DPL 10-K 2007
Documents found in this filing:
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2006
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Each of the following classes or series of securities registered pursuant to Section 12 (b) of the Act is registered on the New York Stock Exchange:
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if each registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Indicate by check mark if each registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.
Indicate by check mark whether each registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
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 each 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.
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether each registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
The aggregate market value of DPL Inc.s common stock held by non-affiliates of DPL Inc. as of June 30, 2006 was approximately $3.1 billion based on a closing sale price of $26.80 on that date as reported on the New York Stock Exchange. All of the common stock of The Dayton Power and Light Company is owned by DPL Inc. As of February 22, 2007, each registrant had the following shares of common stock outstanding:
This combined Form 10-K is separately filed by DPL Inc. and The Dayton Power and Light Company. Information contained herein relating to any individual registrant is filed by such registrant on its own behalf. Each registrant makes no representation as to information relating to a registrant other than itself.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of DPLs definitive proxy statement for its 2007 Annual Meeting of Shareholders are incorporated by reference in Part III of this Form 10-K.
DPL Inc. and The Dayton Power and Light Company
Index to Annual Report on Form 10-K
Fiscal Year Ended December 31, 2006
This report includes the combined filing of DPL Inc. (DPL) and The Dayton Power and Light Company (DP&L). DP&L is the principal subsidiary of DPL providing approximately 99% of DPLs total consolidated revenue and approximately 86% of DPLs total consolidated asset base. Throughout this report the terms we, us, our and ours are used to refer to both DPL and DP&L, respectively and altogether, unless the context indicates otherwise. Discussions or areas of this report that apply only to DPL or DP&L will be clearly noted in the section. Historically, DPL and DP&L have filed separate SEC filings. Beginning with this report and in the future, DPL Inc. and The Dayton Power and Light Company will file combined SEC reports on an interium and annual basis.
WEBSITE ACCESS TO REPORTS
DPL Inc. and The Dayton Power and Light Company file current, annual and quarterly reports, proxy statement and other information required by the Securities Exchange Act of 1934, as amended, with the Securities and Exchange Commission (SEC). You may read and copy any document we file at the SECs public reference room located at 100 F Street N.E., Washington, D.C. 20549, USA. Please call the SEC at (800) SEC-0330 for further information on the public reference rooms. Our SEC filings are also available to the public from the SECs web site at http://www.sec.gov.
Our public internet site is http://www.dplinc.com. We make available, free of charge, through our internet site, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and Forms 3, 4 and 5 filed on behalf of our directors and executive officers and amendments to those reports filed or furnished pursuant to the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC.
In addition, our public internet site includes other items related to corporate governance matters, including, among other things, our governance guidelines, charters of various committees of the Board of Directors and our code of business conduct and ethics applicable to all employees, officers and directors. You may obtain copies of these documents, free of charge, by sending a request, in writing, to DPL Investor Relations, 1065 Woodman Drive, Dayton, Ohio 45432.
DPL Inc. (DPL) is a diversified regional energy company organized in 1985 under the laws of Ohio. Our executive offices are located at 1065 Woodman Drive, Dayton, Ohio 45432 - telephone (937) 224-6000.
DPLs principal subsidiary is The Dayton Power and Light Company (DP&L). DP&L is a public utility incorporated in 1911 under the laws of Ohio. DP&L sells electricity to residential, commercial, industrial and governmental customers in a 6,000 square mile area of West Central Ohio. Electricity for DP&Ls 24 county service area is primarily generated at eight coal-fired power plants and is distributed to more than 500,000 retail customers. DP&L also purchases retail peak load requirements from DPL Energy, LLC (DPLE, one of DPLs wholly-owned subsidiaries). Principal industries served include automotive, food processing, paper, plastic manufacturing and defense. DP&Ls sales reflect the general economic conditions and seasonal weather patterns of the area. DP&L sells any excess energy and capacity into the wholesale market.
DPLs other significant subsidiaries (all of which are wholly-owned) include DPLE, which engages in the operation of peaking generating facilities; DPL Energy Resources, Inc. (DPLER), which sells retail electric energy under contract to major industrial and commercial customers in West Central Ohio; MVE, Inc., which was primarily responsible for the management of our financial asset portfolio; and Miami Valley Insurance Company (MVIC), which is our captive insurance company that provides insurance sources to us and our subsidiaries.
DP&L has one significant subsidiary, DPL Finance Company, Inc., which is wholly-owned and provides financing to DPL, DP&L and other affiliated companies.
DPL and DP&L conduct their principal business in one business segment - Electric.
Under the recently enacted Public Utility Holding Company Act of 2005, the Federal Energy Regulatory Commission (FERC) requires that utility holding companies comply with certain accounting, record retention and filing requirements. DPL believes it is exempt from these requirements because DP&Ls operations are confined to a single state. On January 31, 2006, DPL filed a FERC 65B Waiver Notification with the FERC, requesting that the FERC approve DPLs waiver and avoid FERC regulation.
DPL, DP&L and its subsidiaries employed 1,452 persons as of January 31, 2007, of which 1,203 were full-time employees and 249 were part-time employees.
Credit Rating Upgrades
In early 2007 and during 2006, our rating agencies upgraded our corporate credit and debt ratings. The following table outlines the rating of each company and the date of the upgrade:
Peaking Unit Sales
In connection with DPLEs (subsidiary of DPL) decision to sell the Greenville Station and Darby Station electric peaking generation facilities, DPL concluded that an impairment charge for the Greenville Station and Darby Station assets was required. During the fourth quarter of 2006, DPL recorded a $71.0 million impairment charge to record the write-down of the assets to fair market value and other associated costs related to the sales.
Pollution Control Bonds
On September 13, 2006, the Ohio Air Quality Development Authority (OAQDA) issued $100 million of 4.80% fixed interest rate OAQDA Revenue Bonds 2006 Series A due September 1, 2036. In turn, DP&L then borrowed these funds from the OAQDA. DP&L is using the proceeds from this borrowing to assist in financing its portion of the costs of acquiring, constructing and installing certain solid waste disposal and air quality facilities at Miami Fort, Killen and Stuart Generating Stations.
Share Repurchase of DPLs Common Stock
On July 27, 2005, DPLs Board authorized the repurchase of up to $400 million of common stock from time to time in the open market or through private transactions. DPL completed this share repurchase program through a series of open market purchases on August 21, 2006. This resulted in 14.9 million shares being repurchased at an average price of $26.91 per share and a total cost of $400 million. These shares are currently held as treasury shares at DPL Inc.
Increase in Dividends on DPLs Common Stock
On February 1, 2007, DPLs Board of Directors announced that it had raised the quarterly dividend to $0.26 per share payable March 1, 2007 to common shareholders of record on February 14, 2007. This increase results in an annualized dividend rate of $1.04 per share, or a 4% increase.
ELECTRIC SALES AND REVENUES
(a) DP&L sells power to DPLER (a subsidiary of DPL). These sales are classified as wholesale on DP&Ls financial statements and retail sales for DPL. The kWh volumes contain all volumes distributed on the DP&L system which include the retail sales by DPLER. The sales for resale volumes are omitted to avoid duplicate reporting.
ELECTRIC OPERATIONS AND FUEL SUPPLY
include 630 MW of peaking capacity relating to the Darby and Greenville
DPLs present summer generating capacity, including Peaking Units, is approximately 4,409 MW. Of this capacity, approximately 2,860 MW or 65% is derived from coal-fired steam generating stations and the balance of approximately 1,549 MW or 35% consists of combustion turbine and diesel peaking units.
DP&Ls present summer generating capacity, including Peaking Units, is approximately 3,295 MW. Of this capacity, approximately 2,860 MW or 87% is derived from coal-fired steam generating stations and the balance of approximately 435 MW or 13% consists of combustion turbine and diesel peaking units.
Combustion turbine output is dependent on ambient conditions and is higher in the winter than in the summer. Our all-time net peak load was 3,243 MW, occurring July 25, 2005.
Approximately 87% of the existing steam generating capacity is provided by certain units owned as tenants in common with (Duke Energy) The Cincinnati Gas & Electric Company (CG&E) or its subsidiary, Union Heat, Light & Power, and (AEP) Columbus Southern Power Company (CSP). As tenants in common, each company owns a specified undivided share of each of these units, is entitled to its share of capacity and energy output, and has a capital and operating cost responsibility proportionate to its ownership share. DP&Ls remaining steam generating capacity (approximately 365 MW) is derived from a generating station owned solely by DP&L. Additionally, DP&L, CG&E and CSP own as tenants in common, 884 circuit miles of 345,000-volt transmission lines. DP&L has several interconnections with other companies for the purchase, sale and interchange of electricity.
In 2006, we generated 99% of our electric output from coal-fired units and 1% from oil and natural gas-fired units.
The following table sets forth DP&Ls and DPLEs generating stations and, where indicated, those stations which DP&L owns as tenants in common.
*W = Wholly-Owned
C = Commonly-Owned
include 630 MW of peaking capacity relating to the Darby and Greenville
We have substantially all of the total expected coal volume needed to meet our retail and firm wholesale sales requirements for 2007 under contract. The majority of our contracted coal is purchased at fixed prices. Some contracts provide for periodic adjustments and some are priced based on market indices. Substantially all contracts have features that limit price escalations in any given year. Our sulfur dioxide (SO2) allowance consumption will be reduced in 2007 due to installation of emission control equipment at a portion of the Companies generation facilities. We do not expect to purchase SO2 allowances for 2007. The exact consumption of SO2 allowances will depend on market prices for power, availability of our generating units, the timing of FGD (flu gas desulfurization) completion and the actual sulfur content of the coal burned. We do not plan to purchase any nitrogen oxide (NOx) allowances for 2007.
The average cost of fuel used per kilowatt-hour (kWh) was as follows:
The power generation and delivery business is seasonal and weather patterns have a material impact on operating performance. In the region served by our subsidiaries, demand for electricity is generally greater in the summer months associated with cooling and in the winter months associated with heating as compared to other times of the year. Historically, the power generation and delivery operations of our subsidiaries have generated less revenue and income when weather conditions are warmer in the winter and cooler in the summer.
RATE REGULATION AND GOVERNMENT LEGISLATION
DP&Ls sales to retail customers are subject to rate regulation by the Public Utilities Commission of Ohio (PUCO). DP&Ls transmission and wholesale electric rates to municipal corporations, rural electric co-operatives and other distributors of electric energy are subject to regulation by the Federal Energy Regulatory Commission (FERC) under the Federal Power Act.
Ohio law establishes the process for determining rates charged by public utilities. Regulation of rates encompasses the timing of applications, the effective date of rate increases, the cost basis upon which the rates are based and other related matters. Ohio law also established the Office of the Ohio Consumers Counsel (OCC), which has the authority to represent residential consumers in state and federal judicial and administrative rate proceedings.
Ohio legislation extends the jurisdiction of the PUCO to the records and accounts of certain public utility holding company systems, including DPL. The legislation extends the PUCOs supervisory powers to a holding company systems general condition and capitalization, among other matters, to the extent that they relate to the costs associated with the provision of public utility service. Based on existing PUCO and FERC authorization, regulatory assets and liabilities are recorded on the Consolidated Balance Sheets. See Note 3 of Notes to Consolidated Financial Statements.
COMPETITION AND REGULATION
Ohio Retail Rates
Since January 2001, DP&Ls electric customers have been permitted to choose their retail electric generation supplier. DP&L continues to have the exclusive right to provide delivery service in its state certified territory. The PUCO maintains jurisdiction over DP&Ls delivery of electricity, the standard offer supply service that customers receive if they do not choose an alternative retail electricity supplier, and over other rates and charges associated with the market development period that began January 2001.
In 2003, the PUCO approved a Stipulation executed by DP&L and other parties that extended the market development period through the end of 2005, and included provisions that generation rates may be modified as of January 1, 2006, by up to 11% of generation rates to reflect increased costs associated with fuel, environmental compliance, taxes, regulatory changes, and security measures. In 2006, the Ohio Supreme Court affirmed the PUCOs Order approving the Stipulation.
On April 4, 2005, DP&L filed a request at the PUCO to implement a new rate stabilization surcharge effective January 1, 2006 to recover cost increases associated with environmental capital, related operations and maintenance costs and fuel expenses. On November 3, 2005, DP&L entered into a settlement agreement that extended DP&Ls rate stabilization period through December 31, 2010. During this time, DP&L will continue to provide retail electric service at fixed rates with the ability to recover increased fuel and environmental costs through surcharges and riders. Specifically, the agreement provides for:
· A rate stabilization surcharge equal to 11% of generation rates beginning January 1, 2006 and continuing through December 2010. Based on 2004 sales, this rider is expected to result in approximately $65 million in net revenues per year.
· A new environmental investment rider to begin January 1, 2007 equal to 5.4% of generation rates, with incremental increases equal to 5.4% each year through 2010. Based on 2004 sales, this rider is expected to result in approximately $35 million in annual net revenues beginning January 2007, growing to approximately $140 million by 2010.
· An increase to the residential generation discount from January 1, 2006 through December 31, 2008, which is expected to result in a revenue decrease of approximately $7 million per year for three years, based on 2004 sales. The residential discount is accounted for in the $65 million net revenue stated above will expire on December 31, 2008.
On December 28, 2005, the PUCO adopted the settlement with certain modifications (RSS Stipulation). The PUCO ruled that the environmental rider will be bypassable by all customers who take service from alternate generation suppliers. Thus, future additional revenues are dependent upon actual sales and levels of customer switching. Applications for rehearing were denied and the case was appealed to the Ohio Supreme Court by the Ohio Consumers Counsel on April 21, 2006. The Company cannot predict whether the Ohio Supreme Court will affirm the PUCOs approval of the RSS Stipulation, affirm it in part subject to modifications, or reject it. An oral argument has been set for April 17, 2007.
Consistent with the RSS Stipulation approved by the PUCO and prior orders, DP&L made a tariff filing to implement the environmental investment rider beginning January 1, 2007, which was approved by the PUCO in November 2006.
In 2005, DP&L made a tariff filing to recover previously deferred costs associated with administrative fees charged to DP&L under PJMs FERC-approved tariffs. In January 2006, the PUCO approved the recovery, effective February 1, 2006, which should result in approximately $8.5 million in additional revenue per year for three years and $6.0 million per year thereafter.
In March 2006, the PUCO approved the recovery of costs and carrying costs associated with billing system changes made to permit DP&L to provide billing services to Competitive Retail Electric Service (CRES) providers. These costs had previously been deferred for later recovery under a settlement approved in 2004. In separate orders issued in September and December 2006, the Ohio Supreme Court affirmed the PUCO orders approving the settlement and approving the recovery of costs. This will result in approximately $7 million in additional annual revenue beginning March 2006 through 2010.
On September 1, 2005, DP&L requested the PUCO authority to recover distribution costs associated with storm restoration efforts for ice storms that took place in December 2004 and January 2005. In February 2006, DP&L
filed updated schedules in support of its application. On July 12, 2006, the PUCO approved DP&Ls filing, allowing the Company to recover approximately $8.6 million in additional revenues over a two-year period. See Note 3 of Notes to Consolidated Financial Statements.
Ohio Competitive Considerations and Proceedings
As of December 31, 2006, four unaffiliated marketers were registered as CRES providers in DP&Ls service territory. While there has been some customer switching to date, it represents less than 0.15 percent of sales in 2006. DPLER, an affiliated company, is also a registered CRES provider and accounted for 99.8% of the total kWh supplied by CRES providers within DP&Ls service territory in 2006. In addition, several communities in DP&Ls service area have passed ordinances allowing the communities to become government aggregators for the purpose of offering alternative electric generation supplies to their citizens. To date, none of these communities have aggregated their generation load.
DP&L agreed to implement a Voluntary Enrollment Program (VEP) that would provide customers with an option to choose a competitive supplier to provide their retail generation service should switching not reach 20% in each customer class. The 20% threshold has never been reached. In both 2005 and 2006, customers who elected to participate in the program were grouped together and collectively bid out to CRES providers. No bids were received in either year resulting in zero customer switching under the program. DP&L is required to execute the same process again in 2007. Future period effects cannot be determined at this time.
In August of 2006, an electric supply contract with Wright Patterson Air Force Base (WPAFB) expired. WPAFB is DP&Ls single largest retail customer and represents approximately 1% of its annual revenues. In November 2006, WPAFB signed a long-term agreement to allow DPLER to supply competitive generation service to WPAFB through 2010.
On February 20, 2003, the PUCO requested comments from interested stakeholders on the proposed rules for the conduct of a competitive bidding process that will take place at the end of the rate stabilization period. DP&L submitted comments in March 2003. The PUCO issued final rules on December 23, 2003. Under DP&Ls RSS Stipulation discussed above, these rules will not affect DP&L until January 1, 2011. However, the PUCO retains the authority to, at any time, require an Ohio electric utility to conduct a competitive bidding process to measure the market price of competitive retail generation.
Other State Regulatory Proceedings
On August 28, 2006, the Staff of the PUCO issued a report relating to compliance with the Federal Energy Policy of 2005. In that report the Staff makes recommendations to the Commission to implement new rules and procedures relating to net metering, customer generator interconnection, stand by power, time-of-use rates, and renewable energy portfolio standards. DP&L, among others, filed comments on September 18, 2006, and reply comments on October 2, 2006. If adopted by the Commission, the Staffs recommendations may result in new regulatory requirements for Ohio investor owned utilities related to renewable energy standards, fuel sources, automated meter infrastructure and time differentiated rate options for customers. DP&L cannot predict the outcome of this proceeding nor the potential cost that may be associated with any new regulations that may be adopted.
Like other electric utilities and energy marketers, DP&L and DPLE may sell or purchase electric products on the wholesale market. DP&L and DPLE compete with other generators, power marketers, privately and municipally-owned electric utilities, and rural electric cooperatives when selling electricity. The ability of DP&L and DPLE to sell this electricity will depend on how DP&Ls and DPLEs price, terms and conditions compare to those of other suppliers.
As part of Ohios electric deregulation law, all of the states investor-owned utilities are required to join a Regional Transmission Organization (RTO). In October 2004, DP&L successfully integrated its 1,000 miles of high-voltage transmission into the PJM Interconnection, L.L.C. (PJM) RTO. The role of the RTO is to administer an electric marketplace and ensure reliability of the transmission grid. PJM ensures the reliability of the high-voltage electric power system serving 51 million people 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. PJM coordinates and directs the operation of the regions transmission grid, administers the worlds
largest competitive wholesale electricity market and plans regional transmission expansion improvements to maintain grid reliability and relieve congestion.
As a member of PJM, DP&L is subject to charges and costs associated with PJM operations as approved by the FERC. As discussed above in connection with the recovery of such costs in retail rates, these include significant administrative charges. Additionally, PJMs role in administering the regional transmission grid and planning regional transmission expansion improvements results in periodic proposals by PJM and other stakeholder members of PJM to the FERC to allocate and charge costs associated with the transmission system to various entities operating within PJM including DP&L. DP&L and other interested parties have the right to intervene and offer counter-proposals. The FERC is currently considering how to allocate costs associated with new planned transmission facilities. None of these costs were allocated to DP&L under PJMs original filing in the case, but other parties have proposed modified allocation methods that could result in allocations to DP&L. The FERC is also considering the justness and reasonableness of PJMs transmission rate design for existing facilities. DP&L, along with ten other transmission owners, filed in support of PJMs existing rate design, but other participants have proposed rate designs that would shift significant costs to DP&L. Due to complexity of the issues and the number of competing proposals under consideration, DP&L cannot determine what effect the final outcome of this proceeding may have on its costs or the extent to which it may be able to recover such costs.
As a member of PJM, the value of DPLs generation capacity will be affected by changes in the PJM capacity construct. The new construct introduces a new Reliability Pricing Model (RPM) that will change the way generation capacity is priced and planned for by PJM. In September 2006, DP&L, along with most of the parties relating to the case, entered into a settlement agreement that generally retains the RPM concept as proposed by PJM, with certain modifications. The settlement was approved by the FERC on December 21, 2006. The economic effects of the new capacity market will vary depending on present and projected market conditions.
In connection with DP&L and other utilities joining PJM, the FERC ordered utilities to eliminate certain charges to implement transitional payments, known as Seams Elimination Charge Adjustment (SECA), effective December 1, 2004 through March 31, 2006, subject to refund. Through this proceeding, DP&L was obligated to pay SECA charges to other utilities, but received a net benefit from these transitional payments. Several parties have sought rehearing of the FERC orders, which are still pending. The hearing was held in May 2006 and an initial decision was issued on August 10, 2006 that, if upheld by the Commission, would reduce the amount of SECA charges DP&L and other parties are permitted to recover. DP&L, among others, have taken exception to the initial decision. A final Commission order on this issue is still pending. We have entered into a significant number of bi-lateral settlement agreements with certain parties to resolve the matter, which by design will be unaffected by the Commissions decision to affirm, modify or reject the initial decision. DP&L management believes that appropriate reserves have been established in the event that SECA collections not resolved by settlement are required to be refunded. The ultimate outcome of the proceeding establishing SECA rates is uncertain at this time. However, based on the amount of reserves established for this item, the results of this proceeding are not expected to have a material adverse effect on DP&Ls results of operations.
On August 8, 2005, the Energy Policy Act of 2005 (the 2005 Act) was enacted. This new law encompasses several areas including, but not limited to: electric reliability, repeal of the Public Utility Holding Company Act of 1935, promotion of energy infrastructure, preservation of a diverse fuel supply for electricity generation and energy efficiency. Also in response to the Energy Policy Act of 2005, the FERC issued a Notice of Proposed Rulemaking to amend its regulations to incorporate the criteria any entity must satisfy to qualify to be an Electric Reliability Organization (ERO) that will propose and enforce reliability standards subject to FERC approval. The proposed rule also included related matters on delegating ERO authority, the creation of advisory bodies and reporting requirements. In October 2006, the FERC also approved new mandatory reliability standards to be effective mid-2007, with requirements applying to certain assets and activities of DP&L and DPL. The new regulations include potential penalties for failure to comply with these standards. DPL is currently assessing the compliance plans in place to comply with similar, but voluntary, reliability standards administered by the North American Electric Reliability Council and believes that it will be in full compliance with the new mandatory standards when they become effective.
DP&L provides transmission and wholesale electric service to twelve municipal customers in its service territory, which in turn distribute electricity principally within their incorporated limits. DP&L also maintains an interconnection agreement with one municipality that has the capability to generate a portion of its own energy requirements. Approximately 1% of total electricity sales in 2006 represented sales to these municipalities.
DPL, DP&L and our subsidiaries facilities and operations are subject to a wide range of environmental regulations and laws. In the normal course of business, we have investigatory and remedial activities underway at these facilities to comply, or to determine compliance, with such regulations. We record liabilities for probable estimated loss in accordance with Statement of Financial Accounting Standards No. 5 (SFAS 5), Accounting for Contingencies. To the extent a probable loss can only be estimated by reference to a range of equally probable outcomes, and no amount within the range appears to be a better estimate than any other amount, we accrue for the low end of the range. Because of uncertainties related to these matters, accruals are based on the best information available at the time. DPL, through its captive insurance subsidiary, MVIC, has an actuarial calculated reserve for environmental matters. We evaluate the potential liability related to probable losses quarterly and may revise our estimates. Such revisions in the estimates of the potential liabilities could have a material effect on our results of operations, financial position or cash flows.
DP&Ls coal-fired units are subject to the acid rain provisions of the Clean Air Act and the NOx and Ozone Transport rule. All of the SO2 and NOx emissions data submitted to the United States Environmental Protection Agency (USEPA) pursuant to these provisions for 2005 and the first quarter 2006 were recorded and reported in compliance with USEPA regulations. Subsequently DP&L detected a malfunction with its emission monitoring system at one of its generation stations and ultimately determined its SO2 and NOx emissions data were under reported. DP&L has petitioned the USEPA to accept an alternative methodology for calculating actual emissions for 2005 and the first quarter 2006. DP&L has sufficient allowances in its general account to cover the understatement and is working with the USEPA to resolve the matter. Management does not believe the ultimate resolution of this matter will have a material impact on operating results or financial position.
Environmental Regulation and Litigation Related to Air Quality
Regulation Proceedings Air
In 1990 the
federal government amended the Clean Air Act (CAA) to further regulate air
pollution. Under the law, the USEPA sets
limits on how much of a pollutant can be in the air anywhere in the United
States. The CAA allows individual states
to have stronger pollution controls, but states are not allowed to have weaker
pollution controls than those set for the whole country. The CAA has a material
effect on our operations and such effects are detailed below with respect to
certain programs under the CAA.
outcome of the reconsideration proceedings, the petitions or the pending litigation, CAIR has had and will have a material effect on our operations. Phase I of CAIR incentivizes the installation of flue gas desulfurization (FGD) equipment and continual operation of the currently installed Selective Catalytic Reduction equipment. As a result, DP&L is proceeding with the installation of FGD equipment at various generating units.
On January 30, 2004, the USEPA published its proposal to restrict mercury and other air toxics from coal-fired and oil-fired utility plants. The final Clean Air Mercury Rule (CAMR) was signed March 15, 2005 and was published on May 18, 2005. The final rules will have a material effect on our operations. We anticipate that the FGD equipment being installed to meet the requirements of CAIR may be adequate to meet the Phase I requirements of CAMR effective January 1, 2010. We expect that additional controls will be needed to meet the Phase II requirements of CAMR that go into effect January 1, 2018. On March 29, 2005, nine states sued USEPA, opposing the regulatory approach taken by USEPA. On March 31, 2005, various groups requested that USEPA stay implementation of CAMR. On August 4, 2005, the United States Court of Appeals for the District of Columbia denied the motion for stay. USEPA is expected to initiate reconsideration proceedings on one or more issues. We cannot predict the outcome of the reconsideration proceedings or pending litigation.
Under the CAIR and CAMR cap and trade programs for SO2, NOx and mercury, we estimate we will spend more than $225 million from 2007 through 2009 to install the necessary pollution controls. If CAMR litigation results in plant specific mercury controls, our costs may be higher. Due to the ongoing uncertainties associated with the litigation of the CAMR, we cannot project the final costs at this time.
On July 15, 2003, the Ohio EPA submitted to the USEPA its recommendations for eight-hour ozone non-attainment boundaries for the metropolitan areas within Ohio. On April 15, 2004, the USEPA issued its list of ozone non-attainment designations. DP&L owns and/or operates a number of facilities in counties designated as non-attainment with the ozone national ambient air quality standard. DP&L does not know at this time what future regulations may be imposed on its facilities and will closely monitor the regulatory process. Ohio EPA will have until April 15, 2007 to develop regulations to attain and maintain compliance with the eight-hour ozone national ambient air quality standard. Numerous parties have filed petitions for review. DP&L cannot predict the outcome of USEPAs reconsideration petitions.
On January 5, 2005, the USEPA published its final non-attainment designations for the national ambient air quality standard for Fine Particulate Matter 2.5 (PM 2.5). These designations included counties and partial counties in which DP&L operates and/or owns generating facilities. On March 4, 2005, DP&L and other Ohio electric utilities and electric generators filed a petition for review in the D.C. Circuit Court of Appeals, challenging the final rule creating these designations. On November 30, 2005, the court ordered USEPA to decide on all petitions for reconsideration by January 20, 2006. On January 20, 2006, USEPA denied the petitions for reconsideration. The Ohio EPA will have three years to develop regulations to attain and maintain compliance with the PM 2.5 national ambient air quality standard. DP&L cannot determine the outcome of the petition for review or the effect such Ohio EPA regulations will have on its operations.
On May 5, 2004, the USEPA issued its proposed regional haze rule, which addresses how states should determine the best available retrofit technology (BART) for sources covered under the regional haze rule. Final rules were published July 6, 2005, providing states with several options for determining whether sources in the state should be subject to BART. In the final rule, USEPA made the determination that CAIR achieves greater progress than BART and may be used by states as a BART substitute. Numerous units owned and operated by us will be impacted by BART. We cannot determine the extent of the impact until Ohio determines how BART will be implemented.
Sierra Club Litigation
Pending before the U.S. Supreme Court is a proceeding, Environmental Defense v. Duke Energy (Duke Energy) that does not involve the Company as a party but may have a significant effect on the outcome of litigation described below that involves allegations of violations of the CAA. A key issue in that litigation that may be dispositive with respect to other pending cases is what test to apply for measuring whether modifications to electric generating units should trigger application of New Source Review (NSR) standards under the CAA. In general terms, the dispute is whether to measure pre- and post-modification emissions based on the rate of emissions per hour of operation or based on total emissions over time. The latter test, if applied, could trigger NSR requirements for equipment replacements that result in a plant running more often because it is more economical or dependable, even if the emissions rate per hour of operation does not change. A ruling is expected in the first or second quarter of 2007. The Company cannot predict the outcome of the Duke Energy
case. Moreover, in each of the cases identified below, there may be case-specific facts and allegations that may cause a judge to find that the U.S. Supreme Courts ruling is based on different facts and allegations and is therefore not controlling in the case before the judge.
In September 2004, the Sierra Club filed a lawsuit against the Company and the other owners of the Stuart Generating Station in the United States District Court for the Southern District of Ohio for alleged violations of the CAA, including issues that may be decided by the Supreme Court in the Duke Energy case and other issues relating to alleged violations of opacity limitations. DP&L, on behalf of all co-owners, is leading the defense of this matter. A sizable amount of discovery has taken place and expert reports are scheduled to be filed at various times from May through September, 2007. Dispositive motions are to be filed in January 2008. No trial date has been set yet.
Litigation Involving Co-Owned Plants
In March 2000, as amended in June 2004, the United States Department of Justice filed a complaint in an Indiana federal court against Cinergy Corporation (now part of Duke Energy) and two subsidiaries for alleged violations of the CAA at various generation units operated by PSI Energy, Inc. and CG&E, including generation units co-owned by DP&L (Beckjord 6 and Miami Fort 7). In August 2006, the Seventh Circuit upheld the district courts 2005 ruling that an increase in annual emissions could trigger the permitting requirements of the CAA even if there were no increase in hourly emissions per hour of operations.
In November 2004, the State of New York and seven other states filed suit against the American Electric Power Corporation (AEP) and various subsidiaries, alleging various CAA violations at a number of AEP electric generating facilities, including Conesville Unit 4 (co-owned by CG&E, DP&L and Columbus Southern Power (CSP)). AEP, on behalf of all co-owners, is leading the defense of this matter. During 2006, a number of procedural and discovery-related disputes were resolved by the Southern District Court of Ohio. Discovery is ongoing.
In July 2004 and November 2004, various residents of the Village of Moscow, Ohio notified CG&E, as the operator of Zimmer (co-owned by CG&E, DP&L and CSP), of their intent to sue for alleged violations of the CAA and air pollution nuisances. CG&E, on behalf of all co-owners, is leading the defense of this matter. One lawsuit was dismissed on procedural grounds. Several counts of the remaining suit have been dismissed because they were based on activity outside the statute of limitations.
In June 2000, the USEPA issued a Notice of Violation (NOV) to DP&L operated Stuart Generating Station (co-owned by DP&L, CG&E and CSP) for alleged violations of the CAA. The NOV contained allegations consistent with NOVs and complaints that the USEPA had recently brought against numerous other coal-fired utilities in the Midwest. The NOV indicated the USEPA may (1) issue an order requiring compliance with the requirements of the Ohio State Implementation Plan (SIP) or (2) bring a civil action seeking injunctive relief and civil penalties of up to $27,500 per day for each violation. To date, neither action has been taken.
In November 1999, the USEPA filed civil complaints and NOVs against operators and owners of certain generation facilities for alleged violations of the CAA. Generation units operated by CG&E (Beckjord 6) and CSP (Conesville 4) and co-owned by DP&L were referenced in these actions. Numerous northeast states have filed complaints or have indicated that they will be joining the USEPAs action against CG&E and CSP. DP&L was not identified in the NOVs, civil complaints or state actions.
Environmental Regulation and Litigation Related to Water Quality
On July 9, 2004 the USEPA issued final rules pursuant to the Clean Water Act governing existing facilities that have cooling water intake structures. The rules require an assessment of impingement and/or entrainment of organisms as a result of cooling water withdrawal. A number of parties appealed the rules to the federal Court of Appeals for the Second Circuit in New York and the Court issued an opinion on January 25, 2007 remanding several aspects of the rule to USEPA for reconsideration. We are undertaking studies at two facilities but cannot predict the impact such studies may have on future operations or the outcome of the remanded rulemaking.
In May 2004, the Ohio EPA issued a final National Pollutant Discharge Elimination System permit for J.M. Stuart Station that continued the stations 316(a) variance which exempts DP&L from having to meet the temperature Standards in the Ohio River. During the three-year term of the permit, DP&L conducted a thermal discharge
study to evaluate the technical feasibility and economic reasonableness of water cooling methods other than cooling towers. We cannot predict the impact of this issue on future operations.
Environmental Regulation and Litigation Related to Land Use and Solid Waste Disposal
DP&L has been identified, either by a government agency or by a private party seeking contribution to site clean-up costs, as a potentially responsible party (PRP) at a site pursuant to state and federal laws.
In September 2002, DP&L and other parties received a special notice that the USEPA considers us to be PRPs for the clean-up of hazardous substances at the South Dayton Dump landfill site. In August 2005, DP&L and other parties received a general notice regarding the performance of a Remedial Investigation and Feasibility Study (RI/FS) under a Superfund Alternative approach. In October 2005, DP&L received a special notice letter inviting it to enter into negotiations with USEPA to conduct the RI/FS. Although the information available to DP&L does not demonstrate that it contributed hazardous substances to the site, DP&L will seek from USEPA a de minimis settlement at the site. Should USEPA pursue a civil action, DP&L will vigorously challenge it. In December 2003, DP&L and other parties received a special notice that the USEPA considers us to be PRPs for the clean-up of hazardous substances at the Tremont City landfill site. Information available to DP&L does not demonstrate that it contributed hazardous substances to the site.
In August 2006, Ohio EPA issued draft rules for interested party comment related to the disposal of industrial waste. DP&L, through the Ohio Electric Utility Institute submitted comments on the draft rules. We cannot predict the impact of the draft rules on future operations.
DPLs construction additions were $352 million, $180 million and $98 million in 2006, 2005 and 2004, respectively, and are expected to approximate $310 million in 2007.
DP&Ls construction additions were $349 million, $178 million and $93 million in 2006, 2005 and 2004, respectively, and are expected to approximate $310 million in 2007. Planned construction additions for 2007 relate to DP&Ls environmental compliance program, power plant equipment, and its transmission and distribution system.
Capital projects are subject to continuing review and are revised in light of changes in financial and economic conditions, load forecasts, legislative and regulatory developments and changing environmental standards, among other factors. Over the next three years, DPL, through its subsidiary DP&L, is projecting to spend an estimated $605 million in capital projects, approximately 40% of which is to meet changing environmental standards. Our ability to complete capital projects and the reliability of future service will be affected by our financial condition, the availability of internal funds and the reasonable cost of external funds. We expect to finance our construction additions in 2007 with a combination of cash on hand, short-term financing, tax-exempt debt and cash flows from operations.
This annual report and other documents that we file with the SEC and other regulatory agencies, as well as other oral or written statements we may make from time to time, contain information based on managements beliefs and include forward-looking statements (within the meaning of the Private Securities Litigation Reform Act of 1995) that involve a number of known and unknown risks, uncertainties and assumptions. These forward-looking statements are not guarantees of future performance, and there are a number of factors including, but not limited to, those listed below, which could cause actual outcomes and results to differ materially from the results contemplated by such forward-looking statements. We do not undertake any obligation to publicly update
or revise any forward-looking statements, whether as a result of new information, future events or otherwise. These forward-looking statements are identified by terms and phrases such as anticipate, believe, intend, estimate, expect, continue, should, could, may, plan, project, predict, will, and similar expressions.
The following is a listing of risk factors that we consider to be the most significant to your decision to invest in our stock. If any of these events occurs, our business, financial position or results of operation could be materially affected.
The electric industry in Ohio is partially deregulated
Before 2001, electric utilities provided electric generation, transmission and distribution services as a single product to retail customers at prices set by the PUCO. In 1999, Ohio enacted legislation, effective January 1, 2001, that partially deregulated utility service, making retail generation service a competitive service. Customers may choose to take generation service from CRES providers that register with the PUCO but are otherwise unregulated. In connection with this deregulation of the electric industry in Ohio, electric utilities have had to restructure their service and their rates to accommodate competition.
Many of the requirements of the Ohio deregulation law were premised on the assumption that the wholesale generation market and, in turn, the retail generation market, would fully develop by the end of 2005, and that the price for generation for even those customers who choose to continue to purchase the service from the regulated utility would be set purely by the market. That did not occur. As a result, the Commission and the utilities, including DP&L, have worked out plans to provide market-based pricing for generation service, but also to stabilize those rates for several years. What DP&L may propose and what the PUCO will approve in the future regarding pricing and cost recovery will depend on the degree to which the wholesale and retail electric generation markets have developed.
Moreover, the uncertainty of the future of the wholesale and retail markets could cause the Ohio General Assembly to revisit the issue of competition and customer choice.
Switching by DP&Ls customers to unaffiliated CRES providers could occur in the future, despite insignificant activity to date.
Although retail generation service has been a competitive service since January 1, 2001, the competitive generation market has not developed in DP&Ls service territory to any significant degree. The following are factors that could result in increased switching by customers to CRES providers in the future:
· Voluntary Enrollment Program
As part of a settlement in a PUCO proceeding, DP&L initiated, in November 2004, a VEP to encourage customers to change electric suppliers. Although the VEP did not result in a significant increase in the number of customers switching to CRES providers in 2005 or 2006, the VEP will be initiated again in 2007 and could produce different results.
· DP&Ls Standard Service Offer
The RSS Stipulation discussed above, permits customers that take service from a CRES provider to bypass the environmental investment rider (EIR). Because this charge increases each year, the price that a CRES provider can offer to save customers money changes each year. Depending on the development of the wholesale market and the level of wholesale prices, CRES providers could become more active in DP&Ls service territory.
· CRES Supplier Initiatives
Customers can elect to take generation service from a CRES provider offering services to customers in DP&Ls service territory. As of December 31, 2006, five CRES providers have been certified by the PUCO to provide generation service to DP&L customers. One of those five, DPL Energy Resources, Inc. (DPLER), is an affiliate of DP&L. Although DPLER supplied 99.8% of the total kWh consumed by customers served by CRES providers in DP&Ls service territory in 2006, at the end of 2006 there was a slight increase in unaffiliated CRES provider activity. There has been zero residential customer switching to date. Depending on the development of the wholesale market and the level of wholesale prices, CRES providers could become more active in DP&Ls service territory and may begin to offer
prices lower than DP&Ls standard offer. This could result in more switching by DP&Ls customers and a further loss of revenues by DP&L.
· Governmental Aggregation Programs
Another way in which DP&L could experience customer switching is through governmental aggregation. Under this program, municipalities may contract with a CRES provider to provide generation service to the customers located within the municipal boundaries. Several communities in DP&Ls service territory have passed ordinances allowing them to become government aggregators. Although none has yet implemented an aggregation program, that too, could change provided CRES providers offer prices below DP&Ls standard offer.
DP&L has agreed to provide service at pre-determined rates through December 31, 2010, which limits its ability to pass through its costs to customers.
DP&L has provided service at rates governed by the PUCO-approved transition, market development, and rate stabilization plans. Those rates have included a statutorily-required 5% rate reduction in the generation component of its residential rates, a further 2.5% reduction to the residential generation rate through 2008, fixed generation rates through December 31, 2010, and frozen distribution rates through December 31, 2008. The protection afforded by retail fuel clause recovery mechanisms was eliminated effective January 1, 2001 by the implementation of customer choice in Ohio. Likewise, through the RSS Stipulation, DP&L extended its commitment to maintain pre-determined rates for generation through December 31, 2010, and in exchange is permitted to charge two new rate riders to offset increases in fuel and environmental costs. Beginning January 1, 2006 a new Rate Stabilization Surcharge was implemented that recovered approximately $65 million additional revenue in 2006, net of customer discounts and considering less than a full twelve months recovery due to the timing of the PUCO order. The new environmental investment rider could result in approximately $35 million additional revenue in 2007, net of customer discounts and assuming insignificant levels of customer switching. The PUCO ruled this rider will be bypassable by all customers who take service from alternative generation suppliers. Accordingly, the rates DP&L is allowed to charge may or may not match its expenses at any given time. Therefore, during this period (or possibly earlier by order of the PUCO), while DP&L will be subject to prevailing market prices for electricity, it would not necessarily be able to charge rates that produce timely or full recovery of its expenses. DP&L has historically maintained its rates at consistent levels since 1994, when the final phase of DP&Ls last traditional rate case was implemented. However, as DP&L operates under its PUCO-approved RSS Stipulation, there can be no assurance that DP&L would be able to timely or fully recover unanticipated levels of expenses, including but not limited to those relating to fuel, coal and purchased power, compliance with environmental regulation, reliability initiatives, and capital expenditures for the maintenance or repair of its plants or other properties. Furthermore, the RSS Stipulation is currently subject to an appeal to the Ohio Supreme Court, the result of which cannot be determined.
There are uncertainties relating to the operation and continued development of Regional Transmission Organizations (RTOs). DP&L has turned over operational control of its high voltage transmission functions to PJM and much of its generation is subject to dispatch by PJM and is therefore subject to PJMs market rules.
On October 1, 2004, in compliance with Ohio law, DP&L turned over control of its transmission functions and fully integrated into PJM. The price at which DP&L can sell its generation capacity and energy is now more dependent upon the overall operation of the PJM market. While DP&L can continue to make bi-lateral transactions to sell its generation through a willing-buyer and willing-seller relationship, any transactions that are not pre-arranged are subject to market conditions at PJM. The rules governing the various regional power markets also change from time to time which could affect DP&Ls cost and revenues. DP&L incurs fees and costs to participate in the Regional Transmission Organization (RTO). We may be limited with respect to the price at which power may be sold from certain generating units, and we may be required to expand our transmission system according to decisions made by the RTO rather than our internal planning process. While RTO transmission rates were initially designed to be revenue neutral, various proposals and proceedings currently taking place at FERC may cause transmission rates to change from time to time. In addition, developing rules associated with the allocation and methodology of assigning costs associated with improved transmission reliability, reduced transmission congestion and firm transmission rights may have a financial impact on DP&L. Likewise, in December 2006, FERC approved PJMs new Reliability Pricing Model (RPM). RPM will be effective in mid-2007, and will provide forward and locational pricing for generation capacity. The financial impact of RPM on DP&L will depend on a variety of factors, including the market behavior of various participants, and as such is unknown at this time. Because the RTO market rules are continuing to evolve, we
cannot fully assess the impact that these power markets or other ongoing RTO developments may have on DPL.
We rely principally on coal as the fuel to operate virtually all of the power plants that serve our customers daily.
Some of our coal suppliers have not performed their contracts as promised and have failed to timely deliver all coal as specified under their contracts. Such failure could significantly reduce DP&Ls inventory of coal and may cause DP&L to purchase higher priced coal on the spot market. When the failure is for a short period of time, DP&L can absorb the irregularity due to existing inventory levels. If we are required to purchase coal on the spot market, it may affect our cost of operations.
DP&L is a co-owner in certain generation facilities where it is a non-operating partner. DP&L does not procure the fuel for these facilities. Partner operated facilities do not always have realized coal costs that are equal to our co-owners projections.
Greenhouse Gas Emissions
Greenhouse gas (GHG) emissions, consisting primarily of carbon dioxide emissions, are presently unregulated. Numerous bills have been introduced in Congress to regulate GHG emissions, but to date none have passed. Future regulation of GHG emissions is uncertain. However, such regulation would be expected to impose costs on our operations. Such costs could include measures as advanced by various constituencies, including a carbon tax; investments in energy efficiency; installation of CO2 emissions control technology, to the extent such technology exists; purchase of emission allowances, should a trading mechanism be developed; or the use of higher-cost, lower CO2 emitting fuels. We will continue to make prudent investments in energy efficiency that reduces our GHG emissions intensity.
Flue Gas Desulfurization Project
We are currently constructing flue gas desulfurization (FGD) facilities at five units located at our J. M. Stuart and Killen Electric Generating Stations. Construction of the FGD facilities at each unit is scheduled to be completed in phases commencing mid-year 2007 through 2009. We are also co-owners of electric generating stations operated by other investor-owned utilities, who are in various stages of constructing FGD facilities at these stations. Significant construction delays could adversely affect our ability to operate or may substantially increase our cost to operate these electric generating stations under federal environmental laws and regulations that become effective in 2010. For those electric generating stations where we are co-owners but do not operate, significant construction delays may substantially increase our pro rata share of the cost to operate those facilities beginning in 2010.
PJM Infrastructure Risks
Annually, PJM, the regional transmission organization that provides transmission services for a large portion of the Midwest United States, performs a review of the capital additions required to provide reliable electric transmission services throughout its territory. PJM allocates the costs of constructing these facilities to the applicable entity that will benefit from the new construction. FERC is authorized to provide rate recovery to utilities for the costs they incur to construct these transmission facilities. To date, we have not been required to construct any new facilities nor have we been assigned any costs as a result of PJMs annual review, but there is no guarantee that we will not be assigned some costs or be required to construct facilities in the future.
Our stock price may fluctuate
The market price of DPLs common stock has fluctuated over a wide range. In addition, the stock market in recent years has experienced significant price and volume variations that have often been unrelated to our operating performance. Over the past three years, the market price of our common stock has fluctuated with a low of $17.21 and a high of $28.72. The market price of our common stock may continue to fluctuate in the future and may be affected adversely by factors such as actual or anticipated changes in our operating results, acquisition activity, changes in financial estimates by securities analysts, general market conditions, rumors and other factors.
The following are additional factors, including, but not limited to, regulation and competition, economic conditions, reliance on third parties, operating results fluctuations, regulatory uncertainties and litigation, warrant exercise, internal controls and environmental compliance, that may affect our future results.
Regulation and Competition
We operate in a rapidly changing industry with evolving industry standards and regulations. In recent years a number of federal and state developments aimed at promoting competition triggered industry restructuring. Regulatory factors, such as changes in the policies and procedures that set rates; changes in tax laws, tax rates, and environmental laws and regulations; changes in DP&Ls ability to recover expenditures for environmental compliance, fuel and purchased power costs and investments made under traditional regulation through rates; and changes to the frequency and timing of rate increases could affect our results of operations and financial condition. Changes in our customer base, including municipal customer aggregation, could lead to the entrance of competitors in our marketplace, affecting our results of operations and financial condition. Additionally, financial or regulatory accounting principles or policies imposed by governing bodies can increase our operational and monitoring costs affecting our results of operations and financial condition.
Economic pressures, as well as changing market conditions and other factors related to physical energy and financial trading activities, which include price, credit, liquidity, volatility, capacity, transmission and interest rates can have a significant effect on our operations and the operations of our retail, industrial and commercial customers.
During the past few years, the merchant energy industry in many parts of the United States has suffered from oversupply of merchant generation and a decline in trading and marketing activity. As a result of these market conditions, we continue to evaluate the carrying values of certain long-lived generation assets.
Reliance on Third Parties
We rely on many suppliers for the purchase and delivery of inventory, including coal and equipment components, to operate our energy production, transmission and distribution functions. Unanticipated changes in our purchasing processes, delays and supplier availability may affect our business and operating results. In addition, we rely on others to provide professional services, such as, but not limited to, actuarial calculations, internal audit services, payroll processing and various consulting services.
Operating Results Fluctuations
Future operating results are subject to fluctuations based on a variety of factors, including but not limited to: unusual weather conditions; catastrophic weather-related damage; unscheduled generation outages; unusual maintenance or repairs; changes in fuel and purchased power costs, emissions allowance costs, or availability constraints; environmental compliance; and electric transmission system constraints.
Regulatory Uncertainties and Litigation
In the normal course of business, we are subject to various lawsuits, actions, proceedings, claims and other matters asserted under laws and regulations. Additionally, we are subject to diverse and complex laws and regulations, including those relating to corporate governance, public disclosure and reporting, and taxation, which are rapidly changing and subject to additional changes in the future. As further described in Item 3-Legal Proceedings, we are also currently involved in various pieces of litigation in which the outcome is uncertain. Compliance with these rapid changes may substantially increase costs to our organization and could affect our future operating results.
DPLs warrant holders could exercise their 31,560,000 warrants at their discretion until March 12, 2012. As a result, DPL could be required to issue up to 31,560,000 common shares in exchange for the receipt of the exercise price of $21.00 per share or pursuant to a cashless exercise process. The exercise of all warrants would have a dilutive effect on us and would increase the number of common shares outstanding and increase our common share of dividend costs, affecting any existing guidance on EPS and affect our cash flows.
Our internal controls, accounting policies and practices, and internal information systems are designed to enable us to capture and process transactions in a timely and accurate manner in compliance with generally accepted accounting principles (GAAP) in the United States of America, laws and regulations, taxation requirements, and federal securities laws and regulations. We implemented corporate governance, internal control and accounting rules issued in connection with the Sarbanes-Oxley Act of 2002. Our internal controls
and policies have been and continue to be closely monitored by management and our Board of Directors to ensure continued compliance with Section 404 of the Act. While we believe these controls, policies, practices and systems are adequate to verify data integrity, unanticipated and unauthorized actions of employees, temporary lapses in internal controls due to shortfalls in oversight or resource constraints could lead to improprieties and undetected errors that could impact our financial condition, cash flows or results of operations.
Our facilities (both wholly-owned and co-owned with others) are subject to continuing federal and state environmental laws and regulations. We believe that we currently comply with all existing federal and state environmental laws and regulations. We own a non-controlling, minority interest in several generating stations operated by The Cincinnati Gas & Electric Company (CG&E) or its affiliate, Union Heat, Light & Power, and Columbus Southern Power Company (CSP). Either or both of these parties are likely to take steps to ensure that these stations remain in compliance with applicable environmental laws and regulations. As a non-controlling owner in these generating stations, we will be responsible for our pro rata share of these expenditures based upon our ownership interest.
Recently we have seen a growing interest in considering legislation or regulation in response to greenhouse gases generated by numerous sources, vehicles, manufacturing and the electric utility industry. Although, DPL, DP&L and its subsidiaries have operated facilities in compliance with state and federal environmental laws and regulations and is currently engaged in significant capital improvements of five units at the Stuart and Killen Generating Stations for the reduction of SO2, Congress could approve legislation that in the long term may impact operations of the units we and our partners manage or increase the cost for us to do so.
Many of our employees are under a collective bargaining agreement. If we are unable to negotiate future collective bargaining agreements, we could experience work stoppages which may affect its business and operating results.
Information relating to our properties is contained in Item 1 CONSTRUCTION ADDITIONS, and ELECTRIC OPERATIONS AND FUEL SUPPLY, and Note 10 of Notes to Consolidated Financial Statements.
Substantially all property and plant of DP&L is subject to the lien of the mortgage securing DP&Ls First and Refunding Mortgage, dated as of October 1, 1935 with the Bank of New York, as Trustee (Mortgage).
In the normal course of business, we are subject to various lawsuits, actions, proceedings, claims and other matters asserted under laws and regulations. We believe the amounts provided in our consolidated financial statements, as prescribed by GAAP, for these matters are adequate in light of the probable and estimable contingencies. However, there can be no assurances that the actual amounts required to satisfy alleged liabilities from various legal proceedings, claims, and other matters discussed below, and to comply with applicable laws and regulations will not exceed the amounts reflected in our Consolidated Financial Statements. As such, costs, if any, that may be incurred in excess of those amounts provided as of December 31, 2006, cannot be reasonably determined.
Former Executive Litigation
On August 24, 2004, DPL, and its subsidiaries DP&L and MVE, filed a Complaint (and subsequently, amended complaints) against Mr. Forster, Ms. Muhlenkamp and Mr. Koziar (the Defendants) in the Court of Common Pleas of Montgomery County, Ohio asserting legal claims against them relating to the termination of the Valley Partners Agreements, challenging the validity of the purported amendments to the deferred compensation plans and to the employment and consulting agreements, including MVE incentives, with the Defendants, and the propriety of the distributions from the plans to the Defendants, and alleging that the Defendants breached their fiduciary duties and breached their consulting and employment contracts. DPL, DP&L and MVE seek, among
other things, damages in excess of $25,000, disgorgement of all amounts improperly withdrawn by the Defendants from the plans and a court order declaring that DPL, DP&L and MVE have no further obligations under the consulting and employment contracts due to those breaches.
The Defendants have filed their answers (and subsequently, amended answers) denying liability and filed counterclaims (and subsequently, amended counterclaims) against DPL, DP&L, MVE, various compensation plans (the Plans), and current and former employees and current and former members of our Board of Directors. These counterclaims, as amended, allege generally that DPL, DP&L, MVE, the Plans and the individual defendants breached the terms of the employment and consulting contracts of the Defendants and the terms of the Plans. They further allege theories of breach of fiduciary duty, breach of contract, promissory estoppel, tortious interference, conversion, replevin and violations of ERISA under which they seek distribution of deferred compensation balances, conversion of stock incentive units, exercise of options and payment of amounts allegedly owed under the contracts and the Plans. Defendants counterclaims also demand payment of attorneys fees.
On March 15, 2005, Mr. Forster and Ms. Muhlenkamp filed a lawsuit in New York state court against the purchasers of the private equity investments in the financial asset portfolio and against outside counsel to DPL and DP&L concerning purported entitlements in connection with the purchase of those investments. DPL, DP&L and MVE are not defendants in that case; however, DPL, DP&L and MVE are parties to an indemnification agreement with respect to the purchaser defendants. On August 18, 2005, the Ohio court issued a preliminary injunction against Mr. Forster and Ms. Muhlenkamp that precludes them from pursuing certain key issues raised by Mr. Forster and Ms. Muhlenkamp in their New York lawsuit that are identical to the issues raised in the pending Ohio lawsuit in the New York court or any other forum other than the Ohio litigation. In addition, the New York court has stayed the New York litigation pending the outcome of the Ohio litigation. Mr. Forster and Ms. Muhlenkamp have appealed the preliminary injunction and the appeal is pending at the Ohio Supreme Court.
The trial commencement date for this case is set for April 30, 2007.
Cumulatively through December 31, 2006, we have accrued for accounting purposes, obligations of approximately $56 million to reflect claims regarding deferred compensation, estimated MVE incentives and/or legal fees that Defendants assert are payable per contracts. We dispute Defendants entitlement to any of those sums and any other sums the Defendants assert are due to them and, as noted above, we are pursuing litigation against them contesting all such claims.
On or about June 24, 2004, the SEC commenced a formal investigation into the issues raised by the Memorandum (see Note 17 of the Notes to the Consolidated Financial Statements). Although the SEC has not taken any significant action in furtherance of their investigation during 2006, we stand ready to cooperate with their investigation.
On May 28, 2004, the U.S. Attorneys Office for the Southern District of Ohio, assisted by the Federal Bureau of Investigation, notified us that it has initiated an inquiry involving the subject matters covered by our internal investigation. Although the U.S. Attorneys office and the FBI have not taken any significant action in furtherance of their investigation during 2006, we stand ready to cooperate with their investigation.
On June 24, 2004, the Internal Revenue Service (IRS) began an audit of tax years 1998 through 2003 and issued a series of data requests to us including issues raised in the Memorandum. The staff of the IRS requested that we provide certain documents, including but not limited to, matters concerning executive/director deferred compensation plans, management stock incentive plans and MVE financial statements. On September 1, 2005, the IRS issued an audit report for tax years 1998 through 2003 that showed proposed changes to our federal income tax liability for each of those years. The proposed changes resulted in a total tax deficiency, penalties and interest of approximately $23.9 million as of December 31, 2005. On November 4, 2005, we filed a written protest to one of the proposed changes. On April 3, 2006, the IRS conceded the proposed changes that we filed a written protest to and issued a revised audit report for tax years 1998 through 2003. The revised audit report resulted in a total tax deficiency, penalties and interest of approximately $1.2 million. We had previously made a deposit with the IRS of approximately $1.3 million that we requested on April 14, 2006 be applied to offset the $1.2 million tax deficiency, penalties and interest for tax years 1998 through 2003. The Joint Committee on Taxation completed its review of the revised audit report for tax years 1998 through 2003 and sent us a letter dated June 16, 2006 stating that it took no exception to the revised audit report.
Insurance Recovery Claim
On January 13, 2006, we filed a claim against one of our insurers, Associated Electric & Gas Insurance Services (AEGIS), under a fiduciary liability policy to recoup legal fees associated with our litigation against three former executives. An arbitration of this matter was held on August 4, 2006. The arbitration panel ruled on or about September 12, 2006 that the AEGIS policy does not require an advance of defense expenses to us. Rather, the arbitration panel stated that we are required to file a written undertaking as a condition precedent to repay expenses finally established not to be insured. We have filed a written undertaking with AEGIS and will continue to pursue resolution of the claim through mediation and arbitration in 2007.
State Income Tax Audit
On February 13, 2006, we received correspondence from the Ohio Department of Taxation (ODT) notifying us that ODT has completed their examination and review of our Ohio Corporation Franchise Tax Returns for tax years 2002 through 2004 and that the final proposed audit adjustments result in a balance due of $90.8 million before interest and penalties. We have reviewed the proposed audit adjustments and are vigorously contesting the ODT findings and notice of assessment through all administrative and judicial means available. On March 29, 2006, we filed petitions for reassessment with the ODT to protest each assessment as well as request corrected assessments for each tax year. On October 12, 2006, we signed a Memorandum of Understanding with the ODT that stated if the ODTs positions are ultimately sustained in judicial proceedings, the total additional tax liability that we would be subject to for tax years 2002 through 2004 would be no more than $50.7 million before interest as opposed to the $90.8 million stated in the ODTs correspondence of February 13, 2006. We believe we have recorded adequate tax reserves related to the proposed adjustments; however, we cannot predict the outcome, which could be material to our results of operations and cash flows.
We are also under audit review by various state agencies for tax years 2002 through 2004. We have also filed an appeal to the Ohio Board of Tax Appeals for tax years 1998 through 2001. Depending upon the outcome of these audits and the appeal, we may be required to increase our tax provision if actual amounts ultimately determined exceed recorded reserves. We believe we have adequate reserves in each tax jurisdiction but cannot predict the outcome of these audits.
Labor Relations Unasserted Claim
In September 2006, we became aware of an unasserted claim under the Fair Labor Standards Act concerning the calculation of overtime rates for our unionized workforce. By agreement of Local #175 and DP&L, we jointly submitted the claim to a neutral third party who ruled in favor of DP&Ls position. As a result of this decision, Local #175 has decided not to pursue any claim against DP&L.
Pending before the U.S. Supreme Court is a proceeding, Environmental Defense v. Duke Energy (Duke Energy) that does not involve DP&L as a party but may have a significant effect on the outcome of litigation described below that involves allegations of violations of the CAA. A key issue in that litigation that may be dispositive with respect to other pending cases is what test to apply for measuring whether modifications to electric generating units should trigger application of New Source Review (NSR) standards under the CAA. In general terms, the dispute is whether to measure pre- and post-modification emissions based on the rate of emissions per hour of operation or based on total emissions over time. The latter test, if applied, could trigger NSR requirements for equipment replacements that result in a plant running more often because it is more economical or dependable, even if the emissions rate per hour of operation does not change. A ruling is expected in the first or second quarter of 2007. DP&L cannot predict the outcome of the Duke Energy case. Moreover, in each of the cases identified below, there may be case-specific facts and allegations that may cause a judge to find that the U.S. Supreme Courts ruling is based on different facts and allegations and is therefore not controlling in the case before the judge.
In September 2004, the Sierra Club filed a lawsuit against DP&L and the other owners of the Stuart Generating Station in the United States District Court for the Southern District of Ohio for alleged violations of the CAA, including issues that may be decided by the Supreme Court in the Duke Energy case and other issues relating to alleged violations of opacity limitations. DP&L, on behalf of all co-owners, is leading the defense of this matter. A sizable amount of discovery has taken place and expert reports are scheduled to be filed at various times from May through September, 2007. Dispositive motions are to be filed in January 2008. No trial date has been set yet.
Additional information relating to legal proceedings involving DPL and DP&L is contained in Item 1 ENVIRONMENTAL CONSIDERATIONS, Item 1 COMPETITION AND REGULATION, and Item 8 Note 15 of Notes to Consolidated Financial Statements.
Item 5 - Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
As of December 31, 2006, there were 24,434 holders of record of DPL common equity, excluding individual participants in security position listings. The following table presents the high and low per share sales prices for DPL common stock as reported by the New York Stock Exchange for each quarter of 2006 and 2005:
DP&Ls common stock is held solely by DPL and, as a result, is not listed for trading on any stock exchange.
As long as DP&L preferred stock is outstanding, DP&Ls Amended Articles of Incorporation contain provisions restricting the payment of cash dividends on any of its common stock if, after giving effect to such dividend, the aggregate of all such dividends distributed subsequent to December 31, 1946 exceeds the net income of DP&L available for dividends on its Common Stock subsequent to December 31, 1946, plus $1.2 million. As of year-end, all earnings reinvested in the business of DP&L were available for DP&L common stock dividends. We expect all 2006 earnings reinvested in the business of DP&L to be available for DP&L common stock dividends, payable to DPL.
On February 1, 2006, our Board of Directors authorized a 4% dividend increase on DPLs common stock, raising the annual dividend on common shares from $0.96 per share to $1.00 per share. These dividends were paid in each quarter of 2006.
On February 1, 2007, our Board of Directors authorized a 4% dividend increase on DPLs common stock, raising the annual dividend on common shares from $1.00 per share to $1.04 per share. These dividends will be paid each quarter during 2007.
Additional information concerning dividends paid on DPL common stock is set forth under Selected Quarterly Information in Item 8 Financial Statements and Supplementary Data.
Information regarding our equity compensation plans as of December 31, 2006, is disclosed in Item 12 Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters, which incorporates such information by reference to our proxy statement for the 2007 Annual Meeting of Shareholders.
(a) In 2003, we recorded a cumulative effect of an accounting change related to the adoption of SFAS 143 Accounting for Asset Retirement Obligations. In 2005, we recorded an additional obligation in response to FASB Interpretation Number (FIN) 47, Accounting for Conditional Asset Retirement Obligations, an interpretation of FASB Statement No. 143. See Item 7 - Managements Discussion and Analysis of Financial Condition and Results of Operations.
(b) Excludes current maturities of long-term debt. Upon adoption of FASB Interpretation Number 46R Consolidation of Variable Interest Entities (Revised December 2003) an interpretation of ARB No. 51 at December 31, 2003, DPL deconsolidated the DPL Capital Trust II.
(c) During 2006, our rating agencies upgraded our corporate credit and debt ratings. In February 2007, S&P upgraded the corporate credit rating and debt rating from BB to BBB- for DPL and from BBB to BBB+ for DP&L.
(d) In the fourth quarter of 2006, DPL entered into agreements to sell two of its peaking facilities resulting in a $44.2 million ($71 million pre-tax) impairment charge. During 2006, DPL recorded a $37.3 million ($61.2 million pre-tax) charge for early redemption of debt. DP&L recorded a $2.5 million ($4.1 million pre-tax) charge for early redemption of debt.
Item 7 - Managements Discussion and Analysis of Financial Condition and Results of Operations
Certain statements contained in this discussion are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Matters discussed in this report that relate to events or developments that are expected to occur in the future, including managements expectations, strategic objectives, business prospects, anticipated economic performance and financial condition and other similar matters constitute forward-looking statements. Forward-looking statements are based on managements beliefs, assumptions and expectations of our future economic performance, taking into account the information currently available to management. These statements are not statements of historical fact. Such forward-looking statements are subject to risks and uncertainties and investors are cautioned that outcomes and results may vary materially from those projected due to various factors beyond our control, including but not limited to: abnormal or severe weather; unusual maintenance or repair requirements; changes in fuel costs and purchased power, coal, environmental emissions, gas and other commodity prices; increased competition; regulatory changes and decisions; changes in accounting rules; financial market conditions; and general economic conditions.
Forward-looking statements speak only as of the date of the document in which they are made. These forward-looking statements are identified by terms and phrases such as anticipate, believe, intend, estimate, expect, continue, should, could, may, plan, project, predict, will, and similar expressions. We disclaim any obligation or undertaking to provide any updates or revisions to any forward-looking statement to reflect any change in our expectations or any change in events, conditions or circumstances on which the forward-looking statement is based.
The following discussion should be read in conjunction with the accompanying financials and related footnotes included in Item 8 Financial Statements and Supplementary Data.
This report includes the combined filing of DPL Inc. (DPL) and The Dayton Power and Light Company (DP&L). DP&L is the principal subsidiary of DPL providing approximately 99% of DPLs total consolidated revenue and approximately 86% of DPLs total consolidated asset base. Throughout this report the terms we, us, our and ours are used to refer to both DPL and DP&L, respectively and altogether, unless the context indicates otherwise. Discussions or areas of this report that apply only to DPL or DP&L will clearly be noted in the section. Historically, DPL and DP&L have filed separate SEC filings. Beginning with this report and in the future, DPL Inc. and The Dayton Power and Light Company will file combined SEC reports on an interium and annual basis.
DPL is a regional electric energy and utility company and through its principal subsidiary, DP&L, is primarily engaged in the generation, transmission and distribution of electricity in West Central Ohio. DPL and DP&L strive to achieve disciplined growth in energy margins while limiting volatility in both cash flows and earnings and to achieve stable, long-term growth through efficient operations and strong customer and regulatory relations. More specifically, DPL and DP&Ls strategy is to match energy supply with load, or customer demand, maximizing profits while effectively managing exposure to movements in energy and fuel prices and utilizing the transmission and distribution assets that transfer electricity at the most efficient cost while maintaining the highest level of customer service and reliability.
We operate and manage generation assets and are exposed to a number of risks through this management. These risks include but are not limited to electricity wholesale price risk, fuel supply and price risk and power plant performance. We attempt to manage these risks through various means. For instance, we operate a portfolio of wholly owned and jointly owned generation assets that is diversified as to fuel source, cost structure and operating characteristics. We are focused on the operating efficiency of these power plants and maintaining their availability.
We operate and manage transmission and distribution assets in a rate-regulated environment. Accordingly, this subjects us to regulatory risk in terms of the costs that they may recover and the investment returns that they may collect in customer rates. We are focused on delivering electricity and to maintain high standards of customer service and reliability in a cost-effective manner.
We operate in a regulated and deregulated environment. The electric utility industry has historically operated in a regulated environment. However, in recent years, there have been a number of federal and state regulatory and legislative decisions aimed at promoting competition and providing customer choice. Market participants have therefore created new business models to exploit opportunities. The marketplace is now comprised of independent power producers, energy marketers and traders, energy merchants, transmission and
distribution providers and retail energy suppliers. There have also been new market entrants and activity among the traditional participants, such as mergers, acquisitions, asset sales and spin-offs of lines of business. In addition, transmission systems are being operated by Regional Transmission Organizations (RTOs).
As part of Ohios electric deregulation law, all of the states investor-owned utilities were required to join an RTO. DP&L successfully integrated its 1,000 miles of high-voltage transmission into the PJM Interconnection, L.L.C. (PJM) RTO in October 2004. As an RTO, PJMs role is to administer an electric marketplace and ensure the reliability of the high-voltage electric power system serving 51 million people 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. PJM coordinates and directs the operation of the regions transmission grid; administers the worlds largest competitive wholesale electricity market and plans regional transmission expansion improvements to maintain grid reliability and relieve congestion.
2006 FINANCIAL OVERVIEW
As more fully discussed in later sections of this MD&A, the following were the significant themes and events for 2006:
· DPLs revenues increased 8% over 2005 resulting from the rate stabilization surcharge and other regulated asset recovery riders improving gross margin and profitability. DPLs fuel, purchased power costs, and operation and maintenance increased over 2005 by 4%, 19% and 21%, respectively. DPLs cash flow from operations of $308.7 million was in line with the cash flow from operations of $314.7 million in 2005.
· DP&Ls revenues increased 8% over 2005 resulting from the rate stabilization surcharge and other regulated asset recovery riders improving gross margin and profitability. DP&Ls fuel, purchased power costs, and operation and maintenance increased over 2005 by 5%, 17% and 17%, respectively. DP&Ls cash flow from operations of $365.7 million was in line with the cash flow from operations of $366.8 million in 2005.
· In connection with DPLEs decision to sell the Greenville Station and Darby Station electric peaking generation facilities, DPL concluded that an impairment charge for the Greenville Station and Darby Station assets was required. During the fourth quarter of 2006, DPL recorded a $71.0 million impairment charge to record the fair market write-down of the assets and other associated costs related to the sale.
· On September 13, 2006, the Ohio Air Quality Development Authority (OAQDA) issued $100 million of 4.80% fixed interest rate OAQDA Revenue Bonds 2006 Series A due September 1, 2036. In turn, DP&L then borrowed these funds from the OAQDA. DP&L is using the proceeds from these borrowings to assist in financing its portion of the costs of acquiring, constructing and installing certain solid waste disposal and air quality facilities at Miami Fort, Killen and Stuart Generating Stations.
· On July 27, 2005, DPLs Board authorized the repurchase of up to $400 million of common stock from time to time in the open market or through private transactions. DPL completed this share repurchase program on August 21, 2006. These Board-authorized repurchase transactions resulted in 14.9 million shares being repurchased, or 11.7% of the outstanding stock at December 31, 2005 at an average price of $26.91 per share. These shares are currently held as treasury shares at DPL.
RESULTS OF OPERATIONS DPL Inc.
DPLs results of operations include the results of its subsidiaries, including the consolidated results of its principal subsidiary The Dayton Power and Light Company (DP&L) and all of DP&Ls consolidated subsidiaries. DP&L provides approximately 99% of the total revenues of DPL. All material intercompany accounts and transactions have been eliminated in consolidation. A separate specific discussion of the results of operations for DP&L is presented elsewhere in this report.
Financial Highlights - DPL
(a) Purchased power includes ancillary charges from PJM of $49.4 million, $48.5 million and $12.3 million for 2006, 2005 and 2004 respectively.
(b) For purposes of discussing operating results, we present and discuss gross margins. This format is useful to investors because it allows analysis and comparability of operating trends and includes the same information that is used by management to make decisions regarding our financial performance.
DPL Inc. - 2006 Compared to 2005
For the year ended December 31, 2006, basic earnings per share of $1.24 decreased $0.20 from the same period in 2005. The decline was primarily due to a $0.32 per share decrease in Earnings from Discontinued Operations reflecting lower investment income and lower gains on the sale of investments. Most of the investments were sold during 2005. Basic earnings per share for Earnings from Continuing Operations were $0.09 higher in 2006 compared to 2005. This increase is the result of higher revenues relating to the impact of the rate stabilization plan and lower interest expense, partially offset by a $71.0 million impairment charge for the peaking units, higher fuel and purchased power costs and higher operation and maintenance expenses.
DPL Inc. - 2005 Compared to 2004
For the year ended December 31, 2005, basic earnings per share of $1.44 decreased $0.37 from the same period in 2004. The decline was primarily due to a $0.36 per share decrease in Earnings from Discontinued Operations reflecting lower investment income, partially offset by the gain on the sale of investments (In February 2005, DPL agreed to sell its respective interests in forty-six private equity funds). Basic earnings per share for Earnings from Continuing Operations were $0.02 higher in 2005 compared to 2004. This increase is the result of higher revenues relating to higher retail sales volume and ancillary revenues associated with the participation in PJM. Also contributing to this increase were lower operation and maintenance expenses driven by lower corporate costs, higher investment income and lower interest expense related to debt refinancing in 2004. These increases were partially offset by higher fuel and purchased power costs and a $61.2 million charge for the early redemption of debt.
For 2005, basic earnings per share includes a $0.03 after-tax charge related to the cumulative effect of a change in accounting for asset retirement obligations at certain power generating stations.
DPL Inc. Revenues
For the year ended December 31, 2006, revenues increased $108.6 million, or 8% to $1,393.5 from $1,284.9 for the same period in the prior year. This increase was primarily the result of higher average retail rates and higher wholesale sales volume, partially offset by lower retail sales volume and lower average rates for wholesale revenues. Retail revenues increased $64.8 million primarily resulting from an increase in average rates related to the Rate Stabilization Plan surcharge and other regulated asset recovery riders resulting in a $93.0 million price variance, partially offset by lower retail sales volume resulting in a $29.4 million volume variance. Sales volume declined 3% in 2006 from 2005 due to milder weather which resulted in lower heating and cooling degree days. Heating degree days declined 11% and cooling degree days declined 20%. Wholesale revenue increased $40.8 million primarily related to a 34% increase in sales volume (935 GWh) resulting in a $45.8 million volume variance, partially offset by a decrease in wholesale average rates resulting in a $5.0 million price variance. For 2006, the RTO ancillary revenues increased $2.8 million or 4% to $77.2 million from $74.4 million in 2005. RTO ancillary revenues primarily consist of compensation for use of DP&Ls transmission assets, regulation services, reactive supply and operating reserves.
For the year ended December 31, 2005, revenues of $1,284.9 million increased $85 million, or 7% from $1,199.9 million for the same period in 2004. This increase was primarily the result of increased retail sales volume, higher average rates for wholesale revenues, and ancillary revenues associated with participation in PJM that was partially offset by lower wholesale sales volume. Retail revenues increased $29.8 million, primarily resulting from increased sales volume of $32.8 million and $2.8 million in higher average rates, partially offset by $5.8 million in lower miscellaneous retail revenues reflecting transmission services provided in 2004 that are now provided through PJM. Residential customers comprised the bulk of the increase in sales volume reflecting greater weather extremes experienced in 2005 compared to 2004 as cooling degree days were up 39% to 1,075 in 2005 compared to 771 in 2004 and heating degree days were up 4% to 5,702 in 2005 compared to 5,500 in 2004. Wholesale revenue decreased $1.8 million, primarily related to a $37.2 million decline in sales volume that was nearly offset by a $35.4 million increase related to higher average market rates. For 2005, ancillary revenues from RTOs were $74.4 million compared to $17.9 million for 2004, as we did not participate in PJM until October 2004.
DPL Inc. - Margins, Fuel and Purchased Power
For 2006, gross margin of $885.4 million increased $70.7 million, or 9%, from $814.7 million in 2005. As a percentage of total revenues, gross margin remained flat in 2006 at 63.5% compared to 63.4% in 2005. This result reflects the favorable impact of the rate stabilization plan on revenues offsetting the increasing fuel and purchase power costs. In prior years, rising fuel and purchase power costs had eroded gross margin. Fuel costs, which include coal, gas, oil and emission allowance costs, increased by $12.2 million, or 4%, in 2006 compared to the same period in 2005 primarily due to increased fuel prices. Purchased power increased $25.7 million, or 19% in 2006 compared to the same period in 2005 primarily resulting from increased charges of $30.8 million relating to higher purchased power volume and an increase of $0.9 million in RTO ancillary costs. These increases were partially offset by lower average market rates reducing purchased power costs by $6.0 million. The increase in purchase power volume resulted from our decision to purchase power at lower average market rates instead of running our higher cost generating facilities. In addition, from time to time, we purchased power when our generating facilities were not available due to scheduled maintenance and forced outages.
For 2005, gross margin of $814.7 million decreased by $9.0 million from $823.7 million for 2004. As a percentage of total revenues, gross margin decreased by 5.2 percentage points to 63.4% from 68.6%. This decline is primarily the result of increased fuel and purchased power costs, partially offset by an increase in revenues, principally from RTO ancillary revenues and higher average wholesale rates. Fuel costs, which include coal, gas, oil and emission allowance costs, increased by $73.8 million or 28% for 2005 compared to the same period in 2004 primarily resulting from higher average fuel prices of $64.1 million as well as increased generation of $9.7 million. Purchased power costs increased by $20.2 million for 2005 compared to 2004 primarily resulting from increased charges of $36.2 million associated with operating in PJM (we did not participate in PJM until October 2004) and $28.2 million related to higher average market prices, partially offset by $44.2 million related to lower purchased power volume.
DPL Inc. - Operation and Maintenance
For 2006, operation and maintenance expense increased $46.4 million or 21% compared to 2005 year primarily resulting from a $13.5 million increase in legal fees primarily related to the litigation with former executives; a $10.4 million increase in power production costs consisting of $4.1 million of coal brokering credits received in 2005 that were not received in 2006 and increased operating and maintenance expenses of $3.1 million which related to cost of removal and peaker engine repairs; $5.5 million in PJM administrative fees, including $2.5 million deferred in 2005 by PUCO authority (rate relief was granted in February 2006); $5.1 million increase in the low-income assistance program costs; $3.7 million of lump sum bonus and retirement payments to former executives (not related to our ongoing litigation with the three former executives); $2.7 million of line clearance; a $2.6 million increase in mark-to-market adjustments and forfeitures of restricted stock units; $2.1 million in long-term incentive compensation relating to performance and restricted shares compensation; and a $1.0 million increase in pension and benefits expenses. These increases were partially offset by a $3.2 million decrease in Directors and Officers liability insurance premiums and a $1.1 million decrease in Sarbanes-Oxley compliance fees.
For 2005, operation and maintenance expense decreased $18.1 million or 8% compared to 2004 as a result of lower corporate costs that were partially offset by increased electric production, transmission and distribution expenses. Corporate costs declined from the prior year primarily resulting from a decrease of $8.3 million in Directors and Officers liability insurance premiums; approximately $5.8 million related to the decreased level of activity regarding various internal and governmental investigations as well as the securities litigation; $5.8 million in lower executive and management compensation costs; $3.5 million in reduced Sarbanes-Oxley 404 compliance costs and external/internal audit fees; $2.3 million in decreased Low Income Assistance Program costs; and $0.7 million of lower benefits costs (a decrease of $2.8 million for a 2004 adjustment in disability reserves was nearly offset by an increase in pension costs of $2.1 million). These decreases were partially offset by a $4.5 million increase in electric production, transmission, and distribution costs, primarily related to generation operations costs for lime used for pollution control and electric production boiler maintenance costs as well as higher costs related to electric distribution operation and maintenance.
DPL Inc. Impairment of Peaking Stations
In connection with DPLEs decision to sell the Greenville Station and Darby Station electric peaking generation facilities, DPL concluded that an impairment charge for the Greenville Station and Darby Station assets was required. Greenville Station consists of four natural gas peaking units with a net book value of approximately $66 million. Darby Station consists of six natural gas peaking units with a net book value of approximately $156 million. DPLE plans to sell the Greenville and Darby Station assets for $49 million and $102 million, respectively. These sales are expected to take place during the first half of 2007.
During the fourth quarter of 2006, DPL recorded a $71.0 million impairment charge to record the fair market write-down of the assets and other associated costs related to the sale. These assets are now held for sale and are no longer being depreciated. There was no such activity in 2005. See Note 14 of the Notes to the Consolidated Financial Statements.
DPL Inc. Depreciation and Amortization
For 2006, depreciation and amortization expense increased $4.5 million from 2005 relating to completed projects in both the distribution and production areas increasing our overall plant base.
Depreciation and amortization expense was $3.2 million higher in 2005 as compared to 2004 primarily as a result of completed projects in the distribution area (including new services, line transformers, poles, station equipment and overhead and underground conductor) and in the production area (mainly due to the SCRs for Stuart, Killen and Zimmer) that were put into service in the second quarter of 2004.
DPL Inc. - Amortization of Regulatory Assets
For 2006, amortization of regulatory assets increased $5.6 million to $7.6 million compared to the same period in 2005. The increase in amortization of regulatory assets reflects $2.6 million for the amortization of costs incurred to accommodate unbundled rates and electric choice bills in the customer billing system; $1.3 million for the amortization of PJM administrative fees deferred for the period October 2004 through January 2006; $1.2 million for the amortization of incremental 2004/2005 severe storm costs; $0.3 million for the amortization of costs incurred to integrate DP&L into the PJM system; and $0.2 million for the amortization of the Rate Stabilization Surcharge rate case expenses.
For 2005, amortization of regulatory assets increased $1.3 million to $2.0 million compared to the same period in 2004 primarily resulting from PJM start-up costs amortization of $1.1 million and PJM integration costs amortization of $0.2 million reflecting DP&Ls entrance into the PJM market on October 1, 2004.
DPL Inc. - Investment Income
For 2006, investment income decreased $33.1 million to $17.8 million from $50.9 million for the same period in 2005. This decrease was primarily the result of a $23.4 million decrease in gains on public and income investments realized in 2005, a $4.6 million in foreign currency translation gains realized in 2005 for the liquidation of investments denominated in Euros, and a $4.8 million decrease in interest income resulting from lower cash balances in 2006 compared to 2005.
For 2005, investment income increased by $43.0 million compared to 2004 primarily resulting from a net gain on the disposal of public equity and income investments of $23.5 million and from $18.5 million in interest income, principally from new short-term investments relating to a cash surplus from the sale of the private equity portfolio.
DPL Inc. - Interest Expense
For 2006, interest expense decreased $35.5 million, or 26%, compared to the same period in 2005 resulting from the debt reduction that occurred in 2004 and 2005 and a higher capitalized interest of $10.9 million in 2006 compared to 2005 associated with our major construction projects.
For 2005, interest expense decreased $22.5 million, or 14%, compared to 2004 due to the debt reduction of $462.6 million and a full year impact of the $500 million debt retirement completed in 2004 (partially financed with a $175 million note).
DPL Inc. - Charge for Early Redemption of Debt
In 2005, DPL recorded $61.2 million in charges resulting from premiums paid for the early redemption of debt, including write-offs of unamortized debt expense and debt discounts.
DPL Inc. - Other Income (deductions)
For 2006, other income (deductions) was $14.7 million less than the same period in 2005 primarily due to gains of $12.3 million realized in 2005 from the sale of pollution control emission allowances. There were no sales of pollution control emission allowances during 2006.
For 2005, other income was $9.7 million greater than 2004 primarily reflecting $3.5 million of additional gains realized in 2005 over 2004 resulting from sales of pollution control emission allowances; $1.6 million of lower fees resulting from the 2004 cancellation and replacement of DP&Ls revolving credit facility and our term loan termination and $1.5 million from the 2004 write-off of the remaining term loan debt expense resulting from our term loan termination.
DPL Inc. - Income Tax Expense
For 2006, income taxes from continuing operations decreased $10.1 million, or 13%, compared to 2005 due to a decrease in pre-tax book income, a decrease in the effective tax rate primarily reflecting the phase-out of the Ohio Franchise Tax and adjustments recorded in 2005 and 2006 to true-up book tax expense to the tax return.
For 2005, income tax expense from continuing operations increased $13.4 million compared to 2004 resulting from higher income, increased accrual for open tax years and lower state tax coal credits.
On June 30, 2005, Governor Taft signed House Bill 66 into law which significantly changed the tax structure in Ohio. The major provisions of the bill included phasing-out the Ohio Franchise Tax, phasing-out the Ohio Personal Property Tax for non-utility taxpayers and phasing-in a Commercial Activities Tax. The Ohio Franchise Tax phase-out required second quarter 2005 adjustments to income tax expense. Income taxes from continuing operations were reduced by $1.5 million while income taxes from discontinued operations were increased by $1.3 million as a result of the tax law change. Other applicable provisions of House Bill 66 have been reflected in the consolidated financial statements.
DPL Inc. - Discontinued Operations, Net of Tax
On February 13, 2005, our subsidiaries, MVE and MVIC, entered into an agreement to sell their respective interests in forty-six private equity funds to AlpInvest/Lexington 2005, LLC, a joint venture of AlpInvest Partners and Lexington Partners, Inc. Sales proceeds and any related gains or losses were recognized as the sale of each fund closed. Among other closing conditions, each fund required the transaction to be approved by the respective general partner of each fund. During 2005, MVE and MVIC completed the sale of their interests in forty-three and a portion of one of those private equity funds resulting in a $46.6 million pre-tax gain ($53.1 million less $6.5 million professional fees) from discontinued operations and provided approximately $796 million in net proceeds, including approximately $52 million in net distributions from funds while held for sale. As part of this pre-tax gain, DPL realized $30 million that was previously recorded as an unrealized gain as part of other comprehensive income.
During 2005, MVE entered into alternative closing arrangements with AlpInvest/Lexington 2005, LLC for funds where legal title to said funds could not be transferred until a later time. Pursuant to these arrangements, MVE transferred the economic aspects of the remaining private equity funds, consisting of two funds and a portion of another fund, to AlpInvest/Lexington 2005, LLC without a change in ownership of the interests. The terms of the alternative arrangements do not meet the criteria for recording a sale. We are obligated to remit to AlpInvest/Lexington 2005, LLC any distributions MVE receives from these funds, and AlpInvest/Lexington 2005,
LLC is obligated to provide funds to us to pay any contribution notice, capital call or other payment notice or bill for which MVE receives notice with respect to such funds. The alternative arrangements resulted in a deferred gain of $27.1 million until such terms of a sale can be completed (contingent upon receipt of general partner approvals of the transfer) and in 2005 provided approximately $72 million in net proceeds on these funds. DPL recorded an impairment loss of $5.6 million in the second quarter of 2005 to write down assets transferred pursuant to the alternative arrangements to estimated fair value. Ownership of these funds transfer after the general partners of each of the separate funds consent to the transfer.
On March 31, 2006, MVE completed the sale of the remaining portion of one private equity fund, for which MVE had previously entered into an alternative closing arrangement resulting in the recognition of $13.2 million of the deferred gain. On August 31, 2006, MVE completed the sale of a portion of one of the two remaining private equity funds, resulting in recognition of $5.7 million of the deferred gain. The sale of the residual portion of this private equity fund will be completed during the first quarter of 2007, resulting in the recognition of approximately $8.2 million of the deferred gain. The transfer of the remaining fund is expected to be completed in 2008.
There was no investment income from discontinued operations during 2006, however there was $1.3 million of legal costs associated with the ongoing litigation (see Note 11 of Notes to Consolidated Financial Statements). Income from discontinued operations (pre-tax) for the year ended December 31, 2005 of $31.8 million is comprised of $41.3 million of investment income less $9.5 million of associated management fees and other expenses.
For the year ended December 31, 2006, we recognized $18.9 million of the deferred gain from the sale of the remaining private equity funds described above. For the year ended December 31, 2005, we recognized a $46.6 million pre-tax gain ($53.1 million less $6.5 million of professional fees), recorded a $5.6 million impairment loss, deferred gains of $27.1 million on transferred funds from discontinued operations, and provided approximately $868 million in net proceeds, including approximately $52 million in net distributions from funds held for sale. We will continue to incur minor amounts of fees in the near term.
DPL Inc. - Cumulative Effect of Accounting Change, Net of Tax
In 2005, the cumulative effect of an accounting change resulted in a charge of $3.2 million related to the adoption of the provisions of FASB Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations an interpretation of FASB Statement No. 143 (FIN 47). (See Note 1 of Notes to Consolidated Financial Statements.)
RESULTS OF OPERATIONS The Dayton Power and Light Company (DP&L)
Income Statement Highlights DP&L