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Allegheny Energy 10-K 2006
Allegheny Energy Inc. Form 10-K
Table of Contents

 

LOGO

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-K

 


 

FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTIONS 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

  x   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) of the SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2005

 

OR

 

  ¨   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) of the SECURITIES EXCHANGE ACT OF 1934

 

Commission

File Number


  

Registrant;

State of Incorporation;

Address; and Telephone Number


 

I.R.S. Employer

Identification Number


1-267

   ALLEGHENY ENERGY, INC.   13-5531602
     (A Maryland Corporation)    
     800 Cabin Hill Drive    
     Greensburg, Pennsylvania 15601    
     Telephone (724) 837-3000    

1-5164

   MONONGAHELA POWER COMPANY   13-5229392
     (An Ohio Corporation)    
     1310 Fairmont Avenue    
     Fairmont, West Virginia 26554    
     Telephone (304) 366-3000    

1-3376-2

   THE POTOMAC EDISON COMPANY   13-5323955
     (A Maryland and Virginia Corporation)    
     800 Cabin Hill Drive    
     Greensburg, Pennsylvania 15601    
     Telephone (724) 837-3000    

0-14688

   ALLEGHENY GENERATING COMPANY   13-3079675
     (A Virginia Corporation)    
     800 Cabin Hill Drive    
     Greensburg, Pennsylvania 15601    
     Telephone (724) 837-3000    


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

 

Allegheny Energy, Inc.

   Yes   x    No   ¨

Monongahela Power Company

   Yes   ¨    No   x

The Potomac Edison Company

   Yes   ¨    No   x

Allegheny Generating Company

   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.

 

Allegheny Energy, Inc.

   ¨  

Monongahela Power Company

   ¨  

The Potomac Edison Company

   ¨  

Allegheny Generating Company

   ¨  

 

Indicate by check mark whether the registrants (1) have 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) have been subject to such filing requirements for the past 90 days.    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 registrants’ knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the Act).

 

    Large accelerated filer

  Accelerated filer

  Non-accelerated filer

Allegheny Energy, Inc.

  x   ¨   ¨

Monongahela Power Company

  ¨   ¨   x

The Potomac Edison Company

  ¨   ¨   x

Allegheny Generating Company

  ¨   ¨   x

 

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

 

Allegheny Energy, Inc.

   Yes   ¨    No   x

Monongahela Power Company

   Yes   ¨    No   x

The Potomac Edison Company

   Yes   ¨    No   x

Allegheny Generating Company

   Yes   ¨    No   x

 

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

 

Registrant


  

Title of each class


  

Name of each exchange

on which registered


Allegheny Energy, Inc.

  

Common Stock,
$1.25 par value

   New York Stock Exchange
Chicago Stock Exchange
Pacific Stock Exchange

Monongahela Power Company

  

Cumulative Preferred Stock,
$100 par value:
4.40%
4.50%, Series C

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

Allegheny Generating Company

  

Common Stock,
$1.00 par value

   None


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Aggregate market value of

voting and non-voting common

equity held by nonaffiliates of

the registrants at June 30, 2005

  

Number of shares of common stock

of the registrants outstanding at

February 24, 2006

Allegheny Energy, Inc.

   $4,083,469,189    163,182,102 ($1.25 par value)

Monongahela Power Company

   None (a)    5,891,000 ($50 par value)

The Potomac Edison Company

   None (a)    22,385,000 ($.01 par value)

Allegheny Generating Company

   None (b)    1,000 ($1.00 par value)

(a)   All outstanding common stock is held by Allegheny Energy, Inc.
(b)   All outstanding common stock is held by Allegheny Generating Company’s parent companies, Monongahela Power Company and Allegheny Energy Supply Company, LLC.

 

Documents Incorporated by Reference

 

Portions of the Allegheny Energy, Inc. definitive Proxy Statement for its 2006 Annual Meeting of Stockholders are incorporated by reference to Part III of this Annual Report on Form 10-K.

 



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GLOSSARY

 

I.   The following abbreviations and terms are used in this report to identify Allegheny Energy, Inc. and its subsidiaries:

 

ACC

   Allegheny Communications Connect, Inc., a subsidiary of Allegheny Ventures

AE

   Allegheny Energy, Inc., a diversified utility holding company

AESC

   Allegheny Energy Service Corporation, a wholly owned subsidiary of AE

AE Solutions

   Allegheny Energy Solutions, Inc., a subsidiary of Allegheny Ventures

AE Supply

   Allegheny Energy Supply Company, LLC, an unregulated generation subsidiary of AE

AGC

   Allegheny Generating Company, an unregulated generation subsidiary of AE Supply and Monongahela

Allegheny

   Allegheny Energy, Inc., together with its consolidated subsidiaries

Allegheny Ventures

   Allegheny Ventures, Inc., a nonutility, unregulated subsidiary of AE

Distribution Companies

   Collectively, Monongahela, Potomac Edison and West Penn, which do business as Allegheny Power

Green Valley Hydro

   Green Valley Hydro, LLC, a subsidiary of AE

Monongahela

   Monongahela Power Company, a regulated subsidiary of AE

Potomac Edison

   The Potomac Edison Company, a regulated subsidiary of AE

West Penn

   West Penn Power Company, a regulated subsidiary of AE

 

II.   The following abbreviations and acronyms are used in this report to identify entities and terms relevant to Allegheny’s business and operations:

 

Bcf

   Billion cubic feet

CDD

   Cooling Degree-Days

CDWR

   California Department of Water Resources

Clean Air Act

   Clean Air Act of 1970

EPA

   United States Environmental Protection Agency

Energy Policy Act

   Energy Policy Act of 2005

Exchange Act

   Securities Exchange Act of 1934, as amended

FERC

   Federal Energy Regulatory Commission, an independent commission within the U. S. Department of Energy

FPA

   Federal Power Act

GAAP

   Generally accepted accounting principles used in the United States of America

HDD

   Heating Degree-Days

KW

   Kilowatt, which is equal to 1,000 watts

kWh

   Kilowatt-hour, which is a unit of electric energy equivalent to one kilowatt operating for one hour

Maryland PSC

   Maryland Public Service Commission

MW

   Megawatt, which is equal to 1,000,000 watts

MWh

   Megawatt-hour, which is a unit of electric energy equivalent to one megawatt operating for one hour

NSR

   The New Source Performance Review Standards, or “New Source Review,” applicable to facilities deemed “new” sources of emissions by the EPA

OVEC

   Ohio Valley Electric Corporation

Pennsylvania PUC

   Pennsylvania Public Utility Commission

PJM

   PJM Interconnection, L.L.C., a regional transmission organization

PLR

   Provider-of-last-resort

PUCO

   Public Utilities Commission of Ohio

PUHCA 1935

   Public Utility Holding Company Act of 1935, as amended

PUHCA 2005

   Public Utility Holding Company Act of 2005

PURPA

   Public Utility Regulatory Policies Act of 1978

RTO

   Regional Transmission Organization

SEC

   Securities and Exchange Commission

SERP

   Supplemental Executive Retirement Plan

T&D

   Transmission and distribution

Virginia SCC

   Virginia State Corporate Commission

West Virginia PSC

   Public Service Commission of West Virginia


Table of Contents

LOGO

 

 


Table of Contents

CONTENTS

 

Item 1.

  

Business

   1
    

Overview

   1
    

Special Note Regarding Forward-Looking Statements

   8
    

Allegheny’s Sales And Revenues

   9
    

Capital Expenditures

   10
    

Electric Facilities

   11
    

Fuel, Power And Resource Supply

   16
    

Regulatory Framework Affecting Allegheny

   19
    

Federal Regulation And Rate Matters

   19
    

Employees

   27
    

Environmental Matters

   28
    

Research And Development

   32

Item 1A.

  

Risk Factors

   33

Item 2.

  

Properties

   42

Item 3.

  

Legal Proceedings

   43

Item 4.

  

Submission Of Matters To A Vote Of Security Holders

   47

Item 5.

  

Market For The Registrants’ Common Equity And Related Stockholder Matters

   48

Item 6.

  

Selected Financial Data

   50

Item 7.

  

Management’s Discussion And Analysis Of Financial Condition And Results Of Operations

   54

Item 7a.

  

Quantitative And Qualitative Disclosures About Market Risk

   121

Item 8.

  

Financial Statements And Supplementary Data

   124

Item 10.

  

Directors And Executive Officers Of The Registrants

   270

Item 11.

  

Executive Compensation

   274

Item 12.

  

Security Ownership Of Certain Beneficial Owners And Management And Related Stockholder Matters

   288

Item 13.

  

Certain Relationships And Related Transactions

   287

Item 14.

  

Principal Accountant Fees And Services

   287

Item 15.

  

Exhibits And Financial Statement Schedules

   289

Supplemental Information To Be Furnished With Reports Filed Pursuant To Section 15(D) Of The Exchange Act By Registrants Which Have Not Registered Securities Pursuant To Section 12 Of The Exchange Act

   289

Signatures

   290


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THIS COMBINED FORM 10-K IS SEPARATELY FILED BY ALLEGHENY ENERGY, INC., MONONGAHELA POWER COMPANY, THE POTOMAC EDISON COMPANY AND ALLEGHENY GENERATING COMPANY. INFORMATION CONTAINED HEREIN RELATING TO ANY INDIVIDUAL REGISTRANT IS FILED BY THE REGISTRANT ON ITS OWN BEHALF. NONE OF THE REGISTRANTS MAKES ANY REPRESENTATION AS TO INFORMATION RELATING TO THE OTHER REGISTRANTS.

 

PART I

 

ITEM 1.    BUSINESS

 

OVERVIEW

 

Allegheny is an integrated energy business that owns and operates electric generation facilities and delivers electric services to customers in Pennsylvania, West Virginia, Maryland, and Virginia. AE, Allegheny’s parent holding company, was incorporated in Maryland in 1925. Allegheny operates its business primarily through AE’s various directly and indirectly owned subsidiaries.

 

Allegheny has two business segments:

 

    The Delivery and Services segment includes Allegheny’s electric T&D operations.

 

    The Generation and Marketing segment includes Allegheny’s power generation operations.

 

Allegheny also conducted electric T&D operations in Ohio and natural gas T&D operations in West Virginia until it sold these operations as of December 31, 2005 and September 30, 2005, respectively. Monongahela agreed to sell power at a fixed price to Columbus Southern Power Company (“Columbus Southern”), the purchaser of its electric T&D operations in Ohio, to serve Monongahela’s former Ohio customers until May 31, 2007. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—2005 Asset Sales.”

 

The Delivery and Services Segment

 

The principal companies and operations in AE’s Delivery and Services segment include the following:

 

    The Distribution Companies include Monongahela (excluding its West Virginia generation assets), Potomac Edison and West Penn. Each of the Distribution Companies is a public utility company and does business under the trade name Allegheny Power. Allegheny Power’s principal business is the operation of electric public utility systems.

 

    Monongahela was incorporated in Ohio in 1924. It conducts an electric T&D business that serves approximately 371,400 electric customers in northern West Virginia in a service area of approximately 12,400 square miles with a population of approximately 769,700. Monongahela’s Delivery and Services segment had operating revenues of $691.4 million in 2005. Monongahela also has generation assets, which are included in the Generation and Marketing Segment. See “The Generation and Marketing Segment” below. Monongahela also conducted electric T&D operations in Ohio and natural gas T&D operations in West Virginia until it sold the assets related to these operations as of December 31, 2005 and September 30, 2005, respectively. Monongahela agreed to sell power to Columbus Southern to serve Monongahela’s former Ohio customers until May 31, 2007.

 

    Potomac Edison was incorporated in Maryland in 1923 and was also incorporated in Virginia in 1974. It operates an electric T&D system in portions of West Virginia, Maryland and Virginia. Potomac Edison serves approximately 454,400 electric customers in a service area of about 7,300 square miles with a population of approximately 1.2 million. Potomac Edison’s 2005 total operating revenues were $971.2 million. One industrial customer accounted for 12.9% of Potomac Edison’s operating revenues in each of 2004 and 2005. It is anticipated that this customer, which curtailed its operations in December 2005, will have significantly reduced electric usage in 2006.

 

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    West Penn was incorporated in Pennsylvania in 1916. It operates an electric T&D system in southwestern, south-central and northern Pennsylvania. West Penn serves approximately 702,800 customers in a service area of about 9,900 square miles with a population of approximately 1.5 million. West Penn’s 2005 total operating revenues were $1,184.1 million.

 

In April 2002, the Distribution Companies transferred operational control over their transmission systems to PJM. See “The Distribution Companies’ Obligations and the PJM Market” below.

 

    Allegheny Ventures is a nonutility, unregulated subsidiary of AE that was incorporated in Delaware in 1994. Allegheny Ventures engages in telecommunications and unregulated energy-related projects. Allegheny Ventures has two principal wholly-owned subsidiaries, ACC and AE Solutions. Both ACC and AE Solutions are Delaware corporations. ACC develops fiber-optic projects, including fiber and data services. AE Solutions manages energy-related projects. Allegheny Ventures’s 2005 total operating revenues were $30.7 million.

 

During 2005, the Delivery and Services segment had operating revenues of $2,845.5 million and net income of $113.2 million. As of December 31, 2005, the Delivery and Services segment held $4.1 billion of identifiable assets. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 7, “Business Segments,” to the Consolidated Financial Statements.

 

The Generation and Marketing Segment

 

The principal companies and operations in AE’s Generation and Marketing segment include the following:

 

    AE Supply is a Delaware limited liability company formed in 1999. AE Supply owns, operates and manages electric generation facilities. AE Supply also purchases and sells energy and energy-related commodities. As of December 31, 2005, AE Supply owned or contractually controlled 8,245 MWs of generation capacity. AE Supply markets its electric generation capacity to various customers and markets. Currently, the majority of the Generation and Marketing segment’s normal operating capacity is committed to supplying the PLR and other obligations of the Distribution Companies. AE Supply’s 2005 total operating revenues were $1,371.1 million.

 

    Monongahela’s West Virginia generation assets are included in the Generation and Marketing segment. As of December 31, 2005, Monongahela owned or contractually controlled 2,130 MWs of generation capacity. Monongahela’s Generation and Marketing segment had operating revenues of $415.5 million in 2005. Currently, the majority of Monongahela’s Generation and Marketing segment’s normal operating capacity is committed to supplying Monongahela’s Delivery and Services segment.

 

    AGC was incorporated in Virginia in 1981. AGC is owned approximately 77% by AE Supply and approximately 23% by Monongahela. AGC’s sole asset is a 40% undivided interest in the Bath County, Virginia pumped-storage hydroelectric station and its connecting transmission facilities. All of AGC’s revenues are derived from sales of its 1,010 MWs share of generation capacity from the Bath County generation station to AE Supply and Monongahela. AGC’s 2005 total operating revenues were $66.6 million.

 

AE Supply is obligated under contracts with Potomac Edison and West Penn to provide Potomac Edison and West Penn with the power that they need to meet a majority of their PLR obligations. AE Supply sells power into the PJM market and purchases power from the PJM market to meet its obligations under these contracts. See “The Distribution Companies’ Obligations and the PJM Market” below.

 

Although most of the Generation and Marketing segment’s generation capacity is sold into the PJM market, its generation facility in Gleason, Tennessee is outside of PJM. The Gleason generation facility has been classified as held for sale, and its results have been presented as discontinued operations in the accompanying Consolidated Statements of Operations.

 

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During 2005, the Generation and Marketing segment had operating revenues of $1,703.3 million and a net loss of $50.1 million. As of December 31, 2005, the Generation and Marketing segment held $4.0 billion of identifiable assets. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 7, “Business Segments,” to the Consolidated Financial Statements.

 

Intersegment Services

 

AESC was incorporated in Maryland in 1963 as a service company for AE. AESC employs substantially all of the employees who provide services to AE, AE Supply, AGC, the Distribution Companies, Allegheny Ventures and their respective subsidiaries. These companies reimburse AESC at cost for services provided to them by AESC’s employees. AESC had approximately 4,460 employees as of December 31, 2005.

 

The Distribution Companies’ Obligations and the PJM Market

 

Allegheny’s business has been significantly influenced by state and federal deregulation initiatives, including the implementation of retail choice and plans to transition from cost-based to market-based rates, as well as by the development of wholesale electricity markets and RTOs, particularly PJM.

 

Each of the states in Allegheny’s service territory other than West Virginia has, to some extent, deregulated its electric utility industry. Pennsylvania, Maryland and Virginia have instituted retail customer choice and are transitioning to market-based, rather than cost-based pricing for generation. In West Virginia, the rates charged to retail customers are regulated by the West Virginia PSC and are determined through traditional, cost-based, regulated utility rate-making.

 

West Penn has PLR obligations to its customers in Pennsylvania. Potomac Edison has PLR obligations to its customers in Virginia and its residential customers in Maryland. As “providers of last resort,” West Penn and Potomac Edison must supply power to certain retail customers who have not chosen alternative suppliers (or have chosen to return to Allegheny service) at rates that are capped at various levels during the applicable transition period. The transition periods vary across Allegheny’s service area and across customer class:

 

    Potomac Edison. In Maryland, the transition period for residential customers ends on December 31, 2008. The transition period for commercial and industrial customers ended on December 31, 2004. The generation rates that Potomac Edison charges residential customers in Maryland are capped through December 31, 2008, while the T&D rate caps for all customers expired on December 31, 2004. A statewide settlement approved by the Maryland PSC in 2003 extends Potomac Edison’s obligation to provide residential “standard offer service” (“SOS”) at market based rates beyond the expiration of the transition periods. In Virginia, the transition period ends on December 31, 2010. For a more detailed discussion, see “Regulatory Framework Affecting Allegheny” below.

 

    West Penn. In Pennsylvania, the transition period terminates on December 31, 2010. As part of a May 11, 2005 order approving a settlement, the Pennsylvania PUC extended Pennsylvania’s generation rate caps from 2008 to 2010. The settlement approved by the Pennsylvania PUC also extended distribution rate caps from 2005 to 2007, with an additional rate cap in place for 2009 at the rate in effect on January 1, 2009, and provided for increases in generation rates in 2007, 2009 and 2010, in addition to previously-approved increases for 2006 and 2008. Rate caps on transmission services expired on December 31, 2005.

 

These transition periods could be altered by legislative, judicial or, in some cases, regulatory actions. See “Regulatory Framework Affecting Allegheny” below.

 

Potomac Edison and West Penn have contracts with AE Supply under which AE Supply provides Potomac Edison and West Penn with the majority of the power necessary to meet their PLR obligations. All but

 

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one of Allegheny’s generation facilities are located within the PJM market, and virtually all of the power that the Generation and Marketing segment generates is sold into the PJM market. AE Supply sells the power that it generates into the PJM market and purchases from the PJM market the power necessary to meet its obligations to supply power. Prevailing market prices are generally higher than the capped rates currently applicable to most of these PLR obligations.

 

To facilitate the economic dispatch of its generation, Monongahela sells the power that it generates from its West Virginia jurisdictional assets to AE Supply at PJM market prices, and that power is then sold into the PJM market. Monongahela purchases from AE Supply, at PJM market prices, the power necessary to meet its West Virginia jurisdictional customer load.

 

In connection with the sale of its electric T&D operations in Ohio, Monongahela agreed to sell power at a fixed price to Columbus Southern to serve Monongahela’s former Ohio customers through May 2007. Monongahela purchases the power required to meet this obligation from the PJM market.

 

As an RTO, PJM coordinates the movement of electricity over the transmission grid in 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.

 

For a more detailed discussion, see “Fuel, Power and Resource Supply,” “Regulatory Framework Affecting Allegheny” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Overview” below.

 

Strategy

 

Allegheny’s long-term strategy is to focus on its core generation and T&D businesses. Allegheny’s management believes that this emphasis is enabling Allegheny to take advantage of its regional presence, operational expertise and knowledge of its markets.

 

Prior to 1999, Allegheny functioned as an integrated regulated utility within its service area. In response to federal and state deregulation initiatives, however, Allegheny separated part of its energy generation business from its T&D business by transferring a portion of its generation assets to AE Supply. Allegheny’s former senior management sought to transform AE Supply into a national power merchant in order to capitalize on these regulatory and other energy industry trends. As part of this strategy, AE Supply acquired generation assets, which collectively expanded Allegheny’s owned or controlled generation capacity by nearly one-third. AE Supply also began construction of new generation facilities. In addition, AE Supply purchased the energy trading division of Merrill Lynch in 2001. With this acquisition, the focus of AE Supply’s energy trading shifted from asset backed, short-term trading in and around its generation assets to more speculative trading activities. This expansion was financed primarily through debt. Beginning in 2002, difficult market conditions, changes in the regulatory environment and Allegheny’s worsening credit profile placed Allegheny in a weakened financial position. Beginning in June 2003, Allegheny’s new senior management implemented recovery plans and new long-term strategies.

 

Significant recent achievements include:

 

    Focusing on the Core Business.  Allegheny has reoriented its business to focus on its core businesses and assets. In 2005 and 2004, Allegheny completed a number of significant sales of non-core assets, including:

 

    the September 2005 sale by Monongahela of its West Virginia natural gas T&D business for cash proceeds of approximately $161 million and the assumption by the purchaser of approximately $87 million of debt;

 

    the August 2005 sale by AE Supply of its Wheatland generation facility for approximately $100 million;

 

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    the December 2004 sale by AE Supply of its 672 MW natural gas-fired Lincoln generation facility and an accompanying tolling agreement for approximately $175 million; and

 

    the December 2004 sale by AE of a 9% interest in OVEC (AE continues to hold a 3.5% interest in OVEC) for $102 million in cash, $96 million of which was received at the closing of the transaction and the remaining $6 million of which is expected to be received in April, 2006, upon the satisfaction of certain conditions.

 

      In addition, in December 2005, Monongahela sold its electric T&D operations in Ohio for net cash proceeds of approximately $52 million.

 

      Allegheny also exited its speculative trading activities in the Western U. S. and other energy markets in 2003 through, among other transactions, the sale of AE Supply’s contract with the CDWR and related hedge transactions to J. Aron & Company, a subsidiary of the Goldman Sachs Group, Inc., for $354 million. Allegheny continues to pursue the disposition of additional non-core assets, including its Gleason generating facility. See ‘Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources” and Note 4, “Asset Sales,” to the Consolidated Financial Statements.

 

      In addition, Allegheny has announced a proposal to build the Trans-Allegheny Interstate Line. The proposed 500-kV line will span approximately 330 miles, all within Allegheny’s region of the PJM market, the APS Zone, from the Weirton, West Virginia area to near Kemptown, Maryland. The proposed line is subject to approval by PJM, as well as to various regulatory approvals. Initial engineering and planning is expected to begin in 2007, with the first segment in place in 2013. The projected cost is approximately $1.4 billion.

 

    Substantially Reducing and Proactively Managing Debt.  Between December 1, 2003 and December 31, 2005, Allegheny restructured much of its debt and reduced debt by approximately $1.9 billion, significantly exceeding its goal of reducing debt by $1.5 billion during this period. This restructuring effort included debt reductions of approximately $920 million in 2005 alone.

 

      Through these restructuring efforts, Allegheny secured more favorable terms and conditions with respect to much of its debt, including reduced interest rates. The refinancings undertaken by Allegheny since 2003, together with lower debt balances, yielded a reduction in adjusted interest expense from 2004 to 2005 of approximately $60 million. The reductions in interest expense, coupled with the reductions in debt and general improvements in Allegheny’s financial condition, have led to multiple upgrades in Allegheny’s credit ratings. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Changes in Credit Ratings” below and Note 2, “Capitalization,” to the Consolidated Financial Statements.

 

    Improving Liquidity.  Allegheny has improved its liquidity through prudent cash management, opportunistic sales of non-core assets, cutting costs and expenses, extending debt maturities and other financing strategies. The 2004 refinancing of AE’s credit facility established a revolving credit facility for AE, and an additional refinancing of that facility in 2005 doubled the size of the revolving credit facility. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources” below and Note 2, “Capitalization,” to the Consolidated Financial Statements.

 

    Maximizing Operational Efficiency.  Allegheny is working to maximize the availability and operational efficiency of its physical assets, particularly its supercritical generation facilities (those that utilize steam pressure in excess of 3,200 pounds per square inch). Allegheny also is seeking to optimize operations and maintenance costs for its other generation facilities, T&D assets and related corporate functions, to reduce costs and to pursue other productivity improvements necessary to build a high performance organization.

 

     

For example, as part of a program to improve its processes and technology, AE entered into a Professional Services Agreement in September 2005 with Electronic Data Systems Corporation and

 

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EDS Information Services, LLC (together, the “Service Provider”), under which, on November 1, 2005, the Service Provider assumed responsibility for many of Allegheny’s information technology functions. The Service Provider also will assist with the implementation of an enterprise resource planning system. Additionally, Allegheny has entered into various coal supply contracts in an effort to ensure a consistent supply of coal at predictable prices, and currently has contracts in place for the delivery of approximately 98% of its expected coal needs for 2006. See “Business—Fuel, Power and Resource Supply.”

 

    Maximizing Generation Value.  Allegheny is working to maximize the value of the power that it generates by ensuring full recovery of its costs and a reasonable return through the traditional rate-making process for its regulated utilities, as well as through the transition to market prices for AE Supply and its subsidiaries.

 

      For example, in April 2005, Allegheny obtained approval from the Pennsylvania PUC for increases in applicable rate caps in 2007, 2009 and 2010 in connection with a two-year extension of the period during which Pennsylvania customers will transition to market prices. Together with previously approved rate cap increases for 2006 and 2008, these increases will gradually move generation rates in Pennsylvania closer to market prices. In addition, AE Supply won the contracts to serve the PLR customer load in Pennsylvania in 2009 and 2010 and entered into contracts to provide power to Potomac Edison to serve commercial, industrial and municipal customer loads in Maryland. See “Fuel, Power and Resource Supply” and “Regulatory Matters Affecting Allegheny” below.

 

    Managing Environmental Compliance and Risks.  Allegheny is working to effectively manage its environmental compliance efforts to ensure continuing compliance with applicable federal and state regulations while controlling its compliance costs, reducing emissions levels and minimizing its risk exposure. Among other initiatives, AE Supply and Monongahela are currently blending lower-sulfur Powder River Basin coal at several generation facilities and are working to implement the financing and construction of flue gas desulfurization units and related pollution control equipment at the Fort Martin generation facility in West Virginia and the Hatfield generation facility in Pennsylvania, as well as other pollution control projects at other facilities. See “Environmental Matters” and “Proposed Asset Swap and Securitization” below.

 

Allegheny’s management believes that it can continue to build on these successes in 2006 through ongoing debt reduction and other financial improvement efforts, further initiatives to improve operational efficiency and maximize generation value and continued environmental stewardship.

 

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Where You Can Find More Information

 

AE, Monongahela, Potomac Edison and AGC file or furnish Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, proxy statements (for AE) and other information with or to the SEC. You may read and copy any document that the registrants file with the SEC at the SEC’s public reference room at 450 Fifth Street, N.W., Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for further information on the public reference room. These SEC filings are also available to the public from the SEC’s website at http://www.sec.gov.

 

The Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, proxy statements, statements of changes in beneficial ownership and other SEC filings, and any amendments to those reports, that AE, Monongahela, Potomac Edison and AGC file with or furnish to the SEC under the Exchange Act are made available free of charge on AE’s website at http://www.alleghenyenergy.com as soon as reasonably practicable after they are electronically filed with, or furnished to, the SEC. Audited annual financial statements for AE Supply and West Penn, neither of which is a reporting company under the Exchange Act, also will be available on AE’s website. AE’s website and the information contained therein are not incorporated into this report.

 

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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

In addition to historical information, this report contains a number of forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Words such as anticipate, expect, project, intend, plan, believe and words and terms of similar substance used in connection with any discussion of future plans, actions or events identify forward-looking statements. These include statements with respect to:

 

    rate regulation and the status of retail generation service supply competition in states served by the Distribution Companies;

 

    financing plans;

 

    demand for energy and the cost and availability of raw materials, including coal;

 

    PLR and power supply contracts;

 

    results of litigation;

 

    results of operations;

 

    internal controls and procedures;

 

    capital expenditures;

 

    status and condition of plants and equipment;

 

    capacity purchase commitments;

 

    regulatory matters; and

 

    accounting issues.

 

Forward-looking statements involve estimates, expectations and projections and, as a result, are subject to risks and uncertainties. There can be no assurance that actual results will not differ materially from expectations. Actual results have varied materially and unpredictably from past expectations. Factors that could cause actual results to differ materially include, among others, the following:

 

    plant performance and unplanned outages;

 

    changes in the price of power and fuel for electric generation;

 

    general economic and business conditions;

 

    changes in access to capital markets;

 

    complications or other factors that make it difficult or impossible to obtain necessary lender consents or regulatory authorizations on a timely basis;

 

    environmental regulations;

 

    the results of regulatory proceedings, including proceedings related to rates;

 

    changes in industry capacity, development and other activities by Allegheny’s competitors;

 

    changes in the weather and other natural phenomena;

 

    changes in customer switching behavior and their resulting effects on existing and future PLR load requirements;

 

    changes in the underlying inputs and assumptions, including market conditions, used to estimate the fair values of commodity contracts;

 

    changes in laws and regulations applicable to Allegheny, its markets or its activities;

 

    the loss of any significant customers or suppliers;

 

    dependence on other electric transmission and gas transportation systems and their constraints on availability;

 

    changes in PJM, including changes to participant rules and tariffs;

 

    the effect of accounting guidance issued periodically by accounting standard-setting bodies; and

 

    the continuing effects of global instability, terrorism and war.

 

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ALLEGHENY’S SALES AND REVENUES

 

The Generation and Marketing Segment’s Sales and Revenues

 

The Generation and Marketing segment had operating revenues of $1,703.3 million and $1,538.7 million in 2005 and 2004, respectively. For more information regarding the Generation and Marketing segment’s operating revenues, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 7, “Business Segments,” to the Consolidated Financial Statements.

 

The Delivery and Services Segment’s Sales and Revenues

 

The Delivery and Services segment had operating revenues of $2,845.5 million and $2,764.1 million in 2005 and 2004, respectively. These revenues included revenue from electric sales and unregulated services. There were $1,510.9 million and $1,546.7 million of intersegment sales and revenues between the Generation and Marketing segment and the Delivery and Services segment in 2005 and 2004, respectively, which were eliminated for Allegheny’s consolidated results of operations. The following tables describe the segment’s kWh sales and revenues from electric sales:

 

kWh sales (in millions):


   2005

   2004

   % Change

 

Retail:

                    

Residential

     16,923      16,047    5.5 %

Commercial and Industrial

     31,249      31,052    0.6 %

Other

     103      102    1.0 %
    

  

      

Total retail

     48,275      47,201    2.3 %
    

  

      

Revenues (in millions):


   2005

   2004

   % Change

 

Retail:

                    

Residential

   $ 1,164.9    $ 1,109.2    5.0 %

Commercial and industrial

     1,490.4      1,447.4    3.0 %

Other

     15.6      15.0    4.0 %
    

  

      

Subtotal retail

   $ 2,670.9    $ 2,571.6    3.9 %
    

  

      

Transmission services and bulk power

     115.9      127.8    (9.3 )%

Other affiliated and nonaffiliated energy services

     58.7      64.7    (9.3 )%
    

  

      

Total Delivery and Services revenues

   $ 2,845.5    $ 2,764.1    2.9 %
    

  

      

 

Allegheny had operating revenues from discontinued operations of $218.5 million and $335.7 million for the years ended December 31, 2005 and 2004, respectively. These revenues primarily related to its natural gas T&D business in West Virginia, which was sold on September 30, 2005. For more information regarding the Delivery and Services segment’s revenues, see “Management’s Discussion and Analysis of Financial Condition and Operating Results” and Note 7, “Business Segments,” to the Consolidated Financial Statements.

 

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CAPITAL EXPENDITURES

 

The table below shows total capital expenditures for Allegheny in 2005 and estimated capital expenditures for 2006 and 2007, as well as the environmental control expenditures that are included in these capital expenditures or estimated capital expenditures.

 

     2005

   2006

   2007

(In millions)


   (Actual)    (Estimated)

Generation and Marketing:

                    

AE Supply

                    

Total

   $ 84.3    $ 165.0    $ 315.0

Environmental

     44.3      118.0      253.0

Monongahela

                    

Total

     24.4      52.0      87.0

Environmental

     13.8      38.0      81.0

AGC

                    

Total

     13.0      10.0      6.0

Environmental

     —        —        —  
    

  

  

Total Generation and Marketing capital expenditures

   $ 121.7    $ 227.0    $ 408.0
    

  

  

Delivery and Services:

                    

Potomac Edison

                    

Total

   $ 74.0    $ 81.0    $ 98.0

Environmental

     —        —        —  

West Penn

                    

Total

     63.4      72.0      83.0

Environmental

     —        —        —  

Monongahela

                    

Total

     47.3      49.0      54.0

Environmental

     —        —        —  

Allegheny Ventures

                    

Total

     0.1      1.0      1.0

Environmental

     —        —        —  
    

  

  

Total Delivery and Services capital expenditures

   $ 184.8    $ 203.0    $ 236.0
    

  

  

Total capital expenditures

   $ 306.5    $ 430.0    $ 644.0
    

  

  

 

The Generation and Marketing segment’s capital expenditures include projects at generation facilities for environmental control upgrades and to remediate or prevent equipment failure. The Delivery and Services segment’s capital expenditures include projects to upgrade distribution lines and substations, as well as transmission and subtransmission systems enhancements. The amounts shown above include allowance for funds used during construction (“AFUDC”) for the Distribution Companies and Monongahela’s generation and marketing segment and capitalized interest for AE Supply. AFUDC and capitalized interest include the non-cash cost, for the period of construction, of borrowed funds used for construction purposes and a reasonable rate on other funds used in construction.

 

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ELECTRIC FACILITIES

 

All of Allegheny’s owned or controlled generation capacity is part of the Generation and Marketing segment. The Distribution Companies are obligated to purchase 479 MWs of power through state utility commission-approved arrangements pursuant to PURPA. This PURPA capacity is part of the Delivery and Services segment. See “PURPA Capacity” below.

 

Allegheny’s owned and controlled capacity as of December 31, 2005 was 10,375 MWs, of which 7,830 MWs (75.5%) were coal-fired, 1,395 MWs (13.4%) were natural gas-fired, 1,068 MWs (10.3%) were pumped-storage and hydroelectric and 82 MWs (0.8%) were oil-fired.

 

AE holds a 3.5% equity stake in, and is a sponsoring company of, OVEC. Currently, AE Supply and Monongahela are entitled to 9% (202 MWs) and 3.5% (78 MWs), respectively, of OVEC generation. OVEC supplies power to its sponsoring companies under an intercompany power agreement that expires on March 12, 2006. A new intercompany power agreement will go into effect on March 13, 2006. In December 2004, AE sold a 9% equity interest in OVEC to Buckeye Power Generating, LLC (“Buckeye”). In connection with the sale, AE Supply retained its right to 9% of OVEC’s generation under the existing intercompany power agreement through March 12, 2006, but assigned to Buckeye all of its rights and obligations under the new intercompany power agreement effective on March 13, 2006.

 

In August 2005, AE Supply sold its Wheatland generation facility, a 512 MWs natural gas-fired peaking facility located in Knox County, Indiana. AE Supply is also currently seeking to sell its Gleason generation facility in Gleason, Tennessee.

 

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The table below shows the nominal maximum operational generation capacity owned or controlled by Allegheny, as of December 31, 2005. This generation is included in the Generation and Marketing segment. Allegheny is currently contemplating an intra-company transfer of assets that would realign generation ownership and contractual arrangements within the Allegheny system. See “Proposed Asset Swap and Securitization” below.

 

Nominal Maximum Operational Generation Capacity (MW)

 

     Units

  

Project

Total


   Regulated

   Unregulated

  

Service

Commencement

Dates (a)


Stations


         Monongahela

   AE Supply and Other

  

Coal Fired-Supercritical (Steam):

                        

Harrison (Haywood, WV)

   3    1,972    419    1,553    1972-74

Hatfield’s Ferry (Masontown, PA)

   3    1,710    400    1,310    1969-71

Pleasants (Willow Island, WV)

   2    1,300    277    1,023    1979-80

Fort Martin (Maidsville, WV)

   2    1,107    212    895    1967-68

Coal Fired-Other (Steam):

                        

Armstrong (Adrian, PA)

   2    356         356    1958-59

Albright (Albright, WV)

   3    292    184    108    1952-54

Mitchell (Courtney, PA)

   1    288         288    1963

Ohio Valley Electric Corp. (Chelsea, OH) (Madison, IN) (b)

   11    280    78    202     

Willow Island (Willow Island, WV)

   2    243    207    36    1949-60

Rivesville (Rivesville, WV)

   2    142    121    21    1943-51

R. Paul Smith (Williamsport, MD)

   2    116         116    1947-58

Hunlock (Hunlock Creek, PA) (c)

   1    24         24    1957

Pumped-Storage and Hydro:

                        

Bath County (Warm Springs, VA) (d)

   6    1,010    232    778    1985; 2001

Lake Lynn (Lake Lynn, PA) (e)

   4    52         52    1926

Green Valley Hydro (f)

   21    6         6    Various

Gas-Fired:

                        

AE Nos. 3, 4 & 5 (Springdale, PA)

   3    540         540    2003

Gleason (Gleason, TN)

   3    526         526    2001

AE Nos. 1 & 2 (Springdale, PA)

   2    88         88    1999

AE Nos. 8 & 9 (Gans, PA)

   2    88         88    2000

AE Nos. 12 & 13 (Chambersburg, PA)

   2    88         88    2001

Buchanan (Oakwood, VA) (g)

   2    43         43    2002

Hunlock CT (Hunlock Creek, PA) (c)

   1    22         22    2000

Oil-Fired (Steam):

                        

Mitchell (Courtney, PA)

   1    82         82    1949
    
  
  
  
    

Total Capacity

   81    10,375    2,130    8,245     
    
  
  
  
    

(a)   When more than one year is listed as a commencement date for a particular station, the dates refer to the years in which operations commenced for the different units at that station.
(b)   This figure represents capacity entitlement through AE’s ownership of OVEC shares. In December 2004, AE sold a 9% equity interest in OVEC. However, AE Supply will retain its right to 9% of the power from OVEC electric generation facilities through March 12, 2006. AE holds a 3.5% equity interest in OVEC, which entitles Monongahela to 3.5% of the power from OVEC generation facilities.
(c)  

This figure represents capacity entitlement of Allegheny Energy Supply Hunlock Creek, LLC (“Hunlock”) through its 50% ownership in Hunlock Creek Energy Ventures, LLC (“Hunlock Creek”). Hunlock’s entitlement to Hunlock Creek output at maximum generation capacity is indicated on the table for the steam and natural gas-fired facilities. This output is sold exclusively to AE Supply. Allegheny expects to enter into an agreement with UGI in the first quarter of 2006, although Allegheny can provide no assurance that it will

 

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enter into such an agreement. Under the agreement as anticipated, Allegheny will pay approximately $13.8 million (excluding closing price adjustments) and will relinquish its 50% interest in Hunlock’s coal fired generation facility (48 MWs) in exchange for full ownership of the gas fired combustion generating facility (44 MWs).

(d)   This figure represents capacity entitlement through ownership of AGC.
(e)   AE Supply has a license for Lake Lynn through 2024.
(f)   Green Valley Hydro’s license for hydroelectric facilities Dam No. 4 and Dam No. 5, located in West Virginia and Maryland will expire November 30, 2024. Potomac Edison has licenses through 2024 for the Shenandoah, Warren, Luray and Newport projects located in Virginia.
(g)   Buchanan Energy Company of Virginia, LLC, a subsidiary of AE Supply (“Buchanan”), is part-owner of Buchanan Generation LLC (“Buchanan Generation”). Consol Energy, Inc. and Buchanan have equal ownership interests in Buchanan Generation. AE Supply operates and dispatches 100% of Buchanan Generation’s 86 MWs.

 

Proposed Asset Swap and Securitization

 

In May 2005, the state of West Virginia adopted legislation permitting securitization financing for the construction of certain types of pollution control equipment at facilities owned by public utilities that are regulated by the West Virginia PSC, subject to the satisfaction of certain criteria. AE Supply and Monongahela are currently contemplating an intra-company transfer of assets (the “Asset Swap”) that would realign generation ownership and contractual arrangements within the Allegheny system in order to, among other things, allow Monongahela to own 100% of the Fort Martin generation facility in West Virginia (“Fort Martin”) and, along with Potomac Edison, to finance the construction of flue gas desulfurization equipment (“Scrubbers”) at Fort Martin through the securitization of a charge that Monongahela and Potomac Edison will charge their retail customers in West Virginia.

 

As a result of the Asset Swap, Monongahela will also own 100% of the Albright, Rivesville and Willow Island generation facilities in West Virginia. In addition, Monongahela will be contractually entitled to a greater proportion of the generation (189 additional MWs) from the Bath County, Virginia generating facility. Also as a result of the Asset Swap, AE Supply will own 100% of the Hatfield’s Ferry generation facility in Pennsylvania (“Hatfield”), which currently is jointly owned by AE Supply and Monongahela, and will have a greater ownership interest in the Harrison and Pleasants generating facilities in West Virginia, for an additional 13 MWs and 176 MWs, respectively. AE Supply also will have contractual rights to a greater amount of generation (67 additional MWs) from OVEC.

 

In addition, in connection with the Asset Swap and Monongahela’s acquisition of additional generating capacity, Monongahela will become responsible for supplying the generation to meet Potomac Edison’s load obligations in West Virginia. Currently, Potomac Edison has a service agreement with AE Supply to supply Potomac Edison’s West Virginia load. That agreement will be amended and assigned to Monongahela simultaneously with the closing of the Asset Swap.

 

AE Supply and Monongahela expect to complete the Asset Swap by the fourth quarter of 2006. However, due to restrictions in certain debt agreements of Allegheny and AE Supply, Monongahela and AE Supply may be required to implement the Asset Swap in two phases.

 

On March 24, 2005, Monongahela and Potomac Edison filed an application with the West Virginia PSC for a Certificate of Public Convenience and Necessity to construct the Scrubbers at Fort Martin. On May 24, 2005 Monongahela and Potomac Edison filed an application with the West Virginia PSC requesting approval to issue $382 million in environmental control bonds to raise capital for the installation of the Scrubbers at Fort Martin and related costs. Monongahela and Potomac Edison have proposed to secure these environmental control bonds with the rights to collect an environmental control charge from customers over the term of the bonds. Allegheny entered into a settlement agreement with a group of interested parties, which was filed with the West Virginia PSC on January 11, 2006. Pursuant to the settlement agreement, the parties requested that the West Virginia PSC approve construction of the Scrubbers and the related securitization transaction, as well as the Asset Swap. Beginning on January 17, 2006, the West Virginia PSC held hearings on the applications filed by Monongahela and Potomac Edison related to the proposed Asset Swap and for a Certificate of Public Convenience and Necessity related to the proposed installation of the Scrubbers at Fort Martin. The statutory deadline for a ruling

 

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from the West Virginia PSC with respect to the proposed transactions is April 7, 2006. Allegheny received approval for the Asset Swap from FERC on October 21, 2005. Allegheny also may be required to obtain certain lender approvals and other third party consents in order to consummate the Asset Swap. See “Regulatory Framework Affecting Allegheny” below.

 

PURPA Capacity

 

The following table shows additional generation capacity available to the Distribution Companies through state utility commission-approved arrangements pursuant to PURPA. PURPA requires electric utility companies, such as the Distribution Companies, to interconnect with, provide back-up electric service to and purchase electric capacity and energy from qualifying small power production and cogeneration facilities. The amounts shown in this table are included in the Delivery and Services segment.

 

PURPA Stations


 

Project

Total


  Monongahela

 

Potomac

Edison


 

West

Penn


 

PURPA

Contract

Termination

Date


Coal-Fired: Steam

                   

AES Warrior Run (Cumberland, MD) (a)

  180       180       02/10/2030

AES Beaver Valley (Monaca, PA)

  125           125   12/31/2016

Grant Town (Grant Town, WV)

  80   80           05/28/2028

West Virginia University (Morgantown, WV)

  50   50           04/17/2027

Hydro:

                   

Hannibal Lock and Dam (New Martinsville, WV)

  31   31           06/01/2034

Allegheny Lock and Dam 6 (Freeport, PA)

  7           7   06/30/2034

Allegheny Lock and Dam 5 (Freeport, PA)

  6           6   09/30/2034
   
 
 
 
   

Total PURPA Capacity

  479   161   180   138    
   
 
 
 
   

(a)   As required under the terms of a Maryland restructuring settlement, Potomac Edison began to offer the 180 MWs output of the AES Warrior Run project to the wholesale market beginning July 1, 2000 and will continue to do so for the term of the AES Warrior Run contract, which ends on February 10, 2030. Revenue received from the sale reduces the AES Warrior Run surcharge paid by Maryland customers. As of January 1, 2005, AES Warrior Run output is being sold to a non-affiliated third party.

 

The Energy Policy Act amended PURPA. Among other things, the amendments provide that electric utilities are no longer required to enter into any new contractual obligation to purchase energy from a qualifying facility if FERC finds that the facility has non-discriminatory access to a functioning wholesale market and open-access transmission. See “Regulatory Framework Affecting Allegheny—Federal Regulation and Rate Matters—PUHCA.”

 

The following table sets forth the existing miles of tower and pole T&D lines and the number of substations of the Distribution Companies and AGC as of December 31, 2005:

 

     Underground

  

Above-

Ground


  

Total

Miles


  

Total Miles

Consisting of

500-Kilovolt

(kV) Lines


  

Number of

Transmission and

Distribution
Substations


Monongahela

   688    22,051    22,739    246    343

Potomac Edison

   4,649    17,831    22,480    178    186

West Penn

   2,618    24,187    26,805    276    603

AGC (a)

   0    87    87    87    1
    
  
  
  
  

Total

   7,955    64,156    72,111    787    1,133
    
  
  
  
  

(a)   Total Bath County transmission lines, of which AGC owns an undivided 40% interest and Virginia Electric and Power Company owns the remainder.

 

The Distribution Companies’ transmission network has 12 extra-high-voltage (345 kV and above) and 31 lower-voltage interconnections with neighboring utility systems.

 

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LOGO

 

 

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FUEL, POWER AND RESOURCE SUPPLY

 

Generation and Marketing Segment

 

Coal Supply

 

Allegheny purchased 17.6 million tons of coal in 2005 at an average price of $35.40 per ton delivered. Allegheny purchased this coal primarily from mines in Pennsylvania, West Virginia and Ohio. However, Allegheny also purchases coal from other regions. During 2005, Allegheny initiated the blending of coal from the Powder River Basin with eastern bituminous coal at several generation facilities. The Powder River Basin is a major coal producing area in northeastern Wyoming and southeastern Montana. Allegheny currently intends to continue to blend Powder River Basin coal at several generation facilities.

 

Historically, Allegheny has purchased coal from a limited number of suppliers. Of Allegheny’s coal purchases in 2005, 79.0% came from subsidiaries of two companies, the larger of which represented 57.4% of the total tons purchased. As of February 22, 2006, Allegheny had contracts in place for the delivery of approximately 98% of the coal that Allegheny expects to consume in 2006, at an average price of approximately $37 per ton delivered. Various industry and operational factors, including increased costs, transportation constraints, safety issues and operational difficulties, may have negative effects on coal supplier performance.

 

In December 2005, Allegheny signed a coal lease and sales agreement with an affiliate of Alliance Resource Partners, L.P. to permit, develop and mine Allegheny’s coal reserve in Washington County, Pennsylvania. Alliance will evaluate the feasibility of mining the reserve and seek the necessary permits and other governmental approvals to mine the reserve. If the reserve is developed, it is expected to produce high BTU, “scrubber-quality” coal suitable for use in Allegheny’s power plants with SO2 emission controls, and Allegheny has agreed to purchase up to two million tons annually of the mine’s output. Allegheny also will receive estimated royalty payments of $5 to $10 million per year on coal that is mined and sold from the reserve, depending upon production levels and coal prices, after the mine reaches full commercial operation.

 

Natural Gas Supply

 

AE Supply purchases natural gas to supply its natural gas-fired generation facilities. In 2005, AE Supply purchased its natural gas requirements principally in the spot market. One of AE Supply’s subsidiaries has a long-term natural gas agreement in place with a supplier. The natural gas provided under this agreement is used at the Buchanan generation facility.

 

Natural Gas Transportation Contracts

 

Dominion Transmission Transportation Contract.    AE Supply has a long-term agreement with Dominion Transmission, Inc. for the transportation of natural gas under a tariff approved by FERC. This agreement provides for the transportation of 95,000 decatherms of natural gas per day through May 31, 2013, from the Oakford, Pennsylvania interconnection to AE Supply’s combined cycle plant in Springdale, Pennsylvania.

 

Equitable Gas Transportation Contract.    AE Supply has a long-term agreement with Equitable Gas Company, a division of Equitable Resources, Inc., for the transportation of natural gas under a tariff approved by the Pennsylvania PUC. This agreement provides for transportation of 90,000 decatherms of natural gas per day until December 31, 2012 from Greene County, Pennsylvania to the Hatfield’s Ferry generation station in Masontown, Pennsylvania. This transportation agreement was purchased for anticipated natural gas reburn opportunities at Hatfield’s Ferry. Natural gas reburn reduces NOx emissions at a generation station by using natural gas instead of coal for a portion of the generation station’s anticipated fuel requirements. This process is used at Hatfield’s Ferry when the price of natural gas makes reburn economic relative to other NOx emission management activities.

 

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El Paso Transportation Contract.    AE Supply has a long-term agreement with El Paso Natural Gas Company for the transportation of natural gas under tariffs approved by FERC. This agreement provides for the transportation of gas from western Texas and northern New Mexico to the southern California border and was purchased for anticipated natural gas deliveries to a combined-cycle generation project that was contemplated in La Paz, Arizona. This project has been cancelled. In August 2003, AE Supply permanently turned back to the pipeline approximately 85% of its capacity obligation under this contract. In November 2004, AE Supply entered into a release for the balance of this capacity.

 

Kern River Transportation Contract.    AE Supply has a long-term agreement with Kern River Gas Transmission Company for the transportation of natural gas under a tariff approved by FERC. This agreement provides for the transportation of 45,122 decatherms of natural gas per day through April 30, 2018 from Opal, Wyoming to southern California. This transportation agreement was purchased for anticipated natural gas deliveries into southern California and at the Las Vegas Cogeneration II combined-cycle generation facility in Las Vegas, Nevada, in which Allegheny’s participation was terminated in 2003. In June 2004, AE Supply entered into a long-term capacity release for the full contract volume through October 2007. AE Supply recorded charges of $15.5 million related to this release in 2004.

 

The Delivery and Services Segment

 

Electric Power

 

Allegheny reorganized its corporate structure in response to electric utility deregulation within its service area between 1999 and 2001. The Distribution Companies, with the exception of Monongahela and its West Virginia generation assets, do not produce their own power. Monongahela transferred the portion of its generation assets dedicated to its previously-owned Ohio service territory to AE Supply in 2001. Potomac Edison transferred all of its generation assets to AE Supply in 2000. West Penn transferred all of its generation assets to AE Supply in 1999.

 

Each of the states in Allegheny’s service territory other than West Virginia has, to some extent, deregulated its electric utility industry. Pennsylvania, Maryland and Virginia have instituted retail customer choice and are transitioning to market-based, rather than cost-based pricing. West Penn has PLR obligations to its customers in Pennsylvania. Potomac Edison has PLR obligations to its customers in Virginia and its residential customers in Maryland.

 

As “providers of last resort,” West Penn and Potomac Edison must supply power (i.e., generation services) to certain retail customers who have not chosen alternative suppliers (or have chosen to return to Allegheny service) at rates that are capped at various levels during the applicable transition period. West Penn and Potomac Edison provide T&D services to customers in their service areas regardless of electricity generation supplier. See “The Distribution Companies’ Obligations and the PJM Market” above.

 

A significant portion of the power necessary to meet the PLR obligations of West Penn and Potomac Edison and Potomac Edison’s regulated service obligations in West Virginia is purchased from AE Supply. AE Supply is contractually obligated to provide power to West Penn and Potomac Edison during the relevant state deregulation transition periods under the terms of power sales agreements. These power sales agreements include both fixed price and market-based pricing components. These pricing components may not fully reflect the cost of supplying this power. As a result, AE Supply currently absorbs a portion of the risk of fuel price increases and increased costs of environmental compliance. AE Supply also sells power to Potomac Edison to serve customers in Potomac Edison’s West Virginia service territory. A portion of Allegheny’s PLR obligations is satisfied by PURPA contract purchases.

 

When existing power sales agreements with AE Supply terminate, Potomac Edison and West Penn will be unable to rely on the previously dedicated supply of power at specified contract prices to meet their respective power supply requirements. The arrangements to serve the applicable PLR obligations following the termination

 

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of these agreements have been determined in Maryland but are still under development in Pennsylvania and Virginia. AE Supply’s existing power sales agreements with West Penn and Potomac Edison will terminate as set forth in the chart below.

 

Distribution

Company


   State

  

Termination Date of

Power Sale Agreement

with AE Supply


Potomac Edison

   Maryland    December 31, 2008

Potomac Edison

   Virginia    June 30, 2007

Potomac Edison

   West Virginia    See footnote (a)

West Penn

   Pennsylvania    December 31, 2010

(a)   Potomac Edison’s current power sales agreement with AE Supply for West Virginia expires on December 31, 2010. However, Potomac Edison and AE Supply have agreed to a new contract that expires on December 31, 2017. The effectiveness of that contract is subject to West Virginia PSC and FERC approval. As part of Allegheny’s contemplated intra-company exchange of assets, that agreement will be amended and assigned by AE Supply to Monongahela.

 

In connection with the sale of its electric T&D operations in Ohio, Monongahela agreed to sell power to Columbus Southern to serve its former Ohio customers through May 2007. Monongahela purchases the power required to meet this obligation from the PJM market.

 

To facilitate the economic dispatch of its generation, Monongahela sells the power that it generates from its West Virginia jurisdictional assets to AE Supply at PJM market prices, and that power is then sold into the PJM market. Monongahela purchases from AE Supply, at PJM market prices, the power necessary to meet its West Virginia jurisdictional customer load.

 

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REGULATORY FRAMEWORK AFFECTING ALLEGHENY

 

The interstate transmission services and wholesale power sales of the Distribution Companies and AE Supply are regulated by FERC under the FPA. The Distribution Companies’ local distribution service and sales at the retail level are subject to state regulation. The statutory and regulatory framework affecting these companies has evolved significantly over the past decade, and these changes have exposed the companies to significant new risks and opportunities.

 

Prior to February 8, 2006, AE and all of its subsidiaries were also subject to the broad jurisdiction of the SEC under PUHCA 1935. The Energy Policy Act repealed PUHCA 1935, effective February 8, 2006, and replaced it with PUHCA 2005. As discussed in greater detail below, PUHCA 2005 provides for certain regulation of public utility holding companies by FERC. In addition, Allegheny’s communications subsidiary, ACC, is subject, to a limited extent, to the jurisdiction of the Federal Communications Commission and state regulatory commissions. Allegheny is subject to numerous other local, state and federal laws, regulations and rules.

 

Federal Regulation and Rate Matters

 

FERC, Competition and RTOs

 

FERC is an independent agency within the U.S. Department of Energy that regulates the U.S. electric utility industry under the FPA, PUHCA 2005 and PURPA.

 

The Federal Power Act

 

FERC regulates the transmission and wholesale sales of electricity under the authority of the FPA. Under the FPA, as amended by the Energy Policy Act, FERC regulates:

 

    the rates, terms and conditions of wholesale power sales and transmission services offered by public utilities;

 

    the development, operation and maintenance of hydroelectricity projects;

 

    the interconnection of transmission systems with other electric systems, including generation facilities;

 

    the disposition of public utility property and the merger, acquisition and consolidation of public utility systems;

 

    the issuance of certain securities and assumption of certain liabilities by public utilities;

 

    the system of accounts and methods of depreciation used by public utilities;

 

    the reliability of the transmission grid;

 

    the siting of certain transmission facilities;

 

    the allocation of long-term transmission rights;

 

    the types of incentives available to encourage new transmission investment;

 

    the transparency of power sales prices and market manipulation; and

 

    the holding of interlocking positions by directors and officers of public utilities.

 

In addition, FERC has the authority under the FPA to resolve complaints initiated on its own motion or by others as well as to conduct investigations. FERC also has the authority to enforce the FPA through the imposition of penalties.

 

The FPA gives FERC exclusive rate-making jurisdiction over wholesale sales of electricity. Entities, such as the Distribution Companies and AE Supply, that sell electricity at wholesale or own transmission facilities are considered “public utilities” subject to FERC jurisdiction. Public utilities must obtain FERC acceptance for filing of their wholesale rate schedules. Rates for wholesale sales of electricity are determined on a cost-basis, or, if the

 

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seller demonstrates that it does not have market power, FERC may grant market-based rate authority, which allows transactions to be priced based on prevailing market conditions. Rates for transmission facilities are determined on a cost basis.

 

Over the past decade, FERC has taken a number of steps to foster increased competition within the electric industry. Among other things, FERC requires public utilities that own transmission facilities to offer non-discriminatory, open-access transmission services. In addition, FERC has imposed standards of conduct governing communications between employees conducting transmission functions and employees engaged in wholesale power sale activities. These standards of conduct are intended to prevent transmission-owning utilities from giving their power marketing businesses preferential access to the transmission system and transmission information. FERC also has taken steps to encourage utilities to participate in RTOs, such as PJM, by transferring functional control over their transmission assets to RTOs.

 

Following FERC’s initiative to promote competition, a number of states, including Pennsylvania, Maryland, Virginia and Ohio, adopted retail access legislation, which permitted utilities to transfer their generation assets to affiliated companies or third parties. Similar to many other utilities, the Distribution Companies restructured their businesses in Pennsylvania, Maryland, Virginia and Ohio between 1996 and 2001 to comply with retail restructuring requirements in those states by, among other things, transferring generation assets serving customers in those states to AE Supply.

 

However, this trend toward restructuring and increased competition for retail markets has slowed in response to events over the past several years. Among other things, significant price volatility (particularly in the California wholesale market), allegations of improper trading activities and overall declines in electricity demand and in the economy, generally, have contributed to this slowdown. Market-based competition within the wholesale markets is now continuing with greater FERC oversight, and some states have moved away from electricity choice at the retail level by delaying the implementation of retail competition (as in Virginia) or rejecting it outright (as in West Virginia). Delays, discontinuations or reversals of electricity marketing restructurings in states in which Allegheny operates could have a material adverse effect on its results of operation and financial condition.

 

Substantially all of Allegheny’s generation assets and power supply obligations are located within the PJM market, and PJM maintains functional control over the Distribution Companies’ transmission facilities. Changes in the PJM tariff, operating agreement, policies and/or market rules could adversely affect Allegheny’s financial results. These matters include changes involving: the terms, conditions and pricing of transmission services; construction of transmission enhancements; auction of financial transmission rights and the allocation mechanism for the auction revenues; changes in transmission congestion patterns due to the implementation of PJM’s regional transmission expansion planning protocol or other required transmission system upgrades; new generation retirement rules and reliability pricing issues.

 

Recent FERC actions with respect to the transmission rate design within PJM may impact the Distribution Companies. Beginning in July 2003, FERC issued a series of orders related to transmission rate design for the PJM and Midwest Independent Transmission System Operator regions. Specifically, FERC ordered the elimination of multiple and additive (i.e., “pancaked”) rates and called for the implementation of a long-term rate design for these regions. In November 2004, FERC rejected long-term regional rate proposals from the Distribution Companies and others. FERC concluded that neither the rate design proposals, nor the existing PJM rate design, had been shown to be just and reasonable. However, FERC ordered the continuation of the existing PJM rate design and the implementation of a transition charge for these regions through March 31, 2006 through filings made by transmission owners in both regions. FERC also authorized three transmission owners to submit filings that would enable them to assess additional transition charges against the Distribution Companies and other utilities in PJM. In February 2005, FERC accepted these transition charges, effective December 1, 2004, subject to an evidentiary hearing regarding the data and methodology used to determine the charges and proposed adjustments thereto.

 

These additional charges have resulted in net transmission charges to the Distribution Companies of approximately $6.4 million for the 13-month period ended December 31, 2005. Allegheny estimates that these

 

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additional charges will result in approximately $1.7 million of net transmission charges to the Distribution Companies for the three-month period ended March 31, 2006. The order following the evidentiary hearing on these transition charges may require the Distribution Companies to refund some portion of the amounts received from these transition charges or entitle the Distribution Companies to receive additional revenue from these charges. In addition, the Distribution Companies may be required to pay additional amounts as a result of increases in the transition charges previously billed to the Distribution Companies.

 

In a May 2005 order, FERC again determined that the existing PJM rate design may not be just and reasonable. On September 30, 2005, the Distribution Companies, together with another PJM transmission owner, filed a proposed rate design with FERC to replace the existing rate design within PJM, effective April 1, 2006. Two other PJM transmission owners also filed a separate proposed rate design. A hearing is scheduled for April 2006 to determine whether the rate design is unjust and unreasonable and whether it should be replaced by either of the proposed rate designs.

 

In July 2005, Congress passed the Energy Policy Act, which the President signed into law on August 8, 2005. This far-reaching bill will affect many aspects of electric generation, transmission and distribution. The Energy Policy Act gives FERC significant new responsibilities, including oversight of the reliability of the transmission grid, backstop authority to site transmission facilities in national interest electric transmission corridors and the authority to provide incentive-based rates to promote transmission investment.

 

On August 11, 2005, AE Supply, the Distribution Companies and other Allegheny entities that have market-based rate authority granted by FERC filed a triennial analysis of market power with FERC. This filing is required as a condition to continuing to sell electric energy at wholesale market rates. FERC approved this filing on October 20, 2005.

 

PUHCA

 

The Energy Policy Act repealed PUHCA 1935, effective February 8, 2006, and replaced it with PUHCA 2005.

 

Under PUHCA 1935, any entity that owned, controlled or had the power to vote 10% or more of the outstanding voting securities of an “electric utility company,” or a holding company for an electric utility company, was subject to SEC regulation as a “holding company” under PUHCA. Holding companies were required to register under PUHCA 1935 unless they qualified for an exemption from registration.

 

Holding companies that did not qualify for an exemption from registration under PUHCA 1935 were subject to significant financial and operational conditions and restrictions. PUHCA 1935 restricted a registered holding company system from expanding into other businesses by requiring the system to confine itself to a single integrated public utility system, thereby prohibiting the system from engaging in activities that were not functionally related to its core business. Most important in light of Allegheny’s past liquidity issues and poor financial condition, PUHCA 1935 also required pre-approval from the SEC for, among other things, the issuance of debt or equity securities under certain circumstances and for the sale or acquisition of utility assets. The SEC, in certain matters, also required state consents as a condition to authorizations, even though such approvals might not be required under applicable state laws. Thus, the PUHCA 1935 approval process introduced significant lead times into routine transactions under normal circumstances. Many of Allegheny’s competitors were not regulated under PUHCA 1935 and, therefore, did not face these constraints.

 

Regulation under PUHCA 1935, however, did eliminate the need to obtain FERC approval for certain acquisitions and issuances of securities under Sections 203 and 204 of the FPA, as such transactions were otherwise subject to SEC jurisdiction under PUHCA 1935. With the repeal of PUHCA 1935, that exemption from Section 203 and 204 jurisdiction is no longer available effective February 8, 2006. Under rules promulgated by FERC pursuant to PUHCA 2005, FERC has permitted public utilities in a registered holding company system to engage in financing transactions previously authorized by the SEC under PUHCA 1935 without seeking

 

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additional FERC approval under Section 203 and 204 of the FPA during a transition period. Such holding companies are required to notify FERC of their status as holding companies and file with FERC all SEC financing authorizations on which they intend to rely for ongoing financing authority for their public utilities during the transition period, which ends on December 31, 2007. AE Supply and other Allegheny entities with market-based rate authority have been granted blanket authorization for security issuances under Section 204 and will not be required to seek additional financing authority from FERC.

 

Under PUHCA 2005, holding companies and their subsidiaries are subject to FERC jurisdiction with regard to affiliate transactions and cost allocations to public utilities within the holding company system. In addition, holding companies and their subsidiaries must make their books, accounts, memoranda and other records available for review by FERC and relevant state commissions and comply with FERC requirements concerning record retention.

 

PURPA

 

In the past, PURPA has required electric utility companies such as the Distribution Companies to interconnect with, provide back-up electric service to and purchase electric capacity and energy from qualifying small power production and cogeneration facilities that satisfy the eligibility requirements for PURPA benefits established by FERC. State public service commissions or legislatures establish the rates paid for electric energy purchased from these qualifying facilities.

 

The Energy Policy Act has amended PURPA significantly. Most notably, as of the effective date of the Energy Policy Act on August 8, 2005, electric utilities are no longer required to enter into any new contract obligation to purchase energy from a qualifying facility if FERC finds that the facility has non-discriminatory access to a functioning wholesale market and open access transmission. In February 2006, FERC finalized regulations that eliminate ownership restrictions for both new and existing facilities. A qualifying facility may now be owned by a traditional utility. The new rule also ensures that the thermal output of cogeneration facilities is used in a productive and beneficial manner.

 

The Distribution Companies have committed to purchase 479 MWs of qualifying PURPA capacity. In 2005, payments for PURPA capacity and energy pursuant to these contracts totaled approximately $209.0 million. The average cost to the Distribution Companies of these power purchases was 5.3 cents/kWh. The Distribution Companies are currently authorized to recover substantially all of these costs in their retail rates. The Distribution Companies’ obligations to purchase power from qualified PURPA projects in the future may exceed amounts they are authorized to recover from their customers, which could result in losses related to the PURPA contracts. However, the Energy Policy Act amendments to PURPA include a provision authorizing electric utility companies to petition FERC for relief from existing mandatory obligations to purchase electric capacity and energy from qualifying small power production and cogeneration facilities.

 

Pennsylvania

 

The Electricity Generation Customer Choice and Competition Act (the “Customer Choice Act”) gave all retail electricity customers in Pennsylvania the right to choose their electricity generation supplier as of January 2, 2000. Under the Customer Choice Act and a subsequent restructuring settlement approved by the Pennsylvania PUC, West Penn transferred its generation assets to AE Supply. West Penn retained its T&D assets. West Penn is the PLR for those customers who do not choose an alternate supplier or whose alternate supplier does not deliver, and its T&D assets are subject to traditional regulated utility ratemaking (i.e., cost-based rates).

 

In November 1999, under authority granted by the Pennsylvania PUC in its order approving West Penn’s original restructuring settlement, West Penn Funding, LLC, a subsidiary of West Penn, issued $600 million aggregate principal amount of Transition Bonds, Series 1999-A in order to securitize a portion of the anticipated loss in value of its generation-related assets resulting from deregulation, which are known as “stranded costs.”

 

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In November 2003, West Penn requested approval to issue additional transition bonds up to $115 million to securitize the portion of West Penn’s stranded costs that are not recoverable on a timely basis due to operation of the generation rate cap. In September 2004, West Penn, the Pennsylvania Office of Consumer Advocate, the Office of Small Business Advocate and The West Penn Power Industrial Intervenors filed a Joint Petition for Settlement and for Modification of the 1998 Restructuring Settlement (the “Joint Petition”). In March 2005, the parties filed an amendment to the Joint Petition, adding additional parties.

 

By order dated May 11, 2005, the Pennsylvania PUC approved the amended Joint Petition, allowing West Penn to securitize up to $115 million of additional transition costs through the issuance of transition bonds. On September 27, 2005, WPP Funding, LLC, a subsidiary of West Penn, issued $115 million aggregate principal amount of 4.46% Transition Bonds, Series 2005-A.

 

The Joint Petition approved by the Pennsylvania PUC extended generation rate caps from 2008 to 2010. The order approving the Joint Petition also extended distribution rate caps from 2005 to 2007 and provided for increases in generation rates in 2007, 2009 and 2010, in addition to previously approved rate cap increases for 2006 and 2008. These increases will gradually move generation rates closer to market prices. Rate caps on transmission services expired on December 31, 2005.

 

West Penn has long-term power purchase agreements with AE Supply to provide West Penn with the amount of electricity necessary to meet the majority of its PLR retail obligations during the Pennsylvania transition period. According to the terms of the amended Joint Petition described above, a Request for Proposal for full requirements wholesale electric power supply to serve load in 2009 and 2010 was issued May 31, 2005. AE Supply was the successful bidder and was awarded the contract on July 21, 2005. AE Supply filed a request with the FERC for authority to make these wholesale power sales, which FERC granted on October 25, 2005.

 

On August 30, 2005, West Penn filed its annual competitive transition charge reconciliation for the twelve months ended July 31, 2005. The reconciliation showed a twelve-month underrecovery of $14.6 million, for a cumulative underrecovery of approximately $92.9 million. The Pennsylvania PUC approved the reconciliation. The competitive transition charge was recovered by the securitization that was completed on September 27, 2005, concluding all competitive transition charge claims, with recovery from customers occurring from mid-2008 to 2010.

 

Recently enacted legislation requires the implementation of an alternative energy portfolio standard in Pennsylvania that will require electric distribution companies and retail electric suppliers in Pennsylvania to obtain certain percentages of their energy supplies from alternative sources. The new legislation includes an exemption from this requirement for companies, such as West Penn, that are operating within a transition period under the current regulations governing the transition to market competition in Pennsylvania. The full requirement will apply to those companies when the transition period ends. The legislation also includes a provision that will allow the Pennsylvania PUC to modify or eliminate these obligations if alternative sources are not reasonably available. The law directs that all costs related to the purchase of electricity from alternative energy sources and payments for alternative energy credits will be fully recovered pursuant to an automatic energy adjustment clause. The Pennsylvania PUC initiated a proceeding in January 2005 regarding implementation and enforcement of the legislation.

 

West Virginia

 

In 1998, the West Virginia legislature passed legislation directing the West Virginia PSC to determine whether retail electric competition was in the best interests of West Virginia and its citizens. In response, the West Virginia PSC submitted a plan to introduce full retail competition on January 1, 2001. The West Virginia legislature approved, but never implemented, this plan. In March 2003, the West Virginia legislature passed a bill that clarified the jurisdiction of the West Virginia PSC over electric generation facilities. Based on these actions, Allegheny has concluded that retail competition and the deregulation of generation is no longer likely in West

 

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Virginia. In 2000, Potomac Edison received approval to transfer its West Virginia generation assets to AE Supply. The West Virginia PSC never acted on a similar petition by Monongahela, and Monongahela agreed to withdraw its petition.

 

On March 24, 2005, Monongahela and Potomac Edison filed an application with the West Virginia PSC for a Certificate of Public Convenience and Necessity to construct the Scrubbers at Fort Martin. On May 24, 2005 Monongahela and Potomac Edison filed an application with the West Virginia PSC requesting approval to issue $382 million in environmental control bonds to raise capital for the installation of the Scrubbers at Fort Martin and related costs. Monongahela and Potomac Edison have proposed to secure these environmental control bonds with the rights to collect an environmental control charge from customers over the term of the bonds. Allegheny entered into a settlement agreement with a group of interested parties, which was filed with the West Virginia PSC on January 11, 2006. Pursuant to the settlement agreement, the parties requested that the West Virginia PSC approve construction of the Scrubbers and the related securitization transaction, as well as the Asset Swap. Beginning on January 17, 2006, the West Virginia PSC held hearings on the applications filed by Monongahela and Potomac Edison related to the proposed Asset Swap and for a Certificate of Public Convenience and Necessity related to the proposed installation of the pollution control equipment at Fort Martin. The statutory deadline for a ruling from the West Virginia PSC with respect to the proposed transactions is April 7, 2006. Allegheny may also be required to obtain certain lender approvals in order to consummate the Asset Swap. Currently, Allegheny plans to execute the Asset Swap and securitization only to the extent that it receives all of the regulatory and other approvals necessary for each aspect of the combined transaction.

 

On July 13, 2005, Monongahela, Potomac Edison and AE Supply filed a request at the FERC for approval of the proposed generation asset transfers and an amended and restated power purchase agreement, which FERC approved on October 21, 2005.

 

On September 27, 2004, Monongahela, Mountaineer Gas Company (“Mountaineer”) and Mountaineer Gas Holding Limited Partnership (“Mountaineer Holdings”) filed a joint petition with the West Virginia PSC for approval to transfer the stock of Mountaineer and certain other natural gas distribution assets owned by Monongahela to Mountaineer Holdings, the prospective buyer of Monongahela’s West Virginia natural gas business. On August 24, 2005, the West Virginia PSC approved the sale of Mountaineer and Allegheny’s other natural gas operations in West Virginia and a related increase in Mountaineer’s base rates. The sale of these assets was completed on September 30, 2005.

 

Maryland

 

Maryland adopted electric industry restructuring legislation in 1999, which gave Potomac Edison’s Maryland retail electric customers the right to choose their electricity generation suppliers. In 2000, Potomac Edison transferred its Maryland generation assets to AE Supply. Potomac Edison retained its T&D assets. Potomac Edison’s T&D rates for all customers were capped through 2004 and are otherwise subject to traditional regulated utility ratemaking (i.e., cost-based rates). In 2003, the Maryland PSC approved a statewide settlement relating to the future of PLR and SOS. The settlement extended Potomac Edison’s obligation to provide SOS after the expiration of the current generation rate cap periods. After expiration or the rate caps, SOS will be provided through 2012 for residential customers, through 2008 for smaller commercial and industrial customers and through 2006 for Potomac Edison’s large commercial customers. Potomac Edison’s obligation to provide SOS for its for its largest industrial customers expired at the end of 2005. A 2005 settlement extended Potomac Edison’s SOS obligations to its largest commercial customers through May 2007.

 

Potomac Edison has a power purchase agreement with AE Supply to provide the amount of electricity necessary to meet the majority of Potomac Edison’s PLR retail obligations during the Maryland transition period. Potomac Edison will procure the wholesale electric supply services necessary to serve its PLR obligations after the expiration of the transition period and before the expiration of its PLR obligations through a

 

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competitive bid process. Potomac Edison will be allowed to recover its costs for providing these services, including a return for its shareholder, through an administrative charge. In December 2005 and January 2006, AE Supply was awarded contracts under a competitive auction sell power to Potomac Edison to serve approximately 1.3 million MWhs of generation and associated services for certain small commercial and industrial customers in Maryland beginning in June 2006. These contracts expire at various times in 2007 and 2008.

 

Recently enacted legislation requires the implementation of a renewable energy portfolio standard in Maryland. Beginning upon the later of the expiration of the transition period for any particular customer class served by a supplier or January 1, 2006, retail electricity suppliers in Maryland will have to obtain certain percentages of their energy supplies from renewable energy resources. The law provides that if renewable resources are too expensive, or are not available in quantities sufficient to meet the standard in any given year, suppliers can instead opt to pay a “compliance fee.” The law directs the Maryland PSC to allow electric suppliers to recover their costs from customers, including any compliance fees that they incur.

 

Ohio

 

The Ohio General Assembly adopted legislation in 1999 to restructure its electric utility industry, provide retail electric customers the right to choose their electricity generation supplier and begin a transition to market rates. The 1999 legislation granted Ohio’s residential customers a 5% reduction in the generation portion of their rates until December 31, 2005, when the transition period ended. Pursuant to a settlement approved by the PUCO, Monongahela’s transition period for large industrial, commercial and street lighting customers was scheduled to end on December 31, 2003, but, as discussed below, was extended by the PUCO until December 31, 2005. Under the regulatory transition plan approved by the PUCO, Monongahela transferred its Ohio generation assets to AE Supply in June 2001. Monongahela retained its T&D assets. Monongahela’s T&D rates were capped through the end of the transition period.

 

In July 2003, the PUCO authorized Monongahela to issue a request for proposals for wholesale power to supply approximately 130 MW of new standard market-based retail rate service to its large industrial and commercial customers and to its street lighting customers. In October 2003, the PUCO denied approval of the wholesale bid and new retail rates and froze the current fixed rates for these customer classes until December 31, 2005. In February 2004, Monongahela appealed the PUCO’s decision to the Ohio Supreme Court. On December 30, 2004, the Ohio Supreme Court affirmed the PUCO’s October 2003 order extending Monongahela’s rate freeze for large commercial and industrial customers past the end of 2003. In January 2004, Monongahela began purchasing power at PJM market prices for these customers. The price Monongahela paid for that power was higher than the retail generation rates that it charged these customers during 2004 and 2005.

 

In February 2004, Monongahela filed for an injunction in federal court seeking to recover, in retail rates, its costs of purchasing power in the wholesale market. The court partially granted Monongahela’s request, ruling that the Ohio legislation adopted in 1999 to restructure the electric utility industry was unconstitutional to the extent it did not permit Monongahela to make a claim with the PUCO that its rates are confiscatory. Monongahela requested reconsideration of the court’s order, which the court partially granted by retaining jurisdiction over this matter. The PUCO initiated a proceeding in compliance with the federal court’s directive. In June 2004, Monongahela filed its application for rate relief, which the PUCO denied in December 2004. Monongahela appealed this decision to the Ohio Supreme Court and renewed its request for a preliminary injunction against the PUCO in federal court. Given the impeding sale of Monongahela’s electric T&D operations in Ohio, in September 2005, the federal court dismissed, without prejudice, Monongahela’s renewed motion.

 

In June 2005, the PUCO directed Monongahela to begin discussions with American Electric Power’s subsidiary, Columbus Southern, regarding the transfer of Monongahela’s Ohio service territory. On December 31, 2005, Monongahela completed the sale of its Ohio electric T&D assets to Columbus Southern for

 

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net cash proceeds of $51.8 million. The purchase price included $10 million for the termination of the legal and regulatory proceedings described above. In connection with the sale of these assets, Monongahela agreed to sell power to Columbus Southern at a fixed price to serve its former Ohio customers until May 31, 2007. See Note 3, “Discontinued Operations and Assets Held for Sale,” and Note 4, “Asset Sales,” in the Consolidated Financial Statements.

 

Virginia

 

Under the Virginia Electric Utility Restructuring Act of 1999 (as amended, the “Restructuring Act”), Potomac Edison’s retail electric customers in Virginia have the right to choose their electricity generation supplier. Potomac Edison transferred all of its ownership in generation assets in Virginia to AE Supply in 2000, except certain small hydro facilities, which were transferred to Green Valley Hydro, an unregulated subsidiary of AE. Potomac Edison retained its T&D assets. Potomac Edison’s T&D rates are capped through 2010, subject to certain exceptions. Potomac Edison has two opportunities to petition the Virginia SCC for changes to its T&D rates, between January 1, 2004 and June 30, 2007 and once again after July 1, 2007. The Restructuring Act requires the Virginia SCC to adjust Potomac Edison’s capped rates not more than once annually for the timely recovery of costs prudently incurred after July 1, 2004 for transmission or distribution system reliability or to comply with state or federal environmental laws or regulations. In addition, after July 1, 2007, Potomac Edison will have the right to recover annually certain purchased power expenses as an exception to capped rates. Potomac Edison is the PLR for those customers who do not choose an alternate supplier or whose alternate supplier does not deliver.

 

Potomac Edison has a power purchase agreement with AE Supply to provide Potomac Edison with the amount of electricity necessary to meet the majority of its PLR retail obligations through June 30, 2007. After that, Potomac Edison will purchase its PLR requirements from the wholesale market.

 

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EMPLOYEES

 

Substantially all of the registrants’ officers and employees are employed by AESC. As of December 31, 2005, AESC employed approximately 4,460 employees. Of these employees, approximately 29% are subject to collective bargaining arrangements. Approximately 74% of the unionized employees are at the Distribution Companies and approximately 26% are at AE’s other subsidiaries. Approximately 1,082 employees are represented by System Local 102 of the Utility Workers Union of America (the “UWUA”). The collective bargaining arrangement with UWUA Local 102 expires on May 1, 2006. Approximately 175 employees are represented by locals of the International Brotherhood of Electrical Workers (the “IBEW”). Collective bargaining arrangements with the IBEW expire at various dates during the first half of 2010. Each of the registrants believes that current relations between it and its unionized and non-unionized employees are satisfactory.

 

On September 19, 2005, AE entered into a Professional Services Agreement under which, on November 1, 2005, the Service Provider assumed responsibility for many of Allegheny’s information technology functions. The Service Provider also will assist Allegheny with the implementation of an enterprise resource planning system. Unless extended by AE, the Professional Services Agreement will expire on December 31, 2012. Most of the AESC employees performing Allegheny’s information technology functions were offered employment with the Service Provider.

 

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ENVIRONMENTAL MATTERS

 

The operations of Allegheny’s owned facilities, including its generation facilities, are subject to various federal, state and local laws, regulations and uncertainties as to air and water quality, hazardous and solid waste disposal and other environmental matters. Compliance may require Allegheny to incur substantial additional costs to modify or replace existing and proposed equipment and facilities. These costs may adversely affect the cost of Allegheny’s future operations.

 

Information regarding capital expenditures and estimated capital expenditures associated with known environmental standards is provided in “Capital Expenditures” above. Additional legislation or regulatory control requirements have been proposed and, if enacted, may require modification, supplementation or replacement of equipment at existing generation facilities at substantial additional cost.

 

Air Standards

 

Clean Air Act Compliance.  Allegheny currently meets applicable standards for particulate matter emissions at its generation facilities through the use of high-efficiency electrostatic precipitators, cleaned coal, flue-gas conditioning, optimization software, fuel combustion modifications and, at times, through reduction of output. From time to time, minor excursions of stack emission opacity that are normal to fossil fuel operations are experienced and are accommodated by the regulatory process. Allegheny meets current emission standards for sulfer dioxide (“SO2”) by using emission controls, burning low-sulfur coal, purchasing cleaned coal (which has lower sulfur content), blending low-sulfur coal with higher sulfur coal and utilizing emission allowances.

 

Allegheny’s compliance with the Clean Air Act has required, and may require in the future, that Allegheny install post-combustion control technologies on many of its generation facilities. The Clean Air Interstate Rule (“CAIR”) promulgated by the EPA on March 10, 2005, may accelerate the need to install this equipment by phasing out a portion of currently available allowances.

 

The Clean Air Act mandates annual reductions of SO2 and created a SO2 emission allowance trading program. AE Supply and Monongahela comply with current SO2 emission standards through a system-wide plan combining the use of emission controls, low sulfur fuel and emission allowances. Based on current forecasts, Allegheny estimates that it may have an SO2 allowance market exposure of less than 10,000 tons in 2006 and exposure of approximately 20,000 tons and 75,000 tons in 2007 and 2008, respectively. Allegheny’s allowance needs, to a large extent, are affected at any given time by the amount of output produced and the types of fuel used by its generation facilities, as well as the implementation of environmental controls. Therefore, there can be no assurance that Allegheny’s need to purchase SO2 allowances for these periods will not vary from current estimates. Allegheny continues to evaluate options for compliance, and current plans include the potential installation of scrubbers at its Fort Martin generating facility by 2010, as well as the elimination of a scrubber bypass at its Pleasants generating facility by 2008 and consideration of scrubbers at its Hatfield generation facility.

 

Allegheny meets current emission standards for nitrogen oxides (“NOX”) by using low NOX burners, Selective Catalytic Reduction, Selective Non-Catalytic Reduction and over-fire air and optimization software, as well as through the use of emission allowances. Allegheny is currently evaluating its options for CAIR compliance. In 1998, the EPA finalized its NOx State Implementation Plan (“SIP”) call rule (known as the “NOx SIP call”), which addressed the regional transport of ground-level ozone and required the equivalent of a uniform 0.15 lb/mmBtu emission rate throughout a 22-state region, including Pennsylvania, Maryland and West Virginia.

 

AE Supply and Monongahela are completing installation of NOx controls to meet the Pennsylvania, Maryland and West Virginia SIP calls. The NOx compliance plan functions on a system-wide basis, similar to the SO2 compliance plan. AE Supply and Monongahela also have the option, in some cases, to purchase alternate fuels or NOx allowances, if needed, to supplement their compliance strategies. Allegheny estimates that its

 

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emission control activities, in concert with its inventory of banked allowances, will facilitate its compliance with NOx limits established by the SIP through 2008. Allegheny’s current capital expenditure forecast includes the expenditure of $2 million of capital costs during 2007 for additional NOX emission controls. Allegheny’s allowance needs, to a large extent, are affected at any given time by the amount of output produced and the types of fuel used by its generation facilities. Therefore, there can be no assurance that Allegheny’s need to purchase NOX allowances for these periods will not vary from current estimates.

 

On March 15, 2005, the EPA issued the Clean Air Mercury Rule (“CAMR”) establishing a cap and trade system designed to reduce mercury emissions from coal-fired power plants in two phases during 2010 and 2018. This rule will be implemented through state implementation plans currently under development. The rule has been challenged by several parties. Allegheny is currently assessing CAMR and its strategy for compliance.

 

Clean Air Act Litigation.  In August 2000, AE received a letter from the EPA requesting that it provide information and documentation relevant to the operation and maintenance of the following ten electric generation facilities, which collectively include 22 generation units: Albright, Armstrong, Fort Martin, Harrison, Hatfield’s Ferry, Mitchell, Pleasants, Rivesville, R. Paul Smith and Willow Island. AE Supply and Monongahela own these generation facilities. The letter requested information under Section 114 of the Clean Air Act to determine compliance with the Clean Air Act and related requirements, including potential application of the NSR standards of the Clean Air Act, which can require the installation of additional air pollution control equipment when the major modification of an existing facility results in an increase in emissions. AE has provided responsive information to this and a subsequent request. At this time, AE is engaged in discussions with the EPA with respect to environmental matters, including NSR issues.

 

If NSR requirements are imposed on Allegheny’s generation facilities, in addition to the possible imposition of fines, compliance would entail significant capital investments in pollution control technology. There are three recent, significant federal court decisions that have addressed the application of NSR requirements to electric utility generation facilities: the Ohio Edison decision, the Duke Energy decision and the Alabama Power decision. The Ohio Edison decision is favorable to the EPA. The Duke Energy and Alabama Power decisions support the industry’s understanding of NSR requirements. The U.S. Court of Appeals for the Fourth Circuit affirmed the Duke Energy decision on June 15, 2005.

 

In 2003, the EPA issued the Equipment Replacement Rule, which sets forth a clearer set of rules for projects that may be undertaken without triggering NSR requirement. This rule would apply the Routine Maintenance, Repair and Replacement (“RMRR”) exception to the NSR requirement in a manner that is more consistent with the energy industry’s historical compliance approach. That rule was challenged by some states and environmental groups and, on December 24, 2003, the U.S. Court of Appeals for the District of Columbia Circuit issued an order to stay the implementation of that rule. At this time, AE and its subsidiaries are not able to determine the effect that these actions may have on them.

 

On May 20, 2004, AE, AE Supply, Monongahela and West Penn received a Notice of Intent to Sue Pursuant to Clean Air Act §7604 (the “Notice”) from the Attorneys General of New York, New Jersey and Connecticut and from the Pennsylvania Department of Environmental Protection (the “PA DEP”). The Notice alleged that Allegheny made major modifications to some of its West Virginia facilities in violation of the Prevention of Significant Deterioration (“PSD”) provisions of the Clean Air Act at the following coal-fired facilities: Albright Unit No. 3; Fort Martin Units No. 1 and 2; Harrison Units No. 1, 2 and 3; Pleasants Units No. 1 and 2 and Willow Island Unit No. 2. The Notice also alleged PSD violations at the Armstrong, Hatfield’s Ferry and Mitchell generation facilities in Pennsylvania and identifies PA DEP as the lead agency regarding those facilities. On September 8, 2004, AE, AE Supply, Monongahela and West Penn received a separate Notice of Intent to Sue from the Maryland Attorney General that essentially mirrored the previous Notice.

 

On January 6, 2005, AE Supply and Monongahela filed a declaratory judgment action against the Attorneys General of New York, Connecticut and New Jersey in federal district court in West Virginia (“West Virginia DJ Action”). This action requests that the court declare that AE Supply’s and Monongahela’s coal-fired generation facilities in Pennsylvania and West Virginia comply with the Clean Air Act. The Attorneys General filed a

 

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motion to dismiss the West Virginia DJ Action. It is possible that the EPA and other state authorities may join or move to transfer the West Virginia DJ Action.

 

On June 28, 2005, the PA DEP and the Attorneys General of New York, New Jersey, Connecticut and Maryland filed suit against AE, AE Supply and the Distribution Companies in the United States District Court for the Western District of Pennsylvania (the “PA Enforcement Action”). This action alleges NSR violations under the federal Clean Air Act and the Pennsylvania Air Pollution Control Act at the Hatfield’s Ferry, Armstrong and Mitchell facilities in Pennsylvania. The PA Enforcement Action appears to raise the same issues regarding Allegheny’s Pennsylvania generation facilities that are before the federal District Court in the West Virginia DJ Action, except that the PA Enforcement Action also includes the PA DEP and the Maryland Attorney General. Allegheny’s motion to stay the PA Enforcement Action was denied on November 21, 2005. On January 17, 2006, the PA DEP and the Attorneys General filed an amended complaint. On February 15, 2006, Allegheny filed a motion to dismiss the amended complaint.

 

On February 16, 2005, Citizens for Pennsylvania’s Future, an environmental group, sued Allegheny in the U.S. District Court for the Western District of Pennsylvania. The action alleges violations of opacity limits and particulate matter emission limits at the Hatfield’s Ferry generation facility.

 

Allegheny intends to vigorously pursue and defend against the environmental matters described above but cannot predict their outcomes.

 

Other Environmental Litigation

 

Canadian Toxic-Tort Class Action:  On June 30, 2005, AE Supply, Monongahela and AGC, along with 18 other companies with coal-fired generation facilities, were named as defendants in a toxic-tort, purported class action lawsuit filed in the Ontario Superior Court of Justice. On behalf of a purported class comprised of all persons residing in Ontario within the past six years (and/or their family members or heirs), the named plaintiffs allege that the defendants negligently failed to prevent their generation facilities from emitting air pollutants in such a manner as to cause death and multiple adverse health effects, as well as economic damages, to the plaintiff class. The plaintiffs seek damages in the approximate amount of Canadian $49.1 billion (approximately US $41.6 billion, assuming an exchange rate of 1.18 Canadian dollars per US dollar), along with continuing damages in the amount of Canadian $4.1 billion per year and punitive damages of Canadian $1.0 billion (approximately US $3.5 billion and US $850 million, respectively, assuming an exchange rate of 1.18 Canadian dollars per US dollar) along with such other relief as the court deems just. Allegheny has not yet been served with this lawsuit. Allegheny intends to vigorously defend against this action but cannot predict its outcome.

 

Claims Related to Alleged Asbestos Exposure:  The Distribution Companies have been named as defendants, along with multiple other defendants, in pending asbestos cases alleging bodily injury involving multiple plaintiffs and multiple sites. These suits have been brought mostly by seasonal contractors’ employees and do not involve allegations of either the manufacture, sale or distribution of asbestos-containing products by Allegheny. These asbestos suits arise out of historical operations and are related to the installation and removal of asbestos-containing materials at Allegheny’s generation facilities. Allegheny’s historical operations were insured by various foreign and domestic insurers, including Lloyd’s of London. Asbestos-related litigation expenses have to date been reimbursed in full by recoveries from these historical insurers, and Allegheny believes that it has sufficient insurance to respond fully to the asbestos suits. Certain insurers, however, have contested their obligations to pay for the future defense and settlement costs relating to the asbestos suits. Allegheny is currently involved in two asbestos insurance-related actions, Certain Underwriters at Lloyd’s, London et al. v. Allegheny Energy, Inc. et al., Case No. 21-C-03-16733 (Washington County, Md.), and Monongahela Power Company et al. v. Certain Underwriters at Lloyd’s London and London Market Companies, et al., Civil Action No. 03-C-281 (Monongalia County, W.Va.). The parties in these actions are seeking an allocation of responsibility for historic and potential future asbestos liability.

 

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Allegheny and numerous others are plaintiffs in a similar action filed against Zurich Insurance Company in California, Fuller-Austin Asbestos Settlement Trust, et al. v. Zurich-American Insurance Co., et al., Case No. CGC 04 431719 (Superior Court of California, County of San Francisco).

 

In connection with a settlement, Allegheny received payment from one of its insurance companies in the amount of $625,000 on July 5, 2005, with the next payment of $625,000 due July 1, 2006. As part of the settlement, Allegheny released this insurance company from potential liabilities associated with claims against Allegheny alleging asbestos exposure.

 

Allegheny does not believe that the existence or pendency of either the asbestos suits or the actions involving its insurance will have a material impact on its consolidated financial position, results of operations or cash flows. Allegheny believes that it has established adequate reserves, net of insurance receivables and recoveries, to cover existing and future asbestos claims. As of December 31, 2005, Allegheny had 930 open cases remaining in West Virginia and five open cases remaining in Pennsylvania.

 

Allegheny intends to vigorously pursue these matters but cannot predict their outcomes.

 

Comprehensive Environmental Response Compensation and Liability Act of 1980 (“CERCLA”) Claim: On March 4, 1994, Monongahela and certain affiliated companies received notice that the EPA had identified them as potentially responsible parties (“PRPs”) with respect to the Jack’s Creek/Sitkin Smelting Superfund Site in Pennsylvania. Initially, approximately 175 PRPs were involved; however, the current number of active PRPs has been reduced as a result of settlements with de minimis contributors and other contributors to the site. The costs of remediation will be shared by all past and active responsible parties. In 1999, a PRP group that included Monongahela and certain affiliated companies entered into a consent order with the EPA to remediate the site. It is currently estimated that the total remediation costs to be borne by all of the responsible parties will not exceed $30.0 million. Allegheny has an accrued liability representing its estimated share of the remediation costs as of December 31, 2005.

 

Pending Initiatives

 

Allegheny’s compliance with the Clean Air Act has required, and may require in the future, that Allegheny install post-combustion control technologies on many of its generation facilities. CAIR may accelerate the need to install this equipment by phasing out a portion of currently available allowances.

 

The EPA promulgated revisions to particulate matter and ozone standards in July 1997. On December 20, 2005, EPA proposed lowering the ambient air quality standards for particulates. EPA intends to issue final standards by September 27, 2006. The effect of these regulatory changes is unknown at this time, but could be substantial. The EPA also has promulgated final regional haze regulations to improve visibility in national parks and wilderness areas. The effect on Allegheny of these regulations is unknown at this time, but could be substantial.

 

CAMR established a cap and trade system designed to reduce mercury emissions from coal-fired generation facilities in two phases due 2010 and 2018. This rule will be implemented through state implementation plans currently under development. The rule has been challenged by several parties. AE is currently assessing CAMR and its strategy for compliance.

 

The Kyoto Protocol went into effect on February 15, 2005. The Kyoto Protocol, which was signed by the Clinton Administration, but not ratified by the U.S. Senate, would require drastic reductions in greenhouse gas emissions in the United States in response to the perceived threat of global warming. If ratified and implemented by the United States, this treaty would likely require extensive mitigation efforts by Allegheny to reduce

 

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greenhouse gas emissions at its electric generation facilities and would raise considerable uncertainty about the future viability of fossil fuels as an energy source for new and existing electric generation facilities. The Bush Administration has rejected the Kyoto Protocol and has proposed voluntary programs to reduce greenhouse gas intensity over the next decade. Various legislative proposals are under consideration at the international, federal and state level. The ultimate outcome of the global climate change debate and the Kyoto Protocol, which cannot be predicted at this time, could have a significant effect on Allegheny.

 

Water Standards

 

On July 9, 2004, the EPA finalized the Section 316(b) Phase II Cooling Water Intake Structure Rule. The requirements of the final rule will be implemented through National Pollutant Discharge Elimination System Permits. The rule requires site-specific comprehensive demonstration studies to determine the best technology available (as defined in the rule) for achieving compliance with national performance standards. Allegheny is currently developing compliance strategies for its affected facilities. The effect on Allegheny of these regulations are not fully known at this time but could be substantial.

 

RESEARCH AND DEVELOPMENT

 

Allegheny’s expenditures for research in 2005 and 2004 were minimal. In 2005 and 2004, Allegheny’s research and development activity addressed air emissions issues, and Allegheny expects that its research and development activity in 2006 will continue to address these issues. Allegheny spent approximately $0.6 million for research in 2003.

 

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ITEM 1A.    RISK FACTORS

 

Allegheny is subject to a variety of significant risks in addition to the matters set forth under “Special Note Regarding Forward-Looking Statements” above. Allegheny’s susceptibility to certain risks could exacerbate other risks. These risk factors should be considered carefully in evaluating Allegheny’s risk profile. Risks applicable to Allegheny include:

 

Risks Relating to Regulation

 

Allegheny is subject to substantial governmental regulation. Compliance with current and future regulatory requirements and procurement of necessary approvals, permits and certificates may result in substantial costs to Allegheny.

 

Allegheny is subject to substantial regulation from federal, state and local regulatory agencies. Allegheny is required to comply with numerous laws and regulations and to obtain numerous authorizations, permits, approvals and certificates from governmental agencies. These agencies regulate various aspects of Allegheny’s business, including customer rates, services, retail service territories, generation plant operations, sales of securities, asset sales and accounting policies and practices.

 

Prior to February 8, 2006, Allegheny was also subject to regulation by the SEC under PUHCA 1935, which imposed a number of restrictions on the operations of registered utility holding companies and their subsidiaries. These restrictions included a requirement that, subject to a number of exceptions, the SEC approve in advance securities issuances, financings, acquisitions and dispositions of utility assets, or of securities of utility companies, and acquisitions of interests in other businesses, as well as a requirement that transactions between affiliated companies in a registered holding company system be performed at cost. Although the Energy Policy Act repealed PUHCA 1935 effective as of February 8, 2006, it replaced the repealed law with PUHCA 2005, which effectively extends limited jurisdiction over public utility holding companies to FERC. Although PUHCA 2005 grants FERC jurisdiction over public utility holding companies with respect to access to books and records and cost allocation methodologies, it does not impose restrictions as extensive as those imposed by the SEC under PUHCA 1935. See “Regulatory Framework Affecting Allegheny—Federal Regulation and Rate Matters” below.

 

Allegheny cannot predict the impact of any future revisions or changes in interpretations of existing regulations or the adoption of new laws and regulations applicable to it, including the Energy Policy Act. Changes in regulations or the imposition of additional regulations could influence Allegheny’s operating environment and may result in substantial costs to Allegheny.

 

Allegheny’s costs to comply with environmental laws are significant, and the cost of compliance with present and future environmental laws could adversely affect its cash flow and profitability.

 

Allegheny’s operations are subject to extensive federal, state and local environmental statutes, rules and regulations relating to air quality, water quality, waste management, natural resources and site remediation. Compliance with these laws and regulations may require Allegheny to expend significant financial resources to, among other things, meet air emission standards, conduct site remediation, perform environmental monitoring, purchase emission allowances, use alternative fuels and modulate operations of its generation facilities in order to reduce emissions. If Allegheny fails to comply with applicable environmental laws and regulations, even if it is unable to do so due to factors beyond its control, it may be subject to civil liabilities or criminal penalties and may be required to incur significant expenditures to come into compliance. In addition, any alleged violations of environmental laws and regulations may require Allegheny to expend significant resources defending itself against such alleged violations.

 

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New environmental laws and regulations, or new interpretations of existing laws and regulations, could impose more stringent limitations on Allegheny’s generation operations or require it to incur significant additional costs.

 

Applicable standards under the EPA’s NSR initiatives remain in flux. Under the Clean Air Act, modification of Allegheny’s generation facilities in a manner that causes increased emissions could subject Allegheny’s existing facilities to the far more stringent NSR standards applicable to new facilities. The EPA has taken the view that many companies, including many energy producers, have been modifying emissions sources in violation of NSR standards in connection with work believed by the companies to be routine maintenance. See “Regulatory Framework Affecting Allegheny” below.

 

On May 20, 2004, AE, AE Supply, Monongahela and West Penn received a Notice of Intent to Sue Pursuant to Clean Air Act §7604 from the Attorneys General of New York, New Jersey and Connecticut and from the PA DEP. The Notice alleged that Allegheny made major modifications to some of its West Virginia facilities in violation of the PSD provisions of the Clean Air Act at the following coal-fired facilities: Albright Unit No. 3; Fort Martin Units No. 1 and 2; Harrison Units No. 1, 2 and 3; Pleasants Units No. 1 and 2 and Willow Island Unit No. 2. The Notice also alleged PSD violations at the Armstrong, Hatfield’s Ferry and Mitchell generation facilities in Pennsylvania and identifies PA DEP as the lead agency regarding those facilities. On September 8, 2004, AE, AE Supply, Monongahela and West Penn received a separate Notice of Intent to Sue from the Maryland Attorney General that essentially mirrored the previous Notice.

 

On January 6, 2005, AE Supply and Monongahela filed the West Virginia DJ Action. This action requests that the court declare that AE Supply’s and Monongahela’s coal-fired generation facilities in Pennsylvania and West Virginia comply with the Clean Air Act. The Attorneys General filed a motion to dismiss the West Virginia DJ Action. It is possible that the EPA and other state authorities may join or move to transfer the West Virginia DJ Action.

 

On June 28, 2005, the PA DEP and the Attorneys General of New York, New Jersey, Connecticut and Maryland filed the PA Enforcement Action. This action alleges NSR violations under the federal Clean Air Act and the Pennsylvania Air Pollution Control Act at the Hatfield’s Ferry, Armstrong and Mitchell facilities in Pennsylvania. The PA Enforcement Action appears to raise the same issues regarding Allegheny’s Pennsylvania generation facilities that are before the Court in the West Virginia DJ Action, except that the PA Enforcement Action also includes the PA DEP and the Maryland Attorney General. Allegheny’s motion to stay the PA Enforcement Action was denied on November 21, 2005. On January 17, 2006, the PA DEP and the Attorneys General filed an amended complaint. On February 15, 2006 Allegheny filed a motion to dismiss the amended complaint.

 

On February 16, 2005, Citizens for Pennsylvania’s Future, an environmental group, sued Allegheny in the United States District Court for the Western District of Pennsylvania. The action alleges violations of opacity limits and particulate matter emission limits at the Hatfield’s Ferry generation facility.

 

Allegheny intends to vigorously pursue and defend against the environmental matters described above but cannot predict their outcomes.

 

In addition, Allegheny incurs costs 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 Allegheny fails to obtain, maintain or comply with any required approval, operations at affected facilities could be halted, curtailed or subjected to additional costs.

 

For additional information regarding environmental matters, see “Environmental Matters” below.

 

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Shifting state and federal regulatory policies impose risks on Allegheny’s operations.

 

Allegheny’s operations are subject to evolving regulatory policies, including initiatives regarding deregulation of the production and sale of electricity and the restructuring of transmission regulation. Any new requirements arising from these actions could lead to increased operating expenses and capital expenditures, the amount of which cannot be predicted at this time.

 

The continuation of below-market retail rate caps beyond the original scheduled end of transition periods could have adverse consequences for Allegheny. After the expiration of existing power supply contracts, West Penn and Potomac Edison must purchase their power requirements at market prices, whether from AE Supply or an alternative supplier. If retail rates are capped below the prices at which these utilities can obtain power, the power will be sold at a loss. Legislators, regulators and consumer and other groups have sought to extend retail rate regulation in the states in which West Penn and Potomac Edison do business through a variety of mechanisms, including through the extension of the current rate cap regimes, which are set below current market prices. Allegheny cannot predict to what extent these efforts will be successful. See “Regulatory Framework Affecting Allegheny” below.

 

Delays, discontinuations or reversals of electricity market restructurings in the markets in which Allegheny operates could have a material adverse effect on its results of operations and financial condition. At a minimum, these types of actions raise uncertainty concerning the continued development of competitive power markets. Given Allegheny’s multi-state operations and asset base, re-regulation of restructured obligations could prove intricate, time-consuming and costly to ongoing operations.

 

In addition, as a result of FERC’s efforts to implement a long-term rate design for the Midwest and Mid-Atlantic regions, the Distribution Companies may not fully recover their transmission costs and may have costs shifted to them from other transmission owners. Due to capped rates and the timing of state rate cases, the Distribution Companies may not be able to pass through increased transmission costs to these retail customers for some period of time.

 

Risks Related to Allegheny’s Substantial Debt

 

Covenants contained in Allegheny’s principal financing agreements restrict its operating, financing and investing activities.

 

Allegheny’s principal financing agreements contain restrictive covenants that limit its ability to, among other things:

 

    borrow funds;

 

    incur liens and guarantee debt;

 

    enter into a merger or other change of control transaction;

 

    make investments;

 

    dispose of assets; and

 

    pay dividends and other distributions on its equity securities.

 

These agreements limit Allegheny’s ability to implement strategic decisions, including its ability to access capital markets or sell assets without using the proceeds to reduce debt. In addition, Allegheny is required to meet certain financial tests under some of its loan agreements, including interest coverage ratios and leverage ratios. Allegheny’s failure to comply with the covenants contained in its financing agreements could result in an event of default, which could materially and adversely affect its financial condition.

 

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Allegheny’s substantial debt could adversely affect its ability to operate successfully and meet contractual obligations.

 

Although Allegheny reduced debt by approximately $1.9 billion between December 1, 2003 and December 31, 2005 and plans to continue its debt reduction program, Allegheny still has substantial debt. At December 31, 2005, Allegheny had $4.1 billion of debt on a consolidated basis. Approximately $199.0 million of that amount represented AE’s obligations, $2.4 billion represented debt of AE Supply and AGC and the remainder constituted debt of one or more of the Distribution Companies.

 

Allegheny’s substantial debt could have important consequences to it. For example, it could:

 

    make it more difficult for Allegheny to satisfy its obligations under the agreements governing its debt;

 

    require Allegheny to dedicate a substantial portion of its cash flow to payments on its debt, thereby reducing the availability of its cash flow for working capital, capital expenditures and other general corporate purposes;

 

    limit Allegheny’s flexibility in planning for, or reacting to, changes in its business, regulatory environment and the industry in which it operates;

 

    place Allegheny at a competitive disadvantage compared to its competitors that have less debt;

 

    limit Allegheny’s ability to borrow additional funds; and

 

    increase Allegheny’s vulnerability to general adverse economic, regulatory and industry conditions.

 

Allegheny may be unable to engage in desired financing transactions.

 

Allegheny has substantial debt service obligations for the foreseeable future and may need to engage in refinancing and capital-raising transactions in order to pay interest and retire principal. Allegheny also may undertake other types of financing transactions in order to meet its other financial needs and increase its equity ratios. Allegheny may be unable to successfully complete financing transactions due to a number of factors, including:

 

    its credit ratings, many of which are currently below investment grade;

 

    its overall financial condition and results of its operations; and

 

    volatility in the capital markets.

 

Allegheny currently anticipates that, in order to repay the principal of its outstanding debt, it may undertake one or more financing alternatives, such as refinancing or restructuring its debt, selling assets, reducing or delaying capital investments or raising additional capital. Allegheny can provide no assurance that it can complete any of these types of financing transactions on terms satisfactory to it or at all, that any financing transaction would enable it to pay the interest or principal on its debt or meet its other financial needs or that any of these alternatives would be permitted under the terms of the agreements governing its outstanding debt.

 

Changes in prevailing market conditions or in Allegheny’s access to commodities markets may make it difficult for Allegheny to hedge its physical power supply commitments and resource requirements.

 

In the past, unfavorable market conditions, coupled with Allegheny’s credit position, made it difficult for Allegheny to hedge its power supply obligations and fuel requirements. Although substantial improvements have been made in Allegheny’s market positions over the past few years, significant unanticipated changes in commodity market liquidity and/or Allegheny’s access to the commodity markets could adversely impact Allegheny’s ability to hedge its portfolio of physical generation assets and load obligations. In the absence of effective hedges for these purposes, Allegheny must balance its portfolio in the spot markets, which are volatile and can yield different results than expected.

 

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Allegheny’s risk management, wholesale marketing, fuel procurement and energy trading activities, including its decisions to enter into power sales or purchase agreements, rely on models that depend on judgments and assumptions regarding factors such as generating plant availability, future market prices, weather and the demand for electricity and other energy-related commodities. Even when Allegheny’s policies and procedures are followed and decisions are made based on these models, its financial position and results of operations may be adversely affected if the judgments and assumptions underlying those models prove to be inaccurate.

 

Risks Relating to Allegheny’s Operations

 

Allegheny’s generation facilities are subject to unplanned outages and significant maintenance requirements.

 

The operation of power generation facilities involves certain risks, including the risk of breakdown or failure of equipment, fuel interruption and performance below expected levels of output or efficiency. If Allegheny’s facilities, or the facilities of other parties upon which it depends, operate below expectations, Allegheny may lose revenues, have increased expenses or fail to receive or deliver the amount of power for which it has contracted.

 

Many of Allegheny’s facilities were originally constructed many years ago. Older equipment, even if maintained in accordance with good engineering practices, may require significant capital expenditures to operate at peak efficiency or availability. If Allegheny underestimates required maintenance expenditures or is unable to make required capital expenditures due to liquidity constraints, it risks incurring more frequent unplanned outages, higher than anticipated maintenance expenditures, increased operation at higher cost of some of its less efficient generation facilities and the need to purchase power from third parties to meet its supply obligations, possibly at times when the market price for power is high.

 

Allegheny’s operating results are subject to seasonal and weather fluctuations.

 

The sale of power generation output is generally a seasonal business, and weather patterns can have a material impact on Allegheny’s operating results. Demand for electricity peaks during the summer and winter months, and market prices typically also peak during these times. During periods of peak demand, the capacity of Allegheny’s generation facilities may be inadequate to meet its contractual obligations, which could require it to purchase power at a time when the market price for power is high. In addition, although the operational costs associated with the Delivery and Services segment are not weather-sensitive, the segment’s revenues are subject to seasonal fluctuation. Accordingly, Allegheny’s annual results and liquidity position may depend disproportionately on its performance during the winter and summer.

 

Extreme weather or events outside of Allegheny’s service territory can also have a direct effect on the commodity markets. Events, such as hurricanes, that disrupt the supply of commodities used as fuel impact the price and availability of energy commodities and can have a material impact on Allegheny’s financial condition, cash flow and results of operations.

 

Allegheny’s revenues, costs and results of operations are subject to other risks beyond its control, including, but not limited to, accidents, storms, natural catastrophes and terrorism.

 

Much of the value of Allegheny’s business consists of its portfolio of power generation and T&D assets. Allegheny’s ability to conduct its operations depends on the integrity of these assets. The cost of repairing damage to its facilities due to storms, natural disasters, wars, terrorist acts and other catastrophic events may exceed available insurance, if any, for repairs, which may adversely impact Allegheny’s results of operations and financial condition. Although Allegheny has taken, and will continue to take, reasonable precautions to safeguard these assets, Allegheny can make no assurance that its facilities will not face damage or disruptions or that it will

 

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have sufficient insurance, if any, to cover the cost of repairs. In addition, in the current geopolitical climate, enhanced concern regarding the risks of terrorism throughout the economy may impact Allegheny’s operations in unpredictable ways. Insurance coverage may not cover costs associated with any of these risks adequately or at all. While T&D losses may be recoverable through regulatory proceedings, the delay and uncertainty of any such recovery could have a material adverse effect on Allegheny’s financial condition, cash flow and results of operations.

 

The terms of AE Supply’s power sale agreements with Potomac Edison and West Penn could require AE Supply to sell power below its costs or prevailing market prices or require Potomac Edison and West Penn to purchase power at a price above which they can sell power.

 

In connection with regulations governing the transition to market competition, Potomac Edison and West Penn are required to provide electricity at capped rates to certain retail customers who do not choose an alternate electricity generation supplier or who return to utility service from alternate suppliers. Potomac Edison and West Penn satisfy the majority of these obligations by purchasing power under contracts with external counterparties, or their affiliate, AE Supply. Those contracts provide for the supply of a significant portion of their energy needs at the mandated capped rates and for the supply of a specified remaining portion at rates based on market prices. The amount of energy priced at market rates increases over each contract term. The majority of AE Supply’s normal operating capacity is dedicated to these contracts.

 

These power supply agreements present risks for both AE Supply and the utilities. At times, AE Supply may not earn as much as it otherwise could by selling power priced at its contract rates to Potomac Edison and West Penn instead of into competitive wholesale markets. In addition, AE Supply’s obligations under these power supply agreements could exceed its available generation capacity, which may require AE Supply to buy power at prices that are higher than the sale prices in the power supply agreements. Changes in customer switching behavior could also alter both AE Supply’s and the utilities’ obligations under these agreements. Conversely, the utilities’ capped rates may be below current wholesale market prices through the applicable transition periods. As a consequence, Potomac Edison and West Penn may at times pay more for power than they can charge retail customers and may be unable to pass the excess costs on to their retail customers.

 

Rate regulation in West Virginia may delay or deny Monongahela’s full recovery of costs.

 

The West Virginia PSC sets Monongahela’s rates in West Virginia through traditional, cost-based regulated utility ratemaking. As part of Monongahela’s efforts to spur deregulation in West Virginia, it agreed to terminate its fuel clause effective July 1, 2000. Thus, to recover increased, unexpected or necessary costs, including increased coal and other raw material costs, Monongahela must file for approval from the West Virginia PSC to recover such costs or to reinstate its fuel clause. There can be no assurance that Monongahela will be able to recover such costs or reinstate its fuel clause under the ratemaking process. Even if Monongahela is able to recover costs, there may be a significant delay between the time that it incurs such costs and the time that it is allowed to recover such costs. Any inability to recover, or delay in the recovery of, these costs could have a material adverse effect on Monongahela’s financial condition, cash flows and results of operations.

 

Monongahela is required to supply power to serve its former Ohio customers at prices that may be below prevailing market prices.

 

In connection with the sale of its electric T&D operations in Ohio in December 2005, Monongahela entered into a power sales agreement to sell power to Columbus Southern to serve Monongahela’s former Ohio customers through May 31, 2007 (representing a total of approximately 2.5 million MWh over the term of the agreement) at a price of $45 per MWh. To meet its obligations under this agreement, Monongahela will purchase power at market prices, which may, at times, be higher than the $45 per MWh sales price fixed by this agreement.

 

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Monongahela recorded a charge of $29.3 million in 2005 in connection with the sale of its electric T&D operations in Ohio and its agreement to provide power to Columbus Southern at below-market prices. The amount of the charge was based on the estimated value, at December 31, 2005, of Monongahela’s power sales agreement with Columbus Southern, partially offset by approximately $8 million, representing the purchase price for the Ohio assets in excess of the book value of the assets at December 31, 2005 and approximately $2 million in expenses associated with the sale. However, market prices are volatile and can vary over time. Market prices, and therefore, the prices at which Monongahela will be required to purchase power in order to meet its obligations under its agreement with Columbus Southern, may vary significantly over the life of the agreement. Monongahela may incur losses in connection with its agreement with Columbus Southern in excess of those reflected in the $29.3 million charge.

 

The supply and price of fuel and emissions credits may impact Allegheny’s financial results.

 

Allegheny is dependent on coal for much of its electric generation capacity. Allegheny has coal supply contracts in place that partially mitigate its exposure to negative fluctuations in coal prices. Allegheny can provide no assurance, however, that the counterparties to these agreements will fulfill their obligations to supply coal. The suppliers under these agreements may experience financial or technical problems that inhibit their ability to fulfill their obligations. Various industry and operational factors, including increased costs, transportation constraints, safety issues and operational difficulties may have negative effects on coal supplier performance. In addition, the suppliers under these agreements may not be required to supply coal to Allegheny under certain circumstances, such as in the event of a natural disaster. If Allegheny is unable to obtain its coal requirements under these contracts, it may be required to purchase coal at higher prices, which could have a material adverse effect on its financial condition, cash flow and results of operations.

 

Based on current forecasts, Allegheny estimates that it may have an SO2 allowance market exposure of less than 10,000 tons in 2006 and approximately 20,000 tons and 75,000 tons in 2007 and 2008, respectively. Allegheny’s allowance needs, to a large extent, are affected at any given time by the amount of output produced and the types of fuel used by its generation facilities, as well as the implementation of environmental controls. Therefore, there can be no assurance that Allegheny’s need to purchase SO2 allowances for these periods will not vary from current estimates. Fluctuations in the availability or cost of emission allowances could have a material adverse effect on Allegheny’s financial condition, cash flows and results of operations. See “Environmental Matters” below.

 

Allegheny is currently involved in significant litigation that, if not decided favorably to Allegheny, could have a material adverse effect on its results of operations, cash flows and financial condition.

 

Allegheny is currently involved in a number of lawsuits, some of which may be significant. Allegheny intends to vigorously pursue these matters, but the results of these lawsuits cannot be determined. Adverse outcomes in these lawsuits could require Allegheny to make significant expenditures and could have a material adverse effect on its financial condition, cash flow and results of operations. See “Legal Proceedings” below.

 

The Distribution Companies and other AE subsidiaries are and may become subject to legal claims arising from the presence of asbestos or other regulated substances at some of their facilities.

 

The Distribution Companies have been named as defendants in pending asbestos litigation involving multiple plaintiffs and multiple defendants. In addition, asbestos and other regulated substances are, and may continue to be, present at Allegheny-owned facilities where suitable alternative materials are not available. Allegheny’s management believes that any remaining asbestos at Allegheny-owned facilities is contained. The continued presence of asbestos and other regulated substances at Allegheny-owned facilities, however, could result in additional actions being brought against Allegheny. See “Legal Proceedings” below and Note 6, “Asset Retirement Obligations,” to the Consolidated Financial Statements.

 

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Adverse investment returns and other factors may increase Allegheny’s pension liability and pension funding requirements.

 

Substantially all of Allegheny’s employees are covered by a defined benefit pension plan. At present, the pension plan is underfunded in that the projected pension benefit obligation exceeds the aggregate fair value of plan assets. Under applicable law, Allegheny is required to make cash contributions to the extent necessary to comply with minimum funding requirements imposed by regulatory requirements. The amount of such required cash contribution is based on an actuarial valuation of the plan. The funded status of the plan can be affected by investment returns on plan assets, discount rates, mortality rates of plan participants, pending pension reform legislation and a number of other factors. There can be no assurance that the value of Allegheny’s pension plan assets will be sufficient to cover future liabilities. It is possible that Allegheny could incur a significant pension liability adjustment, or could be required to make significant additional cash contributions to its plan, which would reduce the cash available for business and other needs.

 

Changes in PJM market policies and rules may impact Allegheny’s financial results.

 

Substantially all of Allegheny’s generation assets and power supply obligations are located within the PJM region. Any changes in PJM policies or market rules, including changes that are currently under consideration by FERC, could adversely affect Allegheny’s financial results.

 

Energy companies are subject to adverse publicity, which may make Allegheny vulnerable to negative regulatory and litigation outcomes.

 

The energy sector has been the subject of highly-publicized allegations of misconduct. Negative publicity of this nature may make legislators, regulators and courts less likely to view energy companies favorably, which could cause them to make decisions or take actions that are adverse to Allegheny.

 

Allegheny is dependent on its ability to successfully access capital markets. Any inability to access capital may adversely affect Allegheny’s business.

 

Allegheny relies on access to the capital markets as a source of liquidity and to satisfy any of its capital requirements that are not met by the cash flow from its operations. Capital market disruptions, or a downgrade in Allegheny’s credit ratings, could increase Allegheny’s cost of borrowing or could adversely affect its ability to access one or more financial markets. Disruptions to the capital markets could include, but are not limited to:

 

    a recession or an economic slowdown;

 

    the bankruptcy of one or more energy companies or highly-leveraged companies;

 

    significant increases in the prices for oil or other fuel;

 

    a terrorist attack or threatened attacks;

 

    a significant transmission failure; or

 

    changes in technology.

 

Risks Relating to Operational Enhancements

 

Refocusing its business subjects Allegheny to risks and uncertainties.

 

Allegheny has implemented significant changes to its operations as part of its overall strategy to function as an integrated utility company, to the extent practicable and permissible under relevant regulatory constraints. For example, Allegheny has disposed of certain non-core assets, reduced the size of its workforce, made substantial

 

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changes to senior management and undertaken the implementation of a new company-wide enterprise resource planning system. Additional changes to Allegheny’s business will be considered as management seeks to strengthen financial and operational performance. These changes may be disruptive to Allegheny’s established organizational culture and systems. In addition, consideration and planning of strategic changes diverts management attention and other resources from day to day operations.

 

Allegheny may engage in sales of assets and businesses; however, market conditions and other factors may hinder this strategy.

 

Allegheny may continue to sell non-core assets. Sales prices for energy assets and businesses could fluctuate due to prevailing conditions. Asset sales under poor market conditions could result in substantial losses. Buyers also may find it difficult to obtain financing to purchase these assets. As part of any asset sale, Allegheny faces challenges associated with valuing the assets correctly and limiting its environmental or other retained liabilities. These transactions also may divert management attention and other resources from day-to-day operations.

 

Several factors specific to Allegheny could make asset sales particularly challenging. Allegheny and potential purchasers are subject to regulatory approvals, which can impose delays and structuring complications on asset sale transactions. Potential buyers may be reluctant to enter into agreements to purchase assets from Allegheny if they believe that required consents and approvals will result in significant delays or uncertainties in the transaction process.

 

Allegheny may fail to realize the benefits that it expects from its cost-savings initiatives.

 

Allegheny has undertaken and expects to continue to undertake cost-savings initiatives. However, Allegheny can make no assurance that it will realize ongoing cost savings or any other benefits from these initiatives. Even if Allegheny realizes the benefits of its cost savings initiatives, any cash savings that it achieves may be offset by other costs, such as environmental compliance costs and higher fuel, operating and maintenance costs, or could be passed on to customers through revised rates. Staff reductions may reduce Allegheny’s workforce below the level needed to effectively manage its business and service its customers. Allegheny’s failure to realize the anticipated benefits of its cost-savings initiatives could have a material adverse effect on its business, results of operations and financial condition.

 

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ITEM 2.    PROPERTIES

 

Substantially all of AE Supply’s properties are subject to liens of various relative priorities securing debt obligations. Substantially all of Monongahela’s and Potomac Edison’s properties are held subject to the lien of indentures securing their first mortgage bonds. Certain of the properties and other assets owned by AE Supply and Monongahela that were financed by solid waste disposal and pollution control notes are subject to liens securing the obligations under those notes. In many cases, the properties of Monongahela, Potomac Edison and other AE subsidiaries may be subject to certain reservations, minor encumbrances and title defects that do not materially interfere with their use. The indenture under which AGC’s unsecured debentures are issued prohibits AGC, with certain limited exceptions, from incurring or permitting liens to exist on any of its properties or assets unless the debentures are contemporaneously secured equally and ratably with all other debt secured by the lien. Most T&D lines, some substations and switching stations and some ancillary facilities at generation facilities are on lands of others, in some cases by sufferance but, in most instances, pursuant to leases, easements, rights-of-way, permits or other arrangements, many of which have not been recorded and some of which are not evidenced by formal grants. In some cases, no examination of titles has been made as to lands on which T&D lines and substations are located. Each of the Distribution Companies possesses the power of eminent domain with respect to its public utility operations. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources” below and Note 2, “Capitalization” to the Consolidated Financial Statements.

 

Allegheny’s principal corporate headquarters is located in Greensburg, Pennsylvania, in a building that is owned by West Penn. Allegheny also has a corporate center located in Fairmont, West Virginia, in a building owned by Monongahela. Additional ancillary offices exist throughout the Distribution Companies’ service territories.

 

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ITEM 3.    LEGAL PROCEEDINGS

 

Putative Class Actions Under California Statutes

 

Eight related putative class action lawsuits were filed against and served on AE Supply and more than two dozen other named defendant power suppliers in various California superior courts during 2002. These class action suits were removed from state court and transferred to the U.S. District Court for the Southern District of California. Seven of the suits were commenced by consumers of wholesale electricity in California. The eighth, Millar v. Allegheny Energy Supply Co., et al., was filed on behalf of California consumers and taxpayers. The complaints allege, among other things, that AE Supply and the other defendant power suppliers violated California’s antitrust statute and the California unfair business practices statutes by manipulating the California electricity market. The suits also challenge the validity of various long-term power contracts with the State of California, including the CDWR contract.

 

On August 25, 2003, the U.S. District Court granted AE Supply’s motion to dismiss the seven consumer class actions with prejudice. On February 25, 2005, the U.S. Court of Appeals for the Ninth Circuit affirmed the District Court’s judgment dismissing the seven class actions with prejudice.

 

The District Court separately granted plaintiffs’ motion to remand in the eighth action, Millar, on July 9, 2003. On December 18, 2003, the plaintiffs filed an amended complaint in California state court, solely on behalf of consumers, naming certain additional defendants, including The Goldman Sachs Group, Inc. (“Goldman Sachs”). The case was removed to federal court based on the amended complaint. On January 11, 2005, the federal district court remanded the case back to the state court in San Francisco. On May 6, 2005, the defendants in the Millar action filed a series of demurrers seeking to have the action dismissed. On September 7, 2005, the state court ruled that the plaintiff’s complaint would be dismissed without leave to amend. On October 7, 2005, the state court entered judgment dismissing the complaint without leave to amend. Plaintiffs have agreed not to appeal the state court’s judgment. Thus, the eight actions filed against and served on AE Supply each have been dismissed.

 

Nevada Power Contracts

 

On December 7, 2001, Nevada Power Company (“NPC”) filed a complaint with FERC against AE Supply seeking action by FERC to modify prices payable to AE Supply under three trade confirmations between Merrill Lynch and NPC. NPC’s claim was based, in part, on the assertion that dysfunctional California spot markets had an adverse effect on the prices NPC was able to negotiate with Merrill Lynch under the contracts. NPC filed substantially identical complaints against a number of other energy suppliers. On December 19, 2002, the Administrative Law Judge (“ALJ”) issued findings that no contract modification was warranted. The ALJ determined in favor of NPC that AE Supply, rather than Merrill Lynch, was a proper subject of NPC’s complaint.

 

On June 26, 2003, FERC affirmed the ALJ’s decision upholding the long-term contracts negotiated between NPC and Merrill Lynch, among others. FERC did not decide whether AE Supply, rather than Merrill Lynch, was the real party in interest. On November 10, 2003, FERC issued an order, on rehearing, affirming its conclusion that the long-term contracts should not be modified. Snohomish County and other parties filed petitions for review of FERC’s June 26, 2003 order with the U.S. Court of Appeals for the Ninth Circuit (the “NPC Petitions”). The NPC Petitions were consolidated in the Ninth Circuit. On December 17, 2003, AE Supply filed a motion to intervene in this proceeding in the Ninth Circuit. The Ninth Circuit heard oral argument in these cases on December 8, 2004.

 

AE Supply intends to vigorously defend against these actions but cannot predict their outcomes.

 

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Sierra/Nevada

 

On April 2, 2003, NPC and Sierra Pacific Resources, Inc. (together, “Sierra/Nevada”) initiated a lawsuit in U.S. District Court in Nevada against AE and AE Supply, together with Merrill Lynch & Co. and Merrill Lynch Capital Services, Inc. (together, “Merrill”). The complaint alleged that AE, AE Supply and Merrill engaged in fraudulent conduct in connection with NPC’s application to the Public Utilities Commission of Nevada (the “Nevada PUC”) for a deferred energy accounting adjustment, which allegedly caused the Nevada PUC to disallow $180 million of NPC’s deferred energy expenses. Sierra/Nevada asserted claims against AE and AE Supply for: (a) tortious interference with Sierra/Nevada’s contractual and prospective economic advantages; (b) conspiracy and (c) violations of the Nevada state Racketeer Influenced and Corrupt Organization (“RICO”) Act. Sierra/Nevada filed an amended complaint on May 30, 2003, which asserted a fourth cause of action against AE and AE Supply for wrongful hiring and supervision. Sierra/Nevada seeks $180 million in compensatory damages plus attorneys’ fees and seeks in excess of $850 million under the RICO count. AE and AE Supply filed motions to dismiss the complaints on May 6, 2003 and June 23, 2003. Thereafter, plaintiffs filed a motion to stay the action, pending the outcome of certain state court proceedings in which they are seeking to reverse the Nevada PUC’s disallowance of expenses. The District Court granted the stay motion, and the action is currently stayed.

 

AE Supply intends to vigorously defend against this action but cannot predict its outcome.

 

Litigation Involving Merrill Lynch

 

AE and AE Supply entered into an asset purchase agreement with Merrill Lynch and affiliated parties in 2001, under which AE and AE Supply purchased Merrill Lynch’s energy marketing and trading business for approximately $489 million and an equity interest in AE Supply of nearly 2%. The asset purchase agreement provided that Merrill Lynch would have the right to require AE to purchase Merrill Lynch’s equity interest in AE Supply for $115 million plus interest calculated from March 16, 2001 in the event that certain conditions were not met.

 

On September 24, 2002, certain Merrill Lynch entities filed a complaint against AE in the U.S. District Court for the Southern District of New York, alleging that AE breached the asset purchase agreement by failing to repurchase the equity interest in AE Supply from Merrill Lynch and seeking damages in excess of $125 million. On September 25, 2002, AE and AE Supply filed an action against Merrill Lynch in New York state court alleging fraudulent inducement and breach of representations and warranties in the purchase agreement.

 

On May 29, 2003, the U.S. District Court for the Southern District of New York ordered that AE and AE Supply assert their claims against Merrill Lynch, which were initially brought in New York state court, as counterclaims in Merrill Lynch’s federal court action. As a result, AE and AE Supply dismissed the New York state action and filed an answer and asserted affirmative defenses and counterclaims against Merrill Lynch in the U.S. District Court for the Southern District of New York. The counterclaims, as amended, alleged that Merrill Lynch fraudulently induced AE and AE Supply to enter into the purchase agreement, that Merrill Lynch breached certain representations and warranties contained in the purchase agreement, that Merrill Lynch negligently misrepresented certain facts relating to the purchase agreement and that Merrill Lynch breached fiduciary duties owed to AE and AE Supply. The counterclaims sought damages in excess of $605 million, among other relief.

 

On April 12, 2005, the court granted Merrill Lynch’s motion for summary judgment on its breach of contract claim, thereby requiring AE to purchase Merrill Lynch’s equity interest in AE Supply for $115 million plus interest from March 16, 2001, to be offset by any judgment in favor of AE and AE Supply on their counterclaims. The court denied Merrill Lynch’s summary judgment motion with respect to AE and AE Supply’s counterclaims for fraudulent inducement and breach of contract, and granted Merrill Lynch’s motion with respect to the counterclaims for breach of fiduciary duty and negligent misrepresentations.

 

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In May and June of 2005, the District Court conducted a trial with respect to the damages owed Merrill Lynch on its breach of contract claim and with respect to AE and AE Supply’s counterclaims for fraudulent inducement and breach of contract. Following the trial, on July 18, 2005, the District Court entered an order: (a) ruling against AE and AE Supply on their fraudulent inducement and breach of contract claims; (b) requiring AE to pay $115 million plus interest to Merrill Lynch; and (c) requiring Merrill Lynch to return its equity interest in AE Supply to AE. On August 26, 2005, the court entered its final judgment in accordance with its July 18, 2005 ruling. On September 22, 2005, AE and AE Supply filed a notice of appeal of the District Court’s judgment to the U.S. Court of Appeals for the Second Circuit. Although AE will not be required to pay Merrill Lynch the amount of the judgment while the appeal is pending, AE has posted a letter of credit to secure the judgment.

 

As a result of the District Court’s ruling, AE recorded a charge during the first quarter of 2005 in the amount of $38.5 million, representing interest from March 16, 2001 through March 31, 2005, and continues to accrue interest expense thereafter.

 

The federal government is holding certain assets of Daniel L. Gordon, the former head of energy trading for AE Supply. Both AE and AE Supply, on the one hand, and Merrill Lynch, on the other hand, filed petitions with the U.S. District Court for the Southern District of New York claiming rights to the funds. In June 2005, AE, AE Supply, Merrill Lynch and the U.S. Attorney’s Office entered into a settlement agreement pursuant to which AE Supply and Merrill Lynch will receive equal portions of certain of the assets held by the federal government. AE Supply has received approximately $11 million from the forfeited assets and may receive additional amounts if certain funds are released from a separate escrow.

 

Putative Shareholder, Benefit Plan Class Actions and Derivative Action

 

From October 2002 through December 2002, plaintiffs claiming to represent purchasers of AE’s securities filed 14 putative class action lawsuits against AE and several of its former senior managers in U.S. District Courts for the Southern District of New York and the District of Maryland. The complaints alleged that AE and senior management violated federal securities laws when AE purchased Merrill Lynch’s energy marketing and trading business with the knowledge that the business was built on illegal wash or round-trip trades with Enron, which the complaints alleged artificially inflated trading revenue, volume and growth. All of the securities cases were transferred to the District of Maryland and consolidated. The plaintiffs filed an amended complaint on May 3, 2004 that alleged that the defendants violated federal securities laws by failing to disclose weaknesses in Merrill Lynch’s energy marketing and trading business, as well as other internal control and accounting deficiencies.

 

In June 2003, a shareholder derivative action was filed against AE’s Board of Directors and several former senior managers in the Supreme Court of the State of New York for the County of New York. The suit alleges that the Board and former senior management breached fiduciary duties to AE that exposed AE to the securities class action lawsuits. On April 8, 2005, a second shareholder derivative action was filed against AE’s Board of Directors and several former senior managers and former directors. The action was filed in the U.S. District Court for the District of Maryland and consolidated with the securities class actions pending in that court. The Maryland derivative action contains allegations similar to the New York state court derivative action.

 

AE entered into agreements to settle the consolidated securities class action as well as the related shareholder derivative actions. The proposed settlements remain subject to a number of conditions, including court approval following notice to shareholders and class members. Under the proposed settlement in the consolidated securities class action, the action will be dismissed with prejudice in exchange for a cash payment of $15.05 million, which will be made by AE’s insurance carrier. Pursuant to the proposed settlement of the shareholder derivative actions, those actions will be dismissed with prejudice in exchange for a cash payment of $450,000, which will be made by AE’s insurance carrier, and AE’s agreement to adopt certain corporate governance changes. In connection with the settlements, AE and the other settling defendants continue to deny

 

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allegations of wrongdoing, and, if the settlements are approved, they will receive a full release of all claims asserted in the litigation. Pursuant to AE’s charter and bylaws and Section 2-418 of the Maryland General Corporation Law, AE has agreed to advance reasonable expenses to members of its Board of Directors in connection with the shareholder derivative actions.

 

In February and March 2003, two putative class action lawsuits were filed against AE in U.S. District Courts for the Southern District of New York and the District of Maryland. The suits alleged that AE and a senior manager violated ERISA by: (a) failing to provide complete and accurate information to plan beneficiaries regarding the energy trading business, among other things; (b) failing to diversify plan assets; (c) failing to monitor investment alternatives; (d) failing to avoid conflicts of interest and (e) violating fiduciary duties. The ERISA cases were consolidated in the District of Maryland. On April 26, 2004, the plaintiffs in the ERISA cases filed an amended complaint, adding a number of current and former directors of AE as defendants and clarifying the nature of their claims. On June 25, 2004, the defendants filed a motion to dismiss the amended complaint. Plaintiffs have opposed the motion and it remains outstanding. AE intends to vigorously defend against these actions but cannot predict their outcome.

 

Suits Related to the Gleason Generating Facility

 

Allegheny Energy Supply Gleason Generating Facility, LLC, a subsidiary of AE Supply, is the defendant in a suit brought in the Circuit Court for Weakley County, Tennessee, by residents living in the vicinity of the generation facility in Gleason, Tennessee. The original suit was filed on September 16, 2002. AE Supply purchased the generation facility in 2001. The plaintiffs are asserting claims based on trespass and/or nuisance, claiming personal injury and property damage as a result of noise from the generation facility. They seek a restraining order with respect to the operation of the plant and damages of $200 million. Mediation sessions were held on June 17, 2004 and February 22 and 23, 2006 but the parties did not reach settlement. AE has undertaken property purchases and other mitigation measures. AE intends to vigorously defend against this action but cannot predict its outcome.

 

AE Supply demanded indemnification from Siemens Westinghouse, the manufacturer of the turbines used in the Gleason Generating Facility, pursuant to the terms of the related equipment purchase agreement. On October 17, 2002, Siemens Westinghouse filed a declaratory judgment action in the Court of Common Pleas of Allegheny County, Pennsylvania, against AE Supply and its subsidiary seeking a declaration that the prior owner released Siemens Westinghouse from this liability through a release executed after AE Supply purchased the Gleason facility. On September 23, 2005, AE Supply entered into a confidential Settlement Agreement with Siemens Westinghouse that resolved various disputes between the parties. As a result, the declaratory judgment action filed by Siemens Westinghouse was dismissed with prejudice.

 

SEC Matters

 

On October 9, October 25 and November 5, 2002, AE received subpoenas from the SEC. The subpoenas principally concerned: (a) the departure of Daniel L. Gordon; (b) AE’s litigation with Merrill Lynch; (c) AE Supply’s valuation and management of its trading business; (d) AE’s November 4, 2002 press release concerning its financial statements; (e) the departure of AE’s and its subsidiaries’ Controller, Thomas Kloc, in June 2002 and (f) AE’s acquisition of power plants from Enron. AE and AE Supply responded to the subpoenas.

 

On January 16, 2004, the SEC requested that AE voluntarily produce certain documents in connection with an informal investigation of AE that focused on various accounting, internal control, and disclosure issues. In the course of its formal investigation, the SEC requested, and received, various documents. The SEC also took testimony from several current and former employees. Throughout the investigation, AE cooperated fully with the SEC. In its letter dated February 24, 2006, the SEC Division of Enforcement said, “This investigation has been terminated, and no enforcement action has been recommended to the Commission.”

 

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LTI Arbitration

 

On April 22, 2004, Leasing Technologies International, Inc. and its shareholders (collectively, “LTI”) filed a demand for arbitration against Allegheny Ventures and AE before the American Arbitration Association. In December 2000, Allegheny Ventures entered into an agreement to acquire LTI, an equipment leasing company. Allegheny Ventures terminated the agreement on May 4, 2001 based on the existence of a material adverse change under the agreement. LTI alleged that the termination of the agreement was unjustified and sought damages in an unspecified amount for breach of the agreement, as well as other consequential damages. On June 11, 2004, AE and Allegheny Ventures filed an answer to LTI’s demand, denying all claims. On December 15, 2005, AE and Allegheny Ventures entered into a settlement agreement with LTI pursuant to which they paid $15 million in exchange for a full release of all claims asserted by LTI and the dismissal with prejudice of the arbitration. The settlement does not constitute an admission of fault, and Allegheny continues to deny the allegations made by LTI in the arbitration.

 

Litigation with Mobotec

 

On July 20, 2004, MobotecUSA, Inc. (“MobotecUSA”) filed a lawsuit in the Court of Common Pleas of Greene County, Pennsylvania, against AE, AE Supply and an Allegheny employee (the “MobotecUSA Action”). Allegheny had contracted with MobotecUSA for the installation of NOx emissions reduction equipment at certain Allegheny facilities. MobotecUSA’s complaint alleged that AE and AE Supply had breached the contracts by failing to pay MobotecUSA approximately $3.3 million. The complaint also asserted claims for enforcement of mechanics’ liens and claims for (a) intentional interference with prospective business relations; (b) trade libel and defamation; (c) breach of the covenant of good faith and fair dealing; (d) unjust enrichment and quantum meruit; and (e) civil conspiracy. MobotecUSA alleges that Allegheny falsely told third parties that MobotecUSA was unsuccessful in installing equipment and claims that it lost approximately $50 million in prospective business as a result.

 

On September 9, 2004, AE and AE Supply filed an answer denying MobotecUSA’s claims and asserting a counterclaim for breach of contract based on MobotecUSA’s failure to achieve the emissions reduction levels guaranteed in the agreements. On September 23, 2005, MobotecUSA filed a Second Amended Complaint, which added AESC as a party and added claims for breaches of confidentiality agreements and misappropriation of trade secrets. The Allegheny defendants have filed an answer denying MobotecUSA’s claims. On October 19, 2005, AE Supply and Monongahela commenced in the Court of Common Pleas of Greene County, Pennsylvania, a separate but related action against MobotecUSA, Mobotec AB (MobotecUSA’s parent company) and certain individuals affiliated with Mobotec (the “Mobotec Parties”). This separate action was soon thereafter consolidated with the Mobotec Action for all purposes. In their amended complaint, AE Supply and Monongahela asserted claims for breach of contract, restitution, breach of warranty, negligence and negligent misrepresentation, based on Mobotec’s conduct. The Mobotec Parties have filed a motion seeking dismissal of certain claims and certain parties with respect to the amended complaint filed by AE Supply and Monongahela. Allegheny intends to vigorously defend against MobotecUSA’s claims and pursue its affirmative claims in the consolidated action, but cannot predict the outcome.

 

Ordinary Course of Business

 

The registrants and other entities within the Allegheny system are from time to time involved in litigation and other legal disputes in the ordinary course of business. Each registrant is of the belief that there are no other legal proceedings that could have a material adverse effect on its business or financial condition.

 

ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

No matters were submitted to a vote of security holders of AE, AGC, Monongahela or Potomac Edison during the fourth quarter of 2005.

 

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PART II

 

ITEM 5.    MARKET FOR THE REGISTRANTS’ COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

 

AE’s common stock is publicly traded. There are no established trading markets for the common equity securities of AGC, Monongahela or Potomac Edison.

 

AE

 

“AYE” is the trading symbol for AE’s common stock on the New York, Chicago and Pacific Stock Exchanges. As of February 24, 2006, there were 25,722 holders of record of AE’s common stock. The table below shows the high and low sales prices of AE’s common stock on the New York Stock Exchange for the periods indicated:

 

     2005

   2004

     High

   Low

   High

   Low

1st Quarter

   $ 21.28    $ 18.25    $ 13.96    $ 11.75

2nd Quarter

   $ 25.85    $ 20.28    $ 15.46    $ 13.00

3rd Quarter

   $ 31.35    $ 25.25    $ 16.20    $ 13.99

4th Quarter

   $ 32.32    $ 26.40    $ 20.20    $ 15.60

 

AE did not pay any dividends on its common stock during 2004 or 2005.

 

In July 2003, AE’s Board of Directors voted to redeem the share purchase rights issued under AE’s Stockholder Protection Rights Agreement (the “Rights Agreement”). AE terminated the Rights Agreement, effective December 6, 2004, and the share purchase rights issued under it became null and void.

 

Monongahela

 

AE owns 100% of the outstanding shares of common stock of Monongahela. Monongahela did not pay dividends on its common stock in 2005. Monongahela paid dividends on its common stock of approximately $8.2 million, $5.0 million, $9.0 million and $11.0 million on March 31, 2004, June 30, 2004, September 30, 2004 and December 31, 2004, respectively. Monongahela’s charter limits the payment of dividends on common stock.

 

Potomac Edison

 

AE owns 100% of the outstanding common stock of Potomac Edison. Potomac Edison paid dividends on its common stock of approximately $21.0 million, $10.0 million, $16.0 million and $16.0 million on March 31, 2005, June 30, 2005, September 30, 2005 and December 31, 2005, respectively. Potomac Edison paid dividends on its common stock of approximately $8.7 million, $8.1 million, $12.1 million and $14.1 million on March 31, 2004, June 30, 2004, September 30, 2004 and December 31, 2004, respectively.

 

AGC

 

Monongahela and AE Supply own approximately 23% and 77%, respectively, of the outstanding shares of common stock of AGC. AGC paid dividends on its common stock of approximately $7.2 million, $9.0 million and $5.6 million on June 30, 2005, September 30, 2005 and December 31, 2005, respectively. AGC did not pay a dividend on its common stock for the first quarter of 2005. AGC paid dividends on its common stock of approximately $5.5 million and $7.0 million on March 31, 2004 and June 30, 2004, respectively. AGC did not pay any dividends on its common stock for the third and fourth quarters of 2004.

 

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ITEM 6.    SELECTED FINANCIAL DATA

 

     Page No.

Allegheny Energy, Inc. and Subsidiaries

   50

Monongahela Power Company and Subsidiaries

   51

The Potomac Edison Company and Subsidiaries

   51

Allegheny Generating Company

   52

 

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ITEM 6.    SELECTED FINANCIAL DATA

 

ALLEGHENY ENERGY, INC. AND SUBSIDIARIES

 

Year ended December 31, (a)


   2005

    2004

    2003

    2002

    2001

 

(In millions except per share data)


                              

Operating revenues

   $ 3,037.9     $ 2,756.1     $ 2,182.3     $ 2,743.8     $ 3,165.3  

Operating expenses

   $ 2,501.1     $ 2,166.9     $ 2,378.7     $ 3,216.4     $ 2,214.1  

Operating income (loss)

   $ 536.8     $ 589.2     $ (196.4 )   $ (472.6 )   $ 951.2  

Income (loss) from continuing operations

   $ 75.1     $ 129.7     $ (308.9 )   $ (465.8 )   $ 458.1  

Loss from discontinued operations

   $ (6.1 )   $ (440.3 )   $ (25.3 )   $ (36.4 )   $ (9.2 )

Net income (loss)

   $ 63.1     $ (310.6 )   $ (355.0 )   $ (632.7 )   $ 417.8  

Earnings per share:

                                        

Income (loss) from continuing operations,
net of tax

                                        

—basic

   $ 0.48     $ 1.00     $ (2.44 )   $ (3.71 )   $ 3.81  

—diluted

   $ 0.47     $ 0.99     $ (2.44 )   $ (3.71 )   $ 3.80  

Loss from discontinued operations,
net of tax

                                        

—basic

   $ (0.04 )   $ (3.40 )   $ (0.20 )   $ (0.29 )   $ (0.07 )

—diluted

   $ (0.04 )   $ (2.82 )   $ (0.20 )   $ (0.29 )   $ (0.07 )

Net income (loss)

                                        

—basic

   $ 0.40     $ (2.40 )   $ (2.80 )   $ (5.04 )   $ 3.48  

—diluted

   $ 0.40     $ (1.83 )   $ (2.80 )   $ (5.04 )   $ 3.47  

Dividends declared per share

   $ —       $ —       $ —       $ 1.29     $ 1.72  

Short-term debt

   $ —       $ —       $ 53.6     $ 1,132.0     $ 1,238.7  

Long-term debt due within one year (b)

     477.2       385.1       544.9       257.2       353.1  

Debentures, notes and bonds (b)

     —         —         —         3,662.2       —    
    


 


 


 


 


Total short-term debt (b)

   $ 477.2     $ 385.1     $ 598.5     $ 5,051.4     $ 1,591.8  
    


 


 


 


 


Long-term debt and quarterly income debt securities (b)

   $ 3,624.5     $ 4,540.8     $ 5,127.4     $ 115.9     $ 3,200.4  

Capital leases

     16.4       23.8       32.5       39.1       35.3  
    


 


 


 


 


Total long-term obligations (b)

   $ 3,640.9     $ 4,564.6     $ 5,159.9     $ 155.0     $ 3,235.7  
    


 


 


 


 


Total assets

   $ 8,558.8     $ 9,045.1     $ 10,171.9     $ 10,973.2     $ 11,032.5  
    


 


 


 


 



Notes:

(a)   In 2004, Allegheny decided to sell certain non-core assets. The results of operations related to these assets have been reclassified to discontinued operations for all prior periods presented. See Note 3, “Discontinued Operations and Assets Held for Sale,” to the Consolidated Financial Statements for additional information.
(b)   Long-term debt at December 31, 2002 of $3,662.2 million was classified as short-term as a result of debt covenant violations. As of December 31, 2003, the violations had been waived or cured and the debt was classified as long-term.

 

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MONONGAHELA POWER COMPANY AND SUBSIDIARIES

 

Year ended December 31, (a)


   2005

   2004

    2003

   2002

    2001

(In millions)


                          

Operating revenues

   $ 789.9    $ 683.8     $ 718.9    $ 695.5     $ 704.9

Operating expenses

   $ 765.0    $ 637.0     $ 633.8    $ 621.5     $ 561.0

Operating income

   $ 24.9    $ 46.8     $ 85.1    $ 74.0     $ 143.9

Income from continuing operations

   $ 9.2    $ 16.4     $ 72.0    $ 32.4     $ 79.3

Income (loss) from discontinued operations

   $ 1.0    $ (13.9 )   $ 9.2    $ 1.3     $ 10.2

Net income (loss)

   $ 10.2    $ 2.5     $ 80.7    $ (81.7 )   $ 89.5

Short-term debt

   $ —      $ —       $ 53.6    $ —       $ 14.3

Long-term debt due within one year (b)

     300.0      —         3.4      65.9       30.4

Notes and bonds (b)

     —        —         —        690.1       —  
    

  


 

  


 

Total short-term debt (b)

   $ 300.0    $ —       $ 57.0    $ 756.0     $ 44.7
    

  


 

  


 

Long-term debt (b)

   $ 385.1    $ 684.0     $ 715.5    $ 28.5     $ 784.3

Capital leases

     5.6      8.7       12.2      14.3       11.6
    

  


 

  


 

Total long-term obligations (b)

   $ 390.7    $ 692.7     $ 727.7    $ 42.8     $ 795.9
    

  


 

  


 

Total assets

   $ 1,859.2    $ 2,081.4     $ 2,073.1    $ 2,042.2     $ 2,017.2
    

  


 

  


 


Notes:

(a)   In 2004, Monongahela decided to sell certain non-core assets. The results of operations related to these assets have been reclassified to discontinued operations for all prior periods presented, as applicable. See Note 3, “Discontinued Operations and Assets Held for Sale,” to Monongahela’s Consolidated Financial Statements for additional information.
(b)   Long-term debt at December 31, 2002 of $690.1 million was classified as short-term as a result of debt covenant violations. As of December 31, 2003, the violations had been waived or cured and the debt was classified as long-term.

 

THE POTOMAC EDISON COMPANY AND SUBSIDIARIES

 

Year ended December 31,


   2005

   2004

   2003

   2002

   2001

(In millions)


                        

Operating revenues

   $ 971.2    $ 924.4    $ 905.2    $ 870.2    $ 864.5

Operating expenses

   $ 851.1    $ 826.0    $ 833.9    $ 789.8    $ 752.3

Operating income

   $ 120.1    $ 98.4    $ 71.3    $ 80.4    $ 112.2

Net income

   $ 66.4    $ 38.0    $ 40.5    $ 32.7    $ 48.0

Short-term debt

   $ —      $ —      $ —      $ —      $ 24.2

Long-term debt due within one year

     100.0      —        —        —        —  

Notes and bonds (a)

     —        —        —        416.0      —  
    

  

  

  

  

Total short-term debt (a)

   $ 100.0    $ —      $ —      $ 416.0    $ 24.2
    

  

  

  

  

Long-term debt (a)

   $ 318.6    $ 417.9    $ 416.3    $ —      $ 415.8

Capital leases

     4.7      6.2      8.5      10.3      9.2
    

  

  

  

  

Total long-term obligations (a)

   $ 323.3    $ 424.1    $ 424.8    $ 10.3    $ 425.0
    

  

  

  

  

Total assets

   $ 1,366.4    $ 1,365.6    $ 1,341.7    $ 1,309.6    $ 1,110.4
    

  

  

  

  


Notes:

(a)   Long-term debt at December 31, 2002 of $416.0 million was classified as short-term as a result of debt covenant violations. As of December 31, 2003 the violations were waived or cured, and the debt was classified as long-term.

 

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ALLEGHENY GENERATING COMPANY

 

Year ended December 31,


   2005

   2004

   2003

   2002

   2001

(In millions)


                        

Operating revenues

   $ 66.6    $ 69.2    $ 70.5    $ 64.1    $ 68.5

Operating expenses

   $ 24.8    $ 26.1    $ 25.4    $ 25.8    $ 25.5

Operating income

   $ 41.9    $ 43.1    $ 45.1    $ 38.3    $ 43.0

Net income

   $ 31.1    $ 27.4    $ 20.8    $ 18.6    $ 20.3

Short-term debt

   $ —      $ —      $ —      $ 55.0    $ —  

Long-term debt due within one year

     —        —        —        50.0      —  

Debentures (a)

     —        —        —        99.3      —  
    

  

  

  

  

Total short-term debt (a)

   $ —      $ —      $ —      $ 204.3    $ —  
    

  

  

  

  

Long-term debt (a)

   $ 99.4    $ 99.4    $ 99.4    $ —      $ 149.2

Long-term note payable to parent

     —        15.0      30.0      —        —  
    

  

  

  

  

Total long-term obligations (a)

   $ 99.4    $ 114.4    $ 129.4    $ —      $ 149.2
    

  

  

  

  

Total assets

   $ 550.2    $ 557.2    $ 562.4    $ 597.6    $ 591.6
    

  

  

  

  


Notes:

(a)   Long-term debt at December 31, 2002 of $99.3 million was classified as short-term as a result of debt covenant violations. As of December 31, 2003 the violations were waived or cured, and the debt was classified as long-term.

 

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

 

     Page No.

EXECUTIVE SUMMARY:

    

Business Overview

   54

Key Indicators and Performance Factors

   58

Operating Statistics

   60

Primary Factors Affecting Allegheny’s Performance

   60

Critical Accounting Policies and Estimates

   61

RESULTS OF OPERATIONS:

    

Allegheny Energy, Inc. and Subsidiaries

   64

Monongahela Power Company and Subsidiaries

   83

The Potomac Edison Company and Subsidiaries

   94

Allegheny Generating Company

   99

FINANCIAL CONDITION, REQUIREMENTS AND RESOURCES:

    

Liquidity and Capital Requirements

   101

2005 Asset Sales

   105

2004 Asset Sales

   106

Anticipated Asset Sales

   106

Dividends

   106

Other Matters Concerning Liquidity and Capital Requirements

   106

Cash Flows

   111

Financing

   116

Change in Credit Ratings

   117

Derivative Instruments and Hedging Activities

   119

RECENT ACCOUNTING PRONOUNCEMENTS

   119

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK:

    

Allegheny Energy, Inc. and Subsidiaries

   121

Monongahela Power Company and Subsidiaries

   122

The Potomac Edison Company and Subsidiaries

   123

Allegheny Generating Company

   123

 

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

 

Overview

 

Allegheny is an integrated energy business that owns and operates electric generation facilities and delivers electric services to customers in Pennsylvania, West Virginia, Maryland and Virginia. Allegheny operates its business primarily through AE’s various directly and indirectly owned subsidiaries.

 

Allegheny has two business segments:

 

    The Delivery and Services segment includes Allegheny’s electric T&D operations.

 

    The Generation and Marketing segment includes Allegheny’s power generation operations.

 

Allegheny also conducted electric T&D operations in Ohio and natural gas T&D operations in West Virginia until it sold these operations as of December 31, 2005 and September 30, 2005, respectively. Monongahela agreed to sell power at a fixed price to Columbus Southern to serve its former Ohio customers until May 31, 2007. See “Liquidity and Capital Resources—2005 Asset Sales” below.

 

The Delivery and Services Segment

 

The principal companies and operations in AE’s Delivery and Services segment include the following:

 

    The Distribution Companies include Monongahela (excluding its West Virginia generation assets), Potomac Edison and West Penn. Each of the Distribution Companies is a public utility company and does business under the trade name Allegheny Power. Allegheny Power’s principal business is the operation of electric public utility systems.

 

    Monongahela conducts an electric T&D business in northern West Virginia. Monongahela also has generation assets, which are included in the Generation and Marketing Segment. See “The Generation and Marketing Segment” below. Monongahela also conducted electric T&D operations in Ohio and natural gas T&D operations in West Virginia until it sold the assets related to these operations as of December 31, 2005 and September 30, 2005, respectively. Monongahela agreed to sell power to Columbus Southern to serve Monongahela’s former Ohio customers until May 31, 2007.

 

    Potomac Edison operates an electric T&D system in portions of West Virginia, Maryland and Virginia.

 

    West Penn operates an electric T&D system in southwestern, south-central and northern Pennsylvania.

 

In April 2002, the Distribution Companies transferred operational control over their transmission systems to PJM. See “The Distribution Companies’ Obligations and the PJM Market” below.

 

    Allegheny Ventures is a nonutility, unregulated subsidiary of AE that engages in telecommunications and unregulated energy-related projects. Allegheny Ventures has two principal wholly-owned subsidiaries, ACC and AE Solutions. ACC develops fiber-optic projects, including fiber and data services. AE Solutions manages energy-related projects.

 

The Generation and Marketing Segment

 

The principal companies and operations in AE’s Generation and Marketing segment include the following:

 

    AE Supply owns, operates and manages electric generation facilities. AE Supply also purchases and sells energy and energy-related commodities. AE Supply markets its electric generation capacity to various customers and markets. Currently, the majority of the Generation and Marketing segment’s normal operating capacity is committed to supplying the PLR and other obligations of the Distribution Companies.

 

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    Monongahela’s West Virginia generation assets are included in the Generation and Marketing segment. Currently, the majority of Monongahela’s Generation and Marketing segment’s normal operating capacity is committed to supplying Monongahela’s Delivery and Services segment.

 

    AGC is owned approximately 77% by AE Supply and approximately 23% by Monongahela. AGC’s sole asset is a 40% undivided interest in the Bath County, Virginia pumped-storage hydroelectric station and its connecting transmission facilities. All of AGC’s revenues are derived from sales of its 1,010 MWs share of generation capacity from the Bath County generation station to AE Supply and Monongahela.

 

AE Supply is obligated under contracts with Potomac Edison and West Penn to provide Potomac Edison and West Penn with the power that they need to meet a majority of their PLR obligations. AE Supply sells power into the PJM market and purchases power from the PJM market to meet its obligations under these contracts. See “The Distribution Companies’ Obligations and the PJM Market” below.

 

Although most of the Generation and Marketing segment’s generation capacity is sold into the PJM market, its generation facility in Gleason, Tennessee is outside of PJM. The Gleason generation facility has been classified as held for sale, and its results have been presented as discontinued operations in the accompanying Consolidated Statements of Operations.

 

For more information regarding the AE segments and subsidiaries discussed above, see “Business—Overview.”

 

Intersegment Services

 

AESC was incorporated in Maryland in 1963 as a service company for AE. AESC employs substantially all of the employees who provide services to AE, AE Supply, AGC, the Distribution Companies, Allegheny Ventures and their respective subsidiaries. These companies reimburse AESC at cost for services provided to them by AESC’s employees. AESC had approximately 4,460 employees as of December 31, 2005.

 

The Distribution Companies’ Obligations and the PJM Market

 

Allegheny’s business has been significantly influenced by state and federal deregulation initiatives, including the implementation of retail choice and plans to transition from cost-based to market-based rates, as well as by the development of wholesale electricity markets and RTOs, particularly PJM.

 

Each of the states in Allegheny’s service territory other than West Virginia has, to some extent, deregulated its electric utility industry. Pennsylvania, Maryland and Virginia have instituted retail customer choice and are transitioning to market-based, rather than cost-based pricing for generation. In West Virginia, the rates charged to retail customers are regulated by the West Virginia PSC and are determined through traditional, cost-based, regulated utility rate-making.

 

West Penn has PLR obligations to its customers in Pennsylvania. Potomac Edison has PLR obligations to its customers in Virginia and its residential customers in Maryland. As “providers of last resort,” West Penn and Potomac Edison must supply power to certain retail customers who have not chosen alternative suppliers (or have chosen to return to Allegheny service) at rates that are capped at various levels during the applicable transition period. The transition periods vary across Allegheny’s service area and across customer class:

 

   

Potomac Edison.  In Maryland, the transition period for residential customers ends on December 31, 2008. The transition period for commercial and industrial customers ended on December 31, 2004. The generation rates that Potomac Edison charges residential customers in Maryland are capped through December 31, 2008, while the T&D rate caps for all customers expired on December 31, 2004. A

 

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statewide settlement approved by the Maryland PSC in 2003 extends Potomac Edison’s obligation to provide SOS at market based rates beyond the expiration of the transition periods. In Virginia, the transition period ends on December 31, 2010. For a more detailed discussion, see “Regulatory Framework Affecting Allegheny” above.

 

    West Penn.  In Pennsylvania, the transition period terminates on December 31, 2010. As part of a May 11, 2005 order approving a settlement, the Pennsylvania PUC extended Pennsylvania’s generation rate caps from 2008 to 2010. The settlement approved by the Pennsylvania PUC also extended distribution rate caps from 2005 to 2007, with an additional rate cap in place for 2009 at the rate in effect on January 1, 2009, and provided for increases in generation rates in 2007, 2009 and 2010, in addition to previously-approved increases for 2006 and 2008. Rate caps on transmission services expired on December 31, 2005.

 

These transition periods could be altered by legislative, judicial or, in some cases, regulatory actions. See “Regulatory Framework Affecting Allegheny” above.

 

Potomac Edison and West Penn have contracts with AE Supply under which AE Supply provides Potomac Edison and West Penn with the majority of the power necessary to meet their PLR obligations. All but one of Allegheny’s generation facilities are located within the PJM region, and virtually all of the power that the Generation and Marketing segment generates is sold into the PJM market. AE Supply sells the power that it generates into the PJM market and purchases from the PJM market the power necessary to meet its obligations to supply power. Prevailing market prices are generally higher than the capped rates currently applicable to most of these PLR obligations.

 

To facilitate the economic dispatch of its generation, Monongahela sells the power that it generates from its West Virginia jurisdictional assets to AE Supply at PJM market prices, and that power is then sold into the PJM market. Monongahela purchases from AE Supply, at PJM market prices, the power necessary to meet its West Virginia jurisdictional customer load.

 

In connection with the sale of its electric T&D operations in Ohio, Monongahela agreed to sell power at a fixed price to Columbus Southern to serve Monongahela’s former Ohio customers through May 2007. Monongahela currently purchases the power required to meet this obligation from the PJM market.

 

As an RTO, PJM coordinates the movement of electricity over the transmission grid in 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.

 

Strategy

 

Allegheny’s long-term strategy is to focus on its core generation and T&D businesses. Allegheny’s management believes that this emphasis is enabling Allegheny to take advantage of its regional presence, operational expertise and knowledge of its markets.

 

Prior to 1999, Allegheny functioned as an integrated regulated utility within its service area. In response to federal and state deregulation initiatives, however, Allegheny separated part of its energy generation business from its T&D business by transferring a portion of its generation assets to AE Supply. Allegheny’s former senior management sought to transform AE Supply into a national power merchant in order to capitalize on these regulatory and other energy industry trends. As part of this strategy, AE Supply acquired generation assets, which collectively expanded Allegheny’s owned or controlled generation capacity by nearly one-third. AE Supply also began construction of new generation facilities. In addition, AE Supply purchased the energy trading division of Merrill Lynch in 2001. With this acquisition, the focus of AE Supply’s energy trading shifted from asset backed, short-term trading in and around its generation assets to more speculative trading activities. This expansion was financed primarily through debt. Beginning in 2002, difficult market conditions, changes in the regulatory environment and Allegheny’s worsening credit profile placed Allegheny in a weakened financial position. Beginning in June 2003, Allegheny’s new senior management implemented recovery plans and new long-term strategies.

 

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Significant recent achievements include:

 

    Focusing on the Core Business.  Allegheny has reoriented its business to focus on its core businesses and assets. In 2005 and 2004, Allegheny completed a number of significant sales of non-core assets, including:

 

    the September 2005 sale by Monongahela of its West Virginia natural gas T&D business for cash proceeds of approximately $161 million and the assumption by the purchaser of approximately $87 million of debt;

 

    the August 2005 sale by AE Supply of its Wheatland generation facility for approximately $100 million;

 

    the December 2004, sale by AE Supply of its 672 MWs natural gas-fired Lincoln generation facility and an accompanying tolling agreement for approximately $175 million; and

 

    the December 2004, sale by AE of a 9% interest in OVEC (AE continues to hold a 3.5% interest in OVEC) for $102 million in cash, $96 million of which was received at the closing of the transaction and the remaining $6 million of which is expected to be received in April 2006, upon the satisfaction of certain conditions.

 

       In addition, in December 2005 Monongahela sold its electric T&D business in Ohio for net cash proceeds of approximately $52 million.

 

       Allegheny also exited its speculative trading activities in the Western U. S. and other energy markets in 2003 through, among other transactions, the sale of AE Supply contract with the CDWR and related hedge transactions to J. Aron & Company, as subsidiary of The Goldman Sachs Group, Inc., for $354 million. Allegheny continues to pursue the disposition of additional non-core assets, including its Gleason generating facility. See “Liquidity and Capital Resources” below and Note 4, “Asset Sales,” to the Consolidated Financial Statements.

 

         In addition, Allegheny has announced a proposal to build the Trans-Allegheny Interstate Line. The proposed 500-kV line will span approximately 330 miles, all within Allegheny’s region of the PJM market, the APS Zone, from the Weirton, West Virginia area to near Kemptown, Maryland. The proposed line is subject to approval by PJM, as well as to various regulatory approvals. Initial engineering and planning is expected to begin in 2007, with the first segment in place in 2013. The projected cost is approximately $1.4 billion.

 

    Substantially Reducing and Proactively Managing Debt.  Between December 1, 2003 and December 31, 2005, Allegheny restructured much of its debt and reduced debt by approximately $1.9 billion, significantly exceeding its goal of reducing debt by $1.5 billion during this period. This restructuring effort included debt reductions of approximately $920 million in 2005 alone.

 

       Through these restructuring efforts, Allegheny secured more favorable terms and conditions with respect to much of its debt, including reduced interest rates. The refinancings undertaken by Allegheny since 2003, together with lower debt balances, yielded a reduction in adjusted interest expense from 2004 to 2005 of approximately $60 million. The reductions in interest expense, coupled with the reductions in debt and general improvements in Allegheny’s financial condition, have led to multiple upgrades of Allegheny’s credit ratings. See “Changes in Credit Ratings” below and Note 2, “Capitalization,” to the Consolidated Financial Statements.

 

    Improving Liquidity.  Allegheny has improved its liquidity through prudent cash management, opportunistic sales of non-core assets, cutting costs and expenses, extending debt maturities and other financing strategies. The 2004 refinancing of AE’s credit facility established a revolving credit facility for AE, and an additional refinancing of that facility in 2005 doubled the size of the revolving credit facility. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources” below and Note 2, “Capitalization,” to the Consolidated Financial Statements.

 

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    Maximizing Operational Efficiency.  Allegheny is working to maximize the availability and operational efficiency of its physical assets, particularly its supercritical generation facilities (those that utilize steam pressure in excess of 3,200 pounds per square inch). Allegheny also is seeking to optimize operations and maintenance costs for its other generation facilities, T&D assets and related corporate functions, to reduce costs and to pursue other productivity improvements necessary to build a high performance organization.

 

       For example, as part of a program to improve its processes and technology, AE entered into a Professional Services agreement in September 2005, under which, on November 1, 2005, the Service Provider assumed responsibility for many of Allegheny’s information technology functions. The Service Provider also will assist with the implementation of an enterprise resource planning system. Additionally, Allegheny has entered into various coal supply contracts in an effort to ensure a consistent supply of coal at predictable prices, and currently has contracts in place for the delivery of approximately 98% of its expected coal needs for 2006. See “Business—Fuel, Power and Resource Supply.”

 

    Maximizing Generation Value.  Allegheny is working to maximize the value of the power that it generates by ensuring full recovery of its costs and a reasonable return through the traditional rate-making process for its regulated utilities, as well as through the transition to market prices rates for AE Supply and its subsidiaries.

 

       For example, in April 2005, Allegheny obtained approval from the Pennsylvania PUC for increases in applicable generation rate caps in 2007, 2009 and 2010 in connection with a two-year extension of the period during which Pennsylvania customers will transition to market prices. Together with previously approved rate cap increases for 2006 and 2008, these increases will gradually move generation rates in Pennsylvania closer to market prices. In addition, AE Supply won the contracts to serve the PLR customer load in Pennsylvania in 2009 and 2010 and entered into contracts to provide power to Potomac Edison to serve commercial, industrial and municipal customer loads in Maryland. See “Business—Fuel, Power and Resource Supply” and “Business—Regulatory Matters Affecting Allegheny.”

 

    Managing Environmental Compliance and Risks.  Allegheny is working to effectively manage its environmental compliance efforts to ensure continuing compliance with applicable federal and state regulations while controlling its compliance costs, reducing emissions levels and minimizing its risk exposure. Among other initiatives, AE Supply and Monongahela are currently blending lower-sulfur Powder River Basin coal at several generation facilities and are working to implement the financing and construction of flue gas desulfurization units and related pollution control equipment at the Fort Martin generation facility in West Virginia and the Hatfield generation facility in Pennsylvania, as well as other pollution control projects at other facilities. See “Business—Environmental Matters” and “Business—Proposed Asset Swap and Securitization.”

 

Allegheny’s management believes that it can continue to build on these successes in 2006 through ongoing debt reduction and other financial improvement efforts, further initiatives to improve operational efficiency and maximize generation value and continued environmental stewardship.

 

Key Indicators and Performance Factors

 

The Delivery and Services Segment

 

Allegheny monitors the financial and operating performance of its Delivery and Services segment using a number of indicators and performance statistics, including the following:

 

Revenue per MWh sold.    This measure is calculated by dividing total revenues from retail sales of electricity by total MWhs sold to retail customers. Revenue per MWh sold in 2005, 2004 and 2003 was as follows:

 

     2005

   2004

   2003

Revenue per MWh sold

   $ 55.32    $ 54.48    $ 54.44

 

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Operations and maintenance costs (“O&M”).    Management closely monitors and manages O&M in absolute terms, as well as in relation to total revenues.

 

Capital expenditures.    Management manages and prioritizes capital expenditures to meet operational needs and regulatory requirements within available cash flow constraints.

 

The Generation and Marketing Segment

 

Allegheny monitors the financial and operating performance of its Generation and Marketing segment using a number of indicators and performance statistics, including the following:

 

kWhs generated.    This is a measure of the total physical quantity of electricity generated and is monitored at the individual unit level, as well as various unit groupings.

 

Equivalent availability factor (“EAF”).    The EAF measures the percentage of time that a generation unit is available to generate electricity if called upon in the marketplace. A unit’s availability is commonly less than 100%, primarily as a result of unplanned outages or scheduled outages for planned maintenance. Allegheny monitors EAF by individual unit, as well as by various unit groupings. One such grouping is all “supercritical” units. A supercritical unit utilizes steam pressure in excess of 3,200 pounds per square inch. This design characteristic enables these units to be larger and more efficient than other generation units. Fort Martin, Harrison, Hatfield’s Ferry and Pleasants are supercritical generation facilities that have supercritical units. These units generally operate at high capacity for extended periods of time.

 

Station operations and maintenance costs (“Station O&M”).    Station O&M includes base maintenance, operations and special maintenance costs. Base maintenance and operations costs consist of normal recurring expenses related to the day-to-day on-going operation of the generation facility. Special maintenance includes outage related maintenance and projects that relate to all of the generating facilities.

 

Capital expenditures.    Management manages and prioritizes capital expenditures to meet operational needs and regulatory requirements within available cash flow constraints.

 

The following table shows EAFs and Station O&M for supercritical units and for all generating units:

 

     2005

    2004

    2003

 

Supercritical Units:

                        

EAF

     82.8 %     75.6 %     78.1 %

Station O&M: (in millions)

                        

Base

   $ 118.3     $ 117.4     $ 118.4  

Special

     77.5 *     99.5       75.9  
    


 


 


Total Station O&M

   $ 195.8     $ 216.9     $ 194.3  
    


 


 


All Generation Units:

                        

EAF

     85.4 %     82.4 %     83.8 %

Station O&M: (in millions)

                        

Base

   $ 190.0     $ 189.0     $ 179.8  

Special

     96.3 *     125.6       89.0  
    


 


 


Total Station O&M

   $ 286.3     $ 314.6     $ 268.8  
    


 


 



*   Amounts are net of insurance recoveries of $17.7 million related to Hatfield’s Ferry.

 

Contracted coal position.    This measure represents the number of tons of coal under firm purchase contracts in force, expressed as a percentage of the estimated quantity of coal that will be consumed in that same future period. As of February 22, 2006, Allegheny’s contracted coal positions for 2006, 2007 and 2008 were approximately 98%, 85% and 70%, respectively.

 

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Operating Statistics

 

The following table provides kWh sales information for electricity.

 

     2005

   2004

   2003

   2005
% Increase
(Decrease)


    2004
% Increase
(Decrease)


 

Delivery and Services:

                           

kWhs sold (in millions) (a)

   48,276    47,222    46,514    2.2 %   1.5 %

Usage per average number of customers (kWhs):

                           

Residential

   12,538    12,038    11,835    4.2 %   1.7 %

Commercial

   61,458    59,757    58,713    2.8 %   1.8 %

Industrial

   739,892    759,305    749,959    (2.6 )%   1.2 %

HDD (b)

   5,333    5,205    5,622    2.5 %   (7.4 )%

CDD (b)

   1,087    789    663    37.8 %   19.0 %

(a)   Includes retail and wholesale.
(b)   Heating degree-days (“HDD”) and cooling degree-days (“CDD”).    The operations of the Distribution Companies are weather sensitive. Weather conditions directly influence the volume of electricity delivered by the Distribution Companies but represent only one of several factors that impact the volume of electricity. Accordingly, deviations in weather from normal levels can affect Allegheny’s financial performance. HDD and CDD are most likely to impact the usage of Allegheny’s residential and commercial customers. Industrial customers are less weather sensitive. Degree-day data is used to estimate amounts of energy required to maintain comfortable indoor temperature levels based on each day’s average temperature. HDD is the measure of the variation in the weather based on the extent to which the average daily temperature falls below 65° Fahrenheit, and CDD is the measure of the variation in the weather based on the extent to which the average daily temperature rises above 65° Fahrenheit. Each degree of temperature above 65° Fahrenheit is counted as one cooling degree-day, and each degree of temperature below 65° Fahrenheit is counted as one heating degree-day. Normal (historical) HDD are 5,605 and normal (historical) CDD are 776, calculated on a weighted-average basis across the geographic areas served by the Distribution Companies.

 

     2005

   2004

   2003

   2005
% Increase
(Decrease)


    2004
% Increase
(Decrease)


 

Generation and Marketing:

                           

kWhs generated (in millions)

   48,100    46,162    48,334    4.2 %   (4.5 )%

 

Primary Factors Affecting Allegheny’s Performance

 

The principal business, economic and other factors that affect Allegheny’s operations and financial performance include:

 

    changes in regulatory policies and rates,

 

    changes in the competitive electricity marketplace,

 

    coal plant availability,

 

    weather conditions,

 

    environmental compliance costs,

 

    changes in the PJM market, rules and policies,

 

    availability and access to liquidity and changes in interest rates,

 

    cost of fuel (natural gas and coal),

 

    wholesale commodity prices and

 

    labor costs.

 

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Critical Accounting Policies and Estimates

 

Use of Estimates:  Allegheny prepares its financial statements in accordance with GAAP. Application of these accounting principles often requires the use of estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosure of contingencies during the reporting period. Allegheny regularly evaluates its estimates, including those related to the calculation of the fair value of commodity contracts and derivative instruments, unbilled revenues, goodwill, provisions for depreciation and amortization, regulatory assets, income taxes, pensions and other postretirement benefits and contingencies related to environmental matters and litigation. Allegheny bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. In the normal course of business, estimated amounts are subsequently adjusted to actual results that may differ from the estimates.

 

Commodity Contracts:  AE Supply records any commodity contract related to energy trading that is a derivative instrument at its fair value as a component of operating revenues, unless the contract falls within the “normal purchases and normal sales” scope exception of SFAS No. 133 or is designated as a hedge for accounting purposes. The normal purchases and normal sales scope exception requires, among other things, physical delivery in quantities expected to be used or sold over a reasonable period in the normal course of business. Contracts that are designated as normal purchases and normal sales are accounted for under accrual accounting and, therefore, are not recorded on the balance sheet at fair value. For certain transactions that are designed to hedge the cash flows of a forecasted transaction, the effective portion of the hedge is recorded as a separate component of stockholders’ equity under the caption “Accumulated other comprehensive income (loss)” and subsequently reclassified into earnings when the forecasted transaction is completed or settled. The ineffective portion of the hedge is immediately reflected in earnings.

 

Fair values for exchange-traded instruments, principally futures and certain options, are based on quoted market prices. In establishing the fair value of commodity contracts that do not have quoted market prices, such as physical contracts, over-the-counter options and swaps, management makes estimates using available market data and pricing models. Factors such as commodity price risk, operational risk and credit risk of counterparties are evaluated in establishing the fair value of commodity contracts. The commodity contracts include certain financial instruments, such as interest rate swaps, which are used to mitigate the effect of interest rate changes.

 

Allegheny had unique contracts due to their long-term nature and terms that were valued using proprietary pricing models prior to 2004. Inputs to the models included estimated forward natural gas and power prices, interest rates, estimates of market volatility for natural gas and power prices and the correlation of natural gas and power prices. These inputs depended heavily on judgments and assumptions by management. These inputs became more difficult to predict, and the models became less precise, the further into the future these estimates were made. There may have been an adverse effect on Allegheny’s financial position and results of operations if the judgments and assumptions underlying those models’ inputs proved to be wrong or inaccurate. Exposure to these types of contracts has declined significantly as a result of AE Supply’s 2003 exit from the Western U.S. energy markets. Approximately $0.7 million of Allegheny’s contracts were classified as “prices based on models” at December 31, 2005.

 

See Note 5, “Derivative Instruments and Hedging Activities,” to the Consolidated Financial Statements and “Financial Condition, Requirements and Resources—Derivative Instruments and Hedging Activities” below, for additional information regarding Allegheny’s accounting for derivative instruments under SFAS No. 133.

 

Excess of Cost Over Net Assets Acquired (Goodwill):  The goodwill of $367.3 million at December 31, 2005 and 2004 was attributable to the Generation and Marketing segment. There were no additions to, or disposals of, goodwill during 2005 and 2004. Allegheny tests goodwill for impairment at least annually. The annual impairment test used a discounted cash flow methodology to determine the fair value of the Generation and Marketing segment and indicated no impairment of goodwill. This test result reflects that AE Supply’s fleet of generation facilities, comprised primarily of low-cost coal-fired steam generation facilities, has a fair value in excess of the carrying value of those assets sufficient to cover goodwill associated with the 2001 acquisition of the energy trading business, and no impairment of goodwill is required.

 

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Revenue Recognition:  Allegheny follows the accrual method of accounting for revenues and recognizes revenue for electricity that has been delivered to customers but not yet billed through the end of its accounting period. Unbilled revenues are primarily associated with the Distribution Companies. Energy sales to individual customers are based on their meter readings, which are performed on a systematic basis throughout the month. At the end of each month, the amount of energy delivered to each customer after the last meter reading is estimated, and the Distribution Companies recognize unbilled revenues related to these amounts. The unbilled revenue estimates are based on daily generation, purchases of electricity, estimated customer usage by customer type, weather effects, electric line losses and the most recent consumer rates. A change in these estimates and assumptions could have a significant effect on Allegheny’s consolidated results of operations and financial position.

 

Regulatory Accounting:  The Distribution Companies are subject to regulations that set the rates that the Distribution Companies are permitted to charge customers. These rates are based on costs the regulatory agencies determine the Distribution Companies are permitted to recover. At times, regulators permit the future recovery through rates of costs that would otherwise be charged to expense by an unregulated company. Regulators also require that a regulatory liability be established for amounts that will be refunded to customers for various reasons. This ratemaking process often results in the recording of regulatory assets based on estimated future cash inflows and the recording of regulatory liabilities based on estimated future cash outflows.

 

Allegheny regularly reviews its regulatory assets and liabilities and the estimates and assumptions from which they were calculated to assess the ultimate recoverability of the assets and anticipated customer refunds within approved regulatory guidelines. A change in these estimates and assumptions could have a significant effect on Allegheny’s results of operations, cash flows and financial position.

 

Accounting for Pensions and Postretirement Benefits Other Than Pensions:  There are a number of significant estimates and assumptions involved in determining Allegheny’s pension and other postretirement benefit (“OPEB”) obligations and costs each period, such as employee demographics, discount rates, expected rates of return on plan assets, estimated rates of future compensation increases, medical inflation and the fair value of assets funded for the plan. Changes made to provisions for pension or other postretirement benefit plans may also affect current and future pension and OPEB costs. Allegheny’s assumptions are supported by historical data and reasonable projections and are reviewed annually with an outside actuarial firm. See Note 10, “Pension Benefits and Postretirement Benefits Other Than Pensions,” to the Consolidated Financial Statements for additional information concerning these assumptions.

 

In selecting an assumed discount rate, Allegheny uses a modeling process that involves selecting a portfolio of high-quality bonds (AA- or better) whose cash flows (via coupons and maturities) match the timing and amount of Allegheny’s expected future benefit payments. Allegheny considers the results of this modeling process, as well as overall rates of return on high quality corporate bonds and changes in such rates over time, in the determination of its assumed discount rate.

 

Allegheny’s general approach for determining the overall expected long-term rate of return on assets considers historical and expected future asset returns, the current and future targeted asset mix of the plan assets, historical and future expected real rates of return for equities and fixed income securities and historical and expected inflation statistics. The following table shows the effect that a one percentage point increase or decrease in the 5.6% discount rate and the 8.25% expected rate of return on plan assets for 2006 would have on Allegheny’s pension and OPEB obligations and costs:

 

(In millions)


   1-Percentage-Point
Increase


   

1-Percentage-Point

Decrease


Change in the discount rate:

              

Pension and OPEB obligation

   $ (157.8 )   $ 193.3

Net periodic pension and OPEB cost

   $ (12.2 )   $ 14.4

Change in expected rate of return on plan assets:

              

Net periodic pension and OPEB cost

   $ (9.2 )   $ 9.2

 

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Depreciation:  Depreciation expense is determined generally on a straight-line group method over the estimated service lives of depreciable assets for unregulated operations. For regulated utility operations, depreciation expense is determined using a straight-line group method in accordance with currently enacted regulatory rates. Under the straight-line group method, plant components are categorized as “retirement units” or “minor items of property.” As retirement units are replaced, the cost of the replacement is capitalized and the original component is retired. Replacements of minor units of property are expensed as maintenance.

 

Allegheny engaged a third party to assist in a review of the estimated remaining service lives and depreciation practices relating to the generating assets of its unregulated operations during 2005. Allegheny anticipates that the estimated service lives of its unregulated coal-fired generation facilities will be extended prospectively beginning January 1, 2006 for periods ranging from 5 to 15 years to match the estimated remaining economic lives of these generation facilities. Allegheny also expects to concurrently adjust certain other depreciation related practices. Had the changes been made as of January 1, 2005, depreciation expense would have been approximately $32 million lower and operations and maintenance expense would have been approximately $13 million lower than amounts reflected on the Consolidated Statement of Operations for the year ended December 31, 2005. The effect of this change in accounting estimate is expected to reduce depreciation and operations and maintenance expenses $50 million to $60 million, before tax effects, in 2006.

 

Long-Lived Assets:  Allegheny’s Consolidated Balance Sheets include significant long-lived assets that are not subject to recovery under SFAS No. 71. As a result, Allegheny must generate future cash flows from these assets in a non-regulated environment to ensure that the carrying values of these assets are not impaired. Some of these assets are the result of capital investments that have been made in recent years and have not yet reached a mature life cycle. Allegheny assesses the carrying amount and potential impairment of these assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors Allegheny considers in determining if an impairment review is necessary include significant underperformance of the assets relative to historical or projected future operating results, a significant change in Allegheny’s use of the assets or business strategy related to the assets and significant negative industry or economic trends. When Allegheny determines that an impairment review is necessary, it compares the expected undiscounted future cash flows to the carrying amount of the asset. If the carrying amount of the asset is larger, Allegheny recognizes an impairment loss equal to the amount by which the carrying amount of the asset exceeds the fair value of the asset. In these cases, Allegheny determines fair value by the use of quoted market prices, appraisals or valuation techniques, such as expected discounted future cash flows. Allegheny must make assumptions regarding these estimated future cash flows and other factors to determine the fair value of the asset. Significant changes to these assumptions could have a material effect on Allegheny’s consolidated results of operations and financial position.

 

Contingent Liabilities:  Allegheny has established reserves for estimated loss contingencies when management has determined that a loss is probable and the amount can be reasonably estimated. Revisions to contingent liabilities are reflected in income in the period in which different facts or information become known, or circumstances change, that affect the previous assumptions with respect to the likelihood or the amount of loss. Reserves for contingent liabilities are based upon management’s assumptions and estimates and advice of legal counsel or other third parties regarding the probable outcomes of the matter. If the ultimate outcome were to differ from the assumptions and estimates, revisions to the estimated reserves for contingent liabilities would be recognized. Contingent liabilities for Allegheny include, but are not limited to, restructuring liabilities, legal, environmental and other commitments and contingencies.

 

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ALLEGHENY ENERGY, INC.—RESULTS OF OPERATIONS

 

Income (Loss) Summary

 

(In millions)


   Delivery
and
Services


    Generation
and
Marketing


             

2005


       Eliminations

    Total

 

Operating revenues

   $ 2,845.5     $ 1,703.3     $ (1,510.9 )   $ 3,037.9  

Fuel consumed in electric generation

     —         (736.6 )     —         (736.6 )

Purchased power and transmission

     (1,878.7 )     (81.0 )     1,501.4       (458.3 )

Loss on sale of Ohio T&D assets

     (29.3 )     —         —         (29.3 )

Deferred energy costs, net

     1.5       —         —         1.5  

Operations and maintenance

     (388.5 )     (378.7 )     9.5       (757.7 )

Depreciation and amortization

     (153.6 )     (154.6 )     —         (308.2 )

Taxes other than income taxes

     (130.4 )     (82.1 )     —         (212.5 )
    


 


 


 


Operating income

     266.5       270.3       —         536.8  

Other income and expenses, net

     24.2       21.1       (1.1 )     44.2  

Interest expense and preferred dividends

     (123.3 )     (318.2 )     1.0       (440.5 )
    


 


 


 


Income (loss) from continuing operations before income taxes and minority interest

     167.4       (26.8 )     (0.1 )     140.5  

Income tax expense from continuing operations

     (55.2 )     (9.6 )     —         (64.8 )

Minority interest in net income of subsidiaries

     —         (0.6 )     —         (0.6 )
    


 


 


 


Income (loss) from continuing operations

     112.2       (37.0 )     (0.1 )     75.1  

Income (loss) from discontinued operations, net of tax

     1.0       (7.2 )     0.1       (6.1 )

Cumulative effect of accounting change, net of tax

     —         (5.9 )     —         (5.9 )
    


 


 


 


Net income (loss)

   $ 113.2     $ (50.1 )   $ —       $ 63.1  
    


 


 


 


2004


                        

Operating revenues

   $ 2,764.1     $ 1,538.7     $ (1,546.7 )   $ 2,756.1  

Fuel consumed in electric generation

     —         (614.4 )     —         (614.4 )

Purchased power and transmission

     (1,779.0 )     (86.2 )     1,536.8       (328.4 )

Gain on sale of OVEC power agreement and shares

     —         94.8       —         94.8  

Deferred energy costs, net

     (0.2 )     —         —         (0.2 )

Operations and maintenance

     (404.3 )     (424.1 )     9.9       (818.5 )

Depreciation and amortization

     (148.8 )     (150.6 )     —         (299.4 )

Taxes other than income taxes

     (128.5 )     (72.3 )     —         (200.8 )
    


 


 


 


Operating income

     303.3       285.9       —         589.2  

Other income and expenses, net

     23.1       1.7       (0.3 )     24.5  

Interest expense and preferred dividends

     (129.2 )     (276.2 )     0.2       (405.2 )
    


 


 


 


Income from continuing operations before income taxes and minority interest

     197.2       11.4       (0.1 )     208.5  

Income tax benefit (expense) from continuing operations