 million. The energy savings project, which is being performed by Pepco Energy Services, was completed in 2014. Pursuant to the purchase agreement, following acceptance of the energy savings project, the buyer will be entitled to receive the contract payments under the Task Order payable by the customer over approximately 9 years. At December 31, 2014, Pepco included the $12 million received in the Current portion of long-term debt and project funding.

On October 24, 2013, Pepco Energy Services, as seller, entered into a purchase agreement with a buyer to sell receivables from an energy savings project over a period of time pursuant to a Task Order. The purchase price received by Pepco Energy Services was $7 million. Pursuant to the purchase agreement, following acceptance of the energy savings project, the buyer will be entitled to receive the contract payments under the Task Order payable by the customer over approximately 23 years. At December 31, 2014, Pepco Energy Services included the $7 million received in the Current portion of long-term debt and project funding.

Cash and Credit Facility Available as of December 31, 2014

 

     Consolidated
PHI
     PHI Parent      Utility
Subsidiaries
 
     (millions of dollars)  

Credit Facility (Total Capacity)

   $ 1,500      $ 750      $ 750  

Less: Letters of Credit issued

     1        1        —    

Commercial Paper outstanding

     624        287        337  
  

 

 

    

 

 

    

 

 

 

Remaining Credit Facility Available

  875     462     413  

Cash Invested in Money Market Funds (a)

  —       —       —    
  

 

 

    

 

 

    

 

 

 

Total Cash and Credit Facility Available

$ 875   $ 462   $ 413  
  

 

 

    

 

 

    

 

 

 

 

(a) Cash and cash equivalents reported on the PHI consolidated balance sheet totaling $14 million did not include cash invested in money market funds.

 

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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. In the first quarter of 2013, PHI estimated 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 have been obligated to pay $192 million in additional federal taxes and $50 million of interest on the additional federal taxes, totaling $242 million as of March 31, 2013. The estimate of additional federal taxes due includes 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 paid in advance to the IRS.

In order to mitigate PHI’s ongoing interest costs associated with the $242 million estimate of additional taxes and interest, PHI made a $242 million advanced payment to the IRS for the estimated additional taxes and related interest in the first quarter of 2013. This advanced payment was funded from then currently available sources of liquidity and short-term borrowings. During 2013, PHI terminated all of its interests in its cross-border energy lease investments. PHI received aggregate net cash proceeds of $873 million (net of aggregate termination payments of $2.0 billion used to retire the non-recourse debt associated with the terminated leases) and recorded an aggregate pre-tax loss, including transaction costs, of approximately $3 million ($2 million after-tax), representing the excess of the carrying value of the terminated leases over the net cash proceeds received. A portion of the net cash proceeds from the terminated leases was used to repay borrowings utilized to fund the advanced payment discussed above.

Pension and Other Postretirement Benefit Plans

PHI sponsors a non-contributory, defined benefit pension plan (the PHI Retirement Plan) that covers substantially all employees of Pepco, DPL and ACE and certain employees of other PHI subsidiaries. PHI also provides supplemental retirement benefits to certain eligible executive and key employees through nonqualified retirement plans. 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, as modified by subsequent legislation.

Under the Pension Protection Act, if a plan incurs a funding shortfall in the preceding plan year, there can be minimum quarterly contributions required in the current and following plan years. In 2015, PHI expects to make no discretionary tax-deductible contributions to the PHI Retirement Plan. During 2014, PHI, Pepco, DPL and ACE did not make any discretionary tax-deductible contributions to the PHI Retirement Plan. During 2013, PHI, DPL and ACE made discretionary tax-deductible contributions to the PHI Retirement Plan of $80 million, $10 million and $30 million, respectively. PHI satisfied the minimum required contribution rules under the Pension Protection Act in 2014, 2013 and 2012. For additional discussion of PHI’s Pension and Other Postretirement Benefits, see Note (9), “Pension and Other Postretirement Benefits,” to the consolidated financial statements of PHI.

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 health care coverage; however, they will be able to purchase coverage at full cost through PHI.

In 2014 and 2013, Pepco contributed $1 million and $6 million, respectively, DPL contributed zero and $3 million, respectively, and ACE contributed $3 million and $6 million, respectively, to the other postretirement benefit plan. In 2014 and 2013, contributions of zero and $7 million, respectively, were made by other PHI subsidiaries.

Based on the results of the 2014 actuarial valuation, PHI’s net periodic pension and OPEB costs were approximately $58 million in 2014 versus $94 million in 2013. The current estimate of benefit cost for 2015 is $97 million. The increase in costs is primarily due to the adoption of new mortality tables, which generally lengthen the estimated time over which benefits would be paid, and a decrease in the discount

 

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rate. For additional discussion, see Note (9), “Pension and Other Postretirement Benefits,” to the consolidated financial statements of PHI. The utility subsidiaries are responsible for substantially all of the total PHI net periodic pension and OPEB costs. Approximately 36% of net periodic pension and OPEB costs, excluding the nonqualified retirement plan costs, were capitalized in 2014. PHI estimates that its net periodic pension and OPEB expense will be approximately $66 million in 2015, as compared to $34 million in 2014 and $57 million in 2013.

Other Postretirement Benefit Plan Amendments

During 2013, PHI approved two amendments to its other postretirement benefits plan. These amendments impacted the retiree health care and retiree life insurance benefits, and were effective on January 1, 2014. As a result of the amendments, which were cumulatively significant, PHI remeasured its accumulated postretirement benefit obligation as of July 1, 2013. The remeasurement resulted in a $193 million reduction of the accumulated postretirement benefit obligation, which included recording a prior service credit of $124 million, which will be amortized over approximately ten years, and a $69 million reduction from a change in the discount rate from 4.10% as of December 31, 2012 to 4.95% as of July 1, 2013.

Cash Flow Activity

PHI’s cash flows during 2014, 2013 and 2012 are summarized below:

 

     Cash Source (Use)  
     2014      2013      2012  
     (millions of dollars)  

Operating Activities

   $ 854      $ 497      $ 592  

Investing Activities

     (1,226      (411      (969

Financing Activities

     363        (88 )      293  
  

 

 

    

 

 

    

 

 

 

Net decrease in cash and cash equivalents

$ (9 $ (2 $ (84
  

 

 

    

 

 

    

 

 

 

Operating Activities

Cash flows from operating activities during 2014, 2013 and 2012 are summarized below:

 

     Cash Source (Use)  
     2014      2013      2012  
     (millions of dollars)  

Net income from continuing operations

   $ 242       $ 110      $ 218  

Non-cash adjustments to net income

     625         465        451  

Pension contributions

     —          (120      (200

Advanced payment made to taxing authority

     —          (242      —    

Changes in cash collateral related to derivative activities

     (9      31        88  

Changes in other assets and liabilities

     (4      206        60  

Changes in net current assets held for disposition or sale

     —          47        (25
  

 

 

    

 

 

    

 

 

 

Net cash from operating activities

$ 854   $ 497   $ 592  
  

 

 

    

 

 

    

 

 

 

Net cash from operating activities increased $357 million for the year ended December 31, 2014, compared to the same period in 2013. The increase was primarily due to an increase in net income of $132 million, a decrease in pension contributions of $120 million and a $242 million advanced payment to the IRS for estimated additional taxes and related interest made in 2013, partially offset by a $47 million reduction in net current assets held for disposition or sale associated with the termination of all cross-border energy lease investments and the wind-down of Pepco Energy Services’ retail electric and natural gas supply businesses.

 

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Net cash from operating activities decreased $95 million for the year ended December 31, 2013, compared to the same period in 2012. The decrease was primarily due to a decrease in net income of $108 million and a $242 million advanced payment to the IRS for estimated additional taxes and related interest, partially offset by an $80 million decrease in pension contributions and a $72 million reduction in net current assets held for disposition or sale associated with the termination of all cross-border energy lease investments and the wind-down of Pepco Energy Services’ retail electric and natural gas supply businesses.

Investing Activities

Cash flows used by investing activities during 2014, 2013 and 2012 are summarized below:

 

     Cash (Use) Source  
     2014      2013      2012  
     (millions of dollars)  

Investment in property, plant and equipment

   $ (1,223    $ (1,310 )    $ (1,216 )

DOE capital reimbursement awards received

     4        22        40  

Proceeds from sales of land

     9        —          —    

Changes in restricted cash equivalents

     (12      1        (1 )

Net other investing activities

     (4      3        6  

Proceeds from discontinued operations, early termination of finance leases held in trust

     —          873        202  
  

 

 

    

 

 

    

 

 

 

Net cash used by investing activities

$ (1,226 $ (411 ) $ (969 )
  

 

 

    

 

 

    

 

 

 

Net cash used by investing activities increased $815 million for the year ended December 31, 2014, compared to the same period in 2013. The increase was primarily due to $873 million of proceeds from discontinued operations related to the termination of all cross-border energy lease investments received in 2013.

Net cash used by investing activities decreased $558 million for the year ended December 31, 2013, compared to the same period in 2012. The decrease was primarily due to proceeds from the termination of all cross-border energy lease investments.

Financing Activities

Cash flows from financing activities during 2014, 2013 and 2012 are summarized below:

 

     Cash (Use) Source  
     2014      2013      2012  
     (millions of dollars)  

Dividends paid on common stock

   $ (272 )    $ (270 )    $ (248 )

Common stock issued for the Direct Stock Purchase and Dividend
Reinvestment Plan (DRP) and employee-related compensation (a)

     34        50        51  

Issuances of common stock

     —          324        —    

Issuance of Series A preferred stock

     126        —          —    

Issuances of long-term debt

     766        800        450  

Reacquisitions of long-term debt

     (334 )      (558 )      (176 )

Issuances (repayments) of short-term debt, net

     164        (200 )      33  

Issuances of term loans

     —          250        200  

Repayments of term loans

     (100 )      (450 )      —    

Cost of issuances

     (10 )      (23 )      (9 )

Net other financing activities

     (11 )      (11 )      (8 )
  

 

 

    

 

 

    

 

 

 

Net cash from (used by) financing activities

$ 363   $ (88 ) $ 293  
  

 

 

    

 

 

    

 

 

 

 

(a) Prior to October 1, 2013, the DRP was named the Shareholder Dividend Reinvestment Plan.

 

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Net cash from financing activities increased $451 million for the year ended December 31, 2014, compared to the same period in 2013. The increase was primarily due to a net increase of $190 million in long-term debt, a net decrease of $100 million in term loans, an increase of $364 million of short-term debt issuances, and an issuance of preferred stock of $126 million, partially offset by issuances of common stock of $324 million in 2013 primarily due to the settlement of an equity forward transaction. For additional information about the equity forward transaction, please refer to Note (12), “Stock-Based Compensation, Dividend Restrictions, and Calculations of Earnings Per Share of Common Stock,” to the consolidated financial statements of PHI.

Net cash from financing activities decreased $381 million for the year ended December 31, 2013, compared to the same period in 2012. The decrease was primarily due to a net decrease of $400 million in term loans and an increase of $233 million in short-term debt repayments, partially offset by issuances of common stock of $324 million primarily due to the settlement in 2013 of the equity forward transaction.

Common Stock Dividends

Common stock dividend payments were $272 million in 2014, $270 million in 2013, and $248 million in 2012. The increase in common stock dividends paid in 2014 and 2013 was the result of additional shares outstanding, primarily shares issued upon settlement of the equity forward transaction in February 2013 and under the DRP.

Changes in Outstanding Common Stock

PHI issued approximately 1 million shares of common stock in each of 2014, 2013 and 2012 under PHI’s long-term incentive plans.

Under the DRP, PHI issued 1.1 million shares of common stock in 2014, 1.6 million shares of common stock in 2013, and 1.7 million shares of common stock in 2012.

In February 2013, PHI issued 17.9 million shares of common stock pursuant to the settlement of the equity forward transaction.

Changes in Outstanding Long-Term Debt

Cash flows from issuances and reacquisitions of long-term debt in 2014, 2013 and 2012 are summarized in the tables below:

 

     2014      2013      2012  
Issuances    (millions of dollars)  

Pepco

        

3.05% First mortgage bonds due 2022

   $ —         $ —         $ 200   

4.15% First mortgage bonds due 2043

     —           250         —     

4.95% First mortgage bonds due 2043

     —           150         —     

3.60% First mortgage bonds due 2024

     400         —           —     

Project Funding Debt

     12         —           —     
  

 

 

    

 

 

    

 

 

 
  412      400      200   
  

 

 

    

 

 

    

 

 

 

DPL

4.00% First mortgage bonds due 2042

  —        —        250   

3.50% First mortgage bonds due 2023

  204      300      —     
  

 

 

    

 

 

    

 

 

 
  204      300      250   
  

 

 

    

 

 

    

 

 

 

ACE

Variable rate term loan due 2014

  —        100      —     

3.375% First mortgage bonds due 2024

  150      —        —     
  

 

 

    

 

 

    

 

 

 
  150      100      —     
  

 

 

    

 

 

    

 

 

 
$ 766    $ 800    $ 450   
  

 

 

    

 

 

    

 

 

 

 

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     2014      2013      2012  
Reacquisitions    (millions of dollars)  

Pepco

        

5.375% Tax-exempt bonds due 2024 (a)

   $ —         $ —         $ 38   

4.95% First mortgage bonds due 2013

     —           200         —     

4.65% First mortgage bonds due 2014

     175         —           —     
  

 

 

    

 

 

    

 

 

 
  175      200      38   
  

 

 

    

 

 

    

 

 

 

DPL

0.75% Tax-exempt bonds due 2026 (a)

  —        —        35   

1.80% Tax-exempt bonds due 2025 (b)

  —        —        15   

2.30% Tax-exempt bonds due 2028 (b)

  —        —        16   

5.20% Tax-exempt bonds due 2019 (a)

  —        —        31   

6.40% First mortgage bonds due 2013 (a)

  —        250      —     

5.00% Unsecured notes due 2014

  100      —        —     
  

 

 

    

 

 

    

 

 

 
  100      250      97   
  

 

 

    

 

 

    

 

 

 

ACE

Securitization bonds due 2012-2014

  41      39      37   

5.60% First mortgage bonds due 2025 (a)

  —        —        4   

6.625% First mortgage bonds due 2013

  —        69      —     

7.63% First mortgage bonds due 2014

  7      —        —     
  

 

 

    

 

 

    

 

 

 
  48      108      41   
  

 

 

    

 

 

    

 

 

 

PCI

6.59%-6.69% Recourse Debt

  11      —        —     
  

 

 

    

 

 

    

 

 

 
  11      —        —     
  

 

 

    

 

 

    

 

 

 
$ 334    $ 558    $ 176   
  

 

 

    

 

 

    

 

 

 

 

(a) These bonds were secured by an outstanding series of collateral first mortgage bonds issued by the utility, which had maturity dates, optional and mandatory redemption provisions, interest rates and interest payment dates that were identical to the terms of the tax-exempt bonds. The collateral first mortgage bonds were automatically redeemed simultaneously with the redemption of the tax-exempt bonds.
(b) Repurchased by DPL in June 2012 pursuant to a mandatory purchase obligation and then retired.

First Mortgage Bond Issuances

During 2014, Pepco issued $400 million of 3.60% first mortgage bonds due March 15, 2024. These bonds were issued under a Mortgage and Deed of Trust and are secured thereunder by a first lien, subject to certain leases, permitted liens and other exceptions, on substantially all of Pepco’s properties, except for such property excluded from the lien of the Mortgage and Deed of Trust. Pepco used a portion of the net proceeds of the offering to repay in full at maturity $175 million in aggregate principal amount of its 4.65% senior notes due April 15, 2014, plus accrued and unpaid interest.

During 2014, DPL issued $200 million of its 3.50% first mortgage bonds due November 15, 2023. These bonds were issued under a Mortgage and Deed of Trust and are secured thereunder by a first lien, subject to certain leases, permitted liens and other exceptions, on substantially all of DPL’s properties, except for such property excluded from the lien of the Mortgage and Deed of Trust. Net proceeds from the issuance of the bonds, which included a premium of $4 million, were used to repay DPL’s outstanding commercial paper and for general corporate purposes.

During 2014, ACE issued $150 million of its 3.375% first mortgage bonds due September 1, 2024. These bonds were issued under a Mortgage and Deed of Trust and are secured thereunder by a first lien, subject to certain leases, permitted liens and other exceptions, on substantially all of ACE’s properties, except for such property excluded from the lien of the Mortgage and Deed of Trust. ACE used $7.2 million of the net proceeds from the issuance of the bonds to repay in full at maturity $7.0 million in aggregate principal amount of ACE’s 7.63% secured medium term notes due August 29, 2014, plus accrued and unpaid interest thereon. ACE used the remainder of the net proceeds to repay its outstanding commercial paper, including commercial paper that ACE issued to prepay in full its $100 million term loan, and for general corporate purposes.

 

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During 2013, Pepco issued $250 million of 4.15% first mortgage bonds due March 15, 2043 and $150 million of 4.95% first mortgage bonds due November 15, 2043. Net proceeds from the issuance of the 4.15% bonds were used to repay Pepco’s outstanding commercial paper and for general corporate purposes. The net proceeds from the 4.95% bonds were used to repay outstanding commercial paper, including commercial paper issued to repay in full at maturity $200 million of Pepco 4.95% senior notes due November 15, 2013, plus accrued but unpaid interest thereon. The senior notes were secured by a like principal amount of Pepco first mortgage bonds, which under Pepco’s Mortgage and Deed of Trust were deemed to be satisfied with the repayment of the senior notes.

During 2013, DPL issued $300 million of 3.50% first mortgage bonds due November 15, 2023. The net proceeds from the issuance of the bonds were used to repay at maturity $250 million of DPL’s 6.40% first mortgage bonds due December 1, 2013, plus accrued but unpaid interest thereon, to repay outstanding commercial paper and for general corporate purposes.

During 2012, Pepco issued $200 million of 3.05% first mortgage bonds due April 1, 2022. Net proceeds from the issuance of the bonds were used primarily (i) to repay Pepco’s outstanding commercial paper that was issued to temporarily fund capital expenditures and working capital, (ii) to fund the redemption, prior to maturity, of all of the $38.3 million outstanding of the 5.375% tax-exempt pollution control revenue refunding bonds due in 2024 issued by the Industrial Development Authority of the City of Alexandria, Virginia (IDA), on Pepco’s behalf and (iii) for general corporate purposes.

During 2012, DPL issued $250 million of 4.00% first mortgage bonds due June 1, 2042. Net proceeds from the issuance of the bonds were used primarily (i) to repay $215 million of DPL’s outstanding commercial paper that was issued (a) to temporarily fund capital expenditures and working capital and (b) to fund the redemption in June 2012, prior to maturity, of $65.7 million in aggregate principal amount of three series of outstanding tax-exempt pollution control refunding revenue bonds issued by the Delaware Economic Development Authority (DEDA) for DPL’s benefit; (ii) to fund the redemption, prior to maturity, of $31 million of tax-exempt bonds issued by DEDA for DPL’s benefit; and (iii) for general corporate purposes.

Tax Exempt Auction Rate and First Mortgage Bond Redemptions

During 2014, Pepco retired, at maturity, $175 million of its 4.65% senior notes. The senior notes were secured by a like principal amount of its 4.65% first mortgage bonds due April 15, 2014, which under Pepco’s mortgage and deed of trust were deemed to be satisfied when the senior notes were repaid.

During 2014, DPL retired, at maturity, $100 million of its 5.00% unsecured notes.

During 2014, ACE retired, at maturity, $7 million of its 7.63% medium term notes due August 29, 2014. The notes were secured by a like principal amount of first mortgage bonds due August 29, 2014, which under ACE’s mortgage and deed of trust were deemed to be satisfied when the notes were repaid.

During 2014, PCI retired, at maturity, $11 million of bank loans.

During 2013, Pepco retired, at maturity, $200 million of its 4.95% senior notes, which were secured by a like principal amount of Pepco’s first mortgage bonds as previously discussed above.

During 2013, DPL retired, at maturity, $250 million of its 6.40% first mortgage bonds.

During 2013, ACE retired, at maturity, $69 million of its 6.625% non-callable first mortgage bonds. ACE also funded the redemption, prior to maturity, of $4 million of outstanding weekly rate pollution control revenue refunding bonds due 2017, issued by the Pollution Control Financing Authority of Salem County, New Jersey for ACE’s benefit.

 

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During 2012, all of the $38.3 million of the outstanding 5.375% tax-exempt pollution control revenue refunding bonds issued by IDA for Pepco’s benefit were redeemed. In connection with the redemption, Pepco redeemed all of the $38.3 million outstanding of its 5.375% first mortgage bonds due in 2024 that secured the obligations under the pollution control bonds.

During 2012, DPL funded the redemption by DEDA, prior to maturity, of $65.7 million of outstanding tax-exempt pollution control refunding revenue bonds issued by DEDA for DPL’s benefit, as described above. Of the pollution control refunding revenue bonds redeemed, $34.5 million in aggregate principal amount bore interest at 0.75% per year and matured in 2026, $15.0 million in aggregate principal amount bore interest at 1.80% per year and matured in 2025, and $16.2 million in aggregate principal amount bore interest at 2.30% per year and matured in 2028. In connection with such redemption, on June 1, 2012, DPL redeemed, prior to maturity, all of the $34.5 million in aggregate principal amount outstanding of its 0.75% first mortgage bonds due 2026 that secured the obligations under one of the series of pollution control refunding revenue bonds redeemed by DEDA.

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

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

Changes in Short-Term Debt

As of December 31, 2014, PHI had a total of $624 million of commercial paper outstanding as compared to $442 million and $637 million of commercial paper outstanding at December 31, 2013 and 2012, respectively.

Capital Requirements

Capital Expenditures

Pepco Holdings’ capital expenditures for the year ended December 31, 2014 totaled $1,223 million, a decrease of $87 million from $1,310 million in 2013. Capital expenditures in 2014 were $567 million for Pepco, $352 million for DPL, $225 million for ACE, $3 million for Pepco Energy Services and $76 million for Corporate and Other. The Power Delivery expenditures were primarily related to capital costs associated with new customer services, distribution reliability and transmission. Corporate and Other capital expenditures primarily consisted of hardware and software expenditures that will be allocated to Power Delivery when the assets are placed in service.

 

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The table below shows the projected capital expenditures for Power Delivery, Pepco Energy Services and Corporate and Other for the five-year period 2015 through 2019. PHI expects to fund these expenditures through internally generated cash and external financing.

 

     For the Year Ended December 31,         
     2015      2016      2017      2018      2019      Total  
     (millions of dollars)  

Power Delivery

           

Distribution

   $ 739       $ 858       $ 853       $ 832       $ 771       $ 4,053   

Transmission

     423         390         417         405         323         1,958   

Gas Delivery

     32         32         35         36         38         173   

Other

     97         102         91         73         60         423   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total for Power Delivery

  1,291      1,382      1,396      1,346      1,192      6,607   

Pepco Energy Services

  6      6      5      2      2      21   

Corporate and Other

  6      6      6      6      6      30   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total PHI

$ 1,303    $ 1,394    $ 1,407    $ 1,354    $ 1,200    $ 6,658   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Transmission and Distribution

The projected capital expenditures listed in the table for distribution, transmission and gas delivery are primarily for facility replacements and upgrades to accommodate customer growth and service reliability, including capital expenditures for continuing reliability enhancement efforts. For a more detailed discussion of these efforts, see “General Overview – Power Delivery.” The projected capital expenditures related to the DC PLUG initiative are included as part of distribution expenditures in the table above.

DOE Capital Reimbursement Awards

In 2009, the U.S. Department of Energy (DOE) announced awards under the American Recovery and Reinvestment Act of 2009 of:

 

    $105 million and $44 million in Pepco’s Maryland and District of Columbia service territories, respectively, for the implementation of an AMI system, direct load control, distribution automation, and communications infrastructure.

 

    $19 million in ACE’s New Jersey service territory for the implementation of direct load control, distribution automation, and communications infrastructure.

Of the total $168 million in DOE awards, $130 million was offset against smart grid-related capital expenditures of Pepco and ACE. The remaining $38 million is being used to offset incremental expenditures associated with direct load control and other Pepco and ACE programs, which have been deferred as regulatory assets. During 2014, Pepco and ACE received award payments of $3 million and $1 million, respectively. The cumulative award payments received by Pepco and ACE as of December 31, 2014, were $148 million and $19 million, respectively.

The IRS has announced that, to the extent these grants are expended on capital items, they will not be considered taxable income.

Dividends

Pepco Holdings’ annual dividend rate on its common stock is determined by the Board of Directors on a quarterly basis and takes into consideration, among other factors, current and possible future developments that may affect PHI’s income and cash flows. In 2014, PHI’s Board of Directors declared quarterly dividends of 27 cents per share of common stock payable on March 31, 2014, June 30, 2014, September 30, 2014 and December 31, 2014.

 

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On January 22, 2015, the Board of Directors declared a dividend on common stock of 27 cents per share payable March 31, 2015, to shareholders of record on March 10, 2015.

PHI, on a stand-alone basis, generates no operating income of its own. Accordingly, its ability to pay dividends to its shareholders depends on dividends received from its subsidiaries. In addition to their future financial performance, the ability of each of PHI’s direct and indirect subsidiaries to pay dividends is subject to limits imposed by: (i) state corporate laws, which impose limitations on the funds that can be used to pay dividends and when such dividends can be paid, and, in the case of ACE, the regulatory requirement that it obtain the prior approval of the NJBPU before dividends can be paid if its equity as a percent of its total capitalization, excluding securitization debt, falls below 30%; (ii) the prior rights of holders of existing and future mortgage bonds and other long-term debt issued by the subsidiaries, and any preferred stock that may be issued by the subsidiaries in the future, (iii) any other restrictions imposed in connection with the incurrence of liabilities; and (iv) certain provisions of ACE’s charter that impose restrictions on payment of common stock dividends for the benefit of preferred stockholders. None of Pepco, DPL or ACE currently have shares of preferred stock outstanding. Currently, the capitalization ratio limitation to which ACE is subject and the restriction in the ACE charter do not limit ACE’s ability to pay common stock dividends. PHI had approximately $584 million and $595 million of retained earnings free of restrictions at December 31, 2014 and 2013, respectively. These amounts represent the total retained earnings balances at those dates.

Contractual Obligations and Commercial Commitments

Summary information about Pepco Holdings’ consolidated contractual obligations and commercial commitments at December 31, 2014, is as follows:

 

     Contractual Maturity  

Contractual Obligations

   Total      Less
than 1
Year
     2-3
Years
     4-5
Years
     After 5
Years
 
     (millions of dollars)  

Variable rate demand bonds

   $ 105       $ 105       $ —         $ —         $ —     

Commercial paper

     624         624         —           —           —     

Long-term debt (a)

     5,032         410         471         315         3,836   

Long-term project funding

     10         2         2         3         3   

Interest payments on debt

     3,578         252         459         405         2,462   

Capital leases, including interest

     76         15         30         31         —     

Operating leases

     525         45         83         68         329   

Non-derivative power purchase contracts (b)

     2,440        276        509        478        1,177  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total (c)

$ 12,390   $ 1,729   $ 1,554   $ 1,300   $ 7,807  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(a) Includes Transition Bonds issued by ACE Funding.
(b) Excludes contracts for the purchase of electricity to satisfy Default Electricity Supply load service obligations which have neither a fixed commitment amount nor a minimum purchase amount. In addition, costs are recoverable from customers.
(c) Excludes $625 million of net current and non-current liabilities related to uncertain tax positions due to uncertainty in the timing of the associated cash payments.

 

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Guarantees, Indemnifications and Off-Balance Sheet Arrangements

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

PHI guarantees the obligations of Pepco Energy Services under certain contracts in its energy savings performance contracting business and underground transmission and distribution construction business. At December 31, 2014, PHI’s guarantees of Pepco Energy Services’ obligations under these contracts totaled $336 million. PHI also guarantees the obligations of Pepco Energy Services under surety bonds obtained by Pepco Energy Services for construction projects. These guarantees totaled $185 million at December 31, 2014.

In addition, PHI guarantees certain obligations of Pepco, DPL and ACE under surety bonds obtained by these subsidiaries, for construction projects and self-insured workers compensation matters. These guarantees totaled $53 million at December 31, 2014.

For additional discussion of PHI’s third party guarantees, indemnifications, obligations and off-balance sheet arrangements, see Note (16), “Commitments and Contingencies – Third Party Guarantees, Indemnifications, and Off-Balance Sheet Arrangements,” to the consolidated financial statements of PHI.

Contractual Arrangements with Credit Rating Triggers or Margining Rights

Under certain contractual arrangements entered into by PHI’s subsidiaries, the subsidiary may be required to provide cash collateral or letters of credit as security for its contractual obligations if the credit ratings of PHI or the subsidiary are downgraded. In the event of a downgrade, the amount required to be posted would depend on the amount of the underlying contractual obligation existing at the time of the downgrade. Based on contractual provisions in effect at December 31, 2014, a downgrade in the unsecured debt credit ratings of PHI and each of its rated subsidiaries to below “investment grade” would increase the collateral obligation of PHI and its subsidiaries by up to $37 million. This amount is attributable primarily to energy services contracts and accounts payable to independent system operators and distribution companies. PHI believes that it and its subsidiaries currently have sufficient liquidity to fund their operations and meet their financial obligations.

Many of the contractual arrangements entered into by PHI’s subsidiaries in connection with Default Electricity Supply activities include margining rights pursuant to which the PHI subsidiary or a counterparty may request collateral if the market value of the contractual obligations reaches levels in excess of the credit thresholds established in the applicable arrangements. Pursuant to these margining rights, the affected PHI subsidiary may receive, or be required to post, collateral due to energy price movements. PHI believes that it and its subsidiaries currently have sufficient liquidity to fund their operations and meet their financial obligations.

Environmental Remediation Obligations

PHI’s accrued liabilities for environmental remediation obligations as of December 31, 2014 totaled approximately $28 million, of which approximately $4 million is expected to be incurred in 2015, for potential environmental cleanup and related costs at sites owned or formerly owned by an operating subsidiary where an operating subsidiary is a potentially responsible party or is alleged to be a third-party contributor. For further information concerning the remediation obligations associated with these sites, see Note (16), “Commitments and Contingencies – Environmental Matters,” to the consolidated financial statements of PHI. The most significant environmental remediation obligations as of December 31, 2014, are for the following items:

 

    Environmental investigation and remediation costs payable by Pepco with respect to the Benning Road site.

 

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    Amounts payable by Pepco in connection with a January 2011 mineral oil release at Pepco’s Potomac River substation in Alexandria, Virginia.

 

    Estimated costs for implementation of a closure plan and cap on a Pepco right-of-way that traverses the NRG Energy, Inc. (as successor to GenOn MD Ash Management, LLC) (NRG) fly ash disposal site in Brandywine, Prince George’s County, Maryland. PHI and Pepco believe that the costs incurred in this matter will be recoverable from NRG under a 2000 agreement covering the sale of this site, the terms of which specify that the buyer of Pepco’s generation assets assumed environmental liability for hazardous substances, including ash, which remain on or have been removed from the land on which the acquired generating stations are situated.

 

    Estimated costs for implementation of a closure plan for the Edge Moor landfill.

 

    Costs associated with investigation and resolution of potential impacts from a September 2013 mineral oil release from a Pepco underground feeder to Watts Branch.

 

    Amounts payable by DPL in accordance with a 2001 consent agreement reached with the Delaware Department of Natural Resources and Environmental Control, for remediation, site restoration, natural resource damage compensatory projects and other costs associated with environmental contamination that resulted from an oil release at the Indian River power plant, which DPL sold in June 2001.

 

    Potential compliance remediation costs under New Jersey’s Industrial Site Recovery Act payable by PHI associated with the retained environmental exposure from the sale of the Conectiv Energy wholesale power generation business.

 

    Amounts payable by DPL in connection with the Wilmington Coal Gas South site located in Wilmington, Delaware, to remediate residual material from the historical operation of a manufactured gas plant.

Sources of Capital

PHI’s sources to meet its long-term funding needs, such as capital expenditures, dividends, and new investments, and its short-term funding needs, such as working capital and the temporary funding of long-term funding needs, include internally generated funds, issuances by PHI, Pepco, DPL and ACE under their commercial paper programs, securities issuances, medium- and short-term loans, and bank financing under new or existing facilities. PHI’s ability to generate funds from its operations and to access capital and credit markets is subject to risks and uncertainties. Volatile and deteriorating financial market conditions, diminished liquidity and tightening credit may affect access to certain of PHI’s potential funding sources.

Cash Flow from Operations

Cash flow generated by regulated utility subsidiaries in Power Delivery is the primary source of PHI’s cash flow from operations. Additional cash flows are generated by the business of Pepco Energy Services and from the occasional sale of non-core assets.

Short-Term Funding Sources

Pepco Holdings and its regulated utility subsidiaries have traditionally used a number of sources to fulfill short-term funding needs, such as commercial paper, short-term notes and bank term loans and lines of credit. Proceeds from short-term borrowings are used primarily to meet working capital needs but may also be used to temporarily fund long-term capital requirements. For additional discussion of PHI’s short-term debt, see Note (10), “Debt,” to the consolidated financial statements of PHI.

 

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Long-Term Funding Sources

The sources of long-term funding for PHI and its subsidiaries are the issuance of debt and equity securities and borrowing under long-term credit agreements. Proceeds from long-term financings are used primarily to fund long-term capital requirements, such as capital expenditures and new investments, and to repay or refinance existing indebtedness.

Regulatory Restrictions on Financing Activities

The issuance of debt securities by PHI’s principal subsidiaries requires the approval of either FERC or one or more state public utility commissions. Neither FERC approval nor state public utility commission approval is required as a condition to the issuance of securities by PHI.

State Financing Authority

Pepco’s long-term financing activities (including the issuance of securities and the incurrence of long-term debt) are subject to authorization by the DCPSC and MPSC. DPL’s long-term financing activities are subject to authorization by the MPSC and the DPSC. ACE’s long-term and short-term (consisting of debt instruments with a maturity of one year or less) financing activities are subject to authorization by the NJBPU. Each utility, through periodic filings with the state public service commission(s) having jurisdiction over its financing activities, has maintained standing authority sufficient to cover its projected financing needs over a multi-year period.

FERC Financing Authority

Under the Federal Power Act (FPA), FERC has jurisdiction over the issuance of long-term and short-term securities of public utilities, but only if the issuance is not regulated by the state public utility commission in which the public utility is organized and operating. Under these provisions, FERC has jurisdiction over the issuance of short-term debt by Pepco and DPL. Pepco and DPL have obtained FERC authority for the issuance of short-term debt. Because Pepco Energy Services also qualifies as a public utility under the FPA and is not regulated by a state utility commission, FERC also has jurisdiction over the issuance of securities by Pepco Energy Services. Pepco Energy Services has obtained the requisite FERC financing authority in its market-based rate orders.

Money Pool

Pepco Holdings operates a system money pool under a blanket authorization adopted by FERC. The money pool is an unsecured cash management mechanism used by Pepco Holdings to manage the short-term investment and borrowing requirements of its subsidiaries that participate in the money pool. Pepco Holdings may invest in but not borrow from the money pool. Eligible subsidiaries with surplus cash may deposit those funds in the money pool. Deposits in the money pool are guaranteed by Pepco Holdings. Eligible subsidiaries with cash requirements may borrow from the money pool. Depositors in the money pool receive, and borrowers from the money pool pay, an interest rate based primarily on Pepco Holdings’ short-term borrowing rate. Pepco Holdings deposits funds in the money pool to the extent that the pool has insufficient funds to meet the borrowing needs of its participants, which may require Pepco Holdings to borrow funds for deposit from external sources.

Regulatory and Other Matters

Rate Proceedings

Distribution

The rates that each of Pepco, DPL and ACE is permitted to charge for the retail distribution of electricity and natural gas to its various classes of customers are based on the principle that the utility is entitled to generate an amount of revenue sufficient to recover the cost of providing the service, including a reasonable rate of return on its invested capital. These “base rates” are intended to cover all of each utility’s reasonable and prudent expenses of constructing, operating and maintaining its distribution facilities (other than costs covered by specific cost-recovery surcharges).

 

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A change in base rates in a jurisdiction requires the approval of the public service commission. In the rate application submitted to the public service commission, the utility specifies an increase in its “revenue requirement,” which is the additional revenue that the utility is seeking authorization to earn. The “revenue requirement” consists of (i) the allowable expenses incurred by the utility, including operation and maintenance expenses, taxes and depreciation, and (ii) the utility’s cost of capital. The compensation of the utility for its cost of capital takes the form of an overall “rate of return” allowed by the public service commission on the utility’s distribution “rate base” to compensate the utility’s investors for their debt and equity investments in the company. The rate base is the aggregate value of the investment in property used by the utility in providing electricity and natural gas distribution services and generally consists of plant in service net of accumulated depreciation and accumulated deferred taxes, plus cash working capital, material and operating supplies and, depending on the jurisdiction, construction work in progress. Over time, the rate base is increased by utility property additions and reduced by depreciation and property retirements and write-offs.

In addition to its base rates, some of the costs of providing distribution service are recovered through the operation of surcharges. Examples of costs recovered by PHI’s utility subsidiaries through surcharges, which vary depending on the jurisdiction, include: a surcharge to reimburse the utility for the cost of purchasing electricity from NUGs (New Jersey); surcharges to reimburse the utility for costs of public interest programs for low income customers and for demand-side management programs (New Jersey, Maryland, Delaware and the District of Columbia); a surcharge to pay the Transitional Bond Charge (New Jersey); surcharges to reimburse the utility for certain environmental costs (Delaware and Maryland); and surcharges related to the BSA (Maryland and the District of Columbia). Each utility subsidiary regularly reviews its distribution rates in each jurisdiction of its service territory, and files applications to adjust its rates as necessary in an effort to ensure that its revenues are sufficient to cover its operating expenses and its cost of capital. The timing of future rate filings and the change in the distribution rate requested will depend on a number of factors, including changes in revenues and expenses and the incurrence or the planned incurrence of capital expenditures.

As further described in the “– General Overview – Agreement and Plan of Merger with Exelon Corporation,” PHI has entered into the Merger Agreement with Exelon and Merger Sub. Subject to certain exceptions, prior to the Merger or the termination of the Merger Agreement, PHI and its subsidiaries may not, without the consent of Exelon, initiate, file or pursue any rate cases, other than concluding pending filings. In addition, the regulatory commissions may seek to suspend or delay one or more of the ongoing proceedings as a result of the Merger Agreement.

In general, a request for new distribution rates is made on the basis of “test year” balances for rate base allowable operating expenses and a requested rate of return. The test year amounts used in the filing may be historical or partially projected. The public service commission may, however, select a different test period than that proposed by the applicable utility. Although the approved tariff rates are intended to be forward-looking, and therefore provide for the recovery of some future changes in rate base and operating costs, they typically do not reflect all of the changes in costs for the period in which the new rates are in effect. See “– General Overview – Power Delivery Initiatives and Activities – Mitigation of Regulatory Lag.”

 

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The following table shows, for each of the PHI utility subsidiaries, the authorized return on equity as determined in the most recently concluded base rate proceeding and the effective date of the authorized return:

 

    

Authorized

Return on Equity

   Rate Effective Date

Pepco:

     

District of Columbia (electricity)

         9.40%         April 2014

Maryland (electricity)

         9.62%         July 2014

DPL:

     

Delaware (electricity)

         9.70%         May 2014 (a)

Maryland (electricity)

         9.81% (b)    September 2013