10-K 1 phi10k-2008.htm ANNUAL REPORT ON FORM 10-K phi10k-2008.htm
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, 2008
 
Commission
File Number
 
Name of Registrant, State of Incorporation,
Address of Principal Executive Offices,
and Telephone Number
 
I.R.S. Employer
Identification Number
 
001-31403
 
 
PEPCO HOLDINGS, INC.
(Pepco Holdings or PHI), a
  Delaware corporation
701 Ninth Street, N.W.
Washington, D.C.  20068
Telephone: (202)872-2000
 
 
 
52-2297449
001-01072
 
POTOMAC ELECTRIC POWER
COMPANY
(Pepco), a District of
  Columbia and Virginia
  corporation
701 Ninth Street, N.W.
Washington, D.C.  20068
Telephone: (202)872-2000
 
 
53-0127880
001-01405
 
DELMARVA POWER & LIGHT
COMPANY
(DPL), a Delaware and
  Virginia corporation
800 King Street, P.O. Box 231
Wilmington, Delaware  19899
Telephone: (202)872-2000
 
 
51-0084283
001-03559
 
ATLANTIC CITY ELECTRIC
COMPANY
(ACE), a New Jersey
  corporation
800 King Street, P.O. Box 231
Wilmington, Delaware  19899
Telephone: (202)872-2000
 
 
21-0398280


 
 
Continued

 

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 the 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 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 the definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K (applicable to Pepco Holdings only).     X   
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer.  See definition of “accelerated filer and larger accelerated filer” in Rule 12b-2 of the Exchange Act.

 
Large Accelerated Filer
 
Accelerated Filer
 
Non-Accelerated Filer
 
Pepco Holdings
X
         
Pepco
       
X
 
DPL
       
X
 
ACE
       
X
 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the 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, 2008
 
Number of Shares of Common Stock of the Registrant Outstanding at February 2, 2009
Pepco Holdings
 
$5.2 billion
 
219,115,048
($.01 par value)
Pepco
 
None (a)
 
100
($.01 par value)
DPL
 
None (b)
 
1,000
($2.25 par value)
ACE
 
None (b)
 
8,546,017
($3.00 par value)

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

THIS COMBINED FORM 10-K IS SEPARATELY FILED BY PEPCO HOLDINGS, PEPCO, DPL AND ACE.  INFORMATION CONTAINED HEREIN RELATING TO ANY INDIVIDUAL REGISTRANT IS FILED BY SUCH REGISTRANT ON ITS OWN BEHALF.  EACH REGISTRANT MAKES NO REPRESENTATION AS TO INFORMATION RELATING TO THE OTHER REGISTRANTS.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
Portions of the Pepco Holdings, Inc. definitive proxy statement for the 2009 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission on or about March 26, 2009 are incorporated by reference into Part III of this report.



 
 

 


TABLE OF CONTENTS
     
Page
 
-
Glossary of Terms
i
PART I
     
  Item 1.
-
Business
1
  Item 1A.
-
Risk Factors
21
  Item 1B.
-
Unresolved Staff Comments
31
  Item 2.
-
Properties
32
  Item 3.
-
Legal Proceedings
33
  Item 4.
-
Submission of Matters to a Vote of Security Holders
34
PART II
     
  Item 5.
-
Market for Registrant’s Common Equity, Related
   Stockholder Matters and Issuer Purchases of
   Equity Securities
35
  Item 6.
-
Selected Financial Data
38
  Item 7.
-
Management’s Discussion and Analysis of
   Financial Condition and Results of Operations
39
  Item 7A.
-
Quantitative and Qualitative Disclosures
   About Market Risk
140
  Item 8.
-
Financial Statements and Supplementary Data
145
  Item 9.
-
Changes in and Disagreements With Accountants
   on Accounting and Financial Disclosure
361
  Item 9A.
-
Controls and Procedures
361
  Item 9A(T).
-
Controls and Procedures
361
  Item 9B.
-
Other Information
363
PART III
     
  Item 10.
-
Directors, Executive Officers and Corporate Governance
364
  Item 11.
-
Executive Compensation
366
  Item 12.
-
Security Ownership of Certain Beneficial Owners and
   Management and Related Stockholder Matters
367
  Item 13.
-
Certain Relationships and Related Transactions, and
   Director Independence
368
  Item 14.
-
Principal Accounting Fees and Services
368
PART IV
     
  Item 15.
-
Exhibits, Financial Statement Schedules
369
   Financial Statements
Included in Part II, Item 8
369
   Schedule I                                                 -
Condensed Financial Information of Parent Company
370
   Schedule II                                                -
Valuation and Qualifying Accounts
373
   Exhibit 12                                                   -
Statements Re: Computation of Ratios
389
   Exhibit 21                                                   -
Subsidiaries of the Registrant
393
   Exhibit 23                                                   -
Consents of Independent Registered Public Accounting Firm
395
Exhibits 31.1 - 31.8
Rule 13a-14a/15d-14(a) Certifications
399
Exhibits 32.1 - 32.4
Section 1350 Certifications
407
  Signatures
411


 
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GLOSSARY OF TERMS
 

Term
Definition
2007 Maryland Rate Orders
The MPSC orders approving new electric service distribution base rates for Pepco and DPL in Maryland, each effective June 16, 2007.
A&N
A&N Electric Cooperative, purchaser of DPL’s retail electric distribution assets in Virginia
ABO
Accumulated benefit obligation
ACE
Atlantic City Electric Company
ACE Funding
Atlantic City Electric Transition Funding LLC
ADITC
Accumulated deferred investment tax credits
AFUDC
Allowance for Funds Used During Construction
AMI
Advanced Metering Infrastructure
Ancillary services
Generally, electricity generation reserves and reliability services
APIC
Additional paid-in capital
APIC pool
A computation that establishes the beginning balance of the APIC
Appeals Office
The Appeals Office of the IRS
Bankruptcy Funds
$13 million from the Bankruptcy Settlement to accomplish the remediation of the Metal Bank/Cottman Avenue site
Bankruptcy Settlement
The bankruptcy settlement among the parties concerning the environmental proceedings at the Metal Bank/Cottman Avenue site
BGS
Basic Generation Service (the supply of electricity by ACE to retail customers in New Jersey who have not elected to purchase electricity from a competitive supplier)
BGS-FP
BGS-Fixed Price service
BGS-CIEP
BGS-Commercial and Industrial Energy Price service
Bondable Transition   Property
Right to collect a non-bypassable transition bond charge from ACE customers pursuant to bondable stranded costs rate orders issued by the NJBPU
BSA
Bill Stabilization Adjustment
CAA
Federal Clean Air Act
CAIR
EPA’s Clean Air Interstate rule
CAMR
EPA’s Clean Air Mercury rule
CERCLA
Comprehensive Environmental Response, Compensation, and Liability Act of 1980
Citgo
Citgo Asphalt Refining Company
CO2
Carbon dioxide
Conectiv
A wholly owned subsidiary of PHI which is a holding company under PUHCA 2005 and the parent of DPL and ACE
Conectiv Energy
Conectiv Energy Holding Company and its subsidiaries
Conectiv Group
Conectiv and certain of its subsidiaries that were involved in a like-kind exchange transaction under examination by the IRS
Cooling Degree Days
Daily difference in degrees by which the mean (high and low divided by 2) dry bulb temperature is above a base of 65 degrees Fahrenheit
CRMC
PHI’s Corporate Risk Management Committee
CWA
Federal Clean Water Act
D. C. Circuit
United States Court of Appeals for the District of Columbia Circuit
DC OPC
District of Columbia Office of People’s Counsel
DCPSC
District of Columbia Public Service Commission
   


 
  ii

 


Term
Definition
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 and period, is also known as SOS or BGS service
Default Supply Revenue
Revenue received for Default Electricity Supply
Delaware District Court
United States District Court for the District of Delaware
Delta Project
Conectiv Energy’s 545 megawatt natural gas and oil-fired combined-cycle electricity generation plant located in Peach Bottom Township, Pennsylvania
DNREC
Delaware Department of Natural Resources and Environmental Control
DPL
Delmarva Power & Light Company
DPSC
Delaware Public Service Commission
DRP
PHI’s Shareholder Dividend Reinvestment Plan
DSM
Demand Side Management
EDIT
Excess Deferred Income Taxes
EITF
Emerging Issues Task Force
EPA
United States Environmental Protection Agency
EPS
Earnings per share
ERISA
Employee Retirement Income Security Act of 1974
Exchange Act
Securities Exchange Act of 1934, as amended
FAS
Financial Accounting Standards
FASB
Financial Accounting Standards Board
FERC
Federal Energy Regulatory Commission
FHACA
Flood Hazard Area Control Act
FIFO
First in first out
FIN
FASB Interpretation Number
FPA
Federal Power Act
FSP
FASB Staff Position
FSP AUG AIR-1
FSP American Institute of Certified Public Accountants Industry Audit Guide, Audits of Airlines — “Accounting for Planned Major Maintenance Activities”
FWPA
Freshwater Wetlands Protection Act
GAAP
Accounting principles generally accepted in the United States of America
GCR
Gas Cost Recovery
GWh
Gigawatt hour
Heating Degree Days
Daily difference in degrees by which the mean (high and low divided by 2) dry bulb temperature is below a base of 65 degrees Fahrenheit.
HEDD
High electric demand day
HPS
Hourly Priced Service DPL is obligated to provide to its largest customers
IRC
Internal Revenue Code
IRS
Internal Revenue Service
ISO
Independent system operator
ISONE
Independent System Operator - New England
ITC
Investment Tax Credit
LTIP
Pepco Holdings’ Long-Term Incentive Plan
MAPP
Mid-Atlantic Power Pathway
Maryland OPC
Maryland Office of People’s Counsel
Mcf
One thousand cubic feet
Medicare Act
Medicare Prescription Drug, Improvement and Modernization Act of 2003
Mirant
Mirant Corporation
MPSC
Maryland Public Service Commission
NERC
North American Electric Reliability Corporation


 
iii 

 


Term
Definition
NFA
No Further Action letter issued by the NJDEP
NJBPU
New Jersey Board of Public Utilities
NJDEP
New Jersey Department of Environmental Protection
NJPDES
New Jersey Pollutant Discharge Elimination System
Normalization
  provisions
Sections of the IRC and related regulations that dictate how excess deferred income taxes resulting from the corporate income tax rate reduction enacted by the Tax Reform Act of 1986 and accumulated deferred investment tax credits should be treated for ratemaking purposes
NOx
Nitrogen oxide
NPDES
National Pollutant Discharge Elimination System
NUGs
Non-utility generators
NYDEC
New York Department of Environmental Conservation
ODEC
Old Dominion Electric Cooperative, purchaser of DPL’s wholesale transmission business in Virginia
Panda
Panda-Brandywine, L.P.
Panda PPA
PPA between Pepco and Panda
PARS
Performance Accelerated Restricted Stock
PBO
Projected benefit obligation
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 Parties
The PHI Retirement Plan, PHI and Conectiv, parties to cash balance plan litigation brought by three management employees of PHI Service Company
PHI Retirement Plan
PHI’s noncontributory retirement plan
PJM
PJM Interconnection, LLC
Power Delivery
PHI’s Power Delivery Business
PPA
Power Purchase Agreement
PRP
Potentially responsible party
PUHCA 2005
Public Utility Holding Company Act of 2005, which became effective February 8, 2006
RAR
IRS revenue agent’s report
RARM
Reasonable Allowance for Retail Margin
RC Cape May
RC Cape May Holdings, LLC, an affiliate of Rockland Capital Energy Investments, LLC, and the purchaser of the B.L. England generating facility
RECs
Renewable energy credits
Recoverable stranded
  costs
The portion of stranded costs that is recoverable from ratepayers as approved by regulatory authorities
Regulated T&D Electric
  Revenue
Revenue from the transmission and the delivery of electricity to PHI’s customers within its service territories at regulated rates
Revenue Decoupling
  Adjustment
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
RGGI
Regional Greenhouse Gas Initiative
ROE
Return on equity
RPM
Reliability Pricing Model
SEC
Securities and Exchange Commission
Sempra
Sempra Energy Trading LLP
SFAS
Statement of Financial Accounting Standards
SILO
Sale-in/lease-out
SNCR
Selective Non-Catalytic Reduction


 
iv 

 


Term
Definition
SO2
Sulfur dioxide
SOS
Standard Offer Service (the supply of electricity by Pepco in the District of Columbia, by Pepco and DPL in Maryland and by DPL in Delaware on and after May 1, 2006, to retail customers who have not elected to purchase electricity from a competitive supplier)
Spark spread
The market price for electricity less the product of the cost of fuel times the unit heat rate.  It is used to estimate the relative profitability of a generation unit.
SPCC
Spill Prevention, Control, and Countermeasure plan required by EPA
Spot
Commodities market in which goods are sold for cash and delivered immediately
Standard Offer Service
  revenue or SOS revenue
Revenue Pepco and DPL, respectively, receive for the procurement of energy for its SOS customers
Starpower
Starpower Communications, LLC
Stranded costs
Costs incurred by a utility in connection with providing service which would be unrecoverable in a competitive or restructured market.  Such costs may include costs for generation assets, purchased power costs, and regulatory assets and liabilities, such as accumulated deferred income taxes.
T&D
Transmission and distribution
Tolling agreement
A physical or financial contract where one party delivers fuel to a specific generating station in exchange for the power output
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
Treasury lock
A hedging transaction that allows a company to “lock-in” a specific interest rate corresponding to the rate of a designated Treasury bond for a determined period of time
VaR
Value at Risk
VIE
Variable interest entity
VRDBs
Variable Rate Demand Bonds




 


 

 


 

 

 

 

 

 

 

 

 

 

 

 

 
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Item 1.    BUSINESS
 
OVERVIEW
 
Pepco Holdings, Inc. (PHI or Pepco Holdings), a Delaware corporation incorporated in 2001, is a diversified energy company that, through its operating subsidiaries, is engaged primarily in two businesses:

 
·
The distribution, transmission and default supply of electricity and the delivery and supply of natural gas (Power Delivery), conducted through the following regulated public utility companies:

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

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

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

 
·
Competitive energy generation, marketing and supply (Competitive Energy) conducted through subsidiaries of Conectiv Energy Holding Company (collectively Conectiv Energy) and Pepco Energy Services, Inc. and its subsidiaries (collectively Pepco Energy Services).

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


 
1

 


Conectiv is solely a holding company with no business operations.  The activities of Potomac Capital Investment Corporation (PCI) are described below under the heading “Other Business Operations.”

PHI Service Company, a subsidiary service company of PHI, provides a variety of support services, including legal, accounting, treasury, tax, purchasing and information technology services to PHI and its operating subsidiaries.  These services are provided pursuant to a service agreement among PHI, PHI Service Company, and the participating operating subsidiaries.  The expenses of PHI Service Company are charged to PHI and the participating operating subsidiaries in accordance with costing methodologies set forth in the service agreement.
 
Pepco Holdings’ management has identified its operating segments at December 31, 2008 as Power Delivery, Conectiv Energy, Pepco Energy Services, and Other Non-Regulated.For financial information relating to PHI’s segments, see Note (5), “Segment Information” to the consolidated financial statements of PHI set forth in Part II, Item 8.  Each of Pepco, DPL and ACE has one operating segment.

Investor Information
 
Each of PHI, Pepco, DPL and ACE files reports under the Securities Exchange Act of 1934, as amended.  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 of the companies are made available free of charge on PHI’s internet Web site as soon as reasonably practicable after such documents are electronically filed with or furnished to the Securities and Exchange Commission (SEC).  These reports may be found at http://www.pepcoholdings.com/investors.
 
Description of Business
 
The following is a description of each of PHI’s two principal business operations.
 
Power Delivery
 
The largest component of PHI’s business is Power Delivery, which consists of the transmission, distribution and default supply of electricity and the delivery and supply of natural gas.  In 2008, 2007 and 2006, respectively, PHI’s Power Delivery operations produced 51%, 56%, and 61% of PHI’s consolidated operating revenues (including revenue from intercompany transactions) and 72%, 66%, and 67% of PHI’s consolidated operating income (including income from intercompany transactions).
 
Each of Pepco, DPL and ACE is a regulated public utility in the jurisdictions that comprise its service territory.  Each company owns and operates a network of wires, substations and other equipment that is classified either as transmission or distribution facilities.  Transmission facilities are high-voltage systems that carry wholesale electricity into, or across, the utility’s service territory.  Distribution facilities are low-voltage systems that carry electricity to end-use customers in the utility’s service territory.
 

 
2

 

Delivery of Electricity, Natural Gas and Default Electricity Supply
 
The Power Delivery business is conducted by PHI’s three utility subsidiaries:  Pepco, DPL and ACE.  Each company is responsible for the delivery of electricity and, in the case of DPL, also natural gas in its service territory, for which it is paid tariff rates established by the applicable local public service commission.  Each company also supplies electricity at regulated rates to retail customers in its service territory who do not elect to purchase electricity from a competitive energy supplier.  The regulatory term for this supply service varies by jurisdiction as follows:

 
Delaware
Standard Offer Service (SOS)

      
District of Columbia
SOS

 
Maryland
SOS

 
New Jersey
Basic Generation Service (BGS)

Effective January 2, 2008, DPL sold its retail electric distribution assets and its wholesale electric transmission assets in Virginia.  This sale terminated DPL’s obligations as a supplier of electricity to retail customers in its Virginia service territory who do not elect to purchase electricity from a competitive supplier.
 
In this Form 10-K, the supply service obligations of the respective utility subsidiaries are referred to generally as Default Electricity Supply.
 
In the aggregate, the Power Delivery business delivers electricity to more than 1.8 million customers in the mid-Atlantic region and distributes natural gas to approximately 122,000 customers in Delaware.
 
Transmission of Electricity and Relationship with PJM
 
The transmission facilities owned by Pepco, DPL and ACE are interconnected with the transmission facilities of contiguous utilities and are part of an interstate power transmission grid over which electricity is transmitted throughout the mid-Atlantic portion of the United States and parts of the Midwest.  The Federal Energy Regulatory Commission (FERC) has designated a number of regional transmission organizations to coordinate the operation and planning of portions of the interstate transmission grid.  Pepco, DPL and ACE are members of the PJM Regional Transmission Organization (PJM RTO).  In 1997, FERC approved PJM Interconnection, LLC (PJM) as the provider of transmission service in the PJM RTO region, which currently consists of all or parts of Delaware, Illinois, Indiana, Kentucky, Maryland, Michigan, New Jersey, North Carolina, Ohio, Pennsylvania, Tennessee, Virginia, West Virginia and the District of Columbia.  As the independent grid operator, PJM coordinates the electric power market and the movement of electricity within the PJM RTO region.  Any entity that wishes to have electricity delivered at any point in the PJM RTO region must obtain transmission services from PJM, at rates approved by FERC.  In accordance with FERC-approved rules, Pepco, DPL, ACE and the other transmission-owning utilities in the region make their transmission facilities available to the PJM RTO and PJM directs and controls the operation of these transmission facilities.  Transmission rates are proposed by the transmission owner and
 

 
3

 

approved by FERC.  PJM provides billing and settlement services, collects transmission service revenue from transmission service customers and distributes the revenue to the transmission owners.  PJM also directs the regional transmission planning process within the PJM RTO region.  The PJM Board of Managers reviews and approves each PJM regional transmission expansion plan.
 
Distribution of Electricity and Deregulation
 
Historically, electric utilities, including Pepco, DPL and ACE, were vertically integrated businesses that generated all or a substantial portion of the electric power supply that they delivered to customers in their service territories over their own distribution facilities.  Customers were charged a bundled rate approved by the applicable regulatory authority that covered both the supply and delivery components of the retail electric service.  However, legislative and regulatory actions in each of the service territories in which Pepco, DPL and ACE operate have resulted in the “unbundling” of the supply and delivery components of retail electric service and in the opening of the supply component to competition from non-regulated providers.  Accordingly, while Pepco, DPL and ACE continue to be responsible for the distribution of electricity in their respective service territories, as the result of deregulation, customers in those service territories now are permitted to choose their electricity supplier from among a number of non-regulated, competitive suppliers.  Customers who do not choose a competitive supplier receive Default Electricity Supply on terms that vary depending on the service territory, as described more fully below.
 
In connection with the deregulation of electric power supply, Pepco, DPL and ACE have divested all of their respective generation assets, by either selling them to third parties or transferring them to the non-regulated affiliates of PHI that comprise PHI’s Competitive Energy businesses.  Accordingly, Pepco, DPL and ACE are no longer engaged in generation operations.
 
Seasonality
 
Power Delivery’s operating results historically have been seasonal, generally producing higher revenue and income in the warmest and coldest periods of the year.  In Maryland, however, the decoupling of distribution revenue for a given reporting period from the amount of power delivered during the period, as the result of the adoption in 2007 by the Maryland Public Service Commission (MPSC) of a bill stabilization adjustment mechanism for retail customers, has had the effect of eliminating changes in customer usage due to weather conditions or other reasons as a factor having an impact on revenue and income.

Regulation
 
The retail operations of PHI’s utility subsidiaries, including the rates they are permitted to charge customers for the delivery and transmission of electricity and, in the case of DPL, also the distribution and transportation of natural gas, are subject to regulation by governmental agencies in the jurisdictions in which they provide utility service as follows:
 
o  
Pepco’s electricity delivery operations are regulated in Maryland by the MPSC and in Washington, D.C. by the District of Columbia Public Service Commission (DCPSC).
 
o  
DPL’s electricity delivery operations are regulated in Maryland by the MPSC and in Delaware by the Delaware Public Service Commission (DPSC) and, until the sale of
 

 
4

 

its Virginia assets on January 2, 2008, were regulated in Virginia by the Virginia State Corporation Commission.
 
o  
DPL’s natural gas distribution and intrastate transportation operations in Delaware are regulated by the DPSC.
 
o  
ACE’s electricity delivery operations are regulated by the New Jersey Board of Public Utilities (NJBPU).
 
o  
The transmission and wholesale sale of electricity by each of PHI’s utility subsidiaries are regulated by FERC.
 
o  
The interstate transportation and wholesale sale of natural gas by DPL is regulated by FERC.
 
Pepco
 
Pepco is engaged in the transmission, distribution and default supply of electricity in Washington, D.C. and major portions of Prince George’s County and Montgomery County in suburban Maryland.  Pepco’s service territory covers approximately 640 square miles and has a population of approximately 2.1 million.  As of December 31, 2008, Pepco delivered electricity to 767,000 customers (of which 247,000 were located in the District of Columbia and 520,000 were located in Maryland), as compared to 760,000 customers as of December 31, 2007 (of which 241,800 were located in the District of Columbia and 518,200 were located in Maryland).
 
In 2008, Pepco delivered a total of 26,863,000 megawatt hours of electricity, of which 29% was delivered to residential customers, 51% to commercial customers, and 20% to United States and District of Columbia government customers.  In 2007, Pepco delivered a total of 27,451,000 megawatt hours of electricity, of which 30% was delivered to residential customers, 50% to commercial customers, and 20% to United States and District of Columbia government customers.
 
Pepco has been providing market-based SOS in Maryland since July 2004.  Pursuant to an order issued by the MPSC in November 2006, Pepco will continue to be obligated to provide SOS to residential and small commercial customers indefinitely, until further action of the Maryland General Assembly, and to medium-sized commercial customers through May 2010.  Pepco purchases the power supply required to satisfy its SOS obligation from wholesale suppliers under contracts entered into pursuant to competitive bid procedures approved and supervised by the MPSC.  Pepco also has an on-going obligation to provide SOS service, known as Hourly Priced Service (HPS), for the largest customers.  Power to supply the SOS HPS customers is acquired in next-day and other short-term PJM RTO markets.  Pepco is entitled to recover from its SOS customers the cost of the SOS supply plus an average margin of $.001651 per kilowatt-hour.  Because margins vary by customer class, the actual average margin over any given time period depends on the number of Maryland SOS customers from each customer class and the load taken by such customers over the time period.  Pepco is paid tariff delivery rates for the delivery of electricity over its transmission and distribution facilities to all electricity customers in its Maryland service territory regardless of whether the customer receives SOS or purchases electricity from another energy supplier.
 

 
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Pepco has been providing market-based SOS in the District of Columbia since February 2005.  Pursuant to orders issued by the DCPSC, Pepco will continue to be obligated to provide SOS to residential and small and large commercial customers indefinitely, pending investigation by the DCPSC of other alternatives, including the selection of another party to administer the SOS franchise.  Pepco purchases the power supply required to satisfy its SOS obligation from wholesale suppliers under contracts entered into pursuant to a competitive bid procedure approved by the DCPSC.  Pepco is entitled to recover from its SOS customers the costs associated with the acquisition of the SOS supply, plus administrative charges that are intended to allow Pepco to recover the administrative costs incurred to provide the SOS.  These administrative charges include an average margin for Pepco of $.002151 per kilowatt-hour.  Because margins vary by customer class, the actual average margin over any given time period depends on the number of District of Columbia SOS customers from each customer class and the load taken by such customers over the time period.  Pepco is paid tariff delivery rates for the delivery of electricity over its transmission and distribution facilities to all electricity customers in its District of Columbia service territory regardless of whether the customer receives SOS or purchases electricity from another energy supplier.
 
For the year ended December 31, 2008, 50% of Pepco’s Maryland distribution sales (measured by megawatt hours) were to SOS customers, as compared to 51% in 2007, and 33% of its District of Columbia distribution sales were to SOS customers in 2008, as compared to 35% in 2007.
 
DPL
 
DPL is engaged in the transmission, distribution and default supply of electricity in Delaware and portions of Maryland. In northern Delaware, DPL also supplies and distributes natural gas to retail customers and provides transportation-only services to retail customers that purchase natural gas from other suppliers.

Transmission and Distribution of Electricity

In Delaware, electricity service is provided in the counties of Kent, New Castle, and Sussex and in Maryland in the counties of Caroline, Cecil, Dorchester, Harford, Kent, Queen Anne’s, Somerset, Talbot, Wicomico and Worchester.  Prior to January 2, 2008, DPL also provided transmission and distribution of electricity in Accomack and Northampton counties in Virginia.  As discussed below, under the heading “Sale of Virginia Retail Electric Distribution and Wholesale Transmission Assets,” DPL, on January 2, 2008, completed the sale of substantially all of its Virginia retail electric distribution and wholesale electric transmission assets.
 
DPL’s electricity distribution service territory covers approximately 5,000 square miles and has a population of approximately 1.3 million.  As of December 31, 2008, DPL delivered electricity to 498,000 customers (of which 299,000 were located in Delaware and 199,000 were located in Maryland), as compared to 519,000 electricity customers as of December 31, 2007 (of which 298,000 were located in Delaware, 198,000 were located in Maryland, and 23,000 were located in Virginia).
 
In 2008, DPL delivered a total of 13,015,000 megawatt hours of electricity to its customers, of which 39% was delivered to residential customers, 41% to commercial customers
 

 
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and 20% to industrial customers.  In 2007, DPL delivered a total of 13,680,000 megawatt hours of electricity, of which 39% was delivered to residential customers, 40% to commercial customers and 21% to industrial customers.
 
DPL has been providing market-based SOS in Delaware since May 2006.  Pursuant to orders issued by the DPSC, DPL will continue to be obligated to provide fixed-price SOS to residential, small commercial and industrial customers through May 2012 and to medium, large and general service commercial customers through May 2010.  DPL purchases the power supply required to satisfy its fixed-price SOS obligation from wholesale suppliers under contracts entered into pursuant to competitive bid procedures approved by the DPSC.  DPL also has an obligation to provide SOS service, known as HPS for the largest customers.  Power to supply the HPS customers is acquired on next-day and other short-term PJM RTO markets.  DPL’s rates for supplying fixed-price SOS and HPS reflect the associated capacity, energy, transmission, and ancillary services costs and a Reasonable Allowance for Retail Margin (RARM).  Components of the RARM include a fixed annual margin of approximately $3 million, plus estimated incremental expenses, a cash working capital allowance, and recovery with a return over five years of the capitalized costs of the billing system used for billing HPS customers.  DPL is paid tariff delivery rates for the delivery of electricity over its transmission and distribution facilities to all electricity customers in its Delaware service territory regardless of whether the customer receives SOS or purchases electricity from another energy supplier.
 
In Delaware, DPL distribution sales to SOS customers represented 55% of total distribution sales (measured by megawatt hours) for the year ended December 31, 2008, as compared to 54% in 2007.
 
           DPL has been providing market-based SOS in Maryland since June 2004.  Pursuant to an order issued by the MPSC in November 2006, DPL will continue to be obligated to provide SOS to residential and small commercial customers indefinitely until further action of the Maryland General Assembly, and to medium-sized commercial customers through May 2010.  DPL purchases the power supply required to satisfy its SOS obligation from wholesale suppliers under contracts entered into pursuant to competitive bid procedures approved and supervised by the MPSC.  DPL also has an on-going obligation to provide SOS service, known as HPS, for the largest customers.  Power to supply the SOS HPS customers is acquired in next-day and other short-term PJM RTO markets.  DPL purchases the power supply required to satisfy its SOS obligation from wholesale suppliers under contracts entered into pursuant to competitive bid procedures approved and supervised by the MPSC.  DPL is entitled to recover from its SOS customers the costs of the SOS supply plus an average margin of $.001630 per kilowatt-hour.  Because margins vary by customer class, the actual average margin over any given time period depends on the number of Maryland SOS customers from each customer class and the load taken by such customers over the time period.  DPL is paid tariff delivery rates for the delivery of electricity over its transmission and distribution facilities to all electricity customers in its Maryland service territory regardless of whether the customer receives SOS or purchases electricity from another energy supplier.
 
In Maryland, DPL distribution sales to SOS customers represented 65% of total distribution sales (measured by megawatt hours) for the year ended December 31, 2008, as compared to 67% in 2007.
 

 
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DPL provided Default Service in Virginia from March 2004 until the sale of its Virginia retail electric distribution and wholesale transmission assets on January 2, 2008.  DPL was paid tariff delivery rates for the delivery of electricity over its transmission and distribution facilities to all electricity customers in its Virginia service territory regardless of whether the customer received Default Service or purchased electricity from another energy supplier.
 
In Virginia, DPL distribution sales to Default Service customers represented 94% of total distribution sales (measured by megawatt hours) for the year ended December 31, 2007.
 
Sale of Virginia Retail Electric Distribution and Wholesale Transmission Assets

In January 2008, DPL completed (i) the sale of its retail electric distribution assets on the Eastern Shore of Virginia to A&N Electric Cooperative and (ii) the sale of its wholesale electric transmission assets located on the Eastern Shore of Virginia to Old Dominion Electric Cooperative.

Natural Gas Distribution
 
DPL provides regulated natural gas supply and distribution service to customers in a service territory consisting of a major portion of New Castle County in Delaware.  This service territory covers approximately 275 square miles and has a population of approximately 500,000. Large volume commercial, institutional, or industrial natural gas customers may purchase natural gas either from DPL or from other suppliers.  DPL uses its natural gas distribution facilities to transport natural gas for customers that choose to purchase natural gas from other suppliers.  Intrastate transportation customers pay DPL distribution service rates approved by the DPSC.  DPL purchases natural gas supplies for resale to its retail service customers from marketers and producers through a combination of long-term agreements and next-day delivery arrangements.  For the twelve months ended December 31, 2008, DPL supplied 65% of the natural gas that it delivered, compared to 67% in 2007.
 
DPL distributed natural gas to 122,000 customers as of December 31, 2008 and 2007.  In 2008, DPL distributed 20,300,000 Mcf (thousand cubic feet) of natural gas to customers in its Delaware service territory, of which 38% were sales to residential customers, 24% to commercial customers, 3% to industrial customers, and 35% to customers receiving a transportation-only service.  In 2007, DPL delivered 20,700,000 Mcf of natural gas, of which 38% were sales to residential customers, 25% were sales to commercial customers, 4% were to industrial customers, and 33% were sales to customers receiving a transportation-only service.
 
ACE
 
ACE is primarily engaged in the transmission, distribution and default supply of electricity in a service territory consisting of Gloucester, Camden, Burlington, Ocean, Atlantic, Cape May, Cumberland and Salem counties in southern New Jersey.  ACE’s service territory covers approximately 2,700 square miles and has a population of approximately 1.1 million.  As of December 31, 2008, ACE delivered electricity to 547,000 customers in its service territory, as compared to 544,000 customers as of December 31, 2007.  In 2008, ACE delivered a total of 10,089,000 megawatt hours of electricity to its customers, of which 44% was delivered to residential customers, 44% to commercial customers and 12% to industrial customers.  In 2007, ACE delivered a total of 10,187,000 megawatt hours of electricity to its customers, of which
 

 
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44% was delivered to residential customers, 44% to commercial customers, and 12% to industrial customers.
 
Electric customers in New Jersey who do not choose another supplier receive BGS from their electric distribution company.  New Jersey’s electric distribution companies, including ACE, jointly procure the supply to meet their BGS obligations from competitive suppliers selected through auctions authorized by the NJBPU for New Jersey’s total BGS requirements.  The winning bidders in the auction are required to supply a specified portion of the BGS customer load with full requirements service, consisting of power supply and transmission service.
 
ACE provides two types of BGS:

 
·
BGS-Fixed Price (BGS-FP), which is supplied to smaller commercial and residential customers at seasonally-adjusted fixed prices.  BGS-FP rates change annually on June 1 and are based on the average BGS price obtained at auction in the current year and the two prior years.  ACE’s BGS-FP load is approximately 2,198 megawatts, which represents approximately 99% of ACE’s total BGS load.  Approximately one-third of this total load is auctioned off each year for a three-year term.

 
·
BGS-Commercial and Industrial Energy Price (BGS-CIEP), which is supplied to larger customers at hourly PJM RTO real-time market prices for a term of 12 months. ACE’s BGS-CIEP load is approximately 33 megawatts, which represents approximately 1% of ACE’s BGS load.  This total load is auctioned off each year for a one-year term.

ACE is paid tariff rates established by the NJBPU that compensate it for the cost of obtaining the BGS supply.  ACE does not make any profit or incur any loss on the supply component of the BGS it provides to customers.
 
ACE is paid tariff delivery rates for the delivery of electricity over its transmission and distribution facilities to all electricity customers in its New Jersey service territory regardless of whether the customer receives BGS or purchases electricity from another energy supplier.
 
ACE distribution sales to BGS customers represented 78% of total distribution sales (measured by megawatt hours) for the year ended December 31, 2008, as compared to 80% in 2007.
 
In February 2007, ACE completed the sale of its B.L. England generating facility, which is reflected as discontinued operations on ACE’s consolidated statements of earnings for the years ended December 31, 2007 and 2006. ACE’s sale of its interests in the Keystone and Conemaugh generating facilities in September 2006 is also reflected as discontinued operations on the consolidated statement of earnings for the year ended December 31, 2006 of ACE.
 
ACE has several contracts with non-utility generators (NUGs) under which ACE purchased 3.8 million megawatt hours of power in 2008.  ACE sells the electricity purchased under the contracts with NUGs into the wholesale market administered by PJM.
 

 
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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 have been transferred to ACE in exchange for the transfer by ACE to ACE Funding of the right to collect a non-bypassable 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 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.

Competitive Energy

The Competitive Energy businesses provide competitive generation, marketing and supply of electricity and natural gas, and related energy management services primarily in the mid-Atlantic region. These operations are conducted through subsidiaries of Conectiv Energy and Pepco Energy Services. For the years ended December 31, 2008, 2007 and 2006, PHI’s Competitive Energy operations produced 53%, 48%, and 43%, respectively, of PHI’s consolidated operating revenues and 36%, 26%, and 20%, respectively, of PHI’s consolidated operating income.  
 
Conectiv Energy
 
Conectiv Energy divides its activities into two operational categories:  (i) Merchant Generation & Load Service and (ii) Energy Marketing.

Merchant Generation & Load Service

Conectiv Energy provides wholesale electric power, capacity and ancillary services in the wholesale markets and also supplies electricity to other wholesale market participants under long- and short-term bilateral contracts.  Conectiv Energy supplies electric power to Pepco, DPL and ACE to satisfy a portion of their Default Electricity Supply load, as well as the default electricity supply load shares of other utilities within the PJM RTO and Independent System Operator - New England wholesale markets.  Conectiv Energy obtains the electricity required to meet its Merchant Generation & Load Service power supply obligations from its own generation plants, tolling agreements, bilateral contract purchases from other wholesale market participants and purchases in the wholesale market.  Conectiv Energy’s primary fuel source for its generation plants is natural gas.  Conectiv Energy manages its natural gas supply using a portfolio of long-term, firm storage and transportation contracts, and a variety of derivative instruments.

Conectiv Energy’s generation capacity is concentrated in mid-merit plants, which due to their operating flexibility and multi-fuel capability can quickly change their output level on an economic basis.  Like “peak-load” plants, mid-merit plants generally operate during times when demand for electricity rises and prices are higher.  However, mid-merit plants usually operate more frequently and for longer periods of time than peak-load plants because of better heat rates.  As of December 31, 2008, Conectiv Energy owned and operated mid-merit plants with a combined 2,778 megawatts of capacity, peak-load plants with a combined 639 megawatts of capacity and base-load generating plants with a combined 340 megawatts of capacity.  See
 

 
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Item 2 “Properties” of this Form 10-K.  In addition to the generation plants it owns, Conectiv Energy controls another 500 megawatts of capacity through tolling agreements.
 
Conectiv Energy is constructing a 545 megawatt natural gas and oil-fired combined-cycle electricity generation plant located in Peach Bottom Township, Pennsylvania known as the Delta Project.  The plant will be owned and operated as part of Conectiv Energy and is expected to go into commercial operation in 2011.  Conectiv Energy has entered into a six-year tolling agreement with an unaffiliated energy company under which Conectiv Energy will sell the energy, capacity and most of the ancillary services from the plant for the period June 2011 through May 2017 to the other party.  Under the terms of the tolling agreement, Conectiv Energy will be responsible for the operation and maintenance of the plant, subject to the other party’s control over the dispatch of the plant’s output.  The other party will be responsible for the purchase and scheduling of the fuel to operate the plant and all required emissions allowances.
 
Energy Marketing
 
Conectiv Energy also sells natural gas and fuel oil to very large end-users and to wholesale market participants under bilateral agreements.  Conectiv Energy obtains the natural gas and fuel oil required to meet its supply obligations through market purchases for next day delivery and under long- and short-term bilateral contracts with other market participants.  In addition, Conectiv Energy operates a short-term power desk, which generates margin by identifying and capturing price differences between power pools and locational and timing differences within a power pool.  Conectiv Energy also engages in power origination activities, which primarily represent the fixed margin component of structured power transactions such as default supply service.  Conectiv Energy refers to these operations collectively as Energy Marketing.
 
Pepco Energy Services
 
Pepco Energy Services provides retail energy supply and energy services primarily to commercial, industrial, and government customers.  Pepco Energy Services sells electricity, including electricity from renewable resources, to customers located primarily in the mid-Atlantic and northeastern regions of the U.S., Texas and the Chicago, Illinois areas.  As of December 31, 2008, Pepco Energy Services’ estimated retail electricity backlog was approximately 33 million megawatts for delivery through 2014, an increase of approximately 1 million megawatts over December 31, 2007.  Pepco Energy Services also sells natural gas to customers located primarily in the mid-Atlantic region.
 
Pepco Energy Services also provides energy savings performance contracting services principally to federal, state and local government customers, owns and operates two district energy systems and designs, constructs, and operates combined heat and power and central energy plants.

Pepco Energy Services owns three landfill gas-fired electricity plants that have a total generating capacity rating of 10 megawatts and the output of these plants is sold into the wholesale market administered by PJM and a solar photovoltaic plant that has a generating capacity rating of 2 megawatts and the output of this plant is sold to its host facility.


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

Pepco Energy Services owns and operates two oil-fired power plants.  The power plants are located in Washington, D.C. and have a generating capacity rating of approximately 790 megawatts.  See Item 2 “Properties” of this Form 10-K.  Pepco Energy Services sells the output of these plants into the wholesale market administered by PJM.  In February 2007, Pepco Energy Services provided notice to PJM of its intention to deactivate these plants.  In May 2007, Pepco Energy Services deactivated one combustion turbine at its Buzzard Point facility with a generating capacity of approximately 16 megawatts.  Pepco Energy Services currently plans to deactivate the balance of both plants by May 2012.  PJM has informed Pepco Energy Services that these facilities are not expected to be needed for reliability after that time, but that its evaluation is dependent on the completion of transmission and distribution upgrades.  Pepco Energy Services’ timing for deactivation of these units, in whole or in part, may be accelerated or delayed based on the operating condition of the units, economic conditions, and reliability considerations.  Deactivation will not have a material impact on PHI’s financial condition, results of operations or cash flows.
 
Derivatives and Risk Management
 
PHI’s Competitive Energy businesses use derivative instruments primarily to reduce their financial exposure to changes in the value of their assets and obligations due to commodity price fluctuations.  The derivative instruments used by the Competitive Energy businesses include forward contracts, futures, swaps, and exchange-traded and over-the-counter options.  In addition, the Competitive Energy businesses also manage commodity risk with contracts that are not classified as derivatives.  The two primary risk management objectives are (1) to manage the spread between the cost of fuel used to operate electric generation plants and the revenue received from the sale of the power produced by those plants, and (2) to manage the spread between retail sales commitments and the cost of supply used to service those commitments to ensure stable cash flows, and lock in favorable prices and margins when they become available.
 
Conectiv Energy’s goal is to manage the risk associated with the expected power output of its generation facilities and their fuel requirements.  The risk management goals are approved by PHI’s Corporate Risk Management Committee and may change from time to time based on market conditions.  The actual level of coverage may vary depending on the extent to which Conectiv Energy is successful in implementing its risk management strategies.  For additional discussion of Conectiv Energy’s risk management Activities, see Item 7A “Quantitative and Qualitative Disclosures About Market Risk” set forth in Part II of this Form 10-K.
 
PJM Capacity Markets
 
A source of revenue for the Competitive Energy businesses is the sale of capacity by Conectiv Energy and Pepco Energy Services associated with their respective generating facilities.  The wholesale market for capacity in PJM is administered by PJM which is responsible for ensuring that within the transmission control area there is sufficient generating capability available to meet the load requirements plus a reserve margin.  In accordance with PJM requirements, retail sellers of electricity in the PJM market are required to maintain
 

 
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capacity from generating facilities within the control area or generating facilities outside the control area, which have firm transmission rights into the control area that correspond to their load service obligations.  This capacity can be obtained through the ownership of generation facilities, entry into bilateral contracts or the purchase of capacity credits in the auctions administered by PJM. All of the generating facilities owned by the Competitive Energy businesses are located in the transmission control area administered by PJM.  The capacity of a generating unit is determined based on the demonstrated generating capacity of the unit and its forced outage rate.
 
Beginning on June 1, 2007, PJM replaced its former capacity market rules with a forward capacity auction procedure known as the Reliability Pricing Model (RPM), which provides for differentiation in capacity prices between “locational deliverability areas.”  One of the primary objectives of RPM is to encourage the development of new generation sources, particularly in constrained areas.
 
Under RPM, PJM has held five auctions, each covering capacity to be supplied over consecutive 12-month periods, with the most recent auction covering the 12-month period beginning June 1, 2011.  Auctions of capacity for each subsequent 12-month delivery period will be held 36 months ahead of the scheduled delivery year. The next auction, for the period June 2012 through May 2013, will take place in May 2009.  The Competitive Energy businesses are exposed to certain deficiency charges payable to PJM if their generation units fail to meet certain reliability levels.  Some deficiency charges may be reduced by purchasing capacity from PJM or third parties.
 
In addition to participating in the PJM auctions, the Competitive Energy businesses participate in the forward capacity market as both sellers and buyers in accordance with PHI’s risk management policy, and accordingly, prices realized in the PJM capacity auctions may not be indicative of gross margin that PHI earns in respect to its capacity purchases and sales during a given period.
 
Competition
 
The unregulated energy generation, supply and marketing businesses located primarily in the mid-Atlantic region are characterized by intense competition at both the wholesale and retail levels.  At the wholesale level, Conectiv Energy and Pepco Energy Services compete with numerous non-utility generators, independent power producers, wholesale power marketers and brokers, and traditional utilities that continue to operate generation assets.  In the retail energy supply market and in providing energy management services, Pepco Energy Services competes with numerous competitive energy marketers and other service providers.  Competition in both the wholesale and retail markets for energy and energy management services is based primarily on price and, to a lesser extent, the range and quality of services offered to customers.
 
Seasonality
 
The power generation, supply and marketing businesses are seasonal and weather patterns can have a material impact on operating performance.  Demand for electricity generally is higher in the summer months associated with cooling and demand for electricity and natural gas generally is higher in the winter months associated with heating, as compared to other times of the year.  Historically, the competitive energy operations of Conectiv Energy and Pepco
 

 
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Energy Services have generated less revenue when temperatures are milder than normal in the winter and cooler than normal in the summer.  Milder weather can also negatively impact income from these operations.  The energy management services of Pepco Energy Services generally are not seasonal.
 
Other Business Operations
 
Through its subsidiary PCI, PHI maintains a portfolio of cross-border energy sale-leaseback transactions, with a book value at December 31, 2008 of approximately $1.3 billion.  For additional information concerning these cross-border lease transactions, see Note (16), “Commitments and Contingencies” to the consolidated financial statements of PHI set forth in Item 8 “Financial Statements and Supplementary Data” of the Form 10-K.  This activity constitutes a separate operating segment for financial reporting purposes, which is designated “Other Non-Regulated.”
 
EMPLOYEES
 
At December 31, 2008, PHI had 5,474 employees, including 1,343 employed by Pepco, 898 employed by DPL, 523 employed by ACE and 1,893 employed by PHI Service Company.  The remaining were employed by PHI’s Competitive Energy and other non-regulated businesses.  Approximately 2,896 employees (including 1,047 employed by Pepco, 727 employed by DPL, 378 employed by ACE, 341 employed by PHI Service Company, and 403 employed by the Competitive Energy businesses) are covered by collective bargaining agreements with various locals of the International Brotherhood of Electrical Workers.
 
ENVIRONMENTAL MATTERS

PHI, through its subsidiaries, is subject to regulation by various federal, regional, state, and local authorities with respect to the environmental effects of its operations, including air and water quality control, solid and hazardous waste disposal, and limitations on land use.  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’ currently projected capital expenditures plan 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 expected to be approximately $37 million in 2009 and $32 million in 2010. These expenditures include $18 million and $11 million, respectively, to comply with multi-pollutant regulations adopted by the Delaware Department of Natural Resources and Environmental Control (DNREC), as more fully discussed below.  The actual costs of environmental compliance may be materially different from this capital expenditures plan 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.


 
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Air Quality Regulation

The generating facilities and operations of PHI’s subsidiaries are 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.

Sulfur Dioxide, Nitrogen Oxide, Mercury and Nickel Emissions

The acid rain provisions of the CAA regulate total sulfur dioxide (SO2) emissions from affected generating units and allocate “allowances” to each affected unit that permit the unit to emit a specified amount of SO2.  The generating facilities of PHI’s subsidiaries that require SO2 allowances use allocated allowances or allowances acquired, as necessary, in the open market to satisfy the applicable regulatory requirements.  Also under current regulations implementing CAA standards, each of the states in which PHI subsidiaries own and operate generating units regulate nitrogen oxide (NOx) emissions from generating units and allocate NOx allowances.  Most of the generating units operated by PHI subsidiaries are subject to NOx emission limits.  These units use allocated allowances or allowances acquired, as necessary, in the open market to maintain compliance with the regulatory requirements during the calendar year and during the ozone season (May 1 to September 30).

In 2005, the United States Environmental Protection Agency (EPA) issued its Clean Air Interstate Rule (CAIR), which imposes further reductions of SO2 and NOx emissions from electric generating units in 28 eastern states and the District of Columbia, including each of the states in which PHI subsidiaries own and operate generating units.  CAIR uses an allowance system to cap state-wide emissions of SO2 and NOx in two stages beginning in 2009 for NOx and in 2010 for SO2.  States may implement CAIR by adopting EPA’s trading program or through regulations that at a minimum achieve the level of reductions that would be achieved through implementation of EPA’s program.  Each state covered by CAIR may determine independently which emission sources to control and which control measures to adopt.  CAIR includes model rules for multi-state cap and trade programs for power plants that states may choose to adopt to meet the required emissions reductions.  Generating units are permitted to satisfy the CAIR requirements through the use of allocated allowances or allowances acquired in the open market, through the installation of pollution control devices or through fuel modifications.

In July 2008, the United States Court of Appeals for the District of Columbia Circuit (the D.C. Circuit) vacated CAIR and remanded the rule to the EPA for further rulemaking to address the flaws it found with the rule, including EPA’s (1) failure to ensure that CAIR emission reductions from upwind states would assist downwind states in meeting air quality standards, (2) method for allocating SO2 and NOx emission caps among the states and (3) efforts to terminate or limit acid rain SO2 allowances.  In December 2008, the D.C. Circuit held that CAIR nevertheless would remain in effect pending such rulemaking.

The states in which PHI subsidiaries own and operate generating units have either adopted regulations to implement CAIR or will require compliance with the federal CAIR program.  In either case, the regulatory programs will require, beginning in 2009, the surrender of one NOx annual allowance for each ton of NOx emitted during the year and one NOx ozone season allowance for each ton of NOx emitted during the ozone season; and between 2010 and

 
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2014, the surrender of one SO2 annual allowance for each 0.5 ton of SO2 emitted during the year and beginning in 2015, one SO2 allowance for each 0.35 ton of SO2 emitted during the year.  To implement CAIR, the New Jersey Department of Environmental Protection (NJDEP) adopted a new NOx trading program to replace its prior NOx trading program.  This new trading program allocates NOx annual and NOx ozone season allowances to Conectiv Energy’s Carll’s Corner, Cedar, Cumberland, Deepwater, Middle, Mickleton, and Sherman generating units, and will operate in a manner similar to NJDEP’s prior NOx trading program.  Conectiv Energy’s Edge Moor, Christiana and Hay Road generating units in Delaware will be subject to federal CAIR for NOx and SO2.  Pennsylvania promulgated CAIR regulations in 2008 that are applicable to Conectiv Energy’s Bethlehem generating units and the generating units being constructed in Peach Bottom Township, Pennsylvania.  Virginia is implementing CAIR by participating in EPA’s cap and trade program making Conectiv Energy’s Tasley peaking unit subject to federal CAIR for NOx and SO2.  Conectiv Energy’s Crisfield generating units in Maryland, Bayview units in Virginia, Edge Moor 10, Delaware City 10 and West 10 units in Delaware, and Missouri Avenue generating units in New Jersey produce fewer megawatts than CAIR’s applicability threshold and therefore are not subject to CAIR.

Pepco Energy Services’ Benning Road generating units located in the District of Columbia are subject to CAIR requirements.  Pepco Energy Services’ Buzzard Point generating units and its landfill gas generating units produce fewer megawatts than CAIR’s applicability threshold and therefore are not subject to CAIR.

Conectiv Energy and Pepco Energy Services units use NOx annual, NOx ozone season and SO2 allowances allocated or acquired, as necessary, in the open market to comply with CAIR.  Although implementation of CAIR will increase costs for Conectiv Energy and Pepco Energy Services units, PHI currently does not anticipate that CAIR will have a significant impact on the financial results of its business.

In August 2008, NJDEP proposed amendments to its air pollution control regulations applicable to generating units in New Jersey to implement a multi-pollutant strategy to reduce fine particulate matter, SO2 and NOx emissions from coal-fired boilers serving electric generating units and NOx emissions from high electric demand day (HEDD) units, which are units capable of generating 15 or more megawatts and which are operated less than or equal to an average of 50 percent of the time during the ozone season.  The units that will be subject to NJDEP’s multi-pollutant regulations when promulgated also are subject to CAIR requirements, and accordingly, must hold sufficient NOx and SO2 allowances to cover their NOx and SO2 emissions.  The proposed multi-pollutant regulations may require the installation of pollution control equipment at the Deepwater generating station in order to comply with the more stringent maximum allowable emission rates.  For the period 2009 through 2014, the proposed HEDD regulations do not impose specific emission limits at any specific source, but require reductions from HEDD units that Conectiv Energy chooses to operate in accordance with a protocol submitted to NJDEP.  Beginning in May 2015, the proposed regulations establish specific maximum allowable emissions rates for HEDD units.  NJDEP’s regulations are expected to become final in May 2009.  Conectiv Energy is evaluating its options for complying with the proposed regulations.

In 2005, EPA finalized its Clean Air Mercury Rule (CAMR), which established mercury emissions standards for new or modified sources and capped state-wide emissions of mercury beginning in 2010.  The regulations, which permitted states to implement CAMR by adopting

 
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EPA’s market-based cap-and trade allowance program for coal-fired utility boilers or through regulations that at a minimum achieve the reductions that would be achieved through EPA’s program, were vacated by the United States Court of Appeals for the District of Columbia Circuit in February 2008.

In December 2004, NJDEP published final rules regulating mercury emissions from power plants and industrial facilities in New Jersey that impose standards, effective December 15, 2007, that are significantly stricter than EPA’s now vacated federal CAMR for coal-fired plants.  Conectiv Energy has confirmed, based upon the monitoring of mercury emissions at the Deepwater generating facility, that its only coal-fired generating plant in New Jersey is in compliance with the mercury emissions limit without the need for the installation of additional pollution control equipment.

In November 2006, DNREC adopted multi-pollutant regulations to require large coal-fired and residual oil-fired electric generating units to develop control strategies to address air quality in Delaware.  These control strategies are intended to assure attainment of ambient air quality standards for ozone and fine particulate matter, address local scale fine particulate emission problems, reduce mercury emissions, satisfy the now vacated federal CAMR rule, improve visibility and help satisfy Delaware’s regional haze obligations.  For Conectiv Energy’s Edge Moor coal-fired units, these regulations establish stringent short-term limits for emissions of NOx, SO2 and mercury, and for Edge Moor’s residual oil-fired generating unit, impose more stringent sulfur in fuel oil limits and establish stringent short-term limits for NOx emissions.  The regulations also cap annual mass emissions of NOx and SO2 from Edge Moor’s coal-fired and residual oil-fired units, and mercury from Edge Moor’s coal-fired units.  In December 2006, Conectiv Energy filed a complaint with the Delaware Superior Court seeking review of the adoption of the new regulations.  In December 2008, Conectiv Energy reached a settlement with DNREC.  Under the terms of the settlement agreement, Conectiv Energy will comply with the NOx, SO2 and mercury emission reduction requirements by the regulatory compliance dates, except that it will comply with the Phase II mercury emission limit by January 1, 2012, which is one year earlier than the regulatory compliance date.  In addition, DNREC has agreed to increase the annual SO2 mass emission limit as it relates to the Edge Moor residual oil-fired generating unit.  Conectiv Energy is installing new pollution control equipment and/or enhancing existing equipment to comply with the multi-pollutant regulations.  Conectiv Energy currently estimates that it will cost up to $81 million over a period of six years to install the control equipment necessary to comply with the regulations.  These estimated costs do not include increased costs associated with operating control equipment.

Conectiv Energy is installing water injection pollution control equipment on its five stationary combustion turbines in Delaware (Christiana 11 and 14, Edge Moor 10, Delaware City 10 and West 10) to comply with new ozone season NOx emission limits.  Conectiv Energy estimates that the cost of compliance will be approximately $3 million.

In a March 2005 rulemaking, EPA removed coal- and oil-fired units from the list of source categories requiring Maximum Achievable Control Technology for hazardous air pollutants such as mercury and nickel under CAA Section 112, thus, for the time being, eliminating the possibility that control devices would be required under this section of the CAA to reduce nickel emissions from the oil-fired unit at Conectiv Energy’s Edge Moor generating facility.  In the decision issued on February 8, 2008, the U.S. Court of Appeals for the District of

 
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Columbia Circuit determined that the delisting of coal- and oil-fired units from regulation under CAA Section 112 was unlawful.

Carbon Dioxide Emissions

Delaware, Maryland and New Jersey (along with Connecticut, Maine, Massachusetts, New Hampshire, Rhode Island, Vermont and New York) are signatories to the Regional Greenhouse Gas Initiative (RGGI), a cooperative effort by ten Northeast and mid-Atlantic states to first stabilize and then beginning in 2015 incrementally reduce carbon dioxide (CO2) emissions with the goal of achieving an overall 10% reduction from baseline by 2018.  Under RGGI, each of the participating states has adopted legislation or regulations to implement a regional CO2 budget and an allowance trading program to regulate emissions from fossil fuel-fired electric generating units rated at 25 megawatts or greater.  Under the program each covered fossil fuel-fired electric generating unit is required, commencing January 1, 2009, to hold allocated CO2 allowances, or and allowances acquired in the open market equivalent to its CO2 emissions during specified compliance periods.  Beginning in 2009, all covered CO2 sources must have an approved plan to monitor tons of CO2 emitted.  The Maryland and New Jersey CO2 allowance trading programs each provides for auction of substantially all of the allowances allocated to the state by RGGI.  Delaware’s program, in 2009, will auction 60% of allowances and allocate 40% of allowances to existing CO2 sources.  For each year after 2009, Delaware will increase the percentage of allowances for auction by 8%, such that 100% of allowances will be auctioned in 2014.  The first compliance period is the three-year period from 2009 to 2011.  The period may be extended to four years if a safety-valve mechanism is triggered by meeting certain market price targets.  In early 2012, each source will be required to surrender one CO2 allowance for each ton of CO2 emitted during the period.  Conectiv Energy participated in the September and December 2008 RGGI auctions and anticipates participating in subsequent RGGI auctions as necessary.

In February 2007, the New Jersey Governor signed an Executive Order that requires New Jersey to stabilize its statewide greenhouse gas emissions at 1990 levels by 2020, and to reduce statewide greenhouse gas emissions to 80% below 2006 levels by 2050.  The Executive Order requires NJDEP to coordinate with NJBPU, New Jersey’s Department of Transportation, New Jersey’s Department of Community Affairs and other interested parties to evaluate policies and measures that will enable New Jersey to achieve the statewide greenhouse gas emissions reduction levels set forth in the Executive Order.  In July 2007, New Jersey enacted legislation requiring NJDEP to promulgate regulations by July 1, 2009 that establish a statewide greenhouse gas emissions monitoring and reporting program covering all sources within the state to evaluate progress toward the 2020 and 2050 greenhouse gas limits.  These programs are in addition to New Jersey’s participation in RGGI for electric generating units.

Water Quality Regulation

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

 
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the steam generating facilities operated by PHI’s subsidiaries has a NPDES permit authorizing pollutant discharges, which is subject to periodic renewal.

In July 2004, EPA issued final regulations under Section 316(b) of the CWA that are intended to minimize potential adverse environmental impacts from power plant cooling water intake structures on aquatic resources by establishing performance-based standards for the operation of these structures at large existing electric generating plants, including Conectiv Energy’s Deepwater and Edge Moor generating facilities.  These regulations may require changes to cooling water intake structures as part of the NPDES permit renewal process.  In January 2007, the U.S. Court of Appeals for the Second Circuit issued a decision in Riverkeeper, Inc. v. United States Environmental Protection Agency (commonly known as the Riverkeeper II decision), that remanded to EPA for additional rulemaking substantial portions of these regulations for large existing electric generating plants.  In April 2008, the U.S. Supreme Court agreed to review the Riverkeeper II decision.  Briefing and oral argument before the Court have been completed, but no decision has been rendered.  Regardless of the outcome of the pending judicial proceedings, additional EPA rulemaking is expected, and the capital expenditures, if any, that may be needed as a consequence of such new regulations will not be known until the rulemaking process is concluded and each affected facility completes additional studies and addresses related permit requirements.

EPA has delegated authority to administer the NPDES program to a number of state agencies including DNREC.  The NPDES permit for Conectiv Energy’s Edge Moor generating facility expired on October 30, 2003, but has been administratively extended until DNREC issues a renewal permit.  Conectiv Energy submitted a renewal application to the DNREC in April 2003.  Studies required under the existing permit to determine the impact on aquatic organisms of the plant’s cooling water intake structures were completed in 2002.  Site-specific alternative technologies and operational measures have been evaluated and discussed with DNREC.  DNREC, however, has not announced how it intends to address Section 316(b) requirements in the renewal NPDES permit in light of Riverkeeper II and the remand of substantial portions of the federal regulations.

Under the New Jersey Water Pollution Control Act, NJDEP implements regulations, administers the New Jersey Pollutant Discharge Elimination System (NJPDES) program with EPA oversight, and issues and enforces NJPDES permits.  In June 2007, Conectiv Energy filed a timely application for renewal of the NJPDES permit for the Deepwater generating facility, which administratively extended the existing permit.  The existing NJPDES permit for Deepwater requires that Conectiv Energy perform several studies to determine whether or not Deepwater’s cooling water intake structures satisfy applicable requirements for protection of the environment.  While those study requirements were consistent with requirements under EPA’s regulations implementing CWA Section 316(b), the result of the Riverkeeper II decision and any subsequent EPA rulemaking may require reevaluation of the design and operational measures that Conectiv Energy anticipated using for future compliance with Section 316(b) at Deepwater.  In view of the uncertainty associated with Riverkeeper II, NJDEP, at Conectiv Energy’s request, has agreed to stay a cooling water intake structure design upgrade requirement in Deepwater’s existing NJPDES permit.  NJDEP is preparing a renewal permit for Deepwater, which will be published as a draft NJPDES renewal permit together with a request for public comments.

Pepco and a subsidiary of Pepco Energy Services discharge water from a steam generating plant and service center located in the District of Columbia under a NPDES permit

 
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issued by EPA in November 2000.  Pepco filed a petition with EPA’s Environmental Appeals Board seeking review and reconsideration of certain provisions of EPA’s permit determination.  In May 2001, Pepco and EPA reached a settlement on Pepco’s petition, under which EPA withdrew certain contested provisions and agreed to issue a revised draft permit for public comment.  A timely renewal application was filed in May 2005 and the companies are operating under the November 2000 permit, excluding the withdrawn conditions, in accordance with the settlement agreement.  In June 2008, EPA issued a draft permit.  Pepco filed comments on the draft permit in January 2009.  In February 2009, EPA issued the final draft permit and initiated a 30-day public comment period, closing on March 16, 2009.  The capital expenditures, if any, that may be needed as a consequence of new permit conditions, will not be known until the permit process is concluded.

In November 2007, NJDEP adopted amendments to the agency’s regulations under the Flood Hazard Area Control Act (FHACA) to minimize damage to life and property from flooding caused by development in flood plains.  The amended regulations, which took effect November 5, 2007, impose a new regulatory program to mitigate flooding and related environmental impacts from a broad range of construction and development activities, including electric utility transmission and distribution construction that was previously unregulated under the FHACA and that is otherwise regulated under a number of other state and federal programs.  ACE filed an appeal of these regulations with the Appellate Division of the Superior Court of New Jersey on November 3, 2008.  PHI cannot predict at this time the costs of complying with the FHACA regulations due, among other things, to the potential for additional rulemaking as a result of the appeal, as well as the possibility that NJDEP will issue exemptions from the new regulations.

On October 6, 2008, NJDEP adopted amendments to the agency’s regulations under the Freshwater Wetlands Protection Act (FWPA).  PHI believes that the amended FWPA regulations unnecessarily restrict, among other things, various types of electric transmission and distribution system maintenance and construction activity and PHI is evaluating whether to appeal the FWPA regulations to the Appellate Division of the Superior Court of New Jersey.  PHI cannot predict at this time the costs of complying with the amendments to the FWPA regulations due to the potential for additional rulemaking if an appeal is filed, as well as the possibility that NJDEP may issue exemptions from certain aspects of the new regulations.

In 2002, EPA amended its oil pollution prevention regulations to require facilities that, because of their location, could reasonably be expected to discharge oil in quantities that may be harmful to the environment, to implement and amend Spill Prevention, Control, and Countermeasure (SPCC) Plans.  PHI facilities subject to the regulations must now comply with these regulatory requirements by July 1, 2009.  In December 2008, EPA published a final rule to clarify its regulations and streamline certain requirements.  In a February 3, 2009 Federal Register notice, EPA delayed until April 4, 2009 the effective date of the December 2008 final rule and indicated that it is reviewing the dates by which facilities must prepare or amend SPCC Plans and implement those plans.  PHI continues to analyze its facilities to identify equipment and sites for which physical modifications may be necessary to reduce the risk of a release of oil and comply with EPA’s SPCC regulations.  As provided in EPA’s regulations, SPCC Plans for PHI facilities for which the installation of structures or equipment is not practicable include an oil spill contingency plan and a written commitment of manpower, equipment and materials to respond to a discharge of oil.  PHI anticipates that compliance with the EPA regulations will require physical modification of certain facilities through the construction of containment

 
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structures or replacement of oil-filled equipment with non-oil-filled equipment at a total anticipated cost to ACE, DPL and Pepco of approximately $50 million.

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.  Pepco, DPL and ACE each has been named by EPA or a state environmental agency as a potentially responsible party in pending proceedings involving certain contaminated sites.  See (i) Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Capital Resources and Liquidity – Capital Requirements – Environmental Remediation Obligations,” and (ii) Note (16), “Commitments and Contingencies – Legal Proceedings – Environmental Litigation” to the consolidated financial statements of PHI set forth in Part II, Item 8 of this Form 10-K.

Item 1A.   RISK FACTORS
 
The businesses of PHI, Pepco, DPL and ACE 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 companies, including, depending on the circumstances, its financial condition, results of operations and cash flows.  Unless otherwise noted, each risk factor set forth below applies to each of PHI, Pepco, DPL and ACE.
 
PHI and its subsidiaries are subject to substantial governmental regulation, and unfavorable regulatory treatment could have a negative effect.
 
The regulated utilities that compose PHI’s Power Delivery businesses are subject to regulation by various federal, state and local regulatory agencies that significantly affects their operations.  Each of Pepco, DPL and ACE is regulated by state regulatory agencies in its service territories, with respect to, among other things, the rates it can charge retail customers for the supply and distribution of electricity (and additionally for DPL the supply and distribution of natural gas).  In addition, the rates that the companies can charge for electricity transmission are regulated by FERC, and DPL’s natural gas transportation is regulated by FERC.  The companies cannot change supply, distribution, or transmission rates without approval by the applicable regulatory authority.  While the approved distribution and transmission rates are intended to permit the companies to recover their costs of service and earn a reasonable rate of return, the profitability of the companies is affected by the rates they are able to charge.  In addition, if the costs incurred by any of the companies in operating its transmission and distribution facilities exceed the allowed amounts for costs included in the approved rates, the financial results of that company, and correspondingly, PHI, will be adversely affected.
 
PHI’s subsidiaries also are required to have numerous permits, approvals and certificates from governmental agencies that regulate their businesses. PHI believes that each of its
 

 
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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; however, none of the companies is able to predict the impact of future regulatory activities of any of these agencies 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.
 
Pepco may be required to make additional divestiture proceeds gain-sharing payments to customers in the District of Columbia and Maryland.  (PHI and Pepco only)
 
Pepco currently is involved in regulatory proceedings in Maryland and the District of Columbia related to the sharing of the net proceeds from the sale of its generation-related assets.  The principal issue in the proceedings is whether Pepco should be required to share with customers the excess deferred income taxes and accumulated deferred investment tax credits associated with the sold assets and, if so, whether such sharing would violate the normalization provisions of the Internal Revenue Code and its implementing regulations.  Depending on the outcome of the proceedings, Pepco could be required to make additional gain-sharing payments to customers and payments to the Internal Revenue Service (IRS) in the amount of the associated accumulated deferred investment tax credits, and Pepco might be unable to use accelerated depreciation on District of Columbia and Maryland allocated or assigned property.  See Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Regulatory and Other Matters — Divestiture Cases” for additional information.
 
The operating results of the Power Delivery business and the Competitive Energy businesses fluctuate on a seasonal basis and can be adversely affected by changes in weather.
 
The Power Delivery business historically has been seasonal and weather patterns have 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 than normal in the winter and cooler than normal in the summer.  In Maryland, the adoption in 2007 of a bill stabilization adjustment mechanism for retail customers of Pepco and DPL, which decouples distribution revenue for a given reporting period from the amount of power delivered during the period, has had the effect of eliminating changes in the use of electricity by such retail customers due to weather conditions or for other reasons as a factor having an impact on reported revenue and income.
 
Historically, the competitive energy operations of Conectiv Energy and Pepco Energy Services also have produced less revenue when weather conditions are milder than normal, which can negatively impact PHI’s income from these operations.  The energy management services business of Pepco Energy Services is not seasonal.
 

 
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Facilities may not operate as planned or may require significant maintenance expenditures, which could decrease revenues or increase expenses.
 
Operation of the Pepco, DPL and ACE transmission and distribution facilities and the Competitive Energy businesses’ generation facilities involves many risks, including the breakdown or failure of equipment, accidents, labor disputes and performance below expected levels.  Older facilities and equipment, even if maintained in accordance with sound engineering practices, may require significant capital expenditures for additions or upgrades to keep them operating at peak efficiency, to comply with changing environmental requirements, or to provide reliable operations.  Natural disasters and weather-related incidents, including tornadoes, hurricanes and snow and ice storms, also can disrupt generation, transmission and distribution delivery systems.  Operation of generation, transmission and distribution facilities below expected capacity levels can reduce revenues and result in the incurrence of additional expenses that may not be recoverable from customers or through insurance, including deficiency charges imposed by PJM on generation facilities at a rate of up to two times the capacity payment that the generation facility receives.  Furthermore, the generation and transmission facilities of the PHI companies that are defined as elements of the Bulk Electric System, which is defined by the North American Electric Reliability Corporation (NERC) as transmission facilities operating at a voltage of 100 kilovolts and above, are subject to mandatory compliance with the reliability standards established by the NERC and the Reliability First Regional Entity, which is the NERC-designated regional entity with jurisdiction in the PJM region.  Failure to comply with the standards may result in substantial monetary penalties and reflect poorly on the public image of PHI.
 
The transmission facilities of the Power Delivery business are interconnected with the facilities of other transmission facility owners whose actions could have a negative impact on operations.
 
The electricity transmission facilities of Pepco, DPL and ACE are directly interconnected with the transmission facilities of contiguous utilities and, as such, are part of an interstate power transmission grid.  FERC has designated a number of regional transmission organizations to coordinate the operation of portions of the interstate transmission grid.  Pepco, DPL and ACE are members of the PJM RTO.  In 1997, FERC approved PJM as the provider of transmission service in the PJM RTO region, which currently consists of all or parts of Delaware, Illinois, Indiana, Kentucky, Maryland, Michigan, New Jersey, North Carolina, Ohio, Pennsylvania, Tennessee, Virginia, West Virginia and the District of Columbia.  Pepco, DPL and ACE operate their transmission facilities under the direction and control of PJM.  PJM RTO and the other regional transmission organizations have established sophisticated systems that are designed to ensure the reliability of the operation of transmission facilities and prevent the operations of one utility from having an adverse impact on the operations of the other utilities.  However, the systems put in place by PJM RTO and the other regional transmission organizations may not always be adequate to prevent problems at other utilities from causing service interruptions in the transmission facilities of Pepco, DPL or ACE.  If any of Pepco, DPL or ACE were to suffer such a service interruption, it could have a negative impact on it and on PHI.
 

 
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The cost of compliance with environmental laws, including laws relating to emissions of greenhouse gases, is significant and new environmental laws may increase expenses.
 
The operations of PHI’s subsidiaries, including Pepco, DPL and ACE, are subject to extensive federal, state and local environmental laws, rules and regulations relating to air quality, water quality, spill prevention, waste management, natural resources, site remediation, and health and safety.  These laws and regulations can require significant capital and other expenditures to, among other things, meet emissions and effluent standards, conduct site remediation 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 come into 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.
 
There is growing concern at the federal and state levels about CO2 and other greenhouse gas emissions.  As a result, it is possible that, in addition to RGGI, state and federal regulations will be developed that will impose more stringent limitations on emissions than are currently in effect. Any of these factors could result in increased capital expenditures and/or operating costs for one or more generating plants operated by PHI’s Conectiv Energy and Pepco Energy Services businesses.  Until specific regulations are promulgated, the impact that any new environmental regulations, voluntary compliance guidelines, enforcement initiatives or legislation may have on the results of operations, financial position or liquidity of PHI and its subsidiaries is not determinable.  PHI, Pepco, DPL and ACE each continues to monitor federal and state activity related to environmental matters in order to analyze their potential operational and cost implications.
 
New environmental laws and regulations, or new interpretations of existing laws and regulations, could impose more stringent limitations on the operations of PHI’s subsidiaries or require them to incur significant additional costs.  Current compliance strategies may not successfully address the relevant standards and interpretations of the future.
 
Failure to retain and attract key skilled professional and technical employees could have an adverse effect on operations.
 
The ability of each of PHI and its subsidiaries, including Pepco, DPL and ACE, to implement its business strategy is dependent on its ability to recruit, retain and motivate employees.  Competition for skilled employees in some areas is high and the inability to retain and attract these employees could adversely affect the company’s business, operations and financial condition.
 
PHI’s Competitive Energy businesses are highly competitive.  (PHI only)
 
The unregulated energy generation, supply and marketing businesses primarily in the mid-Atlantic region are characterized by intense competition at both the wholesale and retail levels.  PHI’s Competitive Energy businesses compete with numerous non-utility generators,
 

 
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independent power producers, wholesale and retail energy marketers, and traditional utilities.  This competition generally has the effect of reducing margins and requires a continual focus on controlling costs.
 
PHI’s Competitive Energy businesses rely on some generation, transmission, storage, and distribution assets that they do not own or control to deliver wholesale and retail electricity and natural gas and to obtain fuel for their generation facilities.  (PHI only)
 
PHI’s Competitive Energy businesses depend on electric generation and transmission facilities, natural gas pipelines, and natural gas storage facilities owned and operated by others.  The operation of their generation facilities also depends on coal, natural gas or diesel fuel supplied by others.  If electric generation or transmission, natural gas pipelines, or natural gas storage are disrupted or capacity is inadequate or unavailable, the Competitive Energy businesses’ ability to buy and receive and/or sell and deliver wholesale and retail power and natural gas, and therefore to fulfill their contractual obligations, could be adversely affected.  Similarly, if the fuel supply to one or more of their generation plants is disrupted and storage or other alternative sources of supply are not available, the Competitive Energy businesses’ ability to operate their generating facilities could be adversely affected.
 
Changes in technology may adversely affect the Power Delivery business and the Competitive Energy businesses.
 
Research and development activities are ongoing to improve alternative technologies to produce electricity, including fuel cells, wind energy, micro turbines and photovoltaic (solar) cells.  It is possible that advances in these or other alternative technologies will reduce the costs of electricity production from these technologies, thereby making the generating facilities of the Competitive Energy businesses less competitive.  In addition, increased conservation efforts and advances in technology could reduce demand for electricity supply and distribution, which could adversely affect the Power Delivery businesses of Pepco, DPL and ACE and the Competitive Energy businesses.  Changes in technology also could alter the channels through which retail electricity is distributed to customers which could adversely affect the Power Delivery businesses of Pepco, DPL and ACE.
 
PHI’s risk management procedures may not prevent losses in the operation of its Competitive Energy businesses.  (PHI only)
 
The operations of PHI’s Competitive Energy businesses are conducted in accordance with sophisticated risk management systems that are designed to quantify risk.  However, actual results sometimes deviate from modeled expectations.  In particular, risks in PHI’s energy commodity activities are measured and monitored utilizing value-at-risk models to determine the effects of potential one-day favorable or unfavorable price movements.  These estimates are based on historical price volatility and assume a normal distribution of price changes and a 95% probability of occurrence.  Consequently, if prices significantly deviate from historical prices, PHI’s risk management systems, including assumptions supporting risk limits, may not protect PHI from significant losses.  In addition, adverse changes in energy prices may result in economic losses in PHI’s earnings and cash flows and reductions in the value of assets on its balance sheet under applicable accounting rules.
 

 
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The commodity hedging procedures used by the Competitive Energy businesses may not protect them from significant losses caused by volatile commodity prices.  (PHI only)
 
To lower the financial exposure related to commodity price fluctuations, PHI’s Competitive Energy businesses routinely enter into contracts to hedge the value of their assets and operations. As part of this strategy, PHI’s Competitive Energy businesses utilize fixed-price, forward, physical purchase and sales contracts, tolling agreements, futures, financial swaps and option contracts traded in the over-the-counter markets or on exchanges.  Each of these various hedge instruments can present a unique set of risks in its application to PHI’s energy assets.  PHI must apply judgment in determining the application and effectiveness of each hedge instrument.  Changes in accounting rules, or revised interpretations to existing rules, may cause hedges to be deemed ineffective as an accounting matter.  This could have material earnings implications for the period or periods in question.  Conectiv Energy’s objective is to hedge a portion of the expected power output of its generation facilities and the costs of fuel used to operate those facilities so it is not completely exposed to energy price movements.  Hedge targets are approved by PHI’s Corporate Risk Management Committee and may change from time to time based on market conditions.  Conectiv Energy generally establishes hedge targets annually for the next three succeeding 12-month periods.  Within a given 12-month horizon, the actual hedged positioning in any month may be outside of the targeted range, even if the average for a 12-month period falls within the stated range.  Management exercises judgment in determining which months present the most significant risk, or opportunity, and hedge levels are adjusted accordingly.  Since energy markets can move significantly in a short period of time, hedge levels may also be adjusted to reflect revised assumptions.  Such factors may include, but are not limited to, changes in projected plant output, revisions to fuel requirements, transmission constraints, prices of alternate fuels, and improving or deteriorating supply and demand conditions.  In addition, short-term occurrences, such as abnormal weather, operational events, or intra-month commodity price volatility may also cause the actual level of hedging coverage to vary from the established hedge targets.  These events can cause fluctuations in PHI’s earnings from period to period.  Due to the high heat rate of the Pepco Energy Services generating facilities, Pepco Energy Services generally does not enter into wholesale contracts to lock in the forward value of its plants.  To the extent that PHI’s Competitive Energy businesses have unhedged positions or their hedging procedures do not work as planned, fluctuating commodity prices could result in significant losses.  Conversely, by engaging in hedging activities, PHI may not realize gains that otherwise could result from fluctuating commodity prices.
 
The operations of the Competitive Energy businesses can give rise to significant collateral requirements.  The inability to fund those requirements may prevent the businesses from hedging associated price risks or may require curtailment of their operations. (PHI only)

A substantial portion of Pepco Energy Services’ business is the sale of electricity and natural gas to retail customers.  In conducting this business Pepco Energy Services typically enters into electricity and natural gas sale contracts under which it is committed to supply the electricity or natural gas requirements of its retail customers over a specified period at agreed upon prices.  To acquire this energy, Pepco Energy Services enters into wholesale purchase contracts for electricity and natural gas.  These contracts typically impose collateral requirements on each party designed to protect the other party against the risk of nonperformance between the date the contract is entered into and the date the energy is paid for.  The collateral required to be posted can be of varying forms, including cash, letters of credit and guarantees.  When energy market prices decrease relative to the supplier contract prices, Pepco Energy Service’s collateral

 
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obligations increase.  In addition, Conectiv Energy and Pepco Energy Services each enter into contracts to buy and sell electricity, various fuels, and related products, including derivative instruments, to reduce its financial exposure to changes in the value of its assets and obligations due to energy price fluctuations.  These contracts usually require the posting of collateral.  Under various contracts entered into by both businesses, the required collateral is provided in the form of an investment grade guaranty issued by PHI.  Under these contracts, a reduction in PHI’s credit rating can also trigger a requirement to post additional collateral.  To satisfy these obligations when required, PHI and its non-utility subsidiaries rely primarily on cash balances, access to the capital markets and existing credit facilities.

Particularly in periods of energy market price volatility, the collateral obligations associated with the Competitive Energy businesses can be substantial. These collateral demands negatively affect PHI’s liquidity by requiring PHI to draw on its capacity under its credit facilities and other financing sources.  The inability of PHI to maintain the necessary liquidity also could have an adverse effect on PHI’s results of operations and financial condition by requiring the Competitive Energy businesses to forego new business opportunities, by requiring the businesses to curtail their hedging activity, thereby increasing their exposure to energy market price changes or by rendering them unable to meet their collateral obligations to counterparties.

PHI and its subsidiaries have significant exposure to counterparty risk. (PHI only)

Both Conectiv Energy and Pepco Energy Services enter into transactions with numerous counterparties.  These include both commercial transactions for the purchase and sale of electricity and natural gas and derivative and other transactions to manage the risk of commodity price fluctuations.  Under these arrangements, the Competitive Energy businesses are exposed to the risk that the counterparty may fail to perform its obligation to make or take delivery under the contract, fail to make a required payment or fail to return collateral posted by the Competitive Energy businesses when no longer required.  Under many of these contracts, Conectiv Energy and Pepco Energy Services are entitled to receive collateral or other types of performance assurance from the counterparty, which may be in the form of cash, letters of credit or parent guarantees, to protect against performance and credit risk.  Even where collateral is provided, capital market disruptions can prevent the counterparty from meeting its collateral obligations or could degrade the value of letters of credit and guarantees as a result of the lowered rating or insolvency of the issuer or guarantor.  In the event of a bankruptcy of a counterparty, bankruptcy law, in some circumstances, could require Conectiv Energy and Pepco Energy Services to surrender collateral held or payments received.  In addition, Conectiv Energy and Pepco Energy Services are participants in the wholesale electric markets administered by various independent system operators (ISOs), and in particular PJM.  If an ISO incurs losses due to counterparty nonperformance, those losses are allocated to and borne by other market participants in the ISO.  Such defaults could adversely affect PHI’s results of operations, liquidity or financial condition.  These risks are increased during periods of significant commodity price fluctuations, tightened credit and ratings downgrades.

Business operations could be adversely affected by terrorism.
 
The threat of, or actual acts of, terrorism may affect the operations of PHI or any of its subsidiaries in unpredictable ways and may cause changes in the insurance markets, force an increase in security measures and cause disruptions of fuel supplies and markets.  If any of its
 

 
27

 

infrastructure facilities, such as its electric generation, fuel storage, transmission or distribution facilities, were to be a direct target, or an indirect casualty, of an act of terrorism, the operations of PHI, Pepco, DPL or ACE could be adversely affected.  Corresponding instability in the financial markets as a result of terrorism also could adversely affect the ability to raise needed capital.
 
Insurance coverage may not be sufficient to cover all casualty losses that the companies might incur.
 
PHI and its subsidiaries, including Pepco, DPL and ACE, currently have insurance coverage for their facilities and operations in amounts and with deductibles that they consider appropriate.  However, there is no assurance that such insurance coverage will be available in the future on commercially reasonable terms.  In addition, some risks, such as weather related casualties, may not be insurable.  In the case of loss or damage to property, plant or equipment, there is no assurance that the insurance proceeds, if any, received will be sufficient to cover the entire cost of replacement or repair.
 
Revenues, profits and cash flows may be adversely affected by economic conditions.
 
Periods of slowed economic activity generally result in decreased demand for power, particularly by industrial and large commercial customers.  As a consequence, recessions or other downturns in the economy may result in decreased revenues and cash flows for the Power Delivery businesses of Pepco, DPL and ACE and the Competitive Energy businesses.
 
The IRS challenge to cross-border energy sale and lease-back transactions entered into by a PHI subsidiary could result in loss of prior and future tax benefits. (PHI only)

PCI maintains a portfolio of eight cross-border energy lease investments, which as of December 31, 2008, had an equity value of approximately $1.3 billion and from which PHI currently derives approximately $56 million per year in tax benefits in the form of interest and depreciation deductions in excess of rental income.  In 2005, the Treasury Department and IRS issued a notice identifying sale-leaseback transactions with certain attributes entered into with tax-indifferent parties as tax avoidance transactions, and the IRS announced its intention to disallow the associated tax benefits claimed by the investors in these transactions.  PHI’s cross-border energy lease investments, each of which is with a tax-indifferent party, have been under examination by the IRS as part of the normal PHI federal income tax audits.  In connection with the audit of PHI’s 2001 and 2002 income tax returns, the IRS disallowed the depreciation and interest deductions in excess of rental income claimed by PHI with respect to six of its cross-border energy lease investments.  In addition, the IRS has sought to recharacterize the leases as loan transactions as to which PHI would be subject to original issue discount income.

PHI believes that its tax position with regard to its cross-border energy lease investments is appropriate based on applicable statutes, regulations and case law and is protesting the IRS adjustments and the unresolved audit issues have been forwarded to the Appeals Office of the IRS.  In the event that PHI were not to prevail and were to suffer a total disallowance of the tax benefits and incur imputed original issue discount income due to the recharacterization of the leases as loans, as of December 31, 2008, PHI would have been obligated to pay approximately $520 million in additional federal and state taxes and $83 million of interest.  In addition, the IRS could require PHI to pay a penalty of up to 20% on the amount of additional taxes due. PHI

 
28

 

anticipates, however  that any additional taxes that it would be required to pay as a result of the disallowance of prior deductions or a recharacterization of leases as loans would be recoverable in the form of lower taxes over the remaining term of the investments.

For further discussion of this matter see Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Regulatory and Other Matters — Federal Tax Treatment of Cross-Border Leases” of this Form 10-K.

PHI and its subsidiaries are dependent on their ability to successfully access capital markets.  An inability to access capital may adversely affect their businesses.

PHI, Pepco, DPL and ACE all rely on access to both short-term money markets and long-term capital markets as sources of liquidity and to satisfy their capital requirements that are not met by cash flow from their operations.  Capital market disruptions, or a downgrade in their respective credit ratings, could increase the cost of borrowing or could prevent the companies from accessing one or more financial markets.  Factors that could affect the ability of PHI and its subsidiaries to access one or more financial markets could include, but are not limited to:

· recession or an economic slowdown;

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

· significant changes in energy prices;

· a terrorist attack or threatened attacks; or

· a significant transmission failure.

In accordance with the requirements of the Sarbanes-Oxley Act of 2002 and the SEC rules thereunder, PHI’s management is responsible for establishing and maintaining internal control over financial reporting and is required to assess annually the effectiveness of these controls.  The inability to certify the effectiveness of these controls due to the identification of one or more material weaknesses in these controls also could increase financing costs or could adversely affect the ability to access one or more financial markets.

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

PHI holds assets in trust to meet its obligations under the PHI Retirement Plan (a defined benefit pension plan) and its postretirement benefit plan.  The amounts that PHI is required to contribute (including the amounts for which Pepco, DPL and ACE are responsible) to fund the trusts are determined based on assumptions made as to the valuation of future benefit obligations, and the investment performance of the plan assets.  Accordingly, the performance of the capital markets will affect the value of plan assets.  A decline in the market value of plan

 
29

 

assets may increase the plan funding requirements to meet the future benefit obligations.  In addition, changes in interest rates affect the valuation of the liabilities of the plans.  As interest rates decrease, the liabilities increase, potentially requiring additional funding.  Demographic changes, such as a change in the expected timing of retirements or changes in life expectancy assumptions, also may increase the funding requirements of the plans.  A need for significant additional funding of the plans could have a material adverse effect on the cash flow of PHI, Pepco, DPL and ACE.  Future increases in pension plan and other post-retirement 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 results of operations and financial condition of PHI, Pepco, DPL and ACE.

PHI’s cash flow, ability to pay dividends and ability to satisfy debt obligations depend on the performance of its operating subsidiaries.  PHI’s unsecured obligations are effectively subordinated to the liabilities and the outstanding preferred stock of its subsidiaries.  (PHI only)
 
PHI is a holding company that conducts its operations entirely through its 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 the subsidiaries and the distribution of such earnings to PHI in the form of dividends.  The 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.  Because the claims of the creditors of PHI’s subsidiaries and the preferred stockholders of ACE 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 and to the rights of the holders of ACE’s preferred stock to receive dividend payments.
 
Energy companies are subject to adverse publicity which makes them vulnerable to negative regulatory and litigation outcomes.
 
The energy sector has been among the sectors of the economy that have been the subject of highly publicized allegations of misconduct in recent years.  In addition, many utility companies have been publicly criticized for their performance during natural disasters and weather related incidents.  Adverse publicity of this nature may render legislatures, regulatory authorities, and other government officials less likely to view energy companies such as PHI and its subsidiaries in a favorable light, and may cause PHI and its subsidiaries to be susceptible to adverse outcomes with respect to decisions by such bodies.
 
Provisions of the Delaware General Corporation Law may discourage an acquisition of PHI.  (PHI only)
 
As a Delaware corporation, PHI is subject to the business combination law set forth in Section 203 of the Delaware General Corporation Law, which could have the effect of delaying, discouraging or preventing an acquisition of PHI.
 

 
30

 

Because Pepco is a wholly owned subsidiary of PHI, and each of DPL and ACE is an indirect wholly owned subsidiary of PHI, PHI can exercise substantial control over their dividend policies and businesses and operations.  (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 Pepco’s, DPL’s and ACE’s executive officers, are officers of PHI or an affiliate of PHI.  Among other decisions, each of Pepco’s, DPL’s and ACE’s board is responsible for decisions regarding payment of dividends, financing and capital raising activities, and acquisition and disposition of assets.  Within the limitations of applicable law, and subject to the financial covenants under each company’s respective outstanding debt instruments, each of Pepco’s, DPL’s and ACE’s board of directors will base its decisions concerning the amount and timing of dividends, and other business decisions, on the company’s respective earnings, cash flow and capital structure, but may also take into account the business plans and financial requirements of PHI and its other subsidiaries.
 
Item 1B.   UNRESOLVED STAFF COMMENTS
 
Pepco Holdings
 
None.
 
Pepco
 
None.
 
DPL
 
None.
 
ACE
 
None.

 
31

 


Item 2.     PROPERTIES
 
Generation Facilities
 
The following table identifies the electric generating facilities owned by PHI’s subsidiaries at December 31, 2008.

Electric Generating Facilities
Location
Owner
 
Generating Capacity (kilowatts)
Coal-Fired Units
       
 
Edge Moor Units 3 and 4
Wilmington, DE
Conectiv Energya
 
260,000
 
Deepwater Unit 6
Pennsville, NJ
Conectiv Energya
 
80,000
         
340,000
Oil Fired Units
       
 
Benning Road
Washington, DC
Pepco Energy Servicesb
 
550,000
 
Edge Moor Unit 5
Wilmington, DE
Conectiv Energya
 
450,000
     
1,000,000
Combustion Turbines/Combined Cycle Units
     
 
Hay Road Units 1-4
Wilmington, DE
Conectiv Energya
 
555,300
 
Hay Road Units 5-8
Wilmington, DE
Conectiv Energya
 
565,000
 
Bethlehem Units 1-8
Bethlehem, PA
Conectiv Energya
 
1,130,000
 
Buzzard Point
Washington, DC
Pepco Energy Servicesb
 
240,000
 
Cumberland
Millville, NJ
Conectiv Energya
 
84,000
 
Sherman Avenue
Vineland, NJ
Conectiv Energya
 
81,000
 
Middle
Rio Grande, NJ
Conectiv Energya
 
77,000
 
Carll’s Corner
Upper Deerfield Twp., NJ
Conectiv Energya
 
73,000
 
Cedar
Cedar Run, NJ
Conectiv Energya
 
68,000
 
Missouri Avenue
Atlantic City, NJ
Conectiv Energya
 
60,000
 
Mickleton
Mickleton, NJ
Conectiv Energya
 
59,000
 
Christiana
Wilmington, DE
Conectiv Energya
 
45,000
 
Edge Moor Unit 10
Wilmington, DE
Conectiv Energya
 
13,000
 
West
Marshallton, DE
Conectiv Energya
 
15,000
 
Delaware City
Delaware City, DE
Conectiv Energya
 
16,000
 
Tasley
Tasley, VA
Conectiv Energya
 
26,000
         
3,107,300
Landfill Gas-Fired Units
       
 
Fauquier Landfill Project
Fauquier County, VA
Pepco Energy Servicesb
 
2,000
 
Eastern Landfill Project
Baltimore County, MD
Pepco Energy Servicesd
 
3,000
 
Bethlehem Landfill Project
Northampton, PA
Pepco Energy Servicesc
 
5,000
         
10,000
Solar Photovoltaic
       
 
Atlantic City Convention Center
Atlantic City, NJ
Pepco Energy Servicese
 
2,000
         
Other Natural Gas Fired Units
       
 
Deepwater Unit 1
Pennsville, NJ
Conectiv Energya
 
78,000
         
Diesel Units
       
 
Crisfield
Crisfield, MD
Conectiv Energya
 
10,000
 
Bayview
Bayview, VA
Conectiv Energya
 
12,000
         
22,000
Total Electric Generating Capacity
 
4,559,300
     

a
All holdings of Conectiv Energy are owned by its various subsidiaries.
b
These facilities are owned by a subsidiary of Pepco Energy Services.
c
This facility is owned by Bethlehem Renewable Energy LLC, of which Pepco Energy Services holds a 80% membership interest.
d
This facility is owned by Eastern Landfill Gas, LLC, of which Pepco Energy Services holds a 75% membership interest.
e
This facility is owned by Pepco Energy Services, Inc.
 

 
32

 

The preceding table sets forth the net summer electric generating capacity of the electric generating plants owned by Pepco Holdings’ subsidiaries.  Although the generating capacity of these facilities may be higher during the winter months, the plants operated by PHI’s subsidiaries 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 plants.
 
Transmission and Distribution Systems
 
On a combined basis, the electric transmission and distribution systems owned by Pepco, DPL and ACE at December 31, 2008, taking into account the sale by DPL of its Virginia retail electric distribution and wholesale electric transmission assets in January 2008, consisted of approximately 3,200 transmission circuit miles of overhead lines, 300 transmission circuit miles of underground cables, 18,200 distribution circuit miles of overhead lines, and 15,500 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 Maryland.  The computer equipment and systems contained in Pepco’s control center are financed through a sale and leaseback transaction.
 
DPL has a liquefied natural gas plant located in Wilmington, Delaware, with a storage capacity of approximately 3 million gallons and an emergency sendout capability of 48,210 Mcf per day.  DPL owns eight natural gas city gate stations at various locations in New Castle County, Delaware.  These stations have a total sendout capacity of 255,500 Mcf per day.  DPL also owns approximately 111 pipeline miles of natural gas transmission mains, 1,802 pipeline miles of natural gas distribution mains, and 1,301 natural gas pipeline miles of service lines.  The natural gas transmission mains include approximately 7 miles of pipeline, 10% of which is owned and used by DPL for natural gas operations, and 90% of which is owned and used by Conectiv Energy for delivery of natural gas to electric generation facilities.
 
Substantially all of the transmission and distribution property, plant and equipment owned by each of Pepco, DPL and ACE is subject to the liens of the respective mortgages under which the companies issue First Mortgage Bonds.  See Note (11), “Debt” to the consolidated financial statements of PHI set forth in Item 8 of this Form 10-K.
 
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—Legal Proceedings” to the consolidated financial statements of PHI set forth in Item 8 of this Form 10-K.
 
Pepco
 
Other than litigation incidental to its business, Pepco is not a party to, and its property is not subject to, any material pending legal proceedings except as described in Note (13), “Commitments and Contingencies—Legal Proceedings” to the financial statements of Pepco set forth in Item 8 of this Form 10-K.
 

 
33

 

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—Legal Proceedings” to the financial statements of DPL set forth in Item 8 of this Form 10-K.
 
ACE
 
Other than litigation incidental to its business, ACE is not a party to, and its property is not subject to, any material pending legal proceedings except as described in Note (14), “Commitments and Contingencies—Legal Proceedings” to the financial statements of ACE set forth in Item 8 of this Form 10-K.
 
Item 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
Pepco Holdings
 
None.
 
           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.
 

 
34

 

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 fiscal years.

        Period           
Dividends
   
Price Range
 
 
 Per Share
   
High
     Low  
2008:
                                   
First Quarter
$
.27    
 
$
29.640
 
$
23.800
 
Second Quarter
 
.27    
   
27.385
   
24.010
 
Third Quarter
 
.27    
   
26.160
   
21.610
 
Fourth Quarter
 
.27    
   
23.930
   
15.270
 
 
$
1.08    
             
2007:
                 
First Quarter
$
.26    
 
$
29.280
 
$
24.890  
 
Second Quarter
 
.26    
   
30.710
   
26.890  
 
Third Quarter
 
.26    
   
29.280
   
24.200  
 
Fourth Quarter
 
.26    
   
30.100
   
25.730  
 
 
$
1.04    
             
                   

See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Capital Resources and Liquidity — Capital Requirements — Dividends” of this Form 10-K for information regarding restrictions on the ability of PHI and its subsidiaries to pay dividends.
 
At December 31, 2008, there were approximately 61,347 holders of record of Pepco Holdings common stock.
 
Dividends
 
On January 22, 2009, the Board of Directors declared a dividend on common stock of 27 cents per share payable March 31, 2009, to shareholders of record on March 10, 2009.
 
PHI Subsidiaries
 
All of the common equity of Pepco, DPL and ACE is owned directly or indirectly by PHI.  Pepco, DPL and ACE each customarily pays dividends on its common stock on a quarterly basis based on its earnings, cash flow and capital structure, and after taking into account the business plans and financial requirements of PHI and its other subsidiaries.
 

 
35

 

Pepco
 
All of Pepco’s common stock is held by Pepco Holdings.  The table below presents the aggregate amount of common stock dividends paid by Pepco to PHI during each quarter in the last two fiscal years.

        Period           
 
Aggregate
Dividends
2008:
   
First Quarter
$
20,000,000
Second Quarter
 
-
Third Quarter
 
44,000,000
Fourth Quarter
 
25,000,000
 
$
89,000,000
2007:
   
First Quarter
$
15,000,000
Second Quarter
 
14,000,000
Third Quarter
 
45,000,000
Fourth Quarter
 
12,000,000
 
$
86,000,000
     

DPL
 
All of DPL’s common stock is held by Conectiv.  The table below presents the aggregate amount of common stock dividends paid by DPL to Conectiv during each quarter in the last two fiscal years.  Dividends received by Conectiv were used to pay down short-term debt owed to PHI.

        Period           
 
Aggregate
Dividends
2008:
   
First Quarter
$
27,000,000
Second Quarter
 
15,000,000
Third Quarter
 
-
Fourth Quarter
 
10,000,000
 
$
52,000,000
2007:
   
First Quarter
$
8,000,000
Second Quarter
 
19,000,000
Third Quarter
 
-
Fourth Quarter
 
12,000,000
 
$
39,000,000
     


 
36

 

ACE
 
All of ACE’s common stock is held by Conectiv.  The table below presents the aggregate amount of common stock dividends paid by ACE to Conectiv during each quarter in the last two fiscal years. Dividends received by Conectiv were used to pay down short-term debt owed to PHI.

        Period           
 
Aggregate
Dividends
2008:
   
First Quarter
$
-
Second Quarter
 
31,000,000
Third Quarter
 
-
Fourth Quarter
 
15,000,000
 
$
46,000,000
2007:
   
First Quarter
$
20,000,000
Second Quarter
 
10,000,000
Third Quarter
 
20,000,000
Fourth Quarter
 
-
 
$
50,000,000
     

Recent Sales of Unregistered Equity Securities
 
Pepco Holdings
 
None.
 
Pepco
 
None.
 
DPL
 
None.
 
ACE
 
None.
 
Purchases of Equity Securities by the Issuer and Affiliated Purchasers.
 
Pepco Holdings
 
None.
 
Pepco
 
None.
 
DPL
 
None.
 
ACE
 
None.

 
37

 

Item 6    SELECTED FINANCIAL DATA
PEPCO HOLDINGS CONSOLIDATED FINANCIAL HIGHLIGHTS

   
2008
   
2007
   
2006
   
2005
   
2004
 
 
(in millions, except per share data)
Consolidated Operating Results
                             
Total Operating Revenue
$
10,700 
(a)
$
9,366  
 
$
8,363  
 
$
8,066 
 
$
7,223 
 
Total Operating Expenses
 
9,932 
   
8,560  
(c)
 
7,670  
(e)
 
7,160 
(g)(h)(i)
 
6,451 
 
Operating Income
 
768 
   
806  
   
693  
   
906 
   
772 
 
Other Expenses
 
300 
   
284  
   
283  
(f)
 
286 
   
341 
 
Preferred Stock Dividend
  Requirements of Subsidiaries
 
   
   
1  
   
   
 
Income Before Income Tax Expense
  and Extraordinary Item
 
468 
   
522  
   
409  
   
617 
   
428 
 
Income Tax Expense
 
168 
(a)(b)
 
188  
(d)
 
161  
   
255 
(j)
 
167 
(k)
Income Before Extraordinary Item
 
300 
   
334  
   
248  
   
362 
   
261 
 
Extraordinary Item
 
   
-  
   
-  
   
   
 
Net Income
 
300 
   
334  
   
248  
   
371 
   
261 
 
Earnings Available for
  Common Stock
 
300 
   
334  
   
248  
   
371 
   
261 
 
                               
Common Stock Information
                             
Basic Earnings Per Share of Common
  Stock Before Extraordinary Item
$
1.47 
 
$
1.72  
 
$
1.30  
 
$
1.91 
 
$
1.48 
 
Basic - Extraordinary Item Per
  Share of Common Stock
 
   
-  
   
-  
   
.05 
   
 
Basic Earnings Per Share
  of Common Stock
 
1.47 
   
1.72  
   
1.30  
   
1.96 
   
1.48 
 
Diluted Earnings Per Share
  of Common Stock Before
  Extraordinary Item
 
1.47 
   
1.72  
   
1.30  
   
1.91 
   
1.48 
 
Diluted - Extraordinary Item Per
  Share of Common Stock
 
   
-  
   
-  
   
.05 
   
 
Diluted Earnings Per Share
  of Common Stock
 
1.47 
   
1.72  
   
1.30  
   
1.96 
   
1.48 
 
Cash Dividends Per Share
  of Common Stock
 
1.08 
   
1.04  
   
1.04  
   
1.00 
   
1.00 
 
Year-End Stock Price
 
17.76 
   
29.33  
   
26.01 
   
22.37 
   
21.32 
 
Net Book Value per Common Share
 
19.14 
   
20.04  
   
18.82 
   
18.88 
   
17.74 
 
   
  
                         
Weighted Average Shares Outstanding
 
204 
   
194  
   
191 
   
189 
   
177 
 
                               
Other Information
                             
Investment in Property, Plant
  and Equipment
$
12,926 
 
$
12,307  
 
$
11,820  
 
$
11,441
 
$
11,109 
 
Net Investment in Property, Plant
  and Equipment
 
8,314 
   
7,877  
   
7,577  
   
7,369 
   
7,152 
 
Total Assets
 
16,475 
   
15,111  
   
14,244  
   
14,039 
   
13,375 
 
                               
Capitalization
                             
Short-term Debt
$
465 
 
$
289  
 
$
350  
 
$
156 
 
$
320 
 
Long-term Debt
 
4,859 
   
4,175  
   
3,769  
   
4,203 
   
4,362 
 
Current Maturities of Long-Term Debt
  and Project Funding
 
85 
   
332  
   
858  
   
470 
   
516 
 
Transition Bonds issued by ACE
  Funding
 
401 
   
434  
   
464  
   
494 
   
523 
 
Capital Lease Obligations due within
  one year
 
   
6  
   
6  
   
   
 
Capital Lease Obligations
 
99 
   
105  
   
111  
   
117 
   
122 
 
Long-Term Project Funding
 
19 
   
21  
   
23  
   
26 
   
65 
 
Minority Interest
 
   
6  
   
   24  
   
46 
   
55 
 
Common Shareholders’ Equity
 
4,190 
   
4,018  
   
3,612  
   
3,584 
   
3,339 
 
   Total Capitalization
$
10,130 
 
$
9,386  
 
$
9,217  
 
$
9,101 
 
$
9,307 
 
                               

(a)
Includes a pre-tax charge of $124 million ($86 million after-tax) related to the adjustment to the equity value of cross-border energy lease investments, and included in Income Taxes is a $7 million after-tax charge for the additional interest accrued on the related tax obligation.
(b)
Includes $23 million of after-tax net interest income on uncertain and effectively settled tax positions (primarily associated with the reversal of previously accrued interest payable resulting from the final and tentative settlements, respectively, with the IRS on the like-kind exchange and mixed service cost issues and a claim made with the IRS related to the tax reporting for fuel over- and under-recoveries) and a benefit of $8 million (including a $3 million correction of prior period errors) related to additional analysis of deferred tax balances completed in 2008.
(c)
Includes $33 million ($20 million after-tax) from settlement of Mirant bankruptcy claims.
(d)
Includes $20 million ($18 million net of fees) benefit related to Maryland income tax settlement.
(e)
Includes $19 million of impairment losses ($14 million after-tax) related to certain energy services business assets.
(f)
Includes $12 million gain ($8 million after-tax) on the sale of Conectiv Energy’s equity interest in a joint venture which owns a wood burning cogeneration facility.
(g)
Includes $68 million ($41 million after-tax) gain from sale of non-utility land owned by Pepco at Buzzard Point.
(h)
Includes $71 million ($42 million after-tax) gain (net of customer sharing) from settlement of Mirant bankruptcy claims.
(i)
Includes $13 million ($9 million after-tax) related to PCI’s liquidation of a financial investment that was written off in 2001.
(j)
Includes $11 million in income tax expense related to the mixed service cost issue under IRS Revenue Ruling 2005-53.
(k)
Includes a $20 million charge related to an IRS settlement.  Also includes $13 million tax benefit related to issuance of a local jurisdiction’s final consolidated tax return regulations.


 
38

 


INFORMATION FOR THIS ITEM IS NOT REQUIRED FOR PEPCO, DPL, AND ACE AS THEY MEET THE CONDITIONS SET FORTH IN GENERAL INSTRUCTIONS I(1)(a) AND (b) OF FORM 10-K AND THEREFORE ARE FILING THIS FORM WITH THE REDUCED FILING FORMAT.
 
 
 Item 7.   MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
The information required by this item is contained herein, as follows:
 
Registrants
 
Page No.
 
Pepco Holdings
 
  41
Pepco
 
104
DPL
 
116
ACE
 
129


 

 

 

 
39

 


 

 

 

 

 

 

 

 

 
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40

PEPCO HOLDINGS 


MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
  AND RESULTS OF OPERATIONS
 
PEPCO HOLDINGS, INC.
 
GENERAL OVERVIEW
 
In 2008, 2007 and 2006, respectively, PHI’s Power Delivery operations produced 51%, 56%, and 61% of PHI’s consolidated operating revenues (including revenues from intercompany transactions) and 72%, 66%, and 67% of PHI’s consolidated operating income (including income from intercompany transactions).
 
The Power Delivery business consists primarily of the transmission, distribution and default supply of electricity, which for 2008, 2007, and 2006, was responsible for 94%, 94%, and 95%, respectively, of Power Delivery’s operating revenues.  The distribution of natural gas contributed 6%, 6% and 5% of Power Delivery’s operating revenues in 2008, 2007 and 2006, respectively.  Power Delivery represents one operating segment for financial reporting purposes.
 
The Power Delivery business is conducted by PHI’s three utility subsidiaries:  Potomac Electric Power Company (Pepco), Delmarva Power & Light Company (DPL) and Atlantic City Electric Company (ACE).  Each of these companies is a regulated public utility in the jurisdictions that comprise its service territory.  Each company is responsible for the delivery of electricity and, in the case of DPL, natural gas in its service territory, for which it is paid tariff rates established by the applicable local public service commission.  Each company also supplies electricity at regulated rates to retail customers in its service territory who do not elect to purchase electricity from a competitive energy supplier.  The regulatory term for this supply service varies by jurisdiction as follows:

 
Delaware
Standard Offer Service (SOS)
 
 
District of Columbia
SOS
 
 
Maryland
SOS

 
New Jersey
Basic Generation Service (BGS)

Effective January 2, 2008, DPL sold its retail electric distribution assets and its wholesale electric transmission assets in Virginia.  Prior to that date, DPL supplied electricity at regulated rates to retail customers in its service territory who did not elect to purchase electricity from a competitive energy supplier, which is referred to in Virginia as Default Service.
 
In this Form 10-K, the supply service obligations of the respective utility subsidiaries are referred to generally as Default Electricity Supply.
 
Pepco, DPL and ACE are also responsible for the transmission of wholesale electricity into and across their service territories.  The rates each company is permitted to charge for the wholesale transmission of electricity are regulated by the Federal Energy Regulatory Commission (FERC).  Transmission rates are updated annually based on a FERC-approved formula methodology.
 

 
41

PEPCO HOLDINGS   

The profitability of the Power Delivery business depends on its ability to recover costs and earn a reasonable return on its capital investments through the rates it is permitted to charge.  The Power Delivery operating results historically have been seasonal, generally producing higher revenue and income in the warmest and coldest periods of the year.  Operating results also can be affected by economic conditions, energy prices and the impact of energy efficiency measures on customer usage of electricity.

In connection with its approval of new electric service distribution base rates for Pepco and DPL in Maryland, effective in June 2007 (the 2007 Maryland Rate Orders), the Maryland Public Service Commission (MPSC) approved a bill stabilization adjustment mechanism (BSA) for retail customers. For customers to which the BSA applies, Pepco and DPL recognize distribution revenue based on an approved distribution charge per customer.  From a revenue recognition standpoint, the BSA thus decouples the distribution revenue recognized in a reporting period from the amount of power delivered during the period.  This change in the reporting of distribution revenue has the effect of eliminating changes in retail customer usage (whether due to weather conditions, energy prices, energy efficiency programs or other reasons) as a factor having an impact on reported revenue.  As a consequence, the only factors that will cause distribution revenue from retail customers in Maryland to fluctuate from period to period are changes in the number of customers and changes in the approved distribution charge per customer.

The Competitive Energy businesses provide competitive generation, marketing and supply of electricity and gas, and related energy management services primarily in the mid-Atlantic region.  These operations are conducted through:

·  
Subsidiaries of Conectiv Energy Holding Company (collectively, Conectiv Energy), which engage primarily in the generation and wholesale supply and marketing of electricity and gas within the PJM Interconnection, LLC (PJM) and Independent System Operator - New England (ISONE) wholesale markets

·  
Pepco Energy Services, Inc. and its subsidiaries (collectively, Pepco Energy Services), which provides retail energy supply and energy services primarily to commercial, industrial, and governmental customers.

Each of Conectiv Energy and Pepco Energy Services is a separate operating segment for financial reporting purposes.  For the years ended December 31, 2008, 2007 and 2006, the operating revenues of the Competitive Energy businesses (including revenue from intercompany transactions) were equal to 53%, 48%, and 43%, respectively, of PHI’s consolidated operating revenues, and the operating income of the Competitive Energy businesses (including operating income from intercompany transactions) was 36%, 26%, and 20% of PHI’s consolidated operating income for the years ended December 31, 2008, 2007 and 2006, respectively.  For the years ended December 31, 2008, 2007 and 2006, amounts equal to 7%, 10%, and 13% respectively, of the operating revenues of the Competitive Energy businesses were attributable to electric energy and capacity, and natural gas sold to the Power Delivery segment.

Conectiv Energy’s primary objective is to maximize the value of its generation fleet by leveraging its operational and fuel flexibilities.  Pepco Energy Services’ primary objective is to capture retail energy supply and service opportunities predominantly in the mid-Atlantic region.
 

 
42

PEPCO HOLDINGS   

The financial results of the Competitive Energy business can be significantly affected by wholesale and retail energy prices, the cost of fuel and gas to operate the Conectiv Energy plants, and the cost of purchased energy necessary to meet its power and gas supply obligations.
 
The Competitive Energy businesses, like the Power Delivery business, are seasonal, and therefore weather patterns can have a material impact on operating results.
 
Through its subsidiary Potomac Capital Investment Corporation (PCI), PHI maintains a portfolio of cross-border energy sale-leaseback transactions with a book value at December 31, 2008 of approximately $1.3 billion.  This activity constitutes a fourth operating segment, which is designated as “Other Non-Regulated,” for financial reporting purposes.  For a discussion of PHI’s cross-border leasing transactions, see “Regulatory and Other Matters — PHI’s Cross-Border Energy Lease Investments” in this Management’s Discussion and Analysis.
 
IMPACT OF THE CURRENT CAPITAL AND CREDIT MARKET DISRUPTIONS

The recent disruptions in the capital and credit markets, combined with the volatility of energy prices, have had an impact on several aspects of PHI’s businesses.  While these conditions have required PHI and its subsidiaries to make certain adjustments in their financial management activities, PHI believes that it and its subsidiaries currently have sufficient liquidity to fund their operations and meet their financial obligations.  These market conditions, should they continue, could have a negative effect on PHI’s financial condition, results of operations and cash flows.

Liquidity Requirements

PHI and its subsidiaries depend on access to the capital and credit markets to meet their liquidity and capital requirements.  To meet their liquidity requirements, PHI’s utility subsidiaries and its Competitive Energy businesses historically have relied on the issuance of commercial paper and short-term notes and on bank lines of credit to supplement internally generated cash from operations.  PHI’s primary credit source is its $1.5 billion syndicated credit facility, which can be used by PHI and its utility subsidiaries to borrow funds, obtain letters of credit and support the issuance of commercial paper.  This facility is in effect until May 2012 and consists of commitments from 17 lenders, no one of which is responsible for more than 8.5% of the total $1.5 billion commitment.  The terms and conditions of the facility are more fully described below under the heading “Capital Resources and Liquidity ¾ Credit Facilities.”

Due to the capital and credit market disruptions, the market for commercial paper in the latter part of 2008 was severely restricted for most companies.  As a result, PHI and its subsidiaries have not been able to issue commercial paper on a day-to-day basis either in amounts or with maturities that they have typically required for cash management purposes.  To address the challenges posed by the current capital and credit market environment and to ensure that PHI and its subsidiaries will continue to have sufficient access to cash to meet their liquidity needs, PHI and its subsidiaries have undertaken a number of actions, including the following:

·  
PHI has conducted a review to identify cash and liquidity conservation measures, including opportunities to reduce collateral obligations and to defer capital expenditures due to lower than anticipated growth.  Several measures to reduce

 
43

PEPCO HOLDINGS   

collateral obligations and expenditures have been taken.  Additional measures could be undertaken if conditions warrant.

·  
PHI issued an additional 16.1 million shares of the Company’s common stock at a price per share of $16.50 in November 2008, for net proceeds of $255 million.

·  
PHI added a 364-day $400 million credit facility in November 2008.

·  
In November 2008, ACE issued $250 million of First Mortgage Bonds, 7.75% Series due November 15, 2018.

·  
In November 2008, DPL issued $250 million of First Mortgage Bonds, 6.40% Series due December 1, 2013.

·  
In December 2008, Pepco issued $250 million of First Mortgage Bonds, 7.90% Series due December 15, 2038.

At December 31, 2008, the amount of cash, plus borrowing capacity under the syndicated credit facility and PHI’s new 364-day credit facility, available to meet the liquidity needs of PHI on a consolidated basis totaled $1.5 billion, of which $843 million consisted of the combined cash and borrowing capacity of PHI’s utility subsidiaries.  During the months of January and February 2009, the average daily amount of the combined cash and borrowing capacity of PHI on a consolidated basis was $1.4 billion, and of its utility subsidiaries was $831 million.  This decrease in liquidity of PHI on a consolidated basis was primarily due to increased collateral requirements of the Competitive Energy businesses.  During the months of January and February 2009, the combined cash and borrowing capacity of PHI’s utility subsidiaries ranged from a low of $673 million to a high of $1 billion.

Collateral Requirements of the Competitive Energy Businesses

In conducting its retail energy sales business, Pepco Energy Services typically enters into electricity and natural gas sales contracts under which it is committed to supply the electricity or natural gas requirements of its retail customers over a specified period at agreed upon prices.  Generally, Pepco Energy Services acquires the energy to serve this load by entering into wholesale purchase contracts.  To protect the respective parties against the risk of nonperformance by the other party, these wholesale purchase contracts typically impose collateral requirements that are tied to changes in the price of the contract commodity.  In periods of energy market price volatility, these collateral obligations can fluctuate materially on a day-to-day basis.

Pepco Energy Services’ practice of offsetting its retail energy sale obligations with corresponding wholesale purchases of energy has the effect of substantially reducing the exposure of its margins to energy price fluctuations.  In addition, the non-performance risks associated with its retail energy sales are relatively low due to the inclusion of governmental entities among its customers and the purchase of insurance on a significant portion of its commercial and other accounts receivable.  However, because its retail energy sales contracts typically do not have collateral obligations, during periods of declining energy prices Pepco Energy Services is exposed to the asymmetrical risk of having to post collateral under its

 
44

PEPCO HOLDINGS   

wholesale purchase contracts without receiving a corresponding amount of collateral from its retail customers.  In the second half of 2008, the decrease in energy prices has caused a significant increase in the collateral obligations of Pepco Energy Services.

In addition, Conectiv Energy and Pepco Energy Services in the ordinary course of business enter into various contracts to buy and sell electricity, fuels and related products, including derivative instruments, designed to reduce their financial exposure to changes in the value of their assets and obligations due to energy price fluctuations.  These contracts also typically have collateral requirements.

Depending on the contract terms, the collateral required to be posted by Pepco Energy Services and Conectiv Energy can be of varying forms, including cash and letters of credit.  As of December 31, 2008, the Competitive Energy businesses had posted net cash collateral of $331 million and letters of credit of $558 million.

At December 31, 2008, the amount of cash, plus borrowing capacity under the syndicated credit facility and PHI’s new 364-day credit facility, available to meet the liquidity needs of the Competitive Energy businesses on a consolidated basis totaled $684 million.  During the months of January and February 2009, the combined cash and borrowing capacity available to PHI’s Competitive Energy businesses ranged from a low of $378 million to a high of $757 million.

Ongoing Monitoring of Financial and Market Conditions

PHI monitors its liquidity position on a daily basis and routinely conducts stress testing to assess the impact of changes in commodity prices on its collateral requirements.  Stress testing conducted over the months of January and February 2009, based on contractual rights and obligations in effect at the time, indicated that a 1% change in forward prices corresponding to the periods under the various contractual arrangements with respect to which collateral was required would have caused an estimated change of approximately $6 million in Conectiv Energy’s net collateral requirements and a change of approximately $17 million in Pepco Energy Services’ net collateral requirements.  PHI’s net collateral obligations decrease when forward prices increase and increase when forward prices decrease.

PHI also closely monitors its credit ratings and outlooks and those of its rated subsidiaries, and computes the hypothetical effect that changes in credit ratings would have on collateral requirements and the cost of capital.  Based on contractual provisions in effect at December 31, 2008, a one-level downgrade in the unsecured debt credit ratings of PHI and each of its rated subsidiaries, which would decrease ratings to below “investment grade,” would increase the collateral obligations of PHI and its subsidiaries by up to $462 million.

Counterparty Credit Risk

PHI is exposed to the risk that the counterparties to contracts may fail to meet their contractual payment obligations or may fail to deliver purchased commodities or services at the contracted price. PHI attempts to minimize these risks through, among other things, formal credit policies, regular assessments of counterparty creditworthiness, and the establishment of a credit limit for each counterparty.


 
45

PEPCO HOLDINGS   

Pension and Postretirement Benefit Plans

PHI and its subsidiaries sponsor pension and postretirement benefit plans for their employees.  While the plans have not experienced any significant impact in terms of liquidity or counterparty exposure due to the disruption of the capital and credit markets, the stock market declines have caused a decrease in the market value of benefit plan assets over the twelve months ended December 31, 2008.  The negative return did not have an impact on PHI’s results of operations for 2008; however, this reduction in benefit plan assets will result in increased pension and postretirement benefit costs in future years.

PHI currently estimates that its net periodic pension benefit cost will be approximately $85 million in 2009, as compared to $24 million in 2008.  The utility subsidiaries are generally responsible for approximately 80% to 85% of the total PHI net periodic pension benefit cost.  Approximately 30% of net periodic pension benefit cost is capitalized.

PHI expects to make a discretionary tax deductible contribution to the pension plan in 2009 of approximately $300 million.  The utility subsidiaries will be responsible for funding their share of the contribution of approximately $170 million for Pepco, $10 million for DPL and $60 million for ACE.  PHI Service Company is responsible to fund the remaining share of the contribution.  PHI will monitor the markets and evaluate any additional discretionary funding needs later in the year.  See Note (10), “Pensions and Other Postretirement Benefits,” to the consolidated financial statements of PHI set forth in Item 8 of this Form 10-K.

BUSINESS STRATEGY
 
PHI’s business strategy is to remain a mid-Atlantic regional diversified energy delivery utility and competitive energy services company focused on value creation and operational excellence.  The components of this strategy include:

 
·
Achieving earnings growth in the Power Delivery business by focusing on transmission and distribution infrastructure investments and constructive regulatory outcomes, while maintaining a high level of operational excellence.

 
·
Supplementing PHI’s utility earnings through competitive energy businesses that focus on serving the competitive wholesale and retail markets primarily within the PJM Regional Transmission Organization (PJM RTO) market.
 
 
·
Pursuing technologies and practices that promote energy efficiency, energy conservation and the reduction of greenhouse gas emissions.

To further this business strategy, PHI may from time to time examine a variety of transactions involving its existing businesses, including the entry into joint ventures or the disposition of one or more businesses, as well as possible acquisitions.  PHI also may reassess or refine the components of its business strategy as it deems necessary or appropriate in response to a wide variety of factors, including the requirements of its businesses, competitive conditions and regulatory requirements.


 
46

PEPCO HOLDINGS   

Strategic Analysis of Pepco Energy Services’ Retail Energy Supply Business

Over the past several months, PHI has been conducting a strategic analysis of the retail energy supply business of Pepco Energy Services.  This review has included, among other things, the evaluation of potential alternative supply arrangements to reduce collateral requirements or a possible restructuring, sale or wind down of the business.  As discussed above under the heading, “Impact of Current Capital and Credit Market Disruption -- Collateral Requirements of the Competitive Energy Businesses,” as energy prices have declined in the second half of 2008, the collateral that Pepco Energy Services has been required to post to secure its obligations under its wholesale energy purchase contracts has increased substantially.  Among the factors being considered is the return PHI earns by investing capital in the retail energy supply business as compared to alternative investments.  PHI expects the retail energy supply business to remain profitable based on its existing contract backlog and the margins that have been locked in with corresponding wholesale energy purchase contracts. The increased cost of capital associated with its collateral obligations has been factored into its retail pricing and, as a consequence, PES is experiencing reduced retail customer retention levels and reduced levels of new retail customer acquisitions.

EARNINGS OVERVIEW
 
Year Ended December 31, 2008 Compared to the Year Ended December 31, 2007
 
PHI’s net income for the year ended December 31, 2008 was $300 million, or $1.47 per share, compared to $334 million, or $1.72 per share, for the year ended December 31, 2007.
 
Net income for the year ended December 31, 2008, included the charges set forth below in the Other Non-Regulated operating segment, which are presented net of federal and state income taxes and are in millions of dollars:
 
  
Adjustment to the equity value of cross-border energy lease investments to reflect the impact of a change in assumptions regarding the estimated timing of the tax benefits
 
 
$
 
(86)
 
 
 
 
 
 
Additional interest accrued under Financial Accounting Standards Board Interpretation No. 48 (FIN 48) related to the estimated federal and state income tax obligations from the change in assumptions regarding the estimated timing of the tax benefits on cross-border energy lease investments
$
 
(7)
 

Net income for the year ended December 31, 2007, included the credits set forth below in the Power Delivery operating segment, which are presented net of federal and state income taxes and are in millions of dollars.

 
Mirant Corporation (Mirant) bankruptcy damage claims settlement
 
$
 
20
 
 
Maryland income tax settlement, net of fees
$
18
 

Excluding the items listed above, net income would have been $393 million, or $1.93 per share, in 2008 and $296 million, or $1.53 per share, in 2007.

 
47

PEPCO HOLDINGS   

PHI’s net income for the years ended December 31, 2008 and 2007, by operating segment, is set forth in the table below (in millions of dollars):

   
2008
   
2007
   
Change
 
Power Delivery
$
250 
 
$
232 
 
$
18 
 
Conectiv Energy
 
122 
   
73 
   
49 
 
Pepco Energy Services
 
39 
   
38 
   
 
Other Non-Regulated
 
(59)
   
46 
   
(105)
 
Corp. & Other
 
(52)
   
(55)
   
 
     Total PHI Net Income
$
300 
 
$
334 
 
$
(34)
 
                   

Discussion of Operating Segment Net Income Variances:
 
Power Delivery’s $18 million increase in earnings is primarily due to the following:
 
·  
$38 million increase due to the impact of the distribution base rate orders ($23 million related to Maryland, which became effective in June 2007 for Pepco and DPL, and $15 million related to the District of Columbia, which became effective in February 2008 for Pepco).
 
·  
$23 million increase due to favorable income tax adjustments primarily related to FIN 48 interest impact.
 
·  
$15 million increase due to FERC network transmission service rate changes in June 2007 and 2008.
 
·  
$20 million decrease due to the Mirant bankruptcy damage claims settlement in 2007.
 
·  
$18 million decrease due to the Maryland tax settlement, net of fees in 2007.
 
·  
$16 million decrease primarily due to lower sales (primarily decreased customer usage, including an unfavorable impact of weather compared to 2007).
 
·  
$5 million decrease due to higher operating and maintenance costs (primarily higher employee-related costs and bad-debt expense).
 
Conectiv Energy’s $49 million increase in earnings is primarily due to the following:
 
·  
$43 million increase in Merchant Generation & Load Service primarily due to:
 
 
(i)
an increase of $22 million primarily due to short-term sales of firm natural gas and natural gas transportation and storage rights, the dual-fuel capability of the combined cycle mid-merit units (fuel switching), cross-commodity hedging (use of natural gas to hedge power positions), and the opportunities created by the mid-merit combined cycle units’ operating flexibility (option value) in conjunction with short-term power and fuel price volatility,
 
 
(ii)
an increase of $28 million due to higher PJM capacity prices net of capacity hedges,
 
 

 
48

PEPCO HOLDINGS   

 
(iii)
an increase of $11 million due to the application of fair value accounting treatment and associated settlements with respect to excess coal hedges accounted for at fair value,
 
 
(iv)
a decrease of $9 million due to a lower of cost or market adjustment to the value of oil inventory held at the power plants at year-end 2008, and
 
 
(v)
a decrease of $9 million due to lower sales of emissions allowances.
 
 
·
$9 million increase in Energy Marketing primarily due to increased short-term power desk margins, and new default electricity supply contracts.
 
·
$5 million increase due to favorable income tax adjustments primarily due to the reversal of FIN 48 interest accruals.
 
 
·
$10 million decrease primarily due to higher plant maintenance.
 
Pepco Energy Services’ $1 million increase in earnings is primarily due to the following:
 
 
·
$6 million increase resulting from higher volumes due to growth in the retail gas supply business.
 
·
$2 million increase in the retail electricity business due to more favorable congestion costs; partially offset by higher cost of electricity and other electricity supply costs.
 
 
·
$2 million increase resulting from favorable income tax adjustments related to deferred income taxes.
 
 
·
$9 million decrease for the generation plants primarily due to Reliability Pricing Model (RPM) related charges.
 
Other Non-Regulated’s $105 million decrease in earnings is primarily due to the following:
 
 
·
$86 million after-tax charge resulting from a $124 million adjustment to the equity value of PHI’s cross-border energy lease investments.
 
·
$7 million after-tax charge for interest accrued under FIN 48 related to estimated federal and state income tax obligations for the period from January 1, 2001 through June 30, 2008 resulting from the change in assumptions regarding the estimated timing of the tax benefits of PHI’s cross-border energy lease investments.
 
 
·
$9 million decrease primarily due to favorable valuation adjustments to certain other PCI portfolio investments in 2007; partially offset by lower interest expense.
 
Corporate and Other’s $3 million increase in earnings is primarily due to lower interest expense and corporate governance costs.
 

 
49

PEPCO HOLDINGS   

CONSOLIDATED RESULTS OF OPERATIONS
 
The following results of operations discussion compares the year ended December 31, 2008, to the year ended December 31, 2007.  All amounts in the tables (except sales and customers) are in millions.
 
Operating Revenue
 
A detail of the components of PHI’s consolidated operating revenue is as follows:

       
 
      2008        
            2007          
Change     
 
Power Delivery
$   
5,487 
 
$   
5,244 
 
$   
243 
   
Conectiv Energy
 
3,047 
   
2,206 
   
841 
   
Pepco Energy Services
 
2,648 
   
2,309 
   
339 
   
Other Non-Regulated
 
(60)
   
76 
   
(136)
   
Corp. & Other
 
(422)
   
(469)
   
47 
   
     Total Operating Revenue
$   
10,700 
 
$   
9,366 
 
$   
1,334 
   
                     

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

                     
 
               2008               
           2007       
Change     
 
Regulated T&D Electric Revenue
$   
1,690 
 
$   
1,592 
 
$   
98 
   
Default Supply Revenue
 
3,413   
   
3,295 
   
118 
   
Other Electric Revenue
 
66 
   
66 
   
   
     Total Electric Operating Revenue
  
5,169 
   
4,953 
   
216 
   
                     
Regulated Gas Revenue
 
204 
   
211 
   
(7)
   
Other Gas Revenue
 
114 
   
80 
   
34 
   
     Total Gas Operating Revenue
 
318 
   
291 
   
27 
   
                     
Total Power Delivery Operating Revenue
$   
5,487 
 
$   
5,244 
 
$   
243 
   
                     

Regulated Transmission and Distribution (T&D) Electric Revenue includes revenue from the delivery of electricity, including the delivery 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.

Default Supply Revenue is the revenue received for Default Electricity Supply.  The costs related to Default Electricity Supply are included in Fuel and Purchased Energy and Other Services Cost of Sales.  Default Supply Revenue also includes revenue from transition bond charges and other restructuring related revenues.

Other Electric Revenue includes work and services performed on behalf of customers, including other utilities, which is not subject to price regulation.  Work and services includes

 
50

PEPCO HOLDINGS   

mutual assistance to other utilities, highway relocation, rentals of pole attachments, late payment fees, and collection fees.

Regulated Gas Revenue consists of revenues from on-system natural gas sales and the transportation of natural gas for customers by DPL within its service territories at regulated rates.

Other Gas Revenue consists of DPL’s off-system natural gas sales and the sale of excess system capacity.

In response to an order issued by the New Jersey Board of Public Utilities (NJBPU) regarding changes to ACE’s retail transmission rates, ACE has established deferred accounting treatment for the difference between the rates that ACE is authorized to charge its customers for the transmission of Default Electricity Supply and the cost that ACE incurs.  Under the deferral arrangement, any over or under recovery is deferred as part of Deferred Electric Service Costs pending an adjustment of retail rates in a future proceeding.  As a consequence of the order, effective January 1, 2008, ACE’s retail transmission revenue is being recorded as Default Supply Revenue, rather than as Regulated T&D Electric Revenue, thereby conforming to the practice of PHI’s other utility subsidiaries, which previously established deferred accounting treatment for any over or under recovery of retail transmission rates relative to the cost incurred. ACE’s retail transmission revenue for the period prior to January 1, 2008 has been reclassified to Default Supply Revenue in order to conform to the current period presentation.

Electric Operating Revenue

Regulated T&D Electric Revenue
     
 
2008
2007
Change
 
                     
Residential
$   
580 
 
$   
579
 
$   
1
   
Commercial
 
746 
   
720
   
26
   
Industrial
 
29 
   
26
   
3
   
Other
 
335 
   
267
   
68
   
     Total Regulated T&D Electric Revenue
$   
1,690 
 
$    
1,592
 
$   
98
   
                     

Other Regulated T&D Electric Revenue consists primarily of (i) transmission service revenue, (ii) revenue from the resale of energy and capacity under power purchase agreements between Pepco and unaffiliated third parties in the PJM RTO market, and (iii) either (a) a positive adjustment equal to the amount by which revenue from Maryland retail distribution sales falls short of the revenue that Pepco and DPL are entitled to earn based on the distribution charge per customer approved in the 2007 Maryland Rate Orders or (b) 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 (a Revenue Decoupling Adjustment).

 
51

PEPCO HOLDINGS   


Regulated T&D Electric Sales (Gigawatt hours (GWh))
   
 
2008
2007
Change
 
                     
Residential
 
17,186 
   
17,946
   
(760)
   
Commercial
 
28,739 
   
29,137
   
(398)
   
Industrial
 
3,781 
   
3,974
   
(193)